Pre-Litigation Demand and Director Committees

Richard S. Horvath, Jr, is partner at Allen Matkins Leck Gamble Mallory & Natsis LLP. This post is based on his Allen Matkins memorandum and is part of the Delaware law series; links to other posts in the series are available here.

On February 12, 2019, in the matter captioned City of Tamarac Firefighters’ Pension Trust Fund v. Corvi, et al., C.A. No. 2017-0341-KSJM, Vice Chancellor McCormick of the Delaware Court of Chancery provided further guidance on the pre-litigation demand requirement. This decision reaffirms and applies the principle under Delaware law that, while a pre-litigation demand “tacitly concedes” a board of directors is disinterested and independent for purposes of responding to the demand that concession only goes so far. As such, the board, or a subcommittee designated with the task of investigating and responding to the demand, must still in fact act independently, disinterestedly, in good faith, and with due care. While the derivative claims in Corvi were ultimately dismissed, the Court’s decision provides a helpful outline of the steps a board of directors should take in responding to a pre-litigation demand.

The Limited Concession of Director Independence from a Stockholder Demand

The pleading burden for a derivative claim is well-settled. A stockholder wishing to bring a derivative claim on behalf of a corporation must first demand that the board of directors take action on behalf of the company. If a stockholder commences litigation without first making a demand, the Court in Corvi noted that the stockholder then faces the “steep road” of pleading particularized facts showing that a demand would have been futile. But if a demand is made, and then rejected, the stockholder faces the even “steeper road” of pleading particularized facts creating a reasonable doubt that the demand was properly rejected. This second path is steeper because the board is entitled to the full presumption of the business judgment rule and, by making a pre-suit demand, the stockholder “tacitly concedes” the disinterestedness and independence of the board “for purposes of responding to the demand.”

But what happens if the board delegates the investigation of a demand to a subcommittee of the board whose members appear to lack independence? Did the stockholder concede those directors’ independence for purposes of the board’s response to the demand?

Applying Scattered Corp. v. Chicago Stock Exchange, Inc., 701 A.2d 70 (Del. 1997), and earlier precedent, the Court in Corvi answered these questions. By making a demand, a stockholder merely concedes that a majority of the board could act independently on the demand. That concession goes no further. Thus, the Court held that a pre-litigation demand does not “prevent a court from considering obvious conflicts or bias when evaluating a board’s decision to delegate the demand-review process to a committee.”

The Court provided an extreme example in support of its reasoning. The Court hypothesized a board comprised of ten directors, including the company’s CEO. In response to a stockholder demand that the board clawback the CEO’s compensation, the board empowers a one-person special committee, consisting of the CEO, to respond to the demand. The Court noted that “it is easy to understand” why this board would be grossly negligent or acting in bad faith in making such a delegation, and why the Court would need to analyze the CEO’s potential conflicts before reaching that conclusion. Thus, the tacit concession of director independence permitted by a demand extends only to a majority of the board, and does not extend to whether the directors who investigate or respond to the demand in fact act disinterestedly and independently.

Guidelines for Assessing Director Independence

Even though the Court in Corvi went on to reject the plaintiff’s claims that the special committee members tasked with evaluating the demands in that case were conflicted, the Court’s analysis reaffirms basic principles important to consider as a board or a committee assesses a pre-litigation demand.

First, any director tasked with investigating or responding to a demand should not have a financial or personal benefit in the subject of the demand or the litigation that may arise from it. Such personal benefits could include either being a beneficiary of the corporate action at issue in the demand or facing a substantial risk of personal liability if the litigation demanded was commenced.

Second, as a corollary to the first proposition, if a director lacks independence from a party who would have a personal or financial interest in a demand, that director should not be responsible for investigating or passing on the demand.

Third, best practices would be to avoid—to the extent practicable—assigning directors to review a demand if they had a prior involvement with any board action giving rise to the demand.

Fourth, in terms of selecting counsel to assist the directors in evaluating the demand, caution must be taken to ensure that the selected counsel is not conflicted such that the counsel’s independence—and the due care of the directors in selecting that counsel—cannot be questioned. Thus, while the dual representation of both a demand review committee and the company may not suffice to call into doubt counsel’s independence, the representation of the parties who are the targets of the demand would likely preclude those attorneys from advising the committee regarding the demand.

Fifth, while the business judgment rule presumes that directors act in an informed manner, any directors tasked with evaluating a demand must spend sufficient time attending to the demand and the investigation. Such time and care will necessarily depend on the nature and subject matter of the demand.

Conclusion

As any general counsel can attest, it is almost inevitable that a public company board will at some point receive a pre-litigation demand. Such events, however, can be easily managed by following the rules of the road. Ultimately, if those rules are followed, a court should defer to any decision made by independent directors acting in good faith and with due care.

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