Theodore Mirvis comments on London v. Tyrell, a recent Delaware Chancery decision refusing to defer to a special litigation committee's recommendation that a shareholder derivative suit be dismissed:
The decision arose in a suit by the founders and former directors of iGov, alleging that company insiders had intentionally manipulated the valuation process used to set the strike price of certain options for the purpose of entrenching themselves and diluting plaintiffs’ interest in the company. In 2008, after the Court concluded that demand on the board was excused and refused to dismiss the complaint, the board formed an SLC comprised of directors appointed after the filing of the lawsuit to evaluate whether the derivative claims should be pursued on behalf of the company. The SLC retained advisors, reviewed documents, and conducted twelve interviews over the course of four months, and then filed a report recommending dismissal.
Under the familiar Zapata test, the SLC must show that it was independent and that the scope of its investigation was reasonable before the Court will even consider the substantive soundness of an SLC’s recommendation. The SLC here was found to have failed on both counts.
As to independence, the Court stressed that the SLC must carry the burden of “fully convinc[ing] the Court that the SLC can act with integrity and objectivity.” Here, one committee member was the husband of the defendant’s cousin, and the other was a former colleague of the defendant who felt indebted to the defendant for getting him “a good price” in the prior sale of a company. The Court ruled that “it will be nigh unto impossible” to show independence where “the SLC member and a director defendant have a family relationship” or where an SLC member “feels he owes something to an interested director.” The Court was further troubled by deposition testimony and notes suggesting that the SLC members viewed their job as “attacking” the plaintiffs’ complaint.
As to the SLC’s investigation, the Court found that the committee wrongly concluded that claims to rescind the options were barred by the exculpation provision in iGov’s charter, made key mistakes of fact, and systematically failed to pursue evidence that might suggest liability. The Court’s bottom line was that an SLC must provide a reasonable record to show that it has fairly evaluated the facts and legal claims that a derivative plaintiff raises, and that an insufficiently vigorous process will not be accorded judicial deference.
In corporate law, one rarely sees the sort of intensive merits review of board of director decisions that occurred in this case. But this case arose in a very special situation. As I explain in my book Corporation Law (Concept and Insight Series)
As illustrated by Zapata’s concern that SLC members will have a “there but for the grace of God go I” empathy for the defendants, concerns about structural bias pervade the law in this area. If structural bias is the main concern, Delaware law seems to get at the problem more directly than, say, does New York. Under Delaware law, demand will be excused where a majority of the board is either interested in the transaction or otherwise failed to validly exercise business judgment. Once demand is excused, Delaware courts take a close look at the merits of allowing the litigation to go forward, while New York courts are barred from doing so.
To be sure, Delaware law in this area could stand a good tweaking. The Aronson/Zapata framework continues to rely unduly on bizarrely worded standards that often fail to grapple with the real issue. The Delaware courts would do well to adopt a simpler standard, which asks whether the board of directors is so clearly disabled by conflicted interests that its judgment cannot be trusted. If so, the shareholder should be allowed to sue. If not, the shareholder should not.
For very detailed commentary on the case, see this post on Francis Pileggi's blog.
