Thanks to The Chancery Daily, I learned about an interesting new Delaware Chancery Court decision dealing with the demand requirement in shareholder litigation: Rowan v. Infinity Q Capital Management LLC, 2002 WL 4127578 at *5 (Del. Ch. Sept. 12, 2022).
The Chancery Daily explains:
Plaintiff mutual fund investor brought derivative claims on behalf of the Delaware statutory trust that issues the fund's securities, alleging that members of the board of trustees and others breached contractual and fiduciary duties, leading to the fund's collapse.
Prior to plaintiff's filing of his complaint, the board had appointed a new trustee and created a special litigation committee ("SLC") composed solely of the new trustee, with authority to investigate potential claims and to "supervise any . . . prosecution, settlement, or other disposition of such Claims." After the complaint was filed, the trust, as nominal defendant, moved to dismiss for failure to plead demand futility.
Plaintiff asserted that, although the full board had authorized the motion, it lacked authority to do so because it had delegated its authority over derivative claims to the SLC.
The Court denies the motion for lack of standing in this Opinion, finding plaintiff raised particularized allegations allowing an inference that, by appointing a special litigation committee comprising a single, unconflicted new director, the non-committee trustees conceded demand futility as to the board as a whole and delegated control over procedural defenses to the SLC.
If plaintiff makes demand on the board before filing suit, that action is deemed a concession that demand was required.[1] Note that making demand only concedes the board’s ex ante good faith and independence, such that plaintiff may not subsequently argue that demand was futile. If the board refuses the demand, the plaintiff is entitled to argue that the board’s refusal was wrongful, although the applicable standard is the business judgment rule, which we will see below is a challenging standard for the plaintiff to meet.[2]
Conversely, however, appointment by the board of a special committee to investigate the challenged transaction is not automatically deemed a concession that demand would be futile. In Seminaris v. Landa,[3] the board responded to a SEC investigation by appointing a special committee to investigate the conduct that had triggered the SEC’s inquiry. Three weeks late a shareholder-plaintiff filed a derivative suit alleging breaches of fiduciary duty in connection with that conduct without making demand. The full board instructed the extant special committee to investigate plaintiff’s complaint. The committee recommended dismissal of the plaintiff’s lawsuit and the defendants moved for dismissal on that basis. Plaintiff argued that appointing the special committee was a concession that demand would be futile and should therefore be excused. (As discussed below, cases in which demand is deemed futile are reviewed under a more shareholder-plaintiff friendly standard than those in which it is required.)
The Seminaris court held that “a disinterested board of directors does not waive its right to control derivative litigation merely by delegating that control to a special committee.”[4] Accordingly, the court went on to determine whether plaintiff had adequately pled demand futility: “To demonstrate that the . . . Board conceded demand futility, plaintiff must allege particularized facts to support a factual determination that the board intended to concede demand.”[5] The court determined that plaintiff had failed to do so.
In contrast, in Abbey v. Computer & Commun. Tech. Corp.,[6] plaintiff made demand before filing suit. Several weeks later, having not received a response, plaintiff filed her derivative suit. The board then appointed a one person special litigation committee. The court held that “that by divesting itself of any power to make a decision on the pending suit, and by adding a new and independent director and by designating him as a special Litigation Committee of one with the final and absolute authority to make the decision on behalf of the corporation, the incumbent board of directors, in effect, conceded that the circumstances alleged in the complaint justified the initiation of the suit by the plaintiff.”[7]
In Rowan v. Infinity Q Capital Management, LLC,[8] the Chancery Court reviewed the relatively sparse precedents on point—including Seminaris and Abbey—and concluded that there are “at least two ways a plaintiff can plead a board's creation of a special litigation committee conceded futility and delegated the ability to bring a procedural motion: (a) a sequence of events in which the board created a fully empowered committee after the complaint was filed, or (b) other particularized facts, perhaps where the committee was created before the complaint was filed but was comprised of new board members that do not labor under an apparent interest that other board members do.”[9] Accordingly, “the most prudent course of conduct for a corporation is to first file a motion to dismiss for failure to make demand before appointing a special litigation committee to investigate the allegations.”[10]
Concern for structural bias presumably influenced this line of cases. Presumably the Delaware courts assume a non-conflicted board would itself review the plaintiff’s allegations rather than delegating them to new, unconflicted directors. In turn, the new directors will be structurally biased in favor of those who appointed them.
[1] Rales v. Blasband, 634 A.2d 927, 935 n. 12 (Del.1993); Spiegel v. Buntrock, 571 A.2d 767, 775 (Del.1990).
[2] Scattered Corporation v. Chicago Stock Exchange, 701 A.2d 70 (Del.1997).
[3] 662 A.2d 1350 (Del.Ch.1995).
[4] Id. at 1353.
[5] Id.
[6] 457 A.2d 368 (Del. Ch. 1983).
[7] Id. at 373. See Allison on Behalf of Gen. Motors Corp. v. Gen. Motors Corp., 604 F. Supp. 1106, 1121 n.16 (D. Del. 1985), aff'd, 782 F.2d 1026 (3d Cir. 1985) (explaining that “Abbey held that by referring a shareholder demand to a Special Litigation Committee and delegating to it the power to determine the corporation's litigation posture, the corporate Board of Directors concedes being disabled from exercising business judgment”).
[8] 2022-0176-MTZ, 2022 WL 4127578, at *5 (Del. Ch. Sept. 12, 2022).
[9] Id. at 5.
[10] Bradley T. Ferrell, A Hybrid Approach: Integrating the Delaware and the ALI Approaches to Shareholder Derivative Litigation, 60 Ohio St. L.J. 241, 250 n.29 (1999). As discussed below, the policy rationale for this rule likely is judicial concern for structural bias.
