In the following guest post, Marc Casarino, a partner in the White & Williams law firm, and Doug Greene, the National Practice Leader of BakerHostetler’s Securities and Governance Litigation Team, take a look at the special litigation committee process and examine the ways in which the SLC process can be “robust, successful and efficient.” I would like to thank Marc and Doug for their willingness to allow me to publish their article as a guest post on my site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Marc and Doug’s article.
Delaware law gives corporate directors the ability to control shareholder derivative litigation by
- Requiring a shareholder to make a demand on the board before filing a lawsuit, or to demonstrate that the demand should be excused because it would be futile; and
- Allowing a special litigation committee (SLC) of the board to keep control of demand-excused litigation through an independent and thorough investigation.
Despite these well-established, director-friendly procedures, there is much strategic drift in derivative litigation defense. Far too often, we see companies establishing an elaborate investigative process that is vastly more complicated than necessary, akin to what an SLC would do, or battling the underlying merits of the claims instead of setting up a process-based defense.
Also far too often, companies forgo SLC investigations in favor of settling derivative litigation that has survived a demand-futility motion to dismiss. In our view, this hesitation stems from then-Vice Chancellor Leo Strine’s notorious 2003 decision in In Re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003), in which he held that the Oracle board’s SLC lacked sufficient independence. Ever since Oracle, boards have hesitated to form SLCs, even during the stock option backdating wave of derivative litigation when boards had already done a tremendous amount of baseline independent investigative work through audit committee investigations.
This 15-year post-Oracle hangover is unfortunate. Although the law does indeed require SLCs to be highly independent and its investigations to be robust, successful and efficient SLC processes are certainly achievable – and are vastly superior to bloated derivative litigation settlements that make directors and officers look as though they did something wrong. The key for boards is to get good advice and set up investigations properly.
Below, we discuss these issues in more detail, in hopes that we can take boards back to the basics to help them to better address derivative litigation.
I. Brief Overview of Derivative Litigation
The claims the shareholder asserts belong to the corporation, not to the shareholder. Shareholder derivative litigation thus is a fight about which representative of the corporation – the shareholder or the board – has the right to control the pursuit of the corporate claim.
The first step in this fight for control of corporate claims begins with the shareholder’s demand, or failure to make a demand, on the board. A shareholder who makes a demand concedes that the board can impartially consider it. A shareholder who files a lawsuit without making a demand on the board must demonstrate that demand would be futile. If the shareholder succeeds, the shareholder provisionally has the right to pursue the claim, but the corporation can take back this right if it forms an SLC composed of highly independent directors who can conclude that the claim lacks merit or its pursuit is not in the corporation’s interest.
These two board processes are very distinct, and the law governing them is well-developed. A board has wide latitude in how to review a shareholder demand. The review does not need to be a scorched-earth event. Instead, the board simply needs to be informed and make a good-faith decision, which can take into account the best interests of the corporation. If the board’s review is informed and made in good faith, the shareholder does not have the right to challenge the underlying merits. In contrast, an SLC’s investigation of a claim for which a court has held that demand is excused as futile must be highly independent and thorough, and the SLC bears the burden of proving that its decision is appropriate, because the business judgment rule does not apply to SLCs.
II. Delaware Law Governing Board Demands
The business and affairs of a Delaware corporation are managed by its board of directors. In this regard, in the first instance, the board controls the response to a shareholder demand. The board is presumed to be independent and disinterested with respect to the demand. This presumption is embodied within the business judgment rule, which is a principled approach by the court to not impose itself unreasonably upon the legitimate business and affairs of a corporation.
When applicable, the business judgment rule restricts the court from questioning the wisdom of the board’s decision itself. In that case, the court instead focuses only upon the process by which the board reached its decision. The process will likely pass judicial muster if it reflects that the board was reasonably informed. What constitutes being reasonably informed requires a circumstance-specific analysis. Some situations may require a comprehensive investigation by an independent subset of the board aided by independent advisers. Most often, however, the business judgment rule will apply when a majority of the board is disinterested and the board has informed itself of facts sufficient to demonstrate that its ultimate conclusion is attributed to some rational business purpose. Significantly, this process generally does not require a “leave no stone unturned” approach or production of a lengthy report of the board’s investigation and conclusions.
As a practical matter, application of the business judgment rule forecloses legal challenges by shareholders. To overcome the business judgment rule, the shareholder must plead facts demonstrating that a majority of the board lacked independence or was interested in the challenged transaction. On a director-by-director basis, the shareholder must show that a majority of the board appears on both sides of the transaction, will receive a personal benefit that constitutes self-dealing, or is so beholden to an interested party that the director’s discretion is sterilized. The focus of the challenge is accordingly on the process utilized by the board – and not on its substantive decision. If the shareholder satisfies his or her burden, the board will lose the benefit of the legitimacy presumption provided by the business judgment rule.
If the business judgment rule does not apply, the court will instead evaluate the transaction under the so-called “entire fairness” standard, under which the burden of persuasion shifts to the board to demonstrate that the transaction was entirely fair. The court evaluates the interrelated concepts of fair process and fair price to determine entire fairness. The fair process element typically embraces the timing of the transaction – how it was initiated, negotiated, disclosed to the board, and approved by shareholders. Fair price relates to the economic and financial considerations of the transaction – assets, market value, earnings, future prospects, and any other element affecting the inherent value of the enterprise. Although the two entire-fairness concepts consider different factors, the court’s analysis is not bifurcated and instead takes a unitary approach.
The shareholder thus faces a choice at the inception of a derivative dispute, make a demand on the board to pursue the alleged claim, or initiate the litigation him- or herself and plead facts demonstrating that demand on the board is excused as futile. A demand on the board effectively constitutes a concession by the complaining shareholder of the board’s independence and disinterestedness in respect to the challenged transaction. The shareholder is accordingly left only to challenge that refusal of the demand was unreasonable and made in bad faith. The business judgment rule applies to a wrongful refusal of demand claim, which generally results in dismissal of the action except in only the most extraordinary cases.
Given the difficulty most shareholders will have demonstrating wrongful refusal of a demand, the more common practice is to file suit and argue futility of the demand. If the shareholder’s claim survives a motion to dismiss for failure to sufficiently plead demand futility, not all is lost by the board. Rather, the board can retain its control of the claim as the managers of the corporation’s business and affairs by appointing an SLC to evaluate whether dismissal of the action is in the best interest of the enterprise.
III. Delaware Law Governing SLCs
An SLC must be composed of disinterested and independent directors. Unlike the deferential approach of the business judgment rule, an SLC is not afforded any presumption of independence, good faith or reasonableness. Rather, the corporation must prove that the formation, composition and work of the SLC were at all times independent, undertaken in good faith and reasonable. The Delaware Supreme Court confirmed in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), that if the corporation can satisfy this showing, the decision to prosecute or dismiss a derivative lawsuit rests on the business judgment of the SLC.
Where an SLC determines that pursuit of the derivative lawsuit is not in the corporation’s best interest, it may file a motion to dismiss, which is a hybrid of a motion for summary judgment and a motion under Rule 41(a)(2) (allowing a plaintiff’s request to dismiss an action). The shareholder may take discovery to investigate and challenge the SLC’s process and conclusions. If following such discovery the court is satisfied by the SLC’s independence, process, and conclusions, it may grant the SLC’s dismissal request or exercise its own independent business judgment to determine whether dismissal is in the corporation’s best interest.
Historically, courts focused on economic ties when evaluating the independence of SLC members. For example in Lewis v. Fuqua, 502 A.2d 962 (Del. Ch. 1985), the court found that numerous financial and political dealings between the company’s CEO and the single member of an SLC conflicted the SLC member’s independence. This resulted in the oft-quoted reference to an SLC member being “above reproach, like Caesar’s wife.” Thereafter, Abrams v. Koether, 766 F.Supp. 237 (D. N.J. 1991) (applying Delaware law), rejected a challenge to the independence of an SLC simply because its members would have to consider suing their families, friends, or business associates. The court suggested that a challenge to independence required showing direct financial interest akin to self-dealing by the SLC member. This is consistent with the majority view that mere familial or personal relationships will not undermine a board member’s independence, except in extraordinary circumstances, such as joint ownership of a unique asset like a private airplane.
In 2003, the Delaware Chancery Court ruled in Oracle that more than economic ties should be considered when evaluating the independence of an SLC member. In reaction to a derivative complaint challenging misleading earnings reports and director self-dealing with respect thereto, the board formed an SLC composed of two directors who joined the board following the challenged actions. The SLC members were both tenured professors at Stanford University. The SLC retained independent counsel, who performed considerable due diligence, including interviewing 70 witnesses, reviewing voluminous documents, holding multiple substantive meetings with the SLC, and preparing a comprehensive 1,100-page report documenting its process and conclusions.
Discovery revealed that two of the board members involved in the challenged activities had substantial relationships with Stanford University. One of the board members was a Stanford graduate and had contributed millions of dollars to the university both personally and through a foundation that he controlled. Another of the board members also made significant financial contributions to Stanford through a foundation that he controlled, and was contemplating additional contributions to form a scholarship program in his name.
The court was disconcerted that the SLC’s report had not fully disclosed the board members’ substantial financial ties to the university where both SLC members worked. The court acknowledged the majority of case law concentrated on economic ties when evaluating independence. Nevertheless, it declared that noneconomic factors can influence human behavior and should be considered when evaluating the independence of an SLC member. This assessment of noneconomic factors was held by the court to comport with guidance from the Delaware Supreme Court to ultimately focus on impartiality and objectivity of an SLC member’s ability to make decisions with only the corporation’s best interest in mind.
Following Oracle, the Delaware Supreme Court in Beam v. Stewart, 845 A.2d 1040 (Del. 2004), clarified that the definition of a director’s interest and independence is not substantively different in the pre-suit demand and SLC contexts. Rather, the distinction lies in the burden of proving independence and disinterestedness shifting to the corporation and the availability of limited discovery in the SLC context. This was reinforced in London v. Tyrrell, 2010 Del. Ch. LEXIS 54 (Del. Ch. Mar. 11, 2010), where the court denied a motion to dismiss by an SLC because there existed material questions of fact regarding the SLC’s independence, good faith of its investigation, and reasonableness of its conclusions. The two-member SLC was composed of directors who joined the board following the challenged transaction. There was no evidence that the SLC members were dominated or controlled by any of the defendants and they had no involvement with the challenged transaction. The court acknowledged that in the pre-suit demand context, the SLC members would be independent and disinterested.
Discovery revealed, however, that one of the SLC members was married to the cousin of a defendant director. The court observed that familial relationship is difficult to overlook when considering independence in the SLC context. The second SLC member formerly had been involved in a business venture with a defendant director, and acknowledged a respect for that director because he facilitated the profitable sale of their venture. The court deemed this sufficient evidence of a sense of obligation making the SLC member beholden to the director.
The court then evaluated the good faith and reasonableness of the SLC’s investigation, which analysis provides useful guidance for proper operation of an SLC. First, the court observed that both SLC members described their approach as “attacking” the allegations in the derivative complaint. The court did not deem this to be independently disqualifying, but noted that it suggested lack of independence. Of course, a reasonable investigation is an objective evaluation of all relevant facts and sources of information pertaining to the core allegations of the complaint. The court explained that an SLC cannot stop short its investigation simply because the costs of a full investigation seemingly outweigh the harm that may arise from the challenged transaction. Exploration of less-serious allegations could reveal information about more-serious concerns.
The SLC cannot simply accept the defendants’ version of events without verifying those accounts through independent sources. The SLC must also understand the applicable law, which reinforces the importance of consultation with independent legal counsel.
Applying these standards, the court rejected the SLC’s determination that an exculpation provision in the company’s charter precluded a duty-of-care claim seeking both monetary damages and rescission. An exculpatory provision does not bar a claim for rescission under Delaware law. The inaccuracy of the SLC’s conclusion of law rendered its legal analysis inherently unreasonable according to the court. Last, the court pointed out several flaws in the SLC’s analysis, including the omission in the SLC’s report of an explanation of discrepancies in the financial evidence produced by the company and plaintiffs, and failure to establish the grounds for its valuation conclusions.
These cases suggest that Oracle should not be considered the sea change in use of SLCs as initially thought. Rather, pre- and post-Oracle cases show that the standards for evaluating director independence and disinterestedness are consistent between pre-suit demand and SLC contexts. The distinction lies in the burden of proving independence and disinterestedness, which shifts to the corporation in the SLC context. The care to be taken to properly vet potential relationships between SLC members and director defendants is comparable to how a corporation should approach designation of any independent committee member. Discovering familial, friendship, or past business association relationships is not an onerous task, and should be considered by boards evaluating transactions, whether or not in the SLC context.
Once the SLC is appropriately staffed, it is beyond cavil that it should engage in an objective and reasonable investigation. Failure to do so cannot be attributed to any particular court decision; it is simply good practice to engage in the proper analysis. Given the guidance outlined by the case law for a proper SLC analysis, it is a poor excuse to blame Oracle for being unwilling to engage an SLC.
IV. Good Governance Basics: Proper Use of Board Demands and SLCs
- Shareholder Demand Investigations
Shareholder demands come in two main varieties these days. One variety concerns proxy statement issues, typically related to compensation and equity plans. These are ubiquitous and, while potentially serious, present a challenge of frequency more than severity. Another variety concerns the broader set of matters that are the subject of shareholder challenges to board action and inaction, such as the corporation’s decision to sell an asset or its actual or alleged violations of the law. This variety can run the gamut in terms of seriousness.
Whether the demand is a pesky fly or a roaring tiger, the board’s response is straightforward, guided by the basics of board demands. A shareholder demand actually can be considered a gift to the board; by making a demand, a shareholder concedes that the full board is able to consider it. It’s an admission that the board is sufficiently independent and disinterested – in other words, a shareholder can’t make a demand and then backpedal and file a lawsuit alleging that demand should be excused as futile. Because of this admission, it can be a mistake to empower an SLC to respond to the demand; in fact, an empowered SLC effectively admits that the full board lacks independence and disinterestedness. It is certainly customary for a board to use a committee to do the day-to-day work, and then make a recommendation to the full board, but an empowered committee’s response to a board demand is often a mistake.
The amount of board-demand investigative work required depends on the circumstances, but there is one constant: It is unnecessary for a board to conduct an investigation designed to demonstrate to a court that the underlying claims lack merit. The focus is on process, not substance; as discussed above, a court will not second-guess a board’s informed and good-faith judgment response to a demand, and, critically, it is the shareholder’s burden to challenge the board’s decision. Indeed, sometimes very little investigative work by the board is required in order for the board to make an informed decision on the demand, though occasionally a significant amount of work is required. The touchstone, however, is the same: sufficient work to allow the board to make an informed decision.
Likewise, it is usually unnecessary, and often unwise, for a board to write a detailed investigative report. A detailed report can be an attractive nuisance, inviting the shareholder and the court to examine the substance, when all that matters is the process. Only if the shareholder can show that the board did not act in an informed and good-faith manner does the substance come into play, through litigation on the merits or, ideally, an SLC process.
In addition to being disadvantageous, overdoing a board-demand investigation and writing a report also tend to drastically increase the cost. We certainly don’t advocate cutting any corners on investigative tasks, but an efficient investigation is typically more effective as well.
B. SLC Investigations
An SLC investigation, in contrast, does require an empowered and highly independent committee, and a rigorous examination of the merits. But, as noted above, these standards are not barriers; with good advice, boards can conduct effective SLC processes. And while SLC investigations are often expensive, boards often do not fully appreciate the cost and risks of the alternatives, which include (i) a bloated settlement that makes the directors and officers appear to have acted improperly, and/or (ii) litigation on the merits of a claim for which the corporation cannot indemnify its directors and officers if they are ultimately liable to the corporation. A thoughtful and well-managed SLC process can be handled within a managed expense structure that is preferable to these alternatives.
Every SLC needs to be established based on excellent advice about independence. The standards are well-established and well-known to Delaware practitioners, and as noted above, they should not be cause for aversion. Boards simply need the type of good corporate advice about independence they get all the time in other contexts.
Once it is formed, the SLC’s most important first step is to select the right counsel – a team that has various characteristics. First and foremost, the SLC and its counsel should reject the notion that the more expensive the investigation, the more protective it is. That is simply wrong. A properly tailored investigation is critical to avoid unnecessary inquiries that take the SLC, shareholder – and court – off the appropriate path. London walks through the contours of a reasonable investigation. It’s not particularly complicated.
In addition to having a strategic quarterback and Delaware expertise, the right legal team should include litigators who are good fact-finders – give-no-quarter defense lawyers arguably are often the wrong people to do the fact-finding. Consistent with good fact-finding, the team should be focused and right-sized to achieve legal and factual coherence. Unlike internal investigations that must be rushed to make a required SEC filing or spurred by a government investigation, an SLC investigation should be done deliberately – without rushing.
We very much hope these thoughts help achieve more efficient and thus more effective board investigations of shareholder demands and more use of SLCs. Delaware law gives directors the ability to control the corporation’s destiny – a unique feature of our litigation system – and corporations and their directors and officers will be better off if they maximize the value of these procedures.
Marc S. Casarino is a Partner at White and Williams LLP. Marc helps clients achieve their business objectives, manage risk, and resolve disputes. He handles all aspects of corporate governance, including investigations and board advisory roles. He is also a skilled litigator with first-chair trial experience in all Delaware State and Federal Courts, focusing primarily upon the Delaware Court of Chancery. Marc can be reached at email@example.com.
Doug Greene is the National Practice Leader of BakerHostetler’s Securities and Governance Litigation Team. For the past 21 years of his career, Doug’s practice has been devoted to defending securities class actions, shareholder derivative actions, and shareholder challenges to mergers, and to representing boards, board committees, companies, and individual directors and officers in internal corporate investigations. Doug can be reached at firstname.lastname@example.org.