On my beat here at The D&O Diary, I cover the liabilities of corporate directors and officers. One objection I frequently hear is that I focus too much public companies and not enough on private companies. The reason I write about public company issues more than private company concerns is that the public company world usually is more eventful. However, every now and then, something comes up involving a privately-held company that reminds all of us that plenty happens in the private company D&O world, too. The most recent example is the shareholder derivative and class action lawsuit filed last week against executives of the electronic cigarette company, Juul Labs. As discussed below, this new lawsuit highlights the exposures that private company directors and officers can face and underscores the fact that even private companies can get hit with shareholder class action lawsuits.
Background
San Francisco-based Juul, which is privately-held, designs, manufactures, and markets electronic cigarettes and vaping products. In December 2018, the tobacco and cigarette manufacturing company Altria invested $12.8 billion for a 35% interest in Juul. Altria’s investment in Juul implied that Juul had a valuation of approximately $38 billion.
After the Altria investment, Juul experienced a number of adverse developments. Among other things, in April 2019, the FDA announced an investigation of instances of consumers who allegedly suffered ill health effects after vaping and whether vaping caused seizures. In July 2019, San Francisco became the first major city to ban the sale and distribution of electronic cigarettes. Also in July 2019, a Congressional committee held hearings about vaping at which Juul executives testified.
In September, 2019, Altria announced that Phillip Morris had called off a reported $200 billion merger with Altria, in part allegedly due to increased scrutiny of vaping and Altria’s stake in Juul. Also in September federal health authorities criticized Juul for allegedly unlawfully marketing electronic alternatives as a safer alternative to smoking.
In late October 2019, Altria wrote down the value of its investment in Juul. Immediately following the write-down, Altria, which had valued Juul at $38 billion at the time of its investment, now valued the company at $24 billion, a decline of at least $14 billion.
In November 2019, the New York Attorney General filed a lawsuit against Juul, accusing the company, among other things, of deceptive marketing practices. Numerous consumers have also filed lawsuits against Juul, as have at least two California school districts. There are press reports of a federal criminal investigation of Juul.
The Lawsuit
On January 7, 2020, a Juul shareholder filed a lawsuit in California (San Francisco County) Superior Court against certain present and former directors and officers of Juul. The lawsuit is framed both as a class action lawsuit filed on behalf of a putative class of Juul’s minority shareholders and as a derivative lawsuit filed on behalf of Juul itself. The complaint names as defendants six of the nine current directors of Juul’s board as well as several other former directors and officers. A copy of the complaint can be found here.
The complaint alleges that the defendants “abused their control” of the company to “benefit themselves personally to the detriment of the company’s minority shareholders” and have “engaged in self-dealing and treated the minority shareholders disparately.”
The complaint further alleges that the defendants “breached their fiduciary duties and violated California law by failing to provide financial information, annual reports and other basic information to the minority shareholders, thus inhibiting their ability to discover the true worth of their stock.”
The complaint specifically alleges in connection with the $12.8 billion Altria investment that after negotiating the investment the defendants “paid themselves a special dividend bonus” but did not pay a dividend/bonus to all shareholders, thereby “usurping” a disproportionate amount of the dividend bonus, while at the same time “unfairly imposing restrictions” in minority shareholders’ sale of their stock in the company
The complaint alleges that as a result of the defendants “substantial wrongdoing, mismanagement, and breaches of fiduciary duty” the company experienced an “enormous decrease” in its valuation. The complaint further alleges that as a result of the defendants “bad faith conduct and breaches of the duty of loyalty,” the company has been subject to investigations by the Unites States government and several states attorneys general, as well a federal criminal probe.
The defendants, the complaint alleges, “violated and continue to violate applicable law by directly breaching and/or aiding and abetting the other Defendants’ breaches of the duties of loyalty, due care, independence, good faith, and fair dealing.”
The complaint acknowledges that the plaintiff has not made a pre-suit demand on the company’s board to take up the lawsuit, alleging that any such demand “would be a useless and futile act,” because six of the current board members “are not independent and objective, and are completely dominated and controlled by” the company’s founders.
The complaint specifically alleges seven separate causes of action: a direct class claim for breach of fiduciary duty; a direct class claim for aiding and abetting breaches of fiduciary duties; a direct class claim for an accounting, and for declaratory and injunctive relief; a direct individual clause of action for violations of California Corporations Code Section 1601 (the books and records provisions); a derivative claim for breach of fiduciary duty; a derivative claim for unjust enrichment; and a derivative claim for abuse of control.
The complaint seeks declaratory and injunctive relief, as well as an accounting. The complaint further seeks damages, both for the class and the company, for “all damages caused to them” and an accounting “for all profits and any special benefits obtained as a result of [the defendants’] unlawful conduct and self-dealing,” as well as punitive damages, costs, and expenses.
Discussion
There is no doubt that this lawsuit is the product of an extraordinary situation. While Juul is indeed a private company, it is one with a massive valuation, and it is engaged in a very high-profile and controversial business. It also has been the target of sustained regulatory and possibly prosecutorial scrutiny. It certainly has been the continuing focus of sensational press coverage.
For all of these reasons, it may be hard to generalize from this set of circumstances. Nevertheless, there are certain things that are worth pointing out here, and that are relevant for all of us involved with private companies to consider.
The first is that this lawsuit has been filed, at least in part, as a shareholder class action lawsuit. To be sure, Juul may be different from many other private companies, both because of its valuation and because it has a significant number of outside investors. However, it should not be overlooked that the company has been hit with a shareholder class action lawsuit even though it is not a publicly traded company. While Juul may be very different than many if not most other private companies, the fact is that this lawsuit is a reminder that there is nothing that says that a company can’t be hit with a shareholder class action lawsuit just because it is a private company.
I know that upon learning about this lawsuit, many other readers found themselves thinking (as I did) about the circumstances and litigation that surrounded another high-profile high-valuation California company, Theranos. As I noted at the time, Theranos too was hit with investor litigation, even though it is a private company.
Of course these are two very different companies and Theranos was faced with its own unique set of problems that have nothing whatsoever to do with Juul. However, at a certain level of generalization, what the two companies share is that they are or were both high profile companies with lofty valuations. Because of this, it might be easy to say, well, maybe big high-valuation private companies can get hit with class lawsuits but that is hardly relevant to the vast run of smaller private companies. There is an element of truth in this, but this common sense observation should not distract from the more fundamental point that private companies can be and sometimes are hit with shareholder class action lawsuits.
There is another shareholder lawsuit recently filed against a private company that may also come to mind here for at least some readers, and that is the lawsuit filed late last year against WeWork, its former CEO, and its principal investor, as discussed here. Interestingly, the WeWork complaint, like the recent lawsuit against Juul, was filed both as a direct lawsuit on behalf of a class of the company’s minority shareholders and as a derivative lawsuit. (Readers may be interested to know that both the WeWork lawsuit and the Juul lawsuit were filed by the same plaintiffs’ law firm.)
But while there may be similar features between the Juul lawsuit and the WeWork lawsuit, the WeWork is fundamentally different in one critical respect, which is that the WeWork lawsuit is basically a “failure to launch” claim built around WeWork’s failure to complete its planned IPO. Nevertheless, while there are important differences between the two lawsuits, both lawsuits do represent examples showing that companies can get hit with shareholder class action lawsuits even though they are privately held.
The new lawsuit against Juul has also been filed in the form of a derivative lawsuit. There is nothing particularly extraordinary about this fact. I think most private company D&O practitioners are well aware that private company boards can be hit with derivative lawsuits filed on behalf of the company. But while there is nothing extraordinary about the fact that this private company has been hit with a derivative lawsuit, it should not be overlooked that the possibility of a derivative lawsuit is one of the serious risks that private company board members face, and this consideration should be taken into account both in the way the board conducts its business and in the way that the private company’s D&O insurance is put together.
The fact is that even private companies can get hit with very serious lawsuits, and these lawsuits must be defended and resolved. This fact definitely should be taken into account when private companies are trying to decide how much insurance is sufficient to protect the interests of their boards.
This new lawsuit has only just been filed. The allegations in the complaint are only that, mere allegations. It remains to be seen whether this lawsuit will prove to be meritorious. The defendants will have numerous defenses, including, with respect to the derivative lawsuit at least, the plaintiff’s failure to make a demand on the company’s board.
There appears to be at least one other Juul shareholder engaging in litigation-related activities pertinent to the company’s board. According to a January 9, 2020 Law 360 article (here, subscription required), Juul is engaged in litigation in Delaware relating to another shareholder’s efforts to examine the company’s books and records. Juul is taking the position that the shareholder has waived its rights for a books and records inspection. The likelihood is that the shareholder’s motivation in seeking the inspection is in order to be able to build the factual predicate for a later lawsuit. There is at least the potential for further shareholder litigation involving Juul.