In a series of opinions beginning with the Delaware Supreme Court’s 2019 decision in Marchand v. Barnhill, Delaware courts have sustained a number of so-called “Caremark” claims based on the defendant board members’ breach of their duty of oversight. The courts have denied motions to dismiss in cases where the boards failed to act despite “red flags” alerting them to problems. But what happens if the “red flag” that alerts the board to a problem is a litigation demand letter submitted by a prospective claimant seeking to have the board take up litigation because of problems identified in the letter? In an interesting and troubling May 24, 2022 decision, Vice Chancellor Travis Laster sustained a claim based on these kinds of allegations, accepting what he called a “novel theory” with “admitted trepidation.” Though Laster sought in his opinion to contain some the more “disquieting” implications of this ruling, there is now at least a theoretical basis on which future prospective claimants could argue that a board’s rejection of a litigation demand letter could itself give rise to a separate breach of fiduciary duty claim.
Vice Chancellor Laster’s opinion in Garfield v. Allen can be found here. A detailed June 6, 2022 memo from the Fried Frank law firm about the decision can be found here.
Background
In 2019, ODP Corporation’s board approved an equity compensation plan, which stockholders approved. The plan authorized the board to grant equity compensation awards to officers, employees and directors. Pursuant to the plan, the board established a committee, comprised of four non-officer directors. The plan sets certain limits on the size of the awards that the company can grant. In March 2020, the committee made two grants of performance shares to the company’s CEO, who is also a director. The plaintiff subsequently challenged these grants. Under these grants, the CEO was to receive a variable number of shares based on the company’s performance over a three-year period. However, if the company achieved the maximum performance, the number of shares to be awarded to the CEO would exceed the plan’s share award limitation.
A plaintiff shareholder sent a demand letter to the company’s board asserting that the share grants violated the plan’s share limitation and demanding that the grants be amended. The committee adopted a policy to apply a different limitation than the one in plan, which it was believed would result in the number of shares issuable to not exceed the plan’s share award limitation. The plaintiff then sued the board and the CEO, asserting a direct claim for breach of contract against the directors for violating the plan and a derivative claim for breach of fiduciary duty against the directors and the CEO. The defendants filed a motion to dismiss.
The May 24, 2022 Decision
In a detailed, 115-page opinion, Vice Chancellor Laster denied the defendants’ motion to dismiss. Among other things, Vice Chancellor Laster sustained the plaintiff’s claim that the directors breached their fiduciary duties by “not fixing the Challenged Awards after the [plaintiffs’ demand letter] brought the violation of the [Plan] to their attention.”
In addressing the plaintiff’s “novel theory” that a board’s failure to address a problem that it learns about through a litigation demand letter may constitute a breach of fiduciary duty, Vice Chancellor Laster, while commenting that the theory “lacked precedent,” nonetheless found that “the logic of the theory is sound.”
Vice Chancellor Laster noted that under Caremark directors can be liable for disregarding a “red flag” alerting them to the existence of a problem. The result should be the same, Vice Chancellor Laster reasoned, where the means by which the board became aware of the problem is through a litigation demand letter. Vice Chancellor Laster also noted that a “knowing” violation of a “plain and unambiguous restriction” in a equity compensation plan can, at the motion to dismiss stage, support a “reasonable inference of bad faith conduct” sufficient to negate the protection of the business judgment rule.
Vice Chancellor Laster noted that historically, a board’s rejection of a litigation demand has affected only the question of “who controls the derivative claim” and has “not been analyzed as a separate fiduciary wrong.” In concluding that even though this “theory” was “novel” and “lacking precedent, “the theory that a plaintiff, by making a litigation demand, could create a new claim, is based on “logic” that is “sound.”
Vice Chancellor Laster reasoned that “Delaware law treats a conscious failure to act as the equivalent of action, so if a plaintiff brings a clear violation to the directors’ attention and they do not act, then it is reasonably conceivable that the directors’ conscious inaction constitutes a breach of duty.” Laster noted that “the same logic animates a Caremark claim,” which is based on the theory that a board consciously ignoring a problem that raises “proverbial red flags.” Even though in this case the alleged notice came from the plaintiff’s demand letter, “from an analytical perspective … the source of the directors knowledge should not make a difference,” as the alleged breach lies in the directors’ “conscious failure to act based on the knowledge they possessed.”
Vice Chancellor Laster’s opinion also addresses a number of other issues not further discussed in this blog post.
Discussion
Though Vice Chancellor Laster sustained the plaintiff’s claim that the defendants failure to act in response to information in a litigation demand letter could give rise to a separate breach of fiduciary duty claim, he was also clearly troubled by the implications of the “novel” and unprecedented theory. He said that he found it “disquieting” that under this theory, a plaintiff could “manufacture a claim against directors by acting as a whistleblower and then sue because the directors did not respond to the whistle.”
Laster went on to spell out his concerns about the possible “knock-on effects” from his acceptance of the plaintiff’s theory. Based on this theory, Laster noted, a plaintiff could “undermine salutary doctrines such as laches that force plaintiffs to make claims on a timely basis” and could expose directors who did not approve the challenged board decision to the risk of litigation “by presenting them with a problem that they did not create and asserting that they failed to fix it.”
Based on what he called “serious policy issues” that the theory raises, Laster warned that in future cases courts should not permit a plaintiff to pursue a “strategy” of creating new claims by sending a demand letter as part of an artifice to (for example) bring stale claims or to bring in additional defendants. In light of these “obvious” policy concerns, “future decisions,” Laster warned,” must consider carefully any attempts by plaintiffs to follow a similar path.”
Laster also tried to constrain the “disquieting” aspects of this ruling on the plaintiff’s theory by emphasizing the specific features of this dispute that made the acceptance of the theory in this case to be warranted. The case, Laster said, presents “one of the strongest possible scenarios for … a claim” that a board’s rejection of a litigation demand could support a claim for breach of fiduciary duty. After noting allegations in this case such as the specific share award limitation in the equity compensation plan, and the relatively easy fix for the directors to address the problem, Laster observed that “if there was ever a time when all of the directors had a duty to take action to benefit the Company by addressing an obvious problem, it is reasonably conceivable that this is it.”
Though Laster wove into his opinions a recitation of the dangers of the plaintiff’s theory – that is that the board’s rejection of a shareholder demand letter can give rise to a separate breach of fiduciary duty claim – as well as the exceptional features of this case that he contended to have warranted the acceptance of plaintiff’s theory in this case, the fact is that he recognized the theory. It seems entirely possible to me that future derivative claims asserting demand rejected allegations will likely now all also routinely include a separate claim for breach of fiduciary duty based on the rejection of the demand letter. Cases including these kinds of allegations will entail extensive wrangling over whether the facts alleged in the case are or are not as exceptional as those involved in this case sufficiently to allow this separate breach of fiduciary duty claim to proceed.
Laster was justified in finding the demand letter rejection breach of fiduciary duty theory to be “disquieting,” and he was warranted in worrying about the possible “knock-on effects” of the ruling. But despite all of the notes of caution that Laster noted in his opinion, the fact is that we are likely to see similar breach of fiduciary duty claims asserted in future derivative suits where the board rejected the pre-suit demand. For better or worse, it will have to be sorted out in future suits exactly what is sufficient to sustain one of these kinds of demand letter rejection breach of fiduciary duty claims.
In the meantime, as the law firm memo to which I linked above notes, boards should be aware that, depending on the facts and circumstances involved, directors’ fiduciary duties “may require that they address the corporate problem identified in a demand letter.” Based on Vice Chancellor Laster’s opinion in the Garfield case, a board’s wrongful ignoring of a litigation demand may be analyzed by the court as a possible separate fiduciary wrong by the directors, particularly where the problem identified is clear and the where there is a relatively “easy fix” by the board.