In a recent case, the Delaware Court of Chancery made clear the value of implementing a proper special committee to address the influence of a self-interested controlling party on a transaction as well as the requirements for satisfying demand futility for purposes of derivative actions.
In Lenois v Lawal, C.A. No. 11963 (Del. Ch. Nov. 7, 2017) a derivative claim and putative class action was commenced by a minority stockholder challenging a series of transactions on the basis of breach of fiduciary duties by the CEO (who, together with his affiliates, controlled nearly 60% of the corporation’s shares) as well as breaches of duties by the remaining directors.
Under Delaware law, one of the pre-requisites to a derivative suit by a stockholder on behalf of a corporation is that a demand has been made on the Board to bring the action directly, or alternatively, that no such demand is necessary because the demand would be futile.
Plaintiff was a minority stockholder who claimed the company’s directors breached their fiduciary duties by approving a series of transactions benefiting the company’s chairman, CEO, and controlling stockholder. The claims included allegations that the corporation overpaid for certain assets of an entity affiliated with the CEO as well as claims for alleged disclosure violations in the proxy statement relating to the transactions.
Prior to instituting suit, plaintiff did not make a demand on the Board of Directors. Therefore, the court was required to determine whether the suit could meet the requirements of demand futility. The parties agreed that analysis of demand futility should proceed under the second prong of Aronson v. Lewis, 473 A.2d 805 (Del. 1984), which requires allegation of particularized facts sufficiently raising reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment by the Board.
One key fact in this case was that the Corporation’s certificate of incorporation contained a fairly customary provision which provides for exculpation of directors under section 102(b)(7) which protected directors from duty of care claims. If the directors were protected by such a provision, then such exculpated claims should not impact their ability to act impartially with respect to a demand. Plaintiff argued that despite the exculpatory provision, lack of care allegations could be utilized to evidence bad faith exercise of business judgment.
Following a thorough examination of prior case law, the Court disagreed and held that the purpose of the demand futility analysis is to determine if a majority of the board [emphasis added] cannot consider a demand impartially because of substantial likelihood of liability for non-exculpated claims. The Court then discussed why the plaintiff did not satisfy his pleading obligation because, among other things, a special committee was appointed to evaluate the challenged transactions, the committee retained an investment banker and legal counsel, and efforts by the CEO to interfere in the process were rebuffed by the committee. The Court was further influenced by the committee insisting upon approval by the full board (without the CEO-director), issuance of a proxy statement to stockholders, and stockholder approval of an issuance of additional shares to finance the transactions.
The detailed analysis of demand futility in this decision, and particularly the director-specific evaluation that the Court applies, as well as the protections afforded by a well-functioning special committee, offers guidance for practitioners when advising boards of directors on interested party transactions as well as when drafting or preparing challenges to derivative complaints under Delaware law.