The Chancery Court’s Latest Take On Demand Refusal

/ Business Organizations in Focus Book, Delaware Chancery Court, Demand Requirement, Derivative Actions

 

With the press of the last semester, I find myself in catch up mode.  (I suspect I am not alone!)  This post — which discusses a recent Delaware Chancery Court case involving Rule 23.1 and shareholder derivative actions — is the first a series of posts designed to bring us up to date on recent developments in corporate governance litigation and financial market regulation.  For faculty using Business Organizations in Focus, this post supplements the discussion of derivative actions and Rule 23.1 in Chapter 9 — particularly pp. 481-484.

Summary:  In Andersen v. Mattel, Inc., C.A. No. 11816-VCMR (Del. Ch. Jan. 19, 2017), a shareholder alleged that Mattel’s board improperly investigated and wrongfully refused to bring suit to recover up to $11.5 million paid to the former chairman and CEO of the company as part of a severance package and consulting agreement.  On January 19th, the Delaware Chancery Court granted the director defendants’ motion to dismiss under Delaware Chancery Court Rule 23.1.

The Demand Requirement/ Rule 23.1:  As the caption reflects, this case was filed as a derivative action — i.e., a lawsuit brought by one or more shareholders to enforce a right or cause of action owned by the corporation, but one that the corporation will not enforce.  Because derivative actions, by their very nature, impinge on the board’s authority to decide whether and when to institute litigation, derivative actions are subject to procedural and substantive requirements not applicable to direct actions, including the so-called demand requirement.  For actions in the Delaware Chancery Court, the demand requirement is set forth in Chancery Court Rule 23.1.

Chancery Court Rule 23.1 states that derivative complaints “shall  . . .  allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff’s failure to obtain the action or for not making the effort.”  This rule has been interpreted to offer plaintiffs a choice:  Either make a pre-suit demand upon the board, presenting the allegations to the board and requesting that they file suit, or plead with particularity facts showing that demand ought to be excused as futile.

If a shareholder makes a demand, and demand is refused, the business judgment rule presumptions apply to the board’s refusal to bring the lawsuit.  And, in any subsequent litigation over demand refusal, the shareholder plaintiff will be deemed to have conceded a majority of the board is disinterested and independent.  Taken together, these rules mean that if a plaintiff challenges the board’s refusal to bring suit following a shareholder demand, the “only issues the Court must examine in analyzing whether the board’s demand refusal was proper” are “the good faith and reasonableness of its [the board’s] investigation.”  So long as the board had a rational basis for its decision, the board’s demand refusal will stand, and the plaintiff’s claims will be dismissed.  As the plaintiff in Andersen made a pre-suit demand, we will not discuss the standards relating to demand excused futility in this post.

The Plaintiff’s Demand:  In Andersen, the plaintiff made his demand in a pre-suit letter to the board.  In response, the board conducted an investigation that included interviews with about two dozen witnesses and the review of more than 10,000 documents. After the investigation, the board determined that it would not pursue the claims. Among other reasons, the board reportedly determined that litigation would be a distraction to senior management.  The board also reportedly also concluded that litigation would negatively impact the business at a time when the company was trying to focus on a turnaround strategy. Notably, the board did not form a special committee to conduct the investigation.  Also, notably, although the stockholder asked the board for a copy of documents related to the investigation, the stockholder did not make a pre-demand request under DGCL section 220 for “strategic reasons,” according to the court.

Holding: The court granted the motion to dismiss of the defendant directors based on failure to allege wrongful pre-suit demand refusal under Court of Chancery Rule 23.1.  In reaching its conclusion, the court rejected the plaintiff’s argument that Mattel’s board had acted with gross negligence by keeping the written report of its investigation secret, failing to disclose the identifies of the witnesses interviewed, and by failing to create special committee.  The court observed that while a board has a duty to act on an informed basis in responding to a demand, “there is absolutely no prescribed procedure that a board must follow.”

The court also rejected the plaintiff’s argument that the board’s refusal was in bad faith because it was inexplicable, given the merits of plaintiff’s claim.  The court held that to plead bad faith in the context of demand refusal, a complaint must plead particularized facts showing that the directors: “… acted with scienter, i.e., with a motive to harm, or with indifference to harm that will necessarily result from the challenged decision–here, that decision being rejection of the Plaintiff’s demand.”  The court held that under this standard, “[t]he merits of the underlying claim are relevant only for purposes of ascertaining whether the Board’s decision was so inexplicable that a court may reasonably infer that the directors must have been acting for a purpose unaligned with the best interest of the corporation.” (Internal quotations omitted).

Applying these rules, the court held that the “[t]he question is not whether the [b]oard’s conclusion was wrong; the question is whether the [b]oard intentionally acted in disregard of Mattel’s beset interests in deciding not to pursue the litigation the Plaintiff demanded.”  (Internal quotations omitted).  The Court held that the fact that the board’s justification for refusing the demand falls “within the bounds of reasonable judgment” was fatal to the Plaintiff’s claim.

Takeaway:  Andersen reflects the reality of demand/demand refusal practice under Chancery Court Rule 23.1 — namely, that making a pre-suit demand is almost always outcome determinative for a plaintiff, and not in a good way.  Not surprisingly, this is why plaintiffs are far more likely to allege demand futility.

Christine Chung
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