In Busch v. Richardson Electronics, Ltd.,[1] the Delaware Court of Chancery held that a board of director’s decision not to pursue litigation on behalf of the corporation did not require the heightened two-step demand futility analysis developed in Zapata v. Maldonado[2] because the board was not disqualified by lack of independence from making a valid business decision regarding the litigation. Although deference to the business judgment of an independent and disinterested board is not a controversial concept, the path to its decision in this case required the court to address the unique issue of whether a board’s alleged pre-litigation deception of a stockholder should trigger a Zapata-like analysis of the board’s post-litigation decision-making. The court affirmed that Zapata applies only in the limited circumstance where a disqualified board uses an independent committee to cleanse the board’s decision to not pursue litigation, and refused to expand a Zapata-like analysis to alleged deceptive conduct affiliated with an independent board.
Principles of Corporate Governance
A fundamental tenet of the Delaware General Corporation Law is that directors, not the stockholders, manage the business and affairs of the corporation. Encompassed within this managerial oversight is the responsibility to bring or to refrain from bringing litigation on behalf of the corporation. A stockholder may, however, make a demand upon the board of directors to pursue litigation on behalf of the corporation. In that instance, the stockholder is deemed to have conceded the independence of a majority of the board to properly consider the demand. If the board refuses to pursue the litigation following a demand, the stockholder may only challenge the good faith and reasonableness of the board’s refusal.
Alternatively, a stockholder may file a derivative lawsuit; but within the complaint must plead particularized facts demonstrating that demand upon the board would have been futile. In this regard, the stockholder must overcome the presumption of director independence and disinterestedness by creating a reasonable doubt that the director’s conduct was a valid exercise of business judgment. That is, the stockholder must raise a reasonable doubt as to whether the board acted in good faith consistent with its duties of loyalty and care, on an informed basis, and free from conflict of interest; or rather, was disqualified because of gross negligence or lack of independence. Where a derivative complaint adequately supports demand futility based on lack of independence or a conflict of interest, the board may appoint a special litigation committee to evaluate whether to maintain the litigation on behalf of the corporation. In Zapata, the Delaware Supreme Court established a two-part test for evaluating a special litigation committee’s decision to dismiss a derivative complaint — requiring the trial court to (1) inquire into the independence and good faith of the committee and (2) apply its own business judgment to determine if dismissal is appropriate.
How the Corporate Governance Principles Applied in Busch
These principles came to a crossroads in Busch, where the stockholder obtained books and records from the corporation to evaluate its repurchase of stock from the CEO and a charity that he controlled. As part of the books and records exchange, the board indicated to the stockholder that it had no role in the stock repurchase decision. Thinking the board had no role, and hence was not disqualified, the stockholder initially made a demand on the board asking that it take action to unwind the repurchase, and file litigation if necessary. In response to the demand, the five-member board appointed a committee of three independent directors to investigate the stockholder’s claim and the propriety of pursuing litigation in relation thereto. The special committee retained independent counsel, who engaged in a robust investigation culminating in a substantial report. The report expressed concern over how the transaction was disclosed, but concluded there was no basis to pursue an action against any director or officer. The board adopted the special committee’s conclusions, and informed the stockholder that no further action would be pursued.
The stockholder obtained additional books and records from the corporation regarding the special committee’s investigation. Through that exchange of information, the stockholder determined that the board’s representation of no involvement in the stock repurchase was inaccurate. The stockholder filed a derivative complaint alleging breach of the fiduciary duty of loyalty by the board for failing to properly disclose the stock repurchase and refusal to take action to recover damages from the CEO once the board determined the transaction process was flawed. The stockholder argued that his original demand should not be a concession of the board’s independence because he was tricked into making the demand by the board’s duplicity. As such, the stockholder sought application of a Zapata-like test to the board’s decision to adopt the special committee’s recommendation.
First, the court addressed the sufficiency of the stockholder’s complaint under the normal demand-refusal framework, and determined that the complaint lacked particularized facts to demonstrate the board’s refusal was in bad faith. Second, the court concluded that even if the demand was to be ignored, that would not result in application of a Zapata-like analysis. Rather, the court deemed it logical to simply revert to the normal demand-futility framework if a demand was to be ignored, and determined that the complaint lacked sufficient particularized facts to overcome the presumption of the board’s independence and disinterestedness. The complaint was accordingly dismissed.
Key Takeaways
The court emphasized that the heightened analysis developed by Zapata applies only where a disqualified board (i.e. a board that is not disinterested or has a conflict of interest) uses an independent committee to cleanse the board’s decision to not pursue litigation. A stockholder is not entitled to such heightened analysis of alleged misconduct by an independent board. Rather, the court will address consideration of such claims within the established demand-refusal or demand-futility frameworks. This decision further reinforces that a properly formulated and operated special committee can be a powerful tool for a board, regardless of disqualification, to preserve its control over corporate litigation.
[1] C.A. No. 2017-0868-AGB (Del. Ch. Nov. 14, 2018).
[2] 430 A.2d 779 (Del. 1981).
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