Rule 23.1: Take it to the Board or the Court, Not Both

Kevin Packer

In its recent decision in Zucker v. Hassell, the Court of Chancery addressed when a shareholder can have standing to pursue derivative actions in the demand refusal context. In Zucker the stockholder plaintiff argued that he had derivative standing, under Rule 23.1, because the board’s denial of his request that certain claims be pursued directly by the corporation was grossly negligent.  In Kops v. Hassell, a contemporaneously issued Letter Opinion dealing with the same facts as in Zucker, the court addressed two additional claims regarding the board’s alleged gross negligence along with a claim for violation of the fiduciary duty of loyalty.    

Stockholders can pursue claims for corporate misconduct in two ways.  They may demand that the board of the corporation act directly in pursuing certain claims or bring a derivative action on behalf of the corporation.  If stockholders take the latter option, they must show that the first option, demand on the board, would have been futile.  A demand is futile when the “board would have been unable to exercise its business judgment on behalf of the corporation to evaluate the demand.”  In considering demand futility, the court balances the various interests implicated by allowing the stockholder to pursue derivative claims on behalf of the corporation.

However, if stockholders first make a demand upon the board, and the board in turn refuses to act, the stockholders’ burden to secure derivative standing is greater.  By making the demand stockholders “impliedly conceded that a majority of the directors are disinterested and independent, and that the board could have brought its business judgment to bear on the issue.”  Rule 23.1 requires that for stockholders to overcome this burden, they must plead facts sufficient to raise a reasonable doubt that in declining to pursue claims directly, the board either violated its duty of loyalty by acting in bad faith, or violated its duty of care by acting with gross negligence.

The circumstances surrounding both Zucker and Kops arise from The Bank of New York Mellon Corporation’s (“BNYM”) foreign currency exchange practices.  BNYM claimed that its Standing Instruction service for non-negotiated foreign currency exchanges followed “best execution standards.”  “However, contrary to representations by clients that BNYM offered ‘best rates,’ [BNYM] gave [Standing Instruction] clients prices that were at or near the worst interbank rates during the trading day or session.”  The issue resulted in numerous lawsuits against BNYM and, in March 2015, settlements in the amount of $714 million with the Department of Justice (“DOJ”) and the New York Attorney General’s office.

In Zucker, Plaintiff’s standing claims arose out of a litigation demand made on March 9, 2011 to BNYM’s board of directors requesting investigation of an alleged breach of fiduciary duty.  On April 6, 2011, Plaintiff was informed that the board created a special investigation committee (the “Special Committee”) and hired Cravath, Swain, and Moore LLP (“Cravath”) to assist in the investigation.  On December 14, 2011, Plaintiff received a refusal letter in which “[t]he Special Committee concluded that based on its investigation and deliberations, there was ‘no sound legal basis to assert claims’ and that in any event, ‘such litigation would not be in the best interests of [BNYM].”  The letter indicated that in investigating Plaintiff’s claims Cravath reviewed 10,000 internal documents involving the foreign exchange practices, conducted thirteen interviews of BNYM directors and (current and former) officers, communicated with the Special Committee on multiple occasions and through multiple means, conducted in-person meetings with the Special Committee on October 31, 2011 and December 5, 2011, and assisted the Special Committee in presenting the investigation to the board of directors on December 13, 2011. 

In Zucker, Plaintiff pursue two arguments. “Plaintiff’s primary argument is a species of res ipsa loquitor; because, years after the demand was refused, wrongdoing and liability were admitted by BNYM in connection with a settlement, the investigation by the Board and Special Committee —which failed to turn up wrongdoing—must have been negligent. Plaintiff also argued that the “particulars of the Cravath investigation and the Special [Committee’s]” determination not to pursue certain claims were grossly negligent.

The court determined that Plaintiff’s res ipsa argument was a “non-sequitur” and failed to meet the pleadings standard, whereby “a board’s decision to refuse a plaintiff’s demand is afforded the protection of the business judgment rule unless the plaintiff alleged sufficient facts that raise a reasonable doubt as to whether the board’s decision to refuse the demand was the produce of a valid business judgment.”  The court reiterated that “the decision of an independent committee to refuse a demand should only be set aside if particularized facts are pled to support an inference that the committee, despite being comprised solely of independent directors, breached its duty of loyalty, or breached its duty of care, in the sense of having committed gross negligence.”

Here, the court held that because the Special Committee took sufficient steps to inform itself of any wrongdoing related to its non-negotiated foreign currency exchange practices, it was not grossly negligent in refusing Plaintiff’s demand.  The court recounted Cravath’s investigative efforts and the Special Committee’s diligence in communicating with Cravath regarding the investigation, ultimately holding that the “steps . . . taken by the Special Committee are not consistent with a conclusion that the Special Committee failed to inform itself, or that the investigation was inadequate in scope.”  Plaintiff also argued that “the sampling of documents reviewed by the Special Committee evinces gross negligence.” Plaintiff contended that the Special Committee was grossly negligent because it only reviewed 28 documents and became aware of “damning” information in at least one of the documents it reviewed.  Plaintiff also suggested that evidence produced by Cravath’s investigation and presented to the the Special Committee does not support the Special Committee’s conclusion that “assuming actionable wrongdoing, it was nonetheless not in the Company’s interests to pursue and action.”

The Court found that the special committee through delegating the investigation to Cravath took proper steps to evaluate the documentation relating to the demand, that one “damning” document, although troubling, does not speak to the investigation as a whole, and the redactions should have been handled at an earlier hearing and the Court will not assume, in lieu of well-pleaded facts, that it shows the board did not adopt the special committee and Cravath’s recommendation.  Additionally, the Court held corporations have no duty to revisit past demand refusals following changes to the situation, but the stockholder may re-demand investigation to the board (which was not done by Plaintiff here).  The court ultimately held that “even with all reasonable inferences in Plaintiff’s favor” Plaintiff failed to meet the Rule 23.1 pleading burden, and thus, dismissed Plaintiff’s claims.

In Kops, the Court addressed two separate issues stemming from the same facts as in Zucker: whether a New York Times advertisement by BNYM constituted implied demand refusal and whether the board’s relied entirely on the Zucker investigation in 2011, in addressing Kops’s litigation demand over a year later, on May 24, 2012.  First, the court found that BNYM’s New York Times advertisement proclaiming innocence falls short of implied refusal of demand unless a plaintiff could show the board or special committee was “involved in drafting, preparing, or authorizing such an advertisement.”  Here, Plaintiff did not.

Second, the court reviewed the actions of the special committee between the demand refusal in Zucker and subsequent demand refusal here in Kops. Because the court found in Zucker that “the Board acted within its fiduciary duties when it rejected the Zucker demand[,]” the court’s consideration of the refusal in Kops “turn[ed] on whether intervening developments following the Zucker refusal, and the corresponding actions by the Special Committee, raise a reasonable doubt as to the Board’s compliance with its fiduciary duties in rejecting the Kops demand.”  The court found, however, that, in meetings with Cravath, the Special “Committee discusses ‘whether any developments subsequent to [the Zucker] investigation might affect the validity of the Committee’s prior conclusions.”

The court ultimately dismissed the complaint, finding that Plaintiff failed to meet her burden under Rule 23.1.  In both Zucker and Kops, the court reinforced the heightened burden placed on a stockholder following demand refusal. A stockholder taking demands to the board furthers the goal of efficiency and to achieve the “salutary results of director control” hoped to be established by Rule 23.1.  The issue to overcome the pleadings stage if stockholder’s demand to the board is denied, is incredibly high. Unless there is blatant mishandling of the demand to the board, the plaintiff is in a position where they may feel they have just chosen the wrong alternative.  This realization defeats the purpose of demanding the board to rectify issues and makes the path of demand futility a more attractive option to stockholders.  At this time, the Court’s decisions may deter stockholders from seeking board approval and in substitution try their hand with the Court’s and argue demand futility as a more viable option, and therefore leaves the process in contradiction with the purpose of Rule 23.1.  At this point, there is no real showing of what steps by corporations will not qualify as enough to be above grossly negligent or taken bad faith to at least overcome the pleadings stage.

Kevin is a second year student at Widener University Delaware Law School and a Staff Member on the Delaware Journal of Corporate Law

Suggested Citation: Kevin Packer, Rule 23.1: Take it to the Board or the Court, Not Both, Del. J. Corp. L (Feb. 28, 2017), www.djcl.org/blog. 

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