March 18, 2022

The Corporate Guide: Rule 23.1 and Dealing With Stockholders Demanding Derivative Action

What should our board do first when served with a stockholder demand under Rule 23.1?

  • Directors must determine the legal, financial and factual issues relevant to the board’s response. 
  • Determine whether the directors are adequately informed of those issues. 
    • Review meeting minutes, board presentations and other board materials to see if they contain sufficient information regarding the subject of the demand to respond to it. 
  • If the board lacks sufficient information to respond to the demand, directors must conduct a reasonable investigation, in good faith, to become familiar with and better understand the facts relating to the alleged wrongdoing.

What should my board keep in mind when investigating demand? 

  • When the circumstances of a stockholder’s demand under Rule 23.1 require inquiry, it is typical for the board to form a demand review committee to investigate and make recommendations to the full board regarding how to respond. 
  • A demand on the board is a tacit admission that a majority of the board is capable of impartially considering the demand. 
    • That said, the board must still be careful about who leads or participates in the investigation.
    • If there are seven board members, and just two are conflicted, but the corporation decides to form a demand review committee of three that includes the two conflicted directors, that committee’s review and conclusion likely will be suspect and ripe for scrutiny by the stockholder and likely the court. The standard of review for demand decisions is explained below. 
    • To avoid unnecessary scrutiny the board should identify only directors whose independence, disinterestedness and good faith cannot be questioned. For instance, directors who joined the board after the questioned conduct.
  • In connection with independent counsel (and other advisors, if necessary), the demand review committee typically will draft a charter that details the committee’s objective and gives it sufficient authority and resources to launch a truly independent investigation into the facts and circumstances underlying the demand.
    • The demand review committee should have the power to hire its own advisors, paid for by the corporation, and should have free access to company records, employees and resources. 
    • To cut off any attempt by stockholders to question the recommendation of the demand review committee, the charter should identify the members of the committee and the reason each was included.

What do I need to know about dealing with challenges to the board or demand committee’s investigation? 

  • A demand review committee has broad latitude to structure its investigation in a manner it thinks is appropriate. 
    • There is no set procedure — the demand review committee can choose who and how many people to interview, as well as the documents relevant or necessary to the investigation. 
    • Delaware courts have found an investigation to be sufficient when just two witnesses were interviewed, and the same courts have rejected a stockholder’s contention that an investigation was deficient because certain witnesses, who were not known to have unique knowledge or perspective, were not interviewed. 
    • The effort expended and resources called upon by the committee should be proportional to the issues at stake in the demand. Using minimal time and resources for a serious matter will call into question the committee’s independence.  

Tip: Communicate with the stockholder that issued the demand in an effort to minimize attacks on the adequacy of the investigation. Consider interviewing witnesses and reviewing materials recommended by that stockholder.

What happens once the board decides that it is sufficiently informed? 

  • Once it is adequately informed, the board’s role is to weigh its options for addressing the conduct referenced in the demand. Some common examples include: 
    • Do nothing because the facts underlying the demand are inaccurate or easily disprovable; or the stockholders’ claims have obvious legal inadequacies like statute of limitations or standing concerns.
    • Take internal corrective action, for example, revising applicable corporate policies and procedures, terminating or transferring employees, or amending corporate governance documents.
    • File litigation, and in doing so, think like a plaintiff in assessing the value of the harm and the company, the merits of anticipated claims and their defenses, and whether a judgment can or will be collected. 
  • If the board employs a demand review committee, the committee’s recommendation should be followed, unless there are obvious legal or factual reasons not to do so — i.e. mistake of fact or law, or an undisclosed conflict. 
  • The board should communicate its decision to the stockholder, along with the bases for its decision.

What do I need to know about dealing with challenges to the demand review committee’s recommendation? 

  • When demand on a board has been made and refused, courts apply the business judgment rule in reviewing that decision-making process. 
  • The burden is on the party challenging the demand refusal to rebut the presumption that the decision was the valid exercise of the board’s business judgment. 
    • To effectively overcome the business judgment presumption, a plaintiff must allege particularized facts that raise a reasonable doubt that: 
      • The board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; OR
      • The board acted in good faith, consistent with its duty of loyalty.
    • The plaintiff also must undermine the board’s business judgment concerning the cost and distraction of litigation and the effects litigation could have on the company’s business and operations.

When is a special litigation committee appropriate and what should the board consider when utilizing one? 

  • A special litigation committee typically is deployed after a stockholder has established demand futility, either by order of the court following a motion to dismiss or by the corporation’s admission. 
    • The concept of a special litigation committee emanates from the corporate law concept that directors, rather than shareholders, manage the business and affairs of the corporation. It exists to transition control over the derivative litigation away from the stockholder plaintiff.
  • Like the demand review committee, the special litigation committee must be comprised of only disinterested and independent directors. 
    • It cannot include officers or other nondirectors.
    • A one-member special litigation committee is permissible, but highly scrutinized.
  • The charter for the special litigation committee should authorize the committee to review the circumstances alleged by the stockholder, and ultimately decide how to proceed, without interference from other board members. 
    • Unlike the demand review committee, its role is not to simply make a recommendation.
    • Again, similar to the demand review committee, there is no set procedure a special litigation committee must take in evaluating how to proceed. 
    • The effort expended and resources called upon by the committee should be proportional to the issues at stake in the demand.
  • If the special litigation committee decides not to pursue the derivative lawsuit, the corporation must file a hybrid motion that combines a Rule 41(a)(2) motion to dismiss with a motion for summary judgment. 
    • Merits discovery will be stayed during the special litigation committee’s deliberation process. 
    • As part the motion, however, there likely will be targeted discovery into matters of independence, whether the investigation was conducted in good faith and whether the special litigation committee had a reasonable basis for its conclusion.
  • A special litigation committee that wishes to terminate derivative litigation must establish: 
    • The independence, good faith, and reasonableness of its investigation. 
    • That termination is in the corporation’s best interests, in the court’s judgment. 
      • This standard is more rigorous than the business-judgment rule standard applicable to demand review committees. 
      • The corporation must demonstrate that there are no material issues of fact and that it is entitled to relief.

Tip: If the special litigation committee (or demand review committee) retains independent counsel, the board should be cautious regarding communications with those lawyers or firm because they do not represent the corporation separately. The disclosure of committee reports or legal advice to others in the corporation beyond the members of the special litigation committee can result in a waiver of the attorney-client privilege.

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