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Derivative Claims Dismissed for Failure to Plead Sufficient Facts

December 10, 2014
Lewis H. Lazarus
Delaware Business Court Insider

Claims for breach of fiduciary duty against directors for injury to a Delaware corporation caused by director misconduct are assets of the corporation. In deference to the director-centric model of corporate decision-making embodied in Delaware law, a stockholder may not obtain control over that corporate asset without first making a demand on the board to bring an action or pleading that demand is excused. When a stockholder plaintiff believes that demand is excused but fails first under Section 220 of the Delaware General Corporation Law to seek books and records related to alleged misconduct in a transaction, that plaintiff will need to allege with particularity, and without discovery or pertinent books and records, either that a majority of the board was not disinterested or independent or that the decision to enter into the transaction was not otherwise the product of a valid exercise of business judgment. As the recent case of In re Sanchez Energy Derivative Litigation, Con. C. A. No. 9132-VCG (Del. Ch. Nov. 25, 2014), illustrates, conclusory allegations of personal or financial ties will not suffice to challenge the independence of a board majority and a plaintiff can rarely plead that a transaction was so egregious that no rational board could have approved it, resulting, as occurred in Sanchez, in dismissal of plaintiff's derivative claims.


At issue in Sanchez was a related-party transaction where Sanchez Energy Corp. allegedly overpaid to acquire an undivided one-half working interest in 40,000 acres in developed land and 40,000 acres of undeveloped land held by Sanchez Resources LLC in a Tuscaloosa Marine Shale project. A.R. Sanchez Jr. was a 16 percent stockholder and A.R. Sanchez III was a 5.5 percent stockholder of Sanchez Energy. Sanchez Resources was allegedly a privately held affiliate of Sanchez Energy that was managed by Sanchez Oil & Gas Corp., another Sanchez-family-controlled entity that provided services to all Sanchez-affiliated entities. The plaintiffs alleged that Sanchez Energy's $77 million payment valued the transaction at 17 times a comparable arm's-length transaction in August 2013. The plaintiffs alleged as well that Sanchez Energy paid $2,500 per acre for the same working interests that Sanchez Resources had purchased in 2010, prior to development, at $184 per acre.

The plaintiffs alleged that the transaction was approved by a three-person audit committee, each of whom the plaintiff conceded was disinterested. The plaintiffs alleged that two of the audit committee directors, Alan G. Jackson and Gilbert A. Garcia, lacked independence from Sanchez Jr. and Sanchez III. The plaintiffs also alleged that the transaction so egregiously favored Sanchez Resources that no rational director could have approved it. As explained below, the court found that the plaintiffs failed to plead facts sufficient to show that demand was excused.

Conclusory Allegations of Personal or Financial Ties Will Not Suffice

The plaintiffs alleged that audit committee member Jackson lacked independence because he had been a friend of Sanchez Jr. for more than five decades and that he was beholden to Sanchez Jr. for his professional career. The former allegation failed because "allegations of personal friendship that do not detail the extent of the friendship are insufficient to support a reasonable inference that a director lacked independence." Similarly, the plaintiffs alleged that Jackson's employment as an executive at an unrelated insurance company, IBC Insurance Agency Ltd., was material to him, that Sanchez Jr. was one of the nine directors of the parent company of Jackson's employee, International Bancshares Corp., and that Sanchez family members are the largest stockholders in International Bancshares. The court rejected this argument because "without specific allegations that Sanchez Jr. controlled IBC—or could have exercised any ability to retaliatorily remove Jackson from his executive position—Jackson's financial interest in continued employment with IBC cannot provide an adequate basis to infer that Jackson lacked independence from Sanchez Jr."

As to Garcia, the court also rejected the plaintiffs' claim that Garcia lacked independence based on alleged "ongoing and long-term" business relationships with the Sanchez family. This allegation was based on the Sanchez family's ownership of a minority stake in two companies in which Garcia owned a 39 percent and 48 percent interest. This allegation failed because the plaintiffs failed to allege "why Sanchez Jr.'s minority interest in two companies in which Garcia owns a large equity interest will cause Garcia to abandon his fiduciary duties to favor Sanchez Jr." Relying on the Delaware Supreme Court's decision in Beam v. Stewart, 845 A.2d 1040, 1050 (Del. 2004), the court held that allegations of "a mere outside business relationship, standing alone, are insufficient to raise a triable doubt about a director's independence."

Allegations of Substantial Ownership Bloc and Management Authority Are Insufficient

The plaintiffs' allegations here centered on Sanchez Jr. and Sanchez III's 21.6 percent ownership of Sanchez Energy and Sanchez III's service as president and CEO of Sanchez Energy. The court found that the plaintiffs failed to allege that "Sanchez III exercises greater control than that typical of a CEO, that he dominates or controls the board, or that he has even attempted to dominate the board through threats, bullying, or the like." More persuasive to the court was the plaintiffs' admission at oral argument that Sanchez Jr. and Sanchez III could not exert power to remove a dissenting director and that 80 percent of the voting control of Sanchez Energy was in the hands of independent stockholders. Because the court found that Sanchez Jr. and Sanchez III were not controlling stockholders and that a majority of disinterested and independent stockholders approved the transaction, the court rejected the plaintiffs' argument that entire fairness governed the court's review of the transaction.

Plaintiffs Failed to Allege Lack of Valid Exercise of Business Judgment

The court found insufficient the plaintiffs' allegations that Sanchez Energy paid 17 times the market price to acquire the working interests in Sanchez Resources, that the price substantially exceeded the market price of a comparable transaction, that defendants tried to hide an increased royalty payment to Sanchez Resources, and that the conflicted directors were motivated to buy out their partner in Sanchez Resources, and not by a legitimate business objective for Sanchez Energy. As to the first, the court found that by the time of the transaction, half the acreage had been developed and oil had been found, which would explain the alleged discrepancy in price. As to the second, the court found that the plaintiffs failed to allege "sufficient information about the nature, quality and duration" of the prior transaction to allow a meaningful comparison. The court found the other allegations lacked sufficient particularity to demonstrate a nefarious motive or the lack of a good-faith business objective.

Lessons Learned

A stockholder plaintiff seeking to wrest control of derivative claims from a board faces an uphill battle when the transaction at issue was approved by a majority of disinterested and independent directors. Conclusory allegations of business and financial ties will not suffice to challenge independence when the plaintiff fails to plead particularized facts as to why those ties are so material as to cause the director to be willing to risk his or her reputation rather than to risk a relationship with the interested party. Similarly, allegations of substantial stock ownership and day-to-day management authority will not suffice to demonstrate that interested directors were also controlling stockholders where the plaintiff fails to allege voting power sufficient to control the board. Finally, when allegations fail that a majority of the board lacked independence, a plaintiff will have a hard time pleading facts sufficient to show that a business decision was so unfair that it could not have been the product of a valid exercise of business judgment. Perhaps the most important lesson is that a plaintiff's pleading burden is even harder when he or she fails to use the tools at hand to obtain the books and records that may allow the stockholder to plead facts necessary to excuse demand.

Delaware Business Court Insider  |  December 10, 2014