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Derivative Settlement With Benefit Personal to Plaintiff Rejected

February 10, 2016
Lewis H. Lazarus
Delaware Business Court Insider

In 1850, Abraham Lincoln prepared notes for a law lecture. He emphasized the importance of compromise because after litigation, "the nominal winner is often a real loser—in fees, expenses, and waste of time." Delaware law also favors the compromise and settlement of disputes, and that policy preference extends to class and derivative litigation. Settlements must be fair, however, and the courts in representative litigation have a special role to play in reviewing the give and the get to prevent abuse. In recent days, for example, practitioners have received clear guidance that a peppercorn of modest disclosure may not support a class settlement that includes a full release and dismissal of all breach of fiduciary duty claims. Similarly, as the recent case of Smollar v. Potarazu, C.A. No. 10287-VCN (Jan. 14, 2016), illustrates, even where a derivative settlement reflects real value to a Delaware entity, the Court of Chancery rarely will approve a settlement where an individual representative plaintiff receives a benefit personal to her that is not shared with the class she represents as that fact alone calls into question the fairness and reasonableness of the settlement.

Background Facts

Plaintiff Marvin Smollar brought a derivative complaint seeking to remedy what the court characterized as "a series of fundamental failures in corporate governance." Following difficult litigation, Smollar achieved most of what he sought in a settlement: a stockholder's meeting, two independent board members, a special review committee, and the company's hiring of an independent auditor. Had Smollar simply requested an award of attorney fees for his efforts, the court likely would have approved the settlement. However, the settlement agreement also required the company to buy back his stock, and only his stock, for the same price he had originally purchased it 15 years ago for a total of $473,153.64. Several stockholders objected on the ground that Smollar was purporting to receive a benefit personal to him while serving as a fiduciary for the company and its remaining stockholders.

Court Rejects Settlement

Smollar raised several points to justify his separate benefit: the company's stockholders generally supported the settlement even with his buyback; he received merely a return of his original investment after 15 years; the bulk of the settlement benefits were achieved before the negotiation of his personal buyback; the special review committee recommended the settlement with the buyback; and the company indicated that Smollar's investment was actually worth more than the company was paying. The court subjected these arguments to close scrutiny "because an award of enhanced benefits to the class representatives raises a concern that the representatives have breached their duty of loyalty owed to the class." Applying that standard, the court rejected the settlement for three fundamental reasons. First, Smollar made no showing that the purchase of Smollar's stock alone conferred a corporate benefit. Second, the court had no reliable evidence that the price at which the company was re-purchasing his shares was fair and the company's assertion that the value of Smollar's shares was greater than it was paying was self-serving. Third, and most important, even if this aspect of the settlement was negotiated after all the other terms, the special benefit for Smollar "fully undercuts any appearance that the settlement is fair and reasonable to the other stockholders who apparently remain locked into their equity positions with no certain or even probable exit strategy." In short, the benefits that Smollar achieved in the settlement were outweighed by the concerns raised by his also obtaining a personal benefit unavailable to the other shareholders.

Lessons Learned

While Delaware courts recognize the important public policy favoring compromise and settlement of disputes, they also recognize their special responsibility to guard against abuse when asked to approve settlements of class and derivative litigation. The duty of loyalty that a representative plaintiff owes absent class members is real and obtaining a personal benefit unavailable to the remaining class members will not pass muster without persuasive justification. Lincoln no doubt would approve as class and derivative actions (and their resolution by settlement) would not long survive were it perceived that courts were permitting representative plaintiffs to obtain a personal benefit not shared with those to whom they owe a duty of loyalty.

Delaware Business Court Insider  |  February 10, 2016