Delaware Business Litigation Report

Failure to Plead Demand Futility Risks Losing Attorney Fees

Authored by Lewis H. Lazarus
This article was originally published in the Delaware Business Court Insider | April 11, 2012

When a defendant engages in arguably unlawful conduct, a plaintiff files an action to complain about and seek relief prohibiting the unlawful conduct, and the defendant thereafter changes its practices and moots the plaintiff's complaint, a plaintiff may be entitled to attorney fees based upon the benefit conferred. Absent such a rule, a plaintiffs counsel could undertake a contingent-fee case, incur fees to investigate and file the action and then wind up with no case and no compensation, even though the defendant had changed its practices in a manner consistent with the plaintiff's demand.

Even under this scenario, however, Delaware law requires that the action was meritorious when filed. For a derivative claim where a plaintiff does not make a demand upon the board, a complaint is not meritorious when filed if it is subject to dismissal because the plaintiff fails to plead the facts with sufficient particularity to demonstrate that demand was excused. As the plaintiff in Freedman v. Adams, C.A. No. 4199-VCN (Del. Ch.) learned in the March 30 opinion of Vice Chancellor John W. Noble, a plaintiff is not entitled to a fee if he or she fails in his or her derivative complaint to plead facts demonstrating compliance with Rule 23.1 of the Court of Chancery Rules, even if post-filing the defendant board members cause the corporation to alter its conduct in the manner sought in the complaint.

FACTUAL ALLEGATIONS OF FREEDMAN COMPLAINT

Plaintiff Susan Freedman complained in her Nov. 26, 2008, derivative action that the board of defendant XTO Energy Inc. breached fiduciary duties by paying cash bonuses to five executives in a manner that prevented the corporation from realizing a tax deduction for the payments, according to the opinion. The federal tax code permits cash bonuses to be deductible if they are performance-based and thus contingent upon the executive achieving performance goals that meet statutory requirements. The plaintiff pleaded that because the cash bonus payments did not comply with the applicable federal statute that allows for a company tax deduction, the corporation forwent approximately $75 million in tax deductions from 2005 to 2007, according to the opinion. Freedman sought an accounting for the losses sustained, a mandatory injunction requiring the board to formulate a tax-deductible bonus plan, an injunction against the payment of further non-tax-deductible compensation, and an award of attorney fees and expenses.

Approximately 10 weeks after the filing of the complaint, the defendant board adopted a cash-bonus plan that complied with the federal requirements for tax deductibility and submitted it to the stockholders for approval. On May 19, 2009, the stockholders approved the plan, according to the opinion. In early 2010, Freedman sold her shares and thereafter XTO merged with and into a subsidiary of Exxon-Mobil. On April 6, 2011, the parties stipulated to a dismissal of the action and thereafter the plaintiffs sought attorney fees of $1 million based on the benefit conferred of the corporation adopting a cash-bonus plan that permitted bonus payments to be tax-deductible.

COURT REJECTS PLAINTIFF'S ARGUMENTS

Freedman made three arguments as to why a majority of the nine-person board was either interested or not independent: First, that the five outside directors' compensation materially exceeds what is a usual and customary director's fee; second, that the outside directors received unusually large compensation as a quid pro quo for not implementing a tax-deductible cash bonus plan; and third, that the outside directors were actually employees controlled by the interested directors. The court rejected each of these arguments because the plaintiff failed to plead particularized facts to support her arguments. This failure is an abject lesson in the heightened pleading requirements of Court of Chancery Rule 23.1.

Among other lessons, the court's decision indicates that more than just large numbers is required to cause the court to conclude that a plaintiff has adequately pled a material conflict. Thus, outside director compensation of $678,555 to $792,198 in 2007, up from $459,676 to $516,860 in 2006, by itself did not suffice to show that the compensation exceeded what was usual and customary. Of particular significance was that XTO was a relatively large public company that had outperformed its peers in the S&P 500 Index and the Dow Jones U.S. Exploration and Production Index. Practitioners should note that the result might differ for a small, private company that underperformed in the market.

The quid pro quo allegation failed as well for lack of particularized facts. While the court acknowledged that the amount of compensation was larger than in a similar case where the court found sufficient allegations of quid pro quo, the plaintiff presented "no factual allegations from which the court could reasonably infer that the increases in the outside directors' compensation were related to the board's decision to not adopt a [tax-deductible] plan." The most glaring omission was the lack of factual allegations relating to the timing of the votes to increase the outside directors' compensation or the timing of these votes related to the board's decision not to implement a tax-deductible cash bonus plan. The court would not infer a causal connection merely from the general allegation that board compensation had grown during the time period that the board failed to adopt a tax-deductible cash-bonus plan.

The plaintiff's last argument, that the outside directors were controlled by the officer directors, also failed for lack of sufficient well-pleaded factual allegations. The new fact the court considered was the plaintiff's allegation that the outside directors spent significant time on projects assigned to them by the officer directors or people working under them. The court stated that it was "loath to make a ruling under which a board member's somewhat more active engagement in the management of a corporation's affairs may be seen as casting a shadow over that director's presumed loyalty." The court found the allegation of work assignments to be too vague as the plaintiff failed to allege what particular types of assignments the outside directors performed. The lack of particularized allegations precluded the court from inferring that the officer directors controlled the outside directors, according to the opinion.

Most notable in the court's rejection of the plaintiff's argument that the failure to adopt a tax-deductible cash-bonus plan reflected a lack of valid exercise of business judgment was the rejection of a fiduciary duty to minimize taxes. The court's words succinctly speak for themselves:

"Tax strategy is a complex, dynamic area of corporate decision-making that affects and is affected by many other aspects of a company. A company's tax policy may be implicated in nearly every decision it makes, including decisions about its capital structure, the legal forms of the various entities that comprise the company, which jurisdictions to form these entities in, when to purchase capital goods, whether to rent or purchase real property, where to locate its operations, and so on. Minimizing taxes can also require large expenditures for legal and accounting services and may entail some level of legal risk. As such, decisions regarding a company's tax policy are not well-suited to after-the-fact review by courts and typify an area of corporate decision-making best left to management's business judgment, so long as it is exercised in an appropriate fashion. This court rejects the notion that there is a broadly applicable fiduciary duty to minimize taxes, and, therefore, the plaintiff's argument that the board failed to act despite a duty to minimize taxes is unavailing."

LESSONS LEARNED

This case illustrates the importance of pleading particularized facts sufficient to demonstrate that the business judgment rule does not protect a board's decision. In the derivative context, if a plaintiff cannot show that a majority of directors was not disinterested or independent or that the decision was a not a valid exercise of business judgment, and the plaintiff did not first make a demand, the complaint will be dismissed under Court of Chancery Rule 23.1.

In that circumstance, the complaint was not meritorious when filed. That means that a plaintiff cannot recover attorney fees even if, after his or her action is filed, the board takes action that moots his or her complaint. Freedman is thus instructive for both plaintiffs and defendants counsel as to a plaintiff's entitlement to attorney fees if a complaint is susceptible to dismissal for failure to plead demand futility and the defendants after its filing act to moot the claims on the merits.

Share