Delaware’s requirements for stockholders to maintain derivative actions reflect the twin principles of director management and control and accountability. Because directors manage the business and affairs of Delaware entities, they control decision-making about company assets, including legal claims, and thus stockholders wishing to assert claims belonging to the corporation must first make demand on the directors to do so or plead with particularity that demand would be futile. At the same time, directors’ fiduciary duties make them accountable to the stockholders and those stockholders may bring claims in the name of the company if a majority of directors is disabled from considering a demand due to self-interest or a lack of independence. Stockholders need not assert derivative claims based on demand futility in a factual vacuum; the Delaware Supreme Court encourages them to use the tools at hand, including requests for books and records under Section 220 of the Delaware General Corporation Law. Despite these general principles, each case turns on its particular facts and the resolution of motions to dismiss under Rule 23.1 for failure to plead demand futility provides important guidance to practitioners. The recent case of Teamsters Union 25 Health Services & Insurance Plan v. Baiera, C. A. No. 9503-CB, (Del. Ch. July 13, 2015) illustrates among other things the interplay between New York Stock Exchange Rules governing independence and Delaware common law and the Court’s focus in assessing demand futility on the independence of the directors as opposed to the applicable standard of review, and provides yet another reminder that plaintiffs are less likely to have their claims survive if they do not utilize the tools at hand.
Background to Transaction
The transaction at issue was an agreement between Orbitz Worldwide, Inc. (“Orbitz”) and entities affiliated with Travelport Limited (“Travelport”) entered into in February of 2014 (“2014 Agreement”). The 2014 Agreement replaced an earlier agreement regarding Orbitz’s online travel booking business that expired on December 31, 2014. The 2014 Agreement required Orbitz to use Travelport exclusively for all domestic air and car segments through 2014 as well as for certain overseas segments. Beginning January 1, 2015, Travelport’s arrangement with Orbitz for those segments was no longer exclusive but Orbitz was required to provide certain minimum volume levels and pay a shortfall fee in some cases if it failed to do so. Having a contractually guaranteed revenue stream was important to Travelport which anticipated its own IPO which it announced June 4, 2014. Its public disclosure touted the 2014 Agreement and emphasized that the Orbitz relationship was material to Travelport, accounting for 7% of its revenue.
Plaintiff Alleges Four Derivative Counts
Plaintiff in its operative complaint alleged that the Orbitz Audit Committee consisting of three independent directors approved the 2014 Agreement in February, 2014. It also alleged that at that time Travelport controlled 48% of the Orbitz voting common stock. It alleged that a majority of the Board was not independent and that the 2014 Agreement did not comply with market standards and unfairly favored Travelport at the expense of Orbitz. On these facts, Plaintiff alleged four derivative counts: that Travelport breached fiduciary duties as a controlling stockholder by causing Orbitz to enter into an unfair transaction that benefited Travelport; that the Orbitz Board breached fiduciary duties by not negotiating for fair terms in the 2014 Agreement; that the 2014 Agreement unjustly enriched Travelport; and that Travelport and one of its stockholders aided and abetted the breach by the Orbitz directors. As explained below, the Court dismissed these derivative claims because Plaintiff failed to plead particularized facts that a majority of the Orbitz Board was disabled from considering them and thus demand was not futile.
Court Finds Rales Test Governs Transactions Not Approved By a Majority of the Board
In dismissing Plaintiff’s derivative clams for failure to plead demand futility, the Court applied the standard set forth in Rales v. Blasband, 634 A.2d 927 (Del. 1993), rather than the standard in Aronson v. Lewis, 473 A.2d 805 (Del. 1984). The Rales standard applies when the challenged transaction is approved by less than half of the board who would have considered a demand at the time Plaintiff filed its action. In contrast, the Aronson standard applies when the challenged transaction is approved by more than half the directors who would have considered a demand. Here, the Court applied Rales because the well-pleaded allegations established that the challenged 2014 Agreement was only approved by three members of the Audit Committee, which was less than half of the nine-member board who would have considered a demand. In so holding, the Court pointed out that Plaintiff could have avoided speculating about whether in addition to the Audit Committee, the full board also approved the 2014 Agreement, had Plaintiff sought books and records before filing its complaint. The Court also noted his preference for a unified standard in assessing demand futility, and stated that he would have reached the same result had Aronson applied.
Court Rejects Prior Employment at Controlling Stockholder as Grounds to Find Disabling Lack of Independence
In dismissing Plaintiffs’ complaint that a majority of the nine-person board could not have considered impartially Plaintiffs’ derivative claims, the Court emphasized that since Plaintiff accepted the independence of four of the directors, the matter would turn on whether Plaintiff could show through particularized allegations that all five of the remaining directors were disabled. The Court focused its analysis on one director, Esterow, who Plaintiff alleged was legally disabled from impartially considering its claims because he had been employed at Travelport or its parent for 16 years until May, 2011. Plaintiff alleged that he was appointed three months later to the Orbitz board at the behest of Travelport. Moreover, in 2013, Orbitz in its public filings acknowledged that Esterow was not an independent director under the rules of the New York Stock Exchange. The Court found these allegations insufficient to excuse demand and his reasoning is instructive.
Relying on Chancellor Chandler’s decision in In Re Western National Corp. Shareholders Litigation, 2000 WL 710192 (Del. Ch. May 22, 2000) the Court found that Esterow’s prior tenure at Travelport or its parent did not disable him from considering Plaintiff’s claims. In Western National a similar allegation failed even though the director at issue had been employed by and a senior officer of a 46 % stockholder for over two decades. Well-settled law holds that mere nomination to a board by a controlling shareholder does not compromise a director’s independence. Moreover, the Court noted that the per se rule of the New York Stock Exchange that a director is not independent of a party with whom he was affiliated until three years after the affiliation ended do not require a finding of a lack of independence under Delaware law when almost three years later a Plaintiff asserts claims adverse to the former employer. Significant to the Court’s decision was that Esterow was employed in April, 2014 as the President, CEO and a director of Bankrate, Inc., an entity unaffiliated with either Orbitz or Travelport. On these facts and in reliance on Western National, the Court rejected Plaintiff’s challenge to Esterow’s independence and therefore found that Plaintiff had failed to allege that a majority of the Orbitz Board was disabled from considering a demand.
Court Lacks Information to Find Approval of 2014 Agreement Was Outside Bounds of Reasonable Judgment
Plaintiff’s second challenge was that two members of the Audit Committee who remained on the board at the time of the Complaint faced a substantial risk of personal liability because the terms of the 2014 Agreement were patently unfair to Orbitz and thus benefited Travelport. The Court rejected this allegation for lack of any facts sufficient to find that the board members on the Audit Committee who approved the deal did so in bad faith. Once again the Court chided Plaintiff for not first making a Section 220 demand from which it presumably would have learned the financial terms of the 2014 Agreement. The Court rejected as imprudent Plaintiff’s assertion that it should find bad faith based on the publicly-disclosed terms such as the minimum volume guarantee to Travelport and the five-year term because there was no information regarding the mutual exchange of value that comprised the deal. Similarly lacking was any “well-pled baseline from which I can make a “meaningful comparison” between the Agreement and other GDS services contracts in the travel industry, the financial terms of which Plaintiff also failed to allege in the Complaint.” Id. at 35. Lacking well-pled facts concerning the financial terms of the transaction the Court was unable to conclude that the decision of the Audit Committee members to approve the deal was so far beyond the bounds of reasonable judgment as to constitute bad faith.
Court Finds Director Independence Controls Its Determination of Demand Futility, Not the Standard of Review
Plaintiff’s third challenge was that because of the allegation that a controlling stockholder was on both sides of the transaction, entire fairness applied and this by itself was sufficient to excuse demand. The Court found that the Delaware Supreme Court had rejected the principle that the mere presence of a controlling stockholder or alleged self-dealing by a controlling stockholder sufficed to establish demand futility. The test instead is whether a majority of the board is incapable of considering a demand. Having already found that Plaintiff had failed to allege that a majority of the Board was disabled from considering Plaintiff’s claims, the Court held that the possible applicability of the entire fairness standard of review did not change the analysis.
The Baiera decision re-affirms that the applicable test to establish demand futility is whether a majority of the Board to whom a demand would have been made is able impartially to consider the claims at issue. In the absence of particularized facts that a majority of the board is disabled, a plaintiff who fails to make a demand on the board will have its claims dismissed for failure to comply with Rule 23. 1. That is the result even if the Court assumes that the entire fairness standard will apply based on the allegation that the transaction involves a controlling stockholder. A plaintiff who fails to seek books and records is at risk that they will not be able to plead enough information to enable the Court to infer that Board members are disabled because they face a substantial risk of personal liability for approving an allegedly unfair transaction. The Delaware courts are sensitive to the fact that derivative litigation imposes costs on a company and its shareholders and therefore, as here, do not permit derivative litigation to proceed on the basis of speculation or conclusory allegations.