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Court of Chancery Dismisses Derivative Action for Failure to Plead Demand Futility

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A cardinal principle of Delaware law is that directors manage the business and affairs of a Delaware corporation. This includes decisions regarding whether to pursue claims against officers and directors whose breach of duty may have injured the company.

November 22, 2017
By: Lewis H. Lazarus
Delaware Business Court Insider

A cardinal principle of Delaware law is that directors manage the business and affairs of a Delaware corporation. This includes decisions regarding whether to pursue claims against officers and directors whose breach of duty may have injured the company. A stockholder who believes that the board is not pursuing claims of wrongdoing that harmed the company must first demand that the board investigate or pursue those claims so that the board has an opportunity to exhaust intra-corporate remedies.

It is only if the stockholder believes that demand would be futile that the stockholder can skip that step and file a derivative claim on behalf of the corporation. In that circumstance the stockholder must plead adequately why demand would have been futile or have the action dismissed for failure to do so. Lenois v. Lukman, C. A. No. 11963-VCMR (Del. Ch. Nov. 7) is the most recent guidance from the court on the topic of demand futility and the case illustrates, among other things, that the mere fact that one officer or director may have acted in bad faith does not suffice to excuse demand if the plaintiff is unable to plead particularized facts demonstrating that a majority of the board could not act impartially upon a stockholder demand. Where a company has an exculpatory provision in its charter under Section 102(b)(7) that means a plaintiff must plead facts showing that a majority of the board faces a risk of liability for claims not otherwise exculpated, i.e., claims for violation of the duty of loyalty or for not acting in good faith.


Lenois involved a Delaware corporation, Erin Energy Corp. (Erin or the company), whose principal business was oil and gas exploration in sub-Saharan Africa. Defendant Lawal and an entity controlled by his family, CEHL, owned 58.86 percent of the company’s shares. CEHL also had a wholly-owned a subsidiary, AlliedEnergy Plc (Allied), whose assets included certain oil mining leases off the coast of Nigeria. In June of 2013, Lawal negotiated a transaction in which a third-party, Public Investment Corporation Limited (PIC), would invest $300 million in Erin for a 30 percent interest in the company, and Erin would transfer those funds along with additional Erin stock to Allied in exchange for Allied’s oil mining lease interests. On June 14, 2013, Allied and PIC presented these proposed transactions to Erin’s board, which had not authorized and was not previously aware of the proposed transactions. The board formed a special committee consisting of three directors, and the special committee hired independent counsel and a financial advisor. Over several months the special committee and its legal and financial advisors negotiated on behalf of Erin and ultimately recommended a transaction whose terms were that PIC would invest $270 million in Erin to acquire 376,885,422 shares of Erin common  stock; $170 million in cash would go to Allied; Erin would provide a $50 million convertible subordinated note to Allied with a five-year term, interest at LIBOR+5 percent, and a conversion price equal to PIC’s investment price per share; issuance of 497,454, 857 shares of Erin stock so that Erin and CEHL would own 56.97% and the remaining stockholders would own 13.03 percent; a stock dividend of 255,077,157 shares of Erin stock to existing stockholders prior to the new issuances to achieve post-closing ownership of 30 percent for PIC, 56.97 percent for Allied/CEHL, and 13.03 percent for the other stockholders; Allied funding certain drilling costs, with Erin bearing the costs of completion; and the company making two $25 million payments contingent upon certain milestones favorable to Erin regarding development and production for certain other oil mining leases (the transactions). The special committee received a fairness opinion and recommended the transactions to the board which in turn approved and recommended the transactions to the stockholders. Following distribution of a proxy, the stockholders voted to approve the proposals, with approximately 64 percent of the total outstanding minority stockholders and 99.5 percent of the voted shares cast in approval. Thereafter a third party disclosed that Allied had only paid $100 million of the $250 million consideration to acquire the oil mining leases that were the subject of the transactions. The plaintiff sued derivatively claiming breaches of fiduciary duty in connection with the approval of allegedly unfair transactions and also complaining of certain disclosure violations. At issue before the court was a motion to dismiss plaintiff’s derivative complaint for plaintiff’s failure to make demand upon the board or to plead why demand would have been futile as well as to dismiss the disclosure claim for failure to state a claim under Court of Chancery Rule 12(b)(6).

Court Finds That Plaintiff Failed Adequately to Plead that Demand Would Have Been Futile and Dismisses the Complaint

Following a detailed review of the case law, the court held that “where an exculpatory charter provision exists, demand is excused as futile under the second prong of Aronsonwith a showing that a majority of the board faces a substantial likelihood of liability for non-exculpated claims.” Applying that standard, the court acknowledged that plaintiff had pleaded a claim of bad faith action by Lawal for simultaneously acting for all three parties to the transaction and knowingly creating an informational vacuum that prevented the director defendants from having all material information about the transactions, including how and why the parties involved were chosen, whose interests Lawal represented, and the incomplete payment by Allied for the acquisition of the oil field leases. Nonetheless, the court found that based on the complaint’s allegations, the board formed a special committee which pushed back against Lawal, hired independent legal and financial advisors, negotiated substantially more favorable terms for Erin, obtained a fairness opinion, and negotiated for a majority of the minority approval condition.  In short, the conduct of a majority of the board did not reflect bad faith and accordingly a majority of the board did not face a substantial likelihood of liability for nonexculpated claims. Regarding the subsequent disclosure by a third party that Allied only paid $100 million in its initial acquisition of the oil field leases, the court agreed that the only two inferences were that the special committee did not know that Lawal/Allied had paid $100 million of the $250 million agreed price for these assets or the special committee did know and intentionally misled the stockholders. The court held that plaintiff had failed to plead sufficient facts to enable the court to accept the second scenario versus the first. Since the first scenario reflected only a duty of care violation, the court was “forced to conclude that plaintiff has failed to plead nonexculpated claims against a majority of the Erin board. “

Lessons Learned

Lenois illustrates that directors of a Delaware corporation who act in good faith and are able to document their actions in the very materials upon which a plaintiff relies for its pleading will not be made to defend their conduct in costly and time-consuming derivative litigation unless the plaintiff can plead that a majority of the board is disabled from impartially considering a demand.

Where plaintiff does not attack the disinterestedness or independence of a majority of the board, plaintiff must show that a majority of the board faced a substantial risk of personal liability for nonexculpated claims to raise a reasonable doubt that a challenged transaction was not the product of a valid exercise of business judgment. Lenois demonstrates the importance for practitioners advising boards to ensure that the company’s charter includes an exculpatory provision under Section 102(b)(7). In that circumstance, even with a disturbing fact pattern created by one interested director as to whom the plaintiff can plead bad faith conduct, plaintiff must be able to show similar misconduct by a majority of the board.

Failure to do so means that the plaintiff has failed to plead that a majority of the board could not impartially consider a demand since the exculpation provision precludes the board majority’s exposure to a claim for monetary damages and hence that its complaint must be dismissed for failure to plead that demand would have been futile. The case is a reminder to directors that even if a controller acts improperly to propose a transaction, how the board reacts to that proposal can not only prevent a company from entering into an unfair transaction in the first instance but also affect whether a plaintiff thereafter can succeed in derivative litigation challenging the fairness of the transaction the board ultimately approves.

Delaware Business Court Insider  l  November 22, 2017

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