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Court Dismisses Derivative Action in Stockholder's Litigation Demand

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February 1, 2017
By: Lewis H. Lazarus
Delaware Business Court Insider

The Delaware courts have been critical of litigants who bring derivative claims without first seeking books and records. The absence of such records often makes it difficult to overcome the business judgment rule which prevents a stockholder from bringing derivative claims directly without first making a demand on the board of directors. Stockholders cannot so proceed unless they can show that a majority of directors at the time of the demand was not independent or disinterested or that the decision was not the result of a proper exercise of business judgment. The standard is even more difficult if a stockholder makes a demand which the board refuses and then seeks to proceed with litigation by claiming that the board wrongfully refused the demand. The Delaware Court of Chancery's recent decision in Andersen v. Mattel, C.A. No. 11816-VCMR (Jan. 19), illustrates the difficult burden a plaintiff bears in alleging wrongful refusal, particularly when he fails to use the tools at hand to obtain relevant books and records.

Background Facts

Mattel had an executive severance plan that entitled a participant to severance benefits for a "covered termination." That was defined to include a resignation for good reason or an involuntary termination without cause. The plan defined five circumstances that would constitute good reason. In January 2015, Mattel announced that its chairman and CEO, Bryan Stockton, had resigned as an officer and director. In April 2015, Mattel disclosed in its proxy statement that Stockton's "employment was terminated." He received $10 million under the severance plan. Mattel also disclosed that he would be paid $125,000 a month pursuant to a 12-month consulting agreement with Mattel.

The plaintiff reacted to the foregoing disclosures by writing the Mattel board to demand that it investigate violations of law in connection with Stockton's severance payment, initiate litigation against the officers and directors to recover damages for breaches of fiduciary duty, terminate the Stockton consulting agreement, and claw back any severance Stockton already received. The board responded through counsel denying any fiduciary breach and asserting that litigation would distract the board and senior management and adversely affect Mattel's business while management was navigating a turnaround. The plaintiff then asked for a list of documents reviewed, individuals interviewed, any written summaries of the interviews and any report the Board had produced. Counsel responded by indicating that it had interviewed 24 people, including all current members of the board, the relevant current and former officers, and the advisers who were involved in the underlying events and that it had reviewed approximately 12,400 documents. Mattel declined to produce the documents themselves or the report. The plaintiff then sued for breach of fiduciary duty in connection with the severance payments and consulting agreement and defendants moved to dismiss on the ground that the board's demand refusal was a proper exercise of business judgment.

Court Finds Plaintiff Fails to Plead Particularized Facts

The court affirmed that the issue in analyzing demand refusal is whether the refusal was based upon a good faith and reasonable investigation. The plaintiff must allege particularized facts that raise a reasonable doubt that the board's refusal was grossly negligent or that the board did not act in good faith. In rejecting plaintiff's assertion of wrongful refusal, the court noted that the board's counsel interviewed 24 people and reviewed 12,400 documents. The court recognized that Mattel did not produce the report reflecting the results of those interviews and the document review but faulted plaintiff for not making a Section 220 demand to obtain the report when Mattel refused to produce it. The court also rejected plaintiff's claim that the board acted unreasonably for not appointing a special committee because by making its demand on the board plaintiff conceded the board's independence at the time of the demand and there were no particularized facts that the board acted without independence from Stockton.

Court: Plaintiff Failed to Plead Facts Alleging Board Acted in Bad Faith

The court denied the plaintiff's bad faith claim that Mattel's disclosure that Stockton "resigned" without listing a good reason was inconsistent with its later statement that Stockton was "terminated." The court reviewed Delaware case law establishing that a forced resignation is an involuntary termination. The board's determination that Stockton's resignation qualified as a termination by Mattel without cause, said the court, was therefore not inexplicable and hence plaintiff had failed to plead the necessary scienter to demonstrate bad faith. The distraction the litigation would cause while Mattel sought to turn around its business also supported that the board acted in good faith.

Lessons Learned

A stockholder who makes a demand on a board to investigate and bring claims of breach of fiduciary duty against officers and directors must show gross negligence in the board's investigation or bad faith if the board refuses to comply with the demand. Where a board interviews all the relevant personnel and reviews 12,400 documents, a plaintiff will have a difficult time alleging that the board's investigation was unreasonable or that its refusal was wrongful. A plaintiff would be well-advised to seek through a demand under Section 220 any report that the board generates as part of its investigation. If it does not do so, it may not be able to claim that the board's refusal to produce the report evidences bad faith or an unreasonable investigation. The high standard to show wrongful refusal as applied by the Court of Chancery in Andersen reinforces that under Delaware law it is the board that is responsible for litigation brought on the company's behalf.

Delaware Business Court Insider | February 1, 2017

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