Delaware’s demand futility analysis for derivative claims is designed to prevent stockholders from divesting the board of its control of an asset and enabling stockholders to pursue weak claims. To plead demand futility under Court of Chancery Rule 23.1, a plaintiff must allege with particularity that a majority of the board is interested or beholden to an interested person. A qualifying interest for purposes of pleading demand futility may be financial or a personal interest in the transaction, but a substantial risk of liability by a majority of the board in connection with the transaction is also sufficient to plead demand futility. However, if a plaintiff can only allege violations of the duty of care against a majority of the board, the Court of Chancery will dismiss the claim because exculpation under Section 102(b)(7) of the Delaware General Corporation Law (DGCL) will prevent that board majority from facing a substantial risk of personal liability. Pleading bad faith against a majority of the board, however, acts both to excuse demand and to eliminate a defense of exculpation. Of paramount importance to practitioners is what the court will require to allege a colorable claim of subjective bad faith. In IBEW Local Union 480 Defined Contribution Plan and Trust v. Winborne, C.A. No. 2022-0497-JTL (Del. Ch. August 24, 2023), the Court of Chancery provided guidance concerning the holistic inquiry that the court uses to assess good faith, holding that the plaintiff successfully had pleaded that a majority of the board acted in bad faith in approving a buyout of a liability for $850 million that the company contemporaneously valued at $175.3 million in its audited financial statements.
Background
To eliminate a potential liability with a nominal value of $1.8 billion, a board created a special committee charged with negotiating the terms of any buy-out of the liability and considering alternatives (special committee). The liability resulted from tax revenue agreements (TRAs) entered into by a holding company and its Founding Investors shortly before an IPO. As is common in an Up-C IPO, the TRAs provided that if the holding company were to reduce its taxable income by using a tax asset generated by a founding investor (tax asset), then the holding company must pay the Founding Investor 85% of the savings (TRA liability). While potentially significant, there would be no TRA liability unless the holding company generated income against which to generate tax savings. The board created the three-person special committee because members of the nine-person board and management either owned or were affiliated with the TRA holders. The special committee held five meetings over seven months and declined to make a recommendation and instead returned the decision to the full board. The seven directors who voted (voting directors) approved purchasing the TRA liability for $850 million (TRA buyout), even though the holding company contemporaneously valued the TRA liability at $175 million in its audited financial statement. Stockholders sued derivatively and claimed the board acted in bad faith in approving the transaction, thus excusing demand and eliminating any defense to liability for monetary damages based on the exculpatory provisions of the holding company’s charter pursuant to Section 102(b)(7) of the DGCL.
Court Rejects Defendants’ Rigid Framework and Uses Holistic Analysis in Assessing Bad Faith
Defendants argued that the voting directors lacked an interest in the TRA buyout and were independent of the founding investors. Because the plaintiff failed to adequately plead bad faith, and asserted only a due care violation, the defendants argued that as long as the decision could be attributed to any rational business purpose, the inquiry ends and the deferential business judgment standard of review applies. In that circumstance a majority of the board does not face a substantial risk of personal liability and demand is not excused. The court disagreed, stating that “Properly understood, the good faith inquiry is a holistic one. It requires a collective assessment of the complaint’s allegations. In this way, good faith operates as a backstop that prevents the demand futility test from devolving into the type of checklist that the defendants try to deploy.” Critical to the court’s holistic assessment were the complaint’s well-pleaded allegations of the extreme disparity in valuation, conflicting representations by the chief financial officer to the audit committee and holding company’s auditor (more likely than not that the holding company would not generate enough taxable income to use the tax asset owned by the founding investors) and to the special committee (the holding company “would generate so much taxable income that it would use all of the tax asset,” the allegedly knowing failure to consider the effect of the holding company’s M&A strategy which generated additional tax assets that would delay the ability to use the tax asset at issue in the TRAs, the failure of the voting directors to dig in once the special committee punted the decision back to the full board at a 30-minute meeting at which the adviser was not present, and a majority of the voting directors having ties to the founding investors.
Lessons Learned
Good faith has an important role to play in the demand futility analysis. An extreme decision by itself can be indicative of a board’s mental state, an approach the court noted that the Delaware Supreme Court has endorsed and that comports with scientific learning about how the mind works. That type of extreme decision—here approving a buyout of an asset the company contemporaneously had valued at $175 million for $850 million—suggests the same type of mindset to sustain a claim of waste, i.e., a decision so egregious it cannot be based on a valid assessment of the corporation’s best interests. The court held that “at the pleading stage, the test is whether the complaint alleges a constellation of particularized facts which, when viewed holistically, support a reasonably conceivable inference that an improper purpose sufficiently infected a director’s decision to such a degree that the director could be found to have acted in bad faith.” Applying that test, the court sustained plaintiff’s claims of breach of fiduciary duty and waste against the board, and for breach of fiduciary duty against the CFO for providing materially false and misleading information to the special committee, the board and the holding company’s auditor.
