The following is a case update written by Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal. Ret.), analyzing a recent decision of interest:
A stockholder must make a demand on a corporation’s board of directors before initiating a derivative action unless the complaint can allege with particularity that a demand would be futile. Allegations of futility will pass muster when specific facts are alleged showing the existence a disabling conflict affecting a majority of the directors which would have considered a demand. When the corporation’s charter has an exculpatory clause which excuses the directors from liability for negligence, only particular facts which show bad faith, fraud, or a disabling interest of a majority of the directors will excuse a demand as futile, as found by the Delaware Supreme Court in McElrath v Kalanick, 2020 WL 131371 (Del. Supr. 1/13/20).
To view the opinion, click here.
In 2016 Uber Technologies, Inc. acquired a company in the autonomous vehicle space, Ottomoto LLC. Ottomoto was alleged to be a front for former Google employees wooed away from Google’s autonomous vehicle project by Travis Kalanick, Uber’s founder, who developed a close relationship with the group’s leader, Anthony Levandowski. Google sued Uber for misappropriation of trade secrets after Google mistakenly received an email containing drawings of a circuit board for autonomous vehicles which resembled Google’s engineered drawings. Uber eventually settled by issuing stock to Google valued at $245 million.
Lenza McElrath, a stockholder and former employee, filed a derivative action on behalf of Uber against the directors who made the acquisition decision. McElrath failed to make a pre-filing demand on the current corporate directors, some of whom were different from those who approved the acquisition, alleging that to do so would have been futile. Based on the allegations of the complaint, the Court of Chancery found that Kalanick was the only interested director and that a majority of the directors were independent of him at the time of filing of the complaint. That was the relevant date since those who were directors at time would have been the ones to consider a litigation demand. Based on this finding, Court of Chancery dismissed the complaint for failure to make a demand. McElrath appealed to the Delaware Supreme Court, which reviewed the matter de novo, and affirmed.
Under Delaware law, the board of directors manages the business and affairs of a corporation, including deciding whether the corporation should pursue litigation. To protect this authority, a stockholder must make a demand on the board before initiating a derivative action. A demand may be bypassed if the complaint can allege with particularity that a demand would have been futile due to a disabling conflict affecting a majority of the directors which would have considered a demand. The Delaware Supreme Court noted that when a majority of the directors at the time of the challenged conduct have been replaced, the allegations must create a reasonable doubt that the current board would have properly exercised independent and disinterested business judgment in responding to the demand. First, the court must consider whether any directors were interested – i.e. if they would face a substantial likelihood of personal liability for the conduct at issue. If a director is interested, then the court must determine whether a majority of other directors were independent of that director.
Working against the ability of McElrath to show the required reasonable doubt was the fact that Uber’s Certificate of Incorporation exculpates its directors from monetary liability for fiduciary duty breaches to the fullest extent allowed under Delaware law. The Delaware Supreme Court here noted that Delaware law allows exculpation from due care violations; in sum, the plaintiff must show directors are liable for “subjective bad faith”, such that their conduct is motivated “by an actual intent to do harm,” or there is an “intentional dereliction of duty, a conscious disregard for one’s responsibilities.” In essence, the Court ruled, the directors “must have acted inconsistent with their fiduciary duties and must have known they were so acting.”
Uber did not contend that Kalanick was disinterested. However, McElrath was still burdened with demonstrating that the other directors were tainted by him or otherwise acted in bad faith. The Court found McElrath could not do so because the complaint alleged that “Uber’s directors heard a presentation that summarized the transaction, reviewed the risk of litigation with Google, generally discussed due diligence, asked questions, and participated in a discussion.” The Court concluded that “[t]he inference from these allegations shows a functioning board that did more than rubberstamp the transaction presented by Uber’s CEO.” Finding that the majority of the board was disinterested and could have fairly considered a demand, the Court affirmed the dismissal.
Although Delaware may have the broadest protections for corporate directors in the country, the underlying principles here are universally applied to derivative litigation. It is clearly insufficient to assume that just because the target of the suggested litigation is one of more members of the board itself, any demand would be futile. At a minimum, a stockholder initiating a derivative suit and claiming that demand is futile must investigate whether the allegedly liable directors are still on the board in sufficient numbers to represent a majority. Even that is not enough, because the bar is high and the complaint must persuasively allege subjective bad faith or conscious disregard of fiduciary duties. Showing mere negligence will not excuse demand.
Those who drafted the complaint here did not grasp the height of the bar. Otherwise, the complaint would not have made specific allegations that the acquisition was handled with care in the first place. It should not be surprising that a reviewing court would read those allegations and conclude they showed a functioning board.
These materials were written by Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal. Ret.), a member of the ad hoc group, with editorial contributions by Dean T. Kirby, Jr., a member of the firm of Kirby & McGuinn, A P.C., located in San Diego, California, also a member of the ad hoc group and a member of the Commercial Transactions Committee of the Business Law Section. Thomas Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomas Reuters.