A recent Delaware Court of Chancery opinion demonstrates the formidable challenge that a stockholder faces when she attempts to proceed with a derivative claim in the face of a pre-suit demand that was refused by the board. In Andersen v. Mattel, Inc., C.A. No. 11816-VCMR (Del. Ch. Jan. 19, 2017), we are presented with an example of the conventional wisdom that if a pre-suit demand is made on the board, and the board refuses to recognize the validity of the demand, there is a slim probability of prevailing on a claim in light of the pre-suit demand refusal.

Background: This derivative action involves allegations that the board of directors improperly investigated and wrongfully refused to bring suit to recover up to $11.5 million paid to the former chairman and CEO of the company as part of a severance package and consulting agreement. The court granted the motion to dismiss of the defendant directors based on failure to allege wrongful pre-suit demand refusal under Court of Chancery Rule 23.1, as well as failure to state a claim under Rule 12(b)(6).

In response to a pre-suit demand letter, the board conducted an extensive investigation involving interviews with about two dozen witnesses and the review of over 10,000 documents. After the investigation, the board determined that it would not pursue the claims. Among the reasons given for the board’s decision was that litigation would be a distraction to senior management and it would have an adverse impact on the business during a difficult period when the company was trying to focus on a turnaround strategy. There was no special committee formed. Although the stockholder asked the board for a copy of documents related to the investigation, the stockholder did not avail itself of DGCL section 220.

Analysis: The Court provides a useful recitation of standards that are of widespread applicability to those who make their living engaged in corporate litigation. For example, the court explained the following well-settled principles:

• By making a pre-suit demand, a plaintiff concedes that the board is disinterested and independent for purposes of responding to the demand. (This imposes at the outset quite a barrier to overcome in the likely event that, as here, the board refuses the demand.)
• Thus, the board’s decision is subject to the business judgment rule, and the only issue for the court to address in this context in order to analyze whether the board’s refusal was proper is: “the good faith and reasonableness of its [the board’s] investigation.” See footnote 21.
• The plaintiff failed to plead particularized facts alleging that the board was grossly negligent, and it was insufficient to argue that: the board did not disclose its investigative report; did not disclose the identity of witnesses interviewed and did not create an independent committee. The court observed that a board has a duty to act on an informed basis in responding to a demand, but “there is absolutely no prescribed procedure that a board must follow.”
• In order to plead bad faith sufficiently in the context of demand refusal, a complaint must plead particularized facts showing that the directors: “… acted with scienter, i.e., with a motive to harm, or with indifference to harm that will necessarily result from the challenged decision–here, that decision being rejection of the Plaintiff’s demand.”

SUPPLEMENT: The venerable Professor Stephen Bainbridge provides scholarly and erudite insights on this case and the standard applied by the court.