This post was prepared by Brian E. O’Neill, Esq. of Eckert Seamans

The Court of Chancery recently denied a motion to dismiss, finding that plaintiff had met the heightened pleading standard for demand utility under Aronson.   In H&N Management Group v. Couch, C.A. No. 12487-VCMR (Del. Ch. Aug. 1, 2017), Vice Chancellor Montgomery-Reeves denied the defendant corporate directors’ motion to dismiss the plaintiff’s claims for breach of fiduciary duties.  The Court found, for motion to dismiss purposes, that the plaintiff adequately pled that the corporate directors breached their fiduciary duties, and were grossly negligent by failing to inform themselves of all material facts before acting and by permitting an interested insider to dominate the acquisition process.

Background:   Plaintiff corporation, H&N, was a stockholder in AGNC Investment Corporation (the “Company”), a Delaware REIT.  American Capital Mortgage Management, LLC (the “Manager”), managed the Company, and also managed MTGE, a separate REIT.  The Manager was a wholly-owned subsidiary of American Capital, Ltd. (“American Capital”).

From 2013 to 2016, the Company and MTGE had the same board members. In 2016, Kain, an individual defendant, became an executive officer and director of the Company and MTGE.  Kain also served as an executive officer of the Manager, and previously served as an officer of American Capital.

Plaintiff alleged that the Manager enjoyed an overly generous annual service contract with the Company, which was subject to annual renewals. Plaintiff also alleged that MTGE paid little or no fees to Manager, and effectively was subsidized at the expense of the Company.

On July 1, 2016, the Company acquired Manager in an all cash deal. The Manager continued to manage MTGE, through its subsidiary, after the acquisition.  Kain was instrumental in orchestrating the acquisition throughout the entire process.

Plaintiff alleged in the Complaint that Company’s directors breached their fiduciary duties by allowing the service contract with Manager to automatically renew for several years without conducting due diligence. Specifically, plaintiff alleged that the directors failed to consider all material information before renewing the service contract and, in some instances, withheld material information from other board members.  Plaintiff also alleged that the defendants committed waste by acting in favor of MTGE, and to the detriment of the Company.

Analysis: Vice Chancellor Montgomery-Reeves noted that in order to survive a Rule 23.1 motion to dismiss, the complaint must adequately allege demand futility.

The Court applied the familiar Aronson test: “plaintiff must plead particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.” In considering whether the board was adequately informed during its decision-making process, the Court employs a “gross negligence” standard.

The Court found that plaintiff met its burden in pleading demand futility based on the Company board’s failure to adequately inform itself of all material facts before renewing the Manager’s contract. Moreover, the board of the Company faced a “dual fiduciary” problem as in Weinberger because its members also served on the manager’s board.  The Complaint alleged that the Company’s board committee tasked with examining the contract renewals spent less than fifteen minutes addressing the topic.  The Complaint also alleged that the board failed to study the issue prior to voting on the renewal.

The Court also found that demand futility was adequately pled with respect to the breach of fiduciary duty claim for the board’s approval of the merger with Manager. Relying on Court of Chancery precedent of McPadden v. Sidhu, the facts of which were discussed in a prior summary on these pages, Vice Chancellor Montgomery-Reeves found that the pleadings adequately alleged that the Company board improperly allowed Kain, a conflicted fiduciary of the Company, to dominate the acquisition process, dictate the transaction structure, and direct the ultimate terms of the deal.  As in McPadden, the facts pled “are sufficient to raise a reason to doubt that the board was adequately informed when it approved [the acquisition].”

The Court next denied the motion to dismiss the breach of fiduciary duty claims, finding that the adequate allegations under the higher standard of demand futility met the “lesser pleading standard required by Rule 12(b)(6).”

Takeaway: The Delaware Court of Chancery will find the high standard of demand futility to be adequately alleged on a ‘failure to inform” basis if the Complaint contains particularized facts leading to a “gross negligence” inference.  The factual allegations in McPadden and in this case were egregious, and are likely to remain more the exception than the rule in demand futility decisions regarding this familiar procedural hurdle in corporate litigation.