The current issue of the Delaware Business Court Insider includes an article on the titular topic by yours truly and my colleague Cheneise Wright. Courtesy of the good folks at the Delaware Business Court Insider, and with their permission, it appears below.

Chancery Declines to Follow First-Filed Rule in Advancement Case

By: Francis G.X. Pileggi*
and
Cheneise V. Wright**

A recent Delaware Court of Chancery opinion applied an exception to the general rule that Delaware courts will often exercise their discretion to dismiss or stay a Delaware action in favor of a first-filed action between the parties that is pending in another jurisdiction. In Lay v. Ram Telecom International, Inc., C.A. No. 2021-0631-SG (Del. Ch. Oct. 4, 2021), the court analyzed the nuances of the first-filed rule regarding an advancement case under Section 145 of the Delaware General Corporation Law.

The first-filed rule, often referred to as the McWane doctrine, based on the Delaware Supreme Court decision in McWane Cast Iron Pipe Corp. v. McDowell-Wellman Eng’g Co., 263 A.2d 281, 283 (Del. 1970), provides that a Delaware court’s “discretion should be exercised freely in favor of the stay when there is a prior action pending elsewhere, in a court capable of doing prompt and complete justice, involving the same parties and the same issues.”

The background of the Lay case involves a demand letter sent in early June of 2021 seeking indemnification and advancement of fees and expenses incurred in defending an action the defendant had filed against the plaintiffs in the Superior Court of California. Instead of responding, five days after that letter was sent, the defendant amended their complaint in California to add a claim for declaratory relief, asking the California court to make a ruling on the indemnification and advancement issues. About a month later, the plaintiffs filed the Delaware suit seeking advancement for fees and costs incurred in the California Action.

In early August, the defendant filed a motion seeking a stay or dismissal of the Delaware advancement case in light of the California Action. Briefing was completed on the motion to stay or dismiss by Sept. 27, 2021. The court distinguished prior Delaware decisions that stayed advancement actions in favor of a first-filed action in which the same indemnitee had already asserted advancement rights. See Johnston v. Caremark RX, Inc., 2000 WL 354381, at * 2-5 (Del. Ch. Mar. 28, 2000). In contrast, the court cited to its decision in Fuisz v. Biovail Technologies, Ltd., 2000 WL 1277369, at * 4 (Del. Ch. Sept. 6, 2000), in which the court denied a stay of an advancement action where the prior action was not filed by the indemnitee.

The Court of Chancery also applied the reasoning in the Fuisz case in which the plaintiffs sought advancement under Section 145(k) for a Virginia action in which they had already asserted their advancement rights as an affirmative defense, but notably did nothing to obtain any relief from the Virginia court on the basis of that defense. The court explained in Fuisz that “unless the person having such an entitlement first actively invokes the jurisdiction of a foreign tribunal and seeks an adjudication of that issue from it . . . this court will not regard the foreign action as ‘first-filed’ for purposes of McWane’s comity-based analysis.” Id. at * 1.

The court in the instant case supported its decision not to apply McWane by noting that the plaintiffs in this case did not select California as the forum and they made no effort to obtain an adjudication from the California court of any of the issues presented in this action. Rather, “it was the defendant in this action who sought a declaratory judgment in the California action concerning the plaintiff’s advancement and indemnification rights.”

The court emphasized the importance to its holding of the fact that the defendant amended the California Action to add a declaratory relief claim after the plaintiffs sent a demand for advancement and indemnification. The court underscored that it would be inequitable to allow any plaintiff that receives an advancement demand from a defendant to circumvent the right to a summary advancement proceeding in Delaware under Section 145(k) by simply amending its complaint in the other forum to add a declaratory relief claim on the advancement issue upon receiving a demand. Instead, the court ruled: “that is not our law.”

The court explained that the first-filed rule under the McWane doctrine does not apply because in this instance the California Action should not be considered a first-filed action.

The court also distinguished a very recent Chancery decision which stayed an advancement action in favor of a federal action even though the plaintiff in the federal action had not claimed advancement. See Harmon 1999 Descendants’ Trust v. CGH Investment Management, LLC, 2021 WL 4270220 at * 3 & n.12 (Del. Ch. Sept. 21, 2021). The court explained why the Harmon case was inapplicable. In Harmon, the court reasoned that the federal action was “in its penultimate phase” and an issue before the federal court was whether the person seeking advancement was a limited partner. That issue was a “material, factually rife, and disputed issue” in the advancement action. Therefore, the Court of Chancery held in that case that because the federal court was likely to resolve the factual issue before the Court of Chancery could, efficiencies would be gained by staying the Delaware suit in favor of the federal action.

In contrast, the pending motion to stay or dismiss did not identify any “material, factually rife and disputed issue” that had to be decided in the California Action before the question of advancement could be resolved in the Court of Chancery, nor does the motion to dismiss in Delaware argue that the California Action is in its “penultimate phase.”

In sum, the Court of Chancery held that the motion to stay or dismiss did “not present exceptional circumstances warranting a departure from the rule that claims under Section 145(k) for advancement of expenses should not be stayed or dismissed in favor of the prior pending foreign litigation that gave rise to them.” Thus, the Court of Chancery declined to stay the Delaware Action in favor of the California Action.

In a concluding footnote the court regaled readers with the entertaining linguistic observation that in addition to not being in its penultimate phase, the California Action did not appear to be in an antepenultimate or even a pre-antepenultimate phase.

____________________________________________________________________________
*Francis G.X. Pileggi is the managing partner of the Delaware office of Lewis Brisbois Bisgaard & Smith LLP, and the primary author of the Delaware Corporate and Commercial Litigation Blog at www.delawarelitigation.com.

**Chenesie V. Wright is a corporate and commercial litigation associate in the Delaware office of Lewis Brisbois Bisgaard & Smith LLP

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Chancery Court recently nixed a shareholder group’s bid to replace CytoDyn Inc.’s directors, finding that the COVID-19 drug developer’s incumbent board rightly rejected the dissidents’ fatally flawed notice of their candidates’ proxy intentions for failure to comply with CytoDyn’s advance notice bylaw. Rosenbaum, et al. v. CytoDyn Inc., et al., No. 2021-0728-JRS, opinion issued (Del. Ch. Oct. 13, 2021).

In his October 13 opinion after a paper record trial, Vice Chancellor Joseph Slights denied the plaintiff shareholder group’s motion for an injunction that would compel the company to place the dissident director candidates on the ballot at CytoDyn’s Oct. 28 annual meeting. The ruling is noteworthy because it clarifies the standards for disclosure required to comply with an advance notice bylaw and for proof of wrongful manipulative conduct by the company that rejects a notice.

Blackrock, not Blasius
The court rejected the plaintiffs’ contention that the incumbent board’s alleged self-serving conduct and mismanagement triggers review under former Chancellor William Allen’s seminal Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651, 660 (Del. Ch. 1988) decision that subjects the defendant directors’ actions to enhanced scrutiny as to whether they “act[ed] for the primary purpose of preventing the effectiveness of a shareholder vote” and requires them to prove a “compelling justification for [their] action[s].”

Instead, the vice chancellor said, the case should be reviewed according to the standards set in BlackRock Credit Allocation Income Tr. v. Saba Cap. Master Fund, Ltd., 224 A.3d 964, 980 (Del. 2020), where the Delaware Supreme Court made clear that “advance notice bylaws are commonplace and are interpreted using contractual principles.” The high court explained that Delaware law will protect shareholders “in instances where there is manipulative conduct or where the electoral machinery is applied inequitably,” but found no justification to apply heightened scrutiny in that situation.

Vice Chancellor Slights said although the incumbent directors in the contest-for-control that sparked the litigation allegedly exhibited some mismanagement and conflicts of interest , they did not use manipulative action and the plaintiff faction went wrong “by playing fast and loose in their responses to key inquiries embedded in the advance notice bylaw, and then submitting their Nomination Notice on the eve of the deadline, leaving no time to fix the deficient disclosures when the incumbent Board exposed the problem.”

Background
CytoDyn’s best hope for a profitable product when it reincorporated in Delaware in 2015 and adopted new bylaws three years later was Leronlimab, a monoclonal antibody intended as a treatment for  HIV and cancer. But when government regulatory approval had not yet appeared on the horizon by March 2021, some of its officers and shareholders began to organize support for a new slate of directors at the next annual meeting in October.

The incumbent directors rejected the dissidents’ advance notice of their intent to nominate rival candidates, claiming it intentionally failed to disclose:

1. Certain information in their Nomination Notice to hide the central role that rival company IncellDx and its shareholders – some of whom overlap CytoDyn — are playing in support of plaintiffs’ nominees,
2. The prior proposal that CytoDyn acquire IncellDx,
3. The existence (much less the identity) of any supporters of the nominations

Not nitpicking
The vice chancellor said plaintiffs fall far short of fulfilling their contractual duty regarding the advance notice bylaw and they seek to excuse that failure by extending Blasius beyond its intended limits. “Blasius does not apply in all cases where a board of directors has interfered with a shareholder vote,” he wrote. Rather, “courts will apply the plaintiffs exacting Blasius standard sparingly, and only in circumstances in which self-interested or faithless fiduciaries act to deprive stockholders of a full and fair opportunity to participate in the matter,” and that isn’t the case here.

Plaintiffs cannot escape the fact that they were obliged to identify their supporters, the vice chancellor ruled. “This was vitally important information; the Board was not nitpicking when it flagged the omission as material and ultimately disqualifying.”

Moreover, “the Board rejected the Nomination Notice, in part, because it did not disclose the possibility that Plaintiffs’ Nominees would propose that CytoDyn revisit its decision to pass on the acquisition of IncellDx,” he said. “The failures with respect to disclosing support for the nominations cut across the entire Nomination Notice and justified the Board’s rejection of the notice in its entirety.”

Anyone who needs to know the latest iterations of Delaware law regarding the intricacies and nuances of the dissolution of a corporation and the related winding-up process–needs to read the recent Delaware Court of Chancery decision styled: In re Altaba, Inc., C.A. No. 2020-0413-JTL (Del. Ch. Oct. 8, 2021). This scholarly and extensive analysis of statutory dissolution of corporations and the related winding-up process, weighing in at 66 pages, could easily qualify as a law review article.

Selected Background Facts:
The context of this decision involved a company that dissolved in October 2019, and elected to pursue the optional court-approved process to wind-up its affairs. In May 2020, the company filed proceedings to ask the court to determine the appropriate amount and form of security for various claims. The company also requested court approval to make interim distributions.

The company was previously known as Yahoo, Inc., and was purchased in 2016 by Verizon. Shortly after the agreement to sell to Verizon, a major attack by hackers resulted in monumental data breaches. As a result, the company agreed to indemnify Verizon for 50% of the financial responsibility for class actions filed in connection with the data breach. A settlement of the class actions was reached and approved by a federal district court, but that decision is on appeal.

Key Issue Addressed

One of the issues for Chancery to decide was the appropriate amount and form of the security for the dissolved company to maintain in the event that the settlement was reversed or overturned on appeal. The company wanted to only maintain security for the 50% of the settlement that the district court approved, but Verizon wanted a much larger number to cover the risk that the court of appeals would not approve the settlement of the class action, and if then the case went to trial.

Highlights:
• The court engaged in a deep dive into the doctrinal underpinning, public policy and statutory procedures required in the winding-up process for a dissolved corporation. The codification of the “absolute priority rule” to make stockholders wait until creditors are paid also was explored. See Slip op. at 22-27.
• The court explained that a dissolved corporation can pursue one of two paths to wind-up its affairs based on the statutory scheme in Sections 280, 281 and 282 of the Delaware General Corporation Law.
• The Court referred to one as the “default path” in which the board decides the amount of security for any claims by creditors of the dissolved corporation. But this approach leaves open the risk that unhappy creditors will challenge the amount or form of security and pursue claims against board members and possibly stockholders as well.
• The court called the second option under the statutory dissolution scheme the “elective path.” Under this statutory option, the dissolved company can seek court approval for the amount and form of security for claims. This approach gives the board and stockholders the protection of court approval against any claims by creditors that the amount of security was not sufficient. See Slip op. at 27-31.
• The court explained that there are three general categories of claims, and three different corresponding standards that apply to each category of claims. The court discussed at length the applicable standard for each category in order to determine if sufficient provisions are made to cover claims against the dissolved corporation. See Slip op. at 38-39.
• The court applied the applicable standard to determine the appropriate form and amount of security for the claim by Verizon in this matter. Id. at  49-60.
• The court discussed the public policy considerations in connection with allowing claims against a dissolved corporation and the need for dissolved corporations to deal fairly with the creditors who have those claims.
• The statute provides for an initial three-year winding-up period, but the statute allows also for automatic extensions of that initial three-year period. See Slip op. 60-64 and footnote 22.
• In this scholarly and thoughtful analysis of the statutory winding-up process for dissolved corporations, the court explains the reasons for its determination of the amount of security for Verizon, including its perception of the expert testimony presented in this matter. See Slip op. 64-66.

The Delaware Supreme Court has announced a revised standard for an important aspect of corporate litigation: the analysis of pre-suit demand futility for purposes of pursuing a derivative stockholder claim, in United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund. v. Zuckerberg, No. 404, 2020 (Del. Sept. 23, 2021).

Before this decision was issued, corporate litigators would need to decide whether the Aronson test or the Rales test should apply to the analysis, but this decision affirmed the Court of Chancery opinion which has questioned the continued utility of the Aronson test.

I cannot improve on the scholarly commentary and insights about this ruling provided by one of Delaware’s favorite corporate law scholars, so I provide below the learned analysis by Prof. Stephen Bainbridge on this case from his eponymous blog:

 

Major Delaware Corporate Law Development: Delaware Supreme Court “Revises” Aronson Standard for Demand Futility

United Food and Commercial Workers Union v. Zuckerberg, et al., 2021 WL _______ (Del. Sep. 23, 2021)

Background

Shareholder litigation comes in two possible forms. Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. Our focus here is on derivative litigation.

The law governing derivative litigation has many complexities, most of which result from the collision of two basic principles. On the one hand, the derivative cause of action belongs to the corporation. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions.

Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.

Accordingly, both Delaware Rule of Civil Procedure 23.1 and the essentially identical Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action.

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[2] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement. More precisely, it depends on whether demand is required or excused as futile.

Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware Supreme Court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[3]

The Court’s use of a reasonable doubt standard has been the subject of much criticism:

The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[4]

In defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly argued that “the term is apt and achieves the proper balance.”[5] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”

The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband, Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:

Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[6]

The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.

As former Delaware Chief Justice Leo Strine explained in an opinion written earlier in his career during his stint as a Vice Chancellor:

At first blush, the Rales test looks somewhat different from Aronson . . .. [The Rales] inquiry makes germane all of the concerns relevant to both the first and second prongs of Aronson. For example, in a situation when a breach of fiduciary duty suit targets acts of self-dealing committed, for example, by the two key managers of a company who are also on a nine-member board, and the other seven board members are not alleged to have directly participated or even approved the wrongdoing (i.e., it was not a board decision), the Rales inquiry will concentrate on whether five of the remaining board members can act independently of the two interested manager-directors. This looks like a first prong Aronsoninquiry.

When, however, there are allegations that a majority of the board that must consider a demand acted wrongfully, the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a “substantial likelihood” of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand.[7]

In United Food and Com. Workers Union v. Zuckerberg,[8] the Delaware Chancery Court (per Vice Chancellor J. Travis Laster), took note of the criticism that Aronson has been subject to over the years and proposals that the courts should abandon Aronson and adopt Rales as the general standard. In UFCWU, VC Laster proposed just such a move:

Both [the Aronson and Rales] tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[9]

VC Laster went on to explain that:

In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[10]

Laster reviewed these changes in detail, explaining how they had called into question the continuing utility of Aronson.

In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.

The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.

Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:

The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”

Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[11]

On appeal, the Delaware Supreme Court (per Justice Montgomery-Reeves) affirmed.[12]

Facts

In 2016, Facebook proposed a stock reclassification that would allow founder and controlling shareholder Mark Zuckerberg to dispose a substantial amount of his shares while still retaining voting control of the company. Numerous shareholder suits were challenging the proposal, which were consolidated into a single class action. Shortly before the trial was scheduled to begin, Facebook withdrew the proposal and settled the case. Facebook spent almost $22 million defending the class action, including over $17 million on attorneys’ fees. The settlement included payments to the plaintiffs’ lawyers of over $68 million.

A Facebook shareholder, the United Food and Commercial Workers Union and Participating Food Industry Employers Tri-State Pension Fund (UFCWU), filed a derivative suit claiming that Facebooks’ board of directors “breached their fiduciary duties of care and loyalty by improperly negotiating and approving” the reclassification. The new suit was brought derivatively on behalf of the corporation to recover the money Facebook had spent defending and settling the original class action.

The plaintiff did not make demand before filing the derivative suit. When the defendants moved to dismiss the suit for failure to do so, plaintiff claimed that demand should be excused as futile. VC Laster granted the motion. Plaintiff appealed.

Held

Affirmed.

Reasoning

The Supreme Court emphasized the centrality of a demand requirement with teeth as a gateway to derivative litigation:

[T]he demand requirement is not excused lightly because derivative litigation upsets the balance of power that the DGCL establishes between a corporation’s directors and its stockholders. Thus, the demand-futility analysis provides an important doctrinal check that ensures the board is not improperly deprived of its decision-making authority, while at the same time leaving a path for stockholders to file a derivative action where there is reason to doubt that the board could bring its impartial business judgment to bear on a litigation demand.[13]

(This is, by the way, a point I made at some length in my book Corporation Law and Economics at 399-404, in which I discussed the application of my director primacy theory to derivative litigation.)

In operationalizing that policy, the Court noted that there had been an important doctrinal shift since Aronsonwas decided; namely, the adoption of FGCL § 102(b)(7), which allows corporations to adopt provisions in their articles of incorporation exculpating monetary liability for duty of care claims against directors. Almost all public Delaware corporations have adopted such provisions.

Accordingly, this Court affirms the Court of Chancery’s holding that exculpated care claims do not satisfy Aronson’s second prong. This Court’s decisions construing Aronson have consistently focused on whether the demand board has a connection to the challenged transaction that would render it incapable of impartially considering a litigation demand. When Aronson was decided, raising a reasonable doubt that directors breached their duty of care exposed them to a substantial likelihood of liability and protracted litigation, raising doubt as to their ability to impartially consider demand. The ground has since shifted, and exculpated breach of care claims no longer pose a threat that neutralizes director discretion.[14]

After disposing of plaintiff’s various objections to that conclusion, the Court turned to the question “whether the three-part test for demand futility the Court of Chancery applied below is consistent with Aronson, Rales, and their progeny.”[15] VC Laster’s version of the Rales test stated:

(i) whether the director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;

(ii) whether the director would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand; and

(iii) whether the director lacks independence from someone who received a material personal benefit from the alleged misconduct that is the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.[16]

Oddly, although the test is phrased in the conjunctive (“and”), it seems clear that the court intends it to be applied in the disjunctive: “If the answer to any of the questions is ‘yes’ for at least half of the members of the demand board, then demand is excused as futile.”[17]

The Supreme Court adopted “the Court of Chancery’s three-part test as the universal test for assessing whether demand should be excused as futile,”[18] explaining:

The purpose of the demand- futility analysis is to assess whether the board should be deprived of its decision-making authority because there is reason to doubt that the directors would be able to bring their impartial business judgment to bear on a litigation demand. That is a different consideration than whether the derivative claim is strong or weak because the challenged transaction is likely to pass or fail the applicable standard of review. It is helpful to keep those inquiries separate.[19]

The court concluded by denying that this amounted to a dramatic change in the law, arguing that “because the three-part test is consistent with and enhances AronsonRales, and their progeny, the Court need not overrule Aronson to adopt this refined test, and cases properly construing AronsonRales, and their progeny remain good law.”[20]

 

[1] Federal Rule 23.1 contemplates that demand may be made on shareholders in appropriate cases. A few jurisdictions require demand on shareholders, at least in some cases. See, e.g., Heilbrunn v. Hanover Equities Corp., 259 F.Supp. 936 (S.D.N.Y.1966) (demand on shareholders excused where wrongdoers hold a majority of corporation’s stock); Mayer v. Adams, 141 A.2d 458 (Del.Supr.1958) (demand on shareholders excused where alleged wrong could not be ratified by shareholders).

[2] See Levine v. Smith, 591 A.2d 194, 207 (Del.1991) (“The demand requirement is not a ‘mere formalit[y] of litigation,’ but rather an important ‘stricture[ ] of substantive law.’ ”); see also Barr v. Wackman, 368 N.Y.S.2d 497, 505 (1975) (“demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits”).

[3] Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984).

[4] Starrels v. First Nat’l Bank of Chicago, 870 F.2d 1168, 1175 (7th Cir.1989) (Easterbrook, J., concurring) (citations omitted).

[5] Grimes v. Donald, 673 A.2d 1207, 1217 (Del.1996).

[6] Rales v. Blasband, 634 A.2d 927, 934 (Del.1993).

[7] Guttman v. Huang, 823 A.2d 492, 501 (Del. Ch. 2003).

[8] 250 A.3d 862 (Del. Ch. 2020).

[9] Id. at 877.

[10] Id. at 880.

[11] Id. at 887.

[12] United Food and Commercial Workers Union v. Zuckerberg, et al., No. 2018-0671-JTL, 2021 WL _______ (Sep. 23, 2021).

[13] Id. at 22.

[14] Id. at 31.

[15] Id. at 37.

[16] Id. at 37-38 (emphasis supplied).

[17] Id. at 41. Interestingly, the same problem arose in Aronson, where the test was phrased in the conjunctive. There was some confusion as a result as to whether a plaintiff needed to create a reasonable doubt as to both prongs. In its subsequent Levine v. Smith opinion, 591 A.2d 194 (Del.1991), the court made clear that the test is in the disjunctive, such that satisfying either prong suffices. Id. at 205.

Note that the United Food and Commercial Workers Union court used the phrase “at least half” rather than “a majority.” See, e.g., Kohls v. Duthie, 791 A.2d 772 (Del.Ch.2000) (holding that demand was excused even though only half of the board was deemed incapable of impartially assessing the litigation).

[18] United Food and Commercial Workers Union, at 38.

[19] Id. at 39.

[20] Id. at 40.

A recent decision by the Delaware Court of Chancery is useful for litigators who need to know what remedies are available when an opposing party does not provide documents required by court-ordered deadlines: Dolan v. Jobu Holdings, LLC, C.A. No. 2020-0962-JRS (Del. Ch. Sept. 2, 2021).

Quick Overview of Case:

In connection with a summary proceeding in a books and records action pursuant to Section 18-305 of the Delaware LLC Act, certain tax returns were required to be produced pursuant to a Stipulation and Consent Order. The deadlines were not met. Notwithstanding various excuses provided by the defendant and the accountant for the defendant who was preparing the tax returns that were required to have been submitted, the plaintiff filed a motion to show cause why the defendant should not be held in contempt for violating the court-ordered deadlines.

Standard for Civil Contempt:

The court recited the standard for holding a party in civil contempt for not complying with the court order as follows:

“To establish civil contempt, the petitioning party must demonstrate that the contemnors violated an Order of this Court of which they had notice and by which they were bound (footnotes omitted). The petitioning party bears the burden of showing contempt by clear and convincing evidence; only upon carrying that burden will the ‘burden . . . shift to the contemnors to show why they were unable to comply with the order. Importantly, to justify a citation for contempt, the violation must not be a mere technical one, but must constitute a failure to obey the Court in a meaningful way. Further, even where there has been a violation, the Court will consider good faith efforts to comply with the order, or to remedy the consequences of non-compliance. Resolution of a motion to show cause why a party should not be held in contempt is addressed to the discretion of this Court.’” (citations omitted.)

Court’s Reasoning:

The Court determined that the conduct of the defendants in not meeting the Court-imposed deadlines did not rise to the level of contempt because the defendants’ actions did not constitute a failure to obey the court in a meaningful way. Although there was a technical violation, the Court reasoned that in order for the failure to be “meaningful,” the defendants would have needed to act in “willful disregard of the Order or have refused to make good faith efforts to comply.” Slip op. at 5.

The Court also imposed a new deadline which I will refer to as the “really, really final deadline” which the Court explained would not be extended “absent good cause shown.” See footnote 12.

Takeaway:

Most readers have encountered the frustration caused by an opposing party not meeting deadlines, which–especially in a summary proceeding or an expedited proceeding–makes it more difficult for the counterparty to meet their own deadlines, and “jams-up” other deadlines in the case when the opposing party does not “keep on schedule.” This decision exemplifies the difficulty in enforcing even deadlines that are part of a court order, but litigators should keep decisions like this in their toolbox so that in appropriate circumstances even if motion practice is not a panacea, there may be reputational reasons for the nonconforming party to comply, perhaps, in the face of a reluctant motion.

 

This post was prepared by Frank Reynolds, who has been following Delaware corporate law, and writing about it for various legal publications, for over 30 years.

The Delaware Court of Chancery recently ruled Boeing Company directors must face shareholder charges that they breached their oversight duty by insulating themselves from safety problems with the new 737 MAX and ignoring red flag warnings of deadly stability defects that crashed two of the jetliners within five months. In Re The Boeing Company Derivative Litigation, No. 2019-0907-MTZ opinion issued, (Del. Ch. Sept. 9, 2021).

In her Sept. 9 opinion, Vice Chancellor Morgan Zurn found pension fund plaintiffs’ director oversight claims met the tough pleading standards of the Delaware Supreme Court’s milestone Marchand ruling with well-supported allegations that a majority of the directors are likely liable for Boeing’s billions of dollars in losses and penalties and can’t be entrusted to bring breach-of-duty charges. Marchand v. Barnhill, 212 A.3d 805 (Del. 2019)

Marchand was the high court’s preeminent interpretation of Chancellor William Allen’s 1996 pioneering In re Caremark International ruling that set standards for shareholder plaintiffs to recover on behalf the corporation itself in the rare oversight case where, “directors, otherwise unconflicted, should nonetheless take actions knowingly inimical to the corporate interest, such as ignoring a known duty to act to prevent the corporation from violating positive law.” In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

Vice Chancellor Zurn’s ruling repeatedly pointed to the Marchand standards in finding that Boeing’s directors:

1. Got no regular safety information on the 737 MAX or any of its planes due to their “complete failure” to establish a committee or regular board reports on safety issues,
2. After the first crash, did not immediately investigate what caused the 737 MAX to repeatedly push its nose down in a series of disastrous dives at low speeds and instead virtually ignored the problem even though safety was a “mission critical” area,
3. Intentionally misled federal regulators about the scope and seriousness of a computer pilot training program meant to help them use software that would allegedly minimize nose-down dives,
4. Allegedly lied to the public and regulators about how comprehensive, good faith and quickly implemented their post-crash safety program was.
5. Never pressed the CEO for more information or questioned his conclusions when he repeatedly told the board the 737 MAX was safe and blamed the crashes on pilot and maintenance errors.

However, she found insufficient proof for charges that Boeing’s officers stifled defect reports and that the board bought ex-CEO Dennis Muilenburg’s silence about their liability with an overly rich exit package.

Some legal experts have questioned whether Vice Cancellor Zurns’ opinion fits into what they see as a trend of recent rulings that have allegedly made it less difficult to meet what the Delaware courts have traditionally called the “onerous” pleading standards of a Caremark duty claim.

Background
Two public pension funds were the co-lead plaintiffs in a shareholder suit that claimed Boeing’s directors were liable for lax safety that caused two crashes of the new 737 MAX jetliner, killing all aboard both planes — which were grounded by federal regulators for 20 months with large financial losses. They contended that the directors were too conflicted by their likelihood of liability to press claims, giving the shareholders standing as derivative plaintiffs.

Was demand futile?
Defendants’ motion to dismiss argued that plaintiffs could not meet the very high hurdle pleading standards for their Caremark claims but Vice Chancellor Zurn found the amended complaint meets both prongs of the threshold demand requirements of Court of Chancery Rule 23.1 under the seminal Rales v. Blasband, 634 A.2d 927 (Del. 1993) opinion “and is therefore permitted to assume control of a claim belonging to the corporation.” She found demand on the board would have been futile because there was adequate support for charges that a majority of the directors lacked both independence and disinterest.

The directors “face a substantial likelihood of liability for failure to fulfill their oversight duties under the standards set forth in Caremark, as applied by the Delaware Supreme Court in Marchand, the vice chancellor wrote, adding that the complaint adequately alleges bad faith, “a necessary condition to director oversight liability.”

In response to defendants’ argument that they met the Federal Aviation Administration’s requirements for certification of the plane and its accompanying training and operation program, the court said, “under Marchand, minimal regulatory compliance and oversight do not equate to a per se indicator of a reasonable reporting system.”

Takeaways
Legal scholars may debate for some time to come whether Boeing and/or any of its predecessors in the past few years used degraded pleading requirements — and what the resultant effect might have been on the “onerous” Caremark standard. However, readers are referred to a previous synopsis on these pages of  another Caremark decision with an interesting similarity. Teamsters Local 443 Health Services & Insurance Plan et al. v. Chou, et al., No. 2019-0816-SG opinion issued (Del. Ch. Aug. 24, 2020).

In that opinion, the Chancery Court found that shareholder plaintiffs also passed the Caremark pre-suit demand test because they adequately alleged that the defendant pharmaceutical company’s directors insulated themselves from bad news and turned a blind eye to red flags concerning a subsidiary’s criminal enterprise of dangerous cancer drug repackaging.

The takeaway from that blog post speculated that, “most may read the ruling as a signal from the nation’s preeminent business court that in this post-Covid world, failure-to-supervise claims involving the director response to red-flagged problems with mission-critical operations at closely-regulated health-related businesses deserve increased scrutiny – especially at the crucial pleading stage.

And some may even see the need to apply that increased scrutiny to director decisions in suits against any closely-regulated business, especially one that impacts human health.”

In my most recent ethics column appearing in the current issue of The Bencher, the publication of the American Inns of Court, I highlighted a recent Delaware Supreme Court decision which confirmed prior decisions that established Delaware’s High Court as the only body in the First State with the authority  to enforce the Delaware rules of ethics applicable to lawyers, with a few exceptions. It reversed a trial court decision that imposed fees on a lawyer who engaged in “ungentlemanly” communications with other counsel.

In a seminal decision that has already been the subject of extensive scholarly commentary within the few days since its issuance, the Delaware Supreme Court overruled its 2006 decision in the Gentile case. That decision held that some stockholder claims can be both direct and derivative. New Delaware law on this topic was announced in Brookfield Asset Management, Inc. v. Rosson [TerraForm],  No. 406, 2020 (Del. Sept. 20, 2021).

The Harvard Law School Forum on Corporate Governance, on which I have published several articles, has a helpful overview of the case.

I typically favor on these pages those Delaware corporate and commercial decisions that are not already the subject of extensive commentary elsewhere, with some exceptions. So many other qualified academics and practitioners have already written about this case, that I’ll defer further comment and direct readers to the abundant analysis already available elsewhere.

 

 

 

A recent ruling of the Delaware Court of Chancery provides a useful refresher on the standards that must be met for various exceptions or waivers of the attorney/client privilege to apply. In Drachman v. BioDelivery Sciences International, Inc., C.A. No. 2019-0728-LWW (Del. Ch. Aug. 25, 2021), the Court addressed the following theories which, if applicable, could prevent one from enjoying the protection of the attorney/client privilege, and might lead to the disclosure of otherwise privileged communications:

  • The Garner doctrine;
  • Crime-Fraud exception;
  • At-Issue exception (placing the privileged document in question “at issue” or using it as both a sword and a shield)

Selected Key Facts

The case involves a stockholder claim that the approvals required by DGCL Section 242 were not obtained for amendments to the corporate charter, and that the related actions of the board of directors were a breach of their fiduciary duties.

Selected Highlights

The Court began with the basics. Chancery Rule 26(b) essentially allows discovery of relevant data that is proportional to the needs of the case. But Delaware Rule of Evidence 502(b), which codifies the attorney/client privilege, insulates from discovery “confidential communications made for the purpose of facilitating the rendition of professional legal services to the client.”

Garner Doctrine

Sometimes referred to as the “fiduciary exception”, the Court notes that this is not actually an exception to the privilege rule. See n. 34. When applicable it provides that “when a stockholder sues a fiduciary for behavior inimical to the stockholder’s interests, she may invade the corporation’s privilege upon a showing of “good cause”.

There are 9 enumerated factors that must be considered, but the first two are “gatekeepers” and the parties in this case focused on the first three factors. Although the party who moved to compel “cleared the first two gates”, the movant did not demonstrate that the data was unavailable from other sources (discovery was in the early stages) or that the data was needed to prove her claim. See Slip op. at 10-17.

The At-Issue Exception

The Court noted that whether this is an exception or a waiver deserves attention but is not determinative in practice. See n. 62. After a thorough analysis and application of the facts, the Court explained why the moving party did not meet the threshold for this exception to apply.

Crime-Fraud Exception

Any reader who needs to know the necessary requirements to determine if this exception applies, should read pages 23 to 26 of this letter ruling to understand why the moving party did not persuade the Court that this exception applied.