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

The Delaware Court of Chancery denied a motion to dismiss two claims in a derivative action, finding pre-suit demand futility was established because the allegations of knowing violation of a federal regulation by the defendant directors sufficiently alleged bad faith conduct. In Kandell v. Niv, C.A. No. 11812-VCG (Del. Ch. Sept. 29, 2017), plaintiff, a stockholder of FXCM, Inc., brought a derivative claim against the directors of FXCM for their alleged mismanagement of the corporation and a drastic decline in its valuation.  More specifically, the plaintiff alleged that the directors embraced a business model premised on pervasive violation of a federal regulation of the Commodity Futures Trading Commission (“CFTC”).

Background: FXCM is an online foreign currency exchange platform that affords its retail and institutional customers the opportunity to engage in often highly leveraged speculative and hedging transactions.  FXCM touted to potential customers that they would not be held accountable for any losses in excess of the amounts invested.  This promise directly violated a regulation of the CFTC, which prohibited an entity under CFTC jurisdiction from guaranteeing customers immunity from losses in excess of their cash investment.

FXCM experienced substantial losses as a result of the foreign currency exchange “Flash Crash” of early 2015. FXCM’s losses led to its need to accept a loan with onerous terms in order to survive as a going concern.

The plaintiff filed a derivative action in Chancery asserting that the defendant FXCM directors breached their fiduciary duties, committed waste with respect to corporate assets, and unjustly enriched themselves. The plaintiff did not make a pre-suit demand upon the board of directors, and asserted that such demand would be futile.  The defendants moved to dismiss the complaint on the grounds that demand should not be excused under the Rales test.

Analysis: The Court noted that the Rales test applied to the challenged transactions at issue.  Under the familiar Rales test, a plaintiff must allege particularized facts to establish a reasonable doubt that the board could have exercised its independent and disinterested business judgment if the plaintiff had made a demand.

The plaintiff argued that demand would have been futile because the board pursued a business model in direct contravention of a federal regulation. The plaintiff did not assert that the directors were interested in or lacked independence with respect to the acts in violation of the CFTC regulation, but instead asserted that the directors “face[d] a substantial likelihood of liability because they violated the duty of loyalty by allowing or causing the Company to become a lawbreaker.”

The Court noted that “[w]here directors intentionally cause their corporation to violate positive law, they act in bad faith; this state does not ‘charter lawbreakers.’” The Court went on to hold that the allegations sufficiently demonstrated the threat of personal liability for the directors, and therefore rendered them incapable of disinterestedly evaluating a litigation demand.  Accordingly, the Court ruled that pre-suit demand was excused with respect to the claims premised on violation of the CFTC regulation.

Take away: Recognizing the unusual facts before the Court, Vice Chancellor Glasscock noted that “I pause to emphasize that this case presents a highly unusual set of facts: a Delaware corporation with a business model allegedly reliant on a clear violation of a federal regulation; a situation of which I can reasonably infer the Board was aware.”