The best way to explain the noteworthiness, for those engaged in corporate litigation, of the recent Delaware Chancery decision in Wilkin v. Narachi, C.A. No. 12412-VCMR (Del. Ch. Feb. 28, 2018), is to quote from the Court’s introduction: “This case … is a prime example of the difference between a best practice and a legal obligation . . . but Plaintiff fails to point to a single legal obligation that directors violated … [and] Plaintiff has not pled facts that give the Court reason to doubt that these [unexpectedly less successful] outcomes stemmed from rational, good faith decisions of faithful, loyal directors.”
This case involved a pharmaceutical company that thought it had a blockbuster drug, but subsequent regulatory and clinical due diligence indicated that the drug would not be as much of a commercial success as originally anticipated. The court explained in this 46-page decision why the complaint failed to plead sufficient facts to show that a majority of the board faced a “substantial likelihood of liability such that they cannot exercise their independent and disinterested business judgment when considering such a [pre-suit] demand.”
The first 23-pages of the decision provide necessary detailed facts that provide the context for the legal analysis, but for purposes of this short overview I will focus on the key legal principles that the Court applies.
This decision is thorough enough to be used as a primer for the prerequisites that a successful derivative action must satisfy in order to survive a challenge under Chancery Rule 23.1.
Basic Delaware Corporate Law Principles Applied:
- The Court began its analysis with a few basic fundamentals of Delaware corporate governance. Namely, the Court began by explaining that DGCL Section 141(a) empowers directors to manage the business and affairs of the corporation which includes the right to bring all suits on behalf of the corporation.
- The right of a stockholder to prosecute a derivative suit is an exception to that rule, and the prerequisites that must be satisfied for a stockholder to bring a lawsuit on behalf of the corporation, contrary to the general rule, are mainly as follows: (1) The complaint must allege with particularity that the board was presented with a demand and refused it wrongfully; or (2) That the board could not properly consider a demand thereby excusing the efforts to make demand as futile. See footnotes 113 through 115.
- The plaintiff in this case only sought to plead demand futility which required the satisfaction of Rule 23.1, which is much more rigorous and requires much more detail than the general notice pleading under Chancery Rule 8(a).
- Under Rule 23.1, the complaint “must set forth particularized factual statements that are essential to the claim of demand futility. Rule 23.1 is not satisfied by conclusory statements or mere notice pleading, nor is mere speculation or opinion enough.” See footnotes 116 through 119.
Aronson and Rales:
- The Court reviewed the seminal cases of Aronson and Rales, quoting a recent Delaware Supreme Court decision which explained that both of those cases addressed the same question: “Whether the board can exercise its business judgment on the corporate behalf in considering demands.” (citing In re Duke Energy Corp., Deriv. Litig. 2016 WL 4543788, at * 14 (Del. Ch. Aug. 31, 2016); see also Kandell ex rel. FXCM, Inc. v. Niv, 2017 WL 4334149, at * 11 (Del. Ch. Sept. 29, 2017) (quoting In re China Agritech, Inc. S’holder Deriv. Litig., 2013 WL 2181514, at * 16 (Del. Ch. May 21, 2013)) (“The tests articulated in Aronson and Rales are complementary versions of the same inquiry.”) See footnote 125.
- Nonetheless, the court described the different procedural context in which Aronson and Rales are usually presented. In order to succeed in a derivative claim that pre-suit demand is excused, the complaint must allege particularized facts sufficient to raise a reasonable doubt that: “(1) The directors are disinterested and independent or (2) The challenged transaction was otherwise the product of a valid exercise of business judgment.” See footnote 123.
- Under Rales, a derivative plaintiff who does not challenge the actions taken by a majority of the board members considering demand must allege particularized facts sufficient to “create a reasonable doubt that as of the time of the complaint being filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” See footnotes 123 and 124.
Breach of the Duty of Loyalty by Violation of Positive Law:
- “Because sophisticated and well advised individuals do not customarily confess knowing violations of law, a plaintiff alleging demand is excused under Aronson or Rales because a majority of the board faces a substantial likelihood of liability for breaching of the duty of loyalty by violating positive law, “must plead facts and circumstances sufficient for a Court to infer that the directors knowingly violated positive law.” See footnotes 126 and 127. The Court noted that one way to establish the breach of the duty of loyalty for failure to act in good faith is to demonstrate that the fiduciary acted in a way with the intent to violate applicable positive law.
Demand Not Excused as Futile:
- The Court explained that pre-suit demand was not excused as futile because even though the complaint alleges that a majority of the board knowingly or intentionally caused the company to violate its obligations and applicable regulations, as well as making improper public statements and breaching confidentiality duties, the Court concluded that “at worst [the board] failed to follow best practices.” Rather, actual knowledge is required to show the directors knew that they were not fulfilling their fiduciary duties. The Court noted that “imposition of liability requires a showing that directors knew they were not discharging their fiduciary duties.
- But, the Court explained a “failure to follow best practices does not create a substantial likelihood of liability and does not suffice to establish a breach of fiduciary duty.”
Requirements to Establish that a Majority of the Board Faces a Substantial Likelihood of Personal Liability in Order to Excuse Pre-Suit Demand:
- A prerequisite for successfully pursuing a derivative claim is to demonstrate that there is no reasonable likelihood that the majority of the board could have exercised its independent and disinterested business judgment in responding to a demand.
- The corollary to that is that a majority of the board must face a “substantial likelihood of personal liability on a claim-by-claim basis. See footnote 31. That requires allegations of conduct that “is so egregious on its face that the board could not have exercised its business judgment in responding to a stockholder demand to pursue those claims.” In essence, the plaintiff must show, for example, that there is a substantial likelihood of liability of a breach of fiduciary duty by, for example, violating positive law.
- The Court explained in great detail why those prerequisites were not satisfied here, in part, because the complaint did not allege any specific positive law or specific regulations that were violated. Therefore, there was no substantial likelihood of liability of the directors.
Allegations of False Disclosures to Stockholders:
- The Court explained the important fiduciary duty of accurate disclosures to stockholders with or without a request for stockholder action. See footnote 155.
- The Court observed that the issue in this case was not whether the directors breached their duty of disclosure, see footnote 157, but instead whether they breached their more general fiduciary of loyalty and good faith by knowingly disseminating to the stockholders false information about the company.
- Relying on the Delaware Supreme Court decision in Malone v. Brincat, 722 A.2d 5 (Del. 1998), the Court explained that a directors’ duty of disclosure, absent a request for stockholder action, must still include: (1) reliance; (2) causation and; (3) damages.
- Malone explained that when shareholder action is absent, the need to show reliance, causation and damages was intended to be consistent with similar federal standards. See footnotes 160 and 161.
- The complaint in this case failed to satisfy those elements of the disclosure claim and therefore the directors would not face a substantial likelihood of liability for breach of the duty of loyalty in that regard.
- The Court explained that the complaint in this case did not plead a single fact related to the element of reliance.
- Moreover, without an allegation of reliance, prior Delaware case law explains that a plaintiff cannot rely on a “rebuttable presumption of reliance”, sometimes described as the “fraud on the market theory.” See footnote 175.
- Thus, the directors did not face a substantial likelihood of liability for knowingly allowing the dissemination of false information to stockholders.
Failure to Exercise Valid Business Judgment:
- The Court explained why it is so difficult to establish that pre-suit demand is excused due to the failure to exercise valid business judgment.
- The board explained the bedrock Delaware corporate law principle that: “A board of directors enjoys a presumption of sound business judgment and its decisions will not be disturbed if they can be attributed to any rational business purpose.” Moreover, the Court will not substitute its own notions of what is sound business judgment and importantly: “rationality is the outer limit of the business judgment rule” which may be the functional equivalent of the waste test. See footnote 183.
- The Court explained that it cannot reasonably conclude that there was no legitimate business purpose for the disclosures that were alleged to be problematic.
- In conclusion, the Court reasoned that the plaintiff failed to plead particularized facts to show that the directors’ actions were “so egregious or rational that it could not have been based on a valid assessment of the corporation’s best interests.”
- Therefore, the motion to dismiss was granted.
POSTSCRIPT: This opinion serves as a primer of the basic prerequisites and the high threshold that must be met to successfully pursue a derivative claim in terms of the specific facts that must be alleged before the Court will allow a claim to proceed against directors.
SUPPLEMENT: Professor Bainbridge has provided a scholarly analysis of this decision and also kindly quotes from this post.