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 dismissed a shareholder’s derivative suit because he could not prove lululemon Athletica, Inc.’s directors breached their duty of loyalty by giving ex-CEO Laurent Potdevin $5 million to leave the athletic wear company instead of firing him for alleged misconduct in Shabbouel v. Potdevin, et al., No. 2018-0847-JRS memorandum opinion, (Del. Ch. April 2, 2020).
In its April 2 memorandum opinion, the Court ruled that plaintiff David Shabbouel’s allegations failed Delaware’s pre-suit demand test because the deferential business judgment rule gave the directors the latitude to settle with Potdevin to avoid a legal battle’s cost, risk and embarrassment.
Therefore, the vice chancellor concluded, Shabbouel is not excused from first demanding the lululemon board take up his charge that the directors disloyally used the resignation settlement to shield them from liability for ignoring Potdevin’s alleged sexual favoritism, harassment and creation of a “toxic culture”.
The opinion says Potdevin abruptly resigned from the Delaware-chartered firm based in Vancouver in 2018 after the board investigated claims of two vaguely-described “inappropriate incidents” tied to his romantic involvement with a clothing designer who worked for him during his 2014-2017 tenure as CEO.
Shabbouel’s suit claimed the directors ignored “red flags” of “well-documented malfeasance” and instead of firing Potdevin for cause, the directors breached their fiduciary duties and wasted company assets by giving him a $5 million severance to leave quietly.
Plaintiff claimed it would have been futile for him to ask those directors to sue themselves for putting their own interests ahead of those of the company because of their conflict of interest.
High bar set higher
But the Court explained that the plaintiff had an even higher bar to clear than the usual pre-suit demand hurdle because lululemon had adopted an exculpatory clause in its charter that exempted the directors from any money liability for ordinary negligence, requiring Shabbouel to prove breach of loyalty or bad faith.
He fell “well short” of either mark, the opinion said, because the charges do not meet either of the prongs of the Delaware Supreme Court’s seminal Aronson v. Lewis opinion. Aronson v. Lewis, 473 A.2d 805, 813–14 (Del. 1984)
That ruling requires that under Chancery Court Rule 23.1(b), when a derivative plaintiff decides to forego making a demand he must make particularized pleadings to support claims that the directors were interested in the deal or that the transaction was either not the product of a valid business judgment or that it was a waste of corporate assets.
Not a Caremark claim?
The Vice Chancellor observed that Shabbouel tried to satisfy that requirement by charging that the board “failed to implement adequate internal controls to ensure that lululemon’s activities complied with a all applicable laws,” which appeared to be one of the suit’s Caremark claims of inadequate oversight. In re Caremark Int’l, Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).
But according to the opinion, the plaintiff says he is not charging a failure of the directors’ duty of oversight that violate legal and regulatory compliance standards — which is the crux of the famous Caremark ruling. Instead, he maintains he is charging the board breached its duty by using the CEO’s separation agreement to sweep its oversight failures under the carpet.
Can’t meet either Aronson
The Court found the suit does not satisfy either prong of the pre-suit demand requirement. It doesn’t plead particularized facts that at least five of lululemon’s 10 directors: appeared on both sides of the agreement, derived a personal benefit from it, or were beholden to an interested person.
The Court reasoned that to properly plead this prong of Aronson, plaintiff would have had to show that the agreement “extinguished a substantial likelihood of board liability,” but Shabbouel admits that lululemon established an ethics code and a whistleblower hotline and used those systems to detect misconduct.
Moreover, the Court noted, there were no allegations that once they discovered the inappropriate behavior, the directors acted in bad faith by ignoring it or significantly delaying its response; instead they hired independent counsel to investigate, reviewed counsel’s report, appointed a director to negotiate with Potdevin and secured his quiet departure.
That is far from a “conscious indifference to red flags” that might generate liability exposure – especially since the company’s exculpatory charter provision requires that the challenged decision “must be so egregious on its face that board approval cannot meet the test of business judgment,” the opinion says.
Benefits cancel waste claim
The settlement was not a waste of assets because it secured the CEO’s release of all claims against lululemon, liberated the firm from his troublesome tenure, swiftly remediated an allegedly “toxic” culture and avoided a potentially costly and embarrassing lawsuit, the vice chancellor said.
The Court ruled that the directors had to make a quick fire-or-settle choice and it was “the board’s prerogative to decide when it had enough information to decide how to separate Potdevin from the company — not plaintiff’s.”
The Court acknowledged that there is an “outer limit” at which such a separation pact would be unconscionable and constitute waste but this agreement did not come close to that limit for pre-suit demand purposes, so “there is nothing wrong with your television set”, he said, referring to a 1960’s science fiction TV series famous for plot twist endings.