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Sutherland v. Sutherland, C.A. No. 2399-VCN (Del. Ch. May 3, 2010), read opinion here.

This is the latest installment in a long-running internecine battle among siblings in a large, closely-held business based in the Pacific Northwest. The eight (8) prior decisions of the Delaware Court of Chancery in this matter have been highlighted on this blog and are available here.

The latest iteration of this family feud involves a motion for partial summary judgment which was granted in part and denied in part. There are many examples in Delaware opinions of lengthy battles among shareholders in large closely-held, family-owned companies that over the span of many years resulted in multiple decisions from the Court of Chancery in the same case. This case deserves a place "on the podium as one of the top three finalists" among such hotly contested disputes.

Procedural History

The first complaint that was filed in this matter was a Section 220 claim filed in 2004. The decision in that case is captioned Sutherland v. Dardanelle Timber Co., 2006 WL 1451531 (Del. Ch. May 16, 2006). The Court allowed documents to be inspected based on credible evidence of possible management entrenchment, as well as possible waste and other breaches of fiduciary duty.
In 2006, the same plaintiff filed a complaint against the same company (and its directors) based on breach of fiduciary duty claims. The company appointed a special litigation committee (“SLC”) which recommended that the company not pursue the derivative claims. However, the Court denied the motion to dismiss based on that SLC report, finding that the investigation by the SLC was lacking in good faith and reasonableness, and that the SLC failed to investigate adequately all of the claims. See Sutherland v. Sutherland, 958 A.2d 235, 242-45 (Del. Ch. 2008).

Claims Addressed

The primary claims addressed in the instant motion for summary judgment include the following: (1) The defendant directors breached their fiduciary duty of loyalty by allowing the company to pay for certain accounting expenses incurred for the benefit of one or more of the directors personally; (2) The purchase and continued use of a company jet was challenged based on the argument that the personal use was a breach of the duty of loyalty, and the decision regarding the jet was allegedly made on an uninformed basis such that it was a breach of the duty of care, and that the purchase and  continuing ownership of the jet was not for a rational business purpose; (3) The third claim was based on the argument that the expenditure by the company of $750,000 in legal fees merely to defend the Section 220 action unsuccessfully, was a waste of corporate assets and was the result of self-dealing and bad faith; (4) The fourth argument was that an amendment to the charter after the litigation commenced to include a Section 102(b)(7) provision to protect the directors with self-dealing; (5) The last primary argument was that an accounting should be provided to establish that the company did not pay for personal expenses of the individual directors.

Analysis

The first claim addressed by the Court is based on the premise that a director may be held liable for receiving some personal benefit that is not shared by other shareholders generally and that was the result of the director’s actions. See footnote 20. However, the Court rejected the argument that simply by appointing the Special Litigation Committee the directors conceded self-dealing. The appointment of an SLC pursuant to Zapata Corp. v. Maldonado, 430 A.2d 779, 786 (Del.1981), may allow for the inference at the initial pleadings stage that a claim for self-dealing was alleged, but it does not concede self-dealing as a substantive matter for purposes of trial or other merits-based decisions by the Court. See footnotes 21 to 26.

In sum, the Court concluded on this particular point that it was a factual issue for purposes of summary judgment, and that the Court could not conclude on the present record that the directors received no material benefit from tax and accounting services that they received personally. Moreover, the Court found that the absence of documentation to support the inference that at least one director received a disproportionate benefit for personal expenses that were paid for him is a problem for the defendants who could not account for the funds paid at this stage of the proceedings.

The second claim concerning the argument that a private jet was not necessary to purchase or to continue to own, was rejected for several reasons. First, it was barred by the statute of limitations, but more importantly, the claims failed to rebut the presumptions of the business judgment rule. The familiar formulation of the business judgment rule was reiterated by the Court. See footnote 71. Moreover, the Court observed that conduct may rebut the presumption upon the showing that the board breached either its fiduciary duty of care, or fiduciary duty of loyalty, but that the decision of the board will be upheld unless it cannot be attributed to any rational business purpose. See footnote 72 and 73.

The duty of due care of directors includes the need to act on an informed basis, although in order to be adequately informed “the board need not know every fact, but is instead responsible only for considering material facts that are reasonably available.” See footnote 76. Moreover, the standard for determining whether the decision of the board was informed is one of gross negligence which is conduct that “constitutes reckless indifference or actions that are without the bounds of reason.” See footnotes 78 and 79. Importantly, the Court emphasized that in connection with analyzing this duty, there is “no prescribed procedure, or a special method that must be followed to satisfy the duty of due care.” See footnotes 80 and 81. See generally DGCL Section 102(b)(7).

The Court also reasoned that the purchase of the aircraft and continued ownership of it clearly had a rational business purpose and was protected by the business judgment rule since it was not otherwise the product of self-dealing.

The argument was also made that because the company incurred approximately $750,000 in legal fees merely to defend the Section 220 action (unsuccessfully), that expense was allegedly an example of the breach of the duty of loyalty because it was merely for self interest that the Section 220 litigation was defended.

The Court observed that it is customary, especially in a closely-held corporation, for the corporation to pay the legal costs to oppose a Section 220 or a Section 225 claim even though there may be some personal benefit to incumbent management by doing so. See footnotes 103. The controlling question, rather, is whether the defendants acted in bad faith by refusing the request for books and records and by contesting the Section 220 action. The Court distinguished the Technicorp and Carlson cases in which the Court had found that there was a bad faith opposition of Section 220 actions that resulted in fee shifting, but those cases were distinguishable from the facts of the instant matter. See footnotes 103 through 106.

The Court also cited to prior Delaware decisions to reject the argument that adopting a Section 102(b)(7) provision (during the litigation) to protect the directors from personal liability was self-dealing. Those arguments had been rejected in prior decisions by the Court of Chancery.

The Court also discussed the Technicorp and Carlson cases in connection with the truism that fiduciaries have a burden to maintain and produce records to explain expenses paid for by the company, but an accounting is only required where improper expenses, or expenses that are unaccounted for, would warrant the Court to require an accounting.

Lastly, the Court acknowledged that because some of the more excessive provisions of the compensation package in the employment agreements of the top executives of the company were changed and made “less generous” as a result of the lawsuit, the Court ruled that some fee shifting would be allowed but that those details would be addressed in a separate proceeding.
 

Live From New York! This is a blog post from a seminar in New York City entitled “Delaware Law Developments 2010: What All Business Lawyers Need to Know”, and presented by the Practising Law Institute.

Co-chairs of the seminar are Vice Chancellor J. Travis Laster of the Delaware Court of Chancery and former Vice Chancellor Stephen Lamb, now of the Paul Weiss firm, as well as Gregory P. Williams of the Richards Layton firm.

The panel members include leading corporate litigators from Delaware as well as a current and a former member of the Delaware Court of Chancery. Among the panel members from the New York Bar are Ted Mirvis of the Wachtell Lipton firm and Julie North of the Cravath Swaine firm. (Also among the luminaries on the panel are Kevin Brady, who readers will recognize as a Delaware litigator who frequently contributes to these pages, and Matthew O’Toole, a Delaware lawyer and co-author of the leading treatise on Delaware LLCs.)

[As an aside, some might wonder why Delaware lawyers are presenting a seminar in New York on Delaware law. Part of the answer is that New York lawyers as a group make up one of the largest “markets” for Delaware law. As noted, New York lawyers are included on the panels for this seminar on Delaware law, and some New York lawyers appear in the Delaware Courts more often that some Delaware lawyers–and a sizeable number of New York lawyers are just as conversant in Delaware corporate law matters as many Delaware lawyers. As a related, illustrative note, although there are readers from all 50 states who read this blog, the number of readers from New York has always been the source of the most readers of this site–whose focus is recent decisions from Delaware’s Supreme Court and Court of Chancery on corporate and commercial law.]

Pam Tikellis of the Delaware Bar discussed the recent Revlon decision that was summarized on these pages here, and she provided tips from that decision that would help to guide those seeking court approval of settlements in derivative or class actions. She also noted that the “newest” Revlon opinion did not announce new standards though it may have put a sharper point on existing standards. Her comments included the following:

• Notify the Court immediately as soon as an MOU is signed. The Court will usually schedule a “status conference” to discuss "in broad strokes" the key aspects of the deal (not the actual hearing to approve it), in order for the court to get an assessment of any issues that may arise. (The Revlon decision was initially assigned to a different member of the Court and one reason this procedure may not have been followed is because it may have been impacted by the "interregnum" before it was assigned to the newest member of the Court).
• She noted that the status of the recent Revlon case is that the defendants decided (after the Court’s recent decision) to "withdraw" their support for the settlement. Thus, the case now will be litigated. So too, the “special discovery” ordered by the Court about the settlement is now moot.

Former Vice Chancellor Stephen Lamb was the first panel’s moderator and his comments included the following insights about the preferred procedure and better practice to seek approval for settlements of class or derivative actions:

• The need for notifying the Court promptly upon the signing of the MOU is in part due to the fact that if the court is not given a timely opportunity to make an initial assessment of the proposed settlement, afterwards it will be too late for the Court to easily deal with the proposed settlement if the transaction that was originally contested has already been consummated before there is an opportunity for the deal to be blessed by the Court. See, e.g., SS & C Technologies case and TD Bank case.

• The point was also made that if a PI hearing had been scheduled then the Court needs to make a determination about the basis for cancelling the PI hearing because after the hearing is cancelled it will likely be too late to fix any problems if the settlement is not ultimately approved by the Court.

Ted Mirvis discussed the impact of the recent Revlon decision on the volume of deal litigation in Delaware, in the following ways:

• There is a real possibility that fewer representative or class action cases will be filed in Delaware as a result of this case and he also observed that more attention is now being given to the advisability of considering an amendment of charter provisions to provide for exclusive jurisdiction in the Delaware Court of Chancery of any derivative actions or suits by shareholders. However, it is uncertain whether non-Delaware courts will enforce such a provision.
• Lately, the most common situation that develops regarding litigation of contested transactions is that many cases are filed in many jurisdictions around the country at the same time, to contest a transaction, but it is no longer certain that the non-Delaware courts will defer to the Delaware case. Thus, the net result is often multiple cases proceeding at the same time in different fora.
• One tactic his firm has used is to file the same motion in all pending jurisdictions to tell each court that “it doesn’t matter which court the case proceeds in but it should not proceed simultaneously in multiple courts.” Due, in part, to the unpredictability of obtaining a prompt—or consistent—ruling on such motions, this approach is not a reliable panacea.

William Lafferty of the Delaware Bar suggested that more contested-transaction-cases controlled by Delaware law have been filed recently outside of Delaware based in part on the perception that these types of cases will receive greater scrutiny in Delaware. (The data supports the argument that fee awards are greater outside of Delaware especially in disclosure cases.) He said that the volume of Chancery cases may be the same but the number of deals that are being contested in Delaware appears to be declining. However, he said, that it “may not necessarily be a bad thing”

Vice Chancellor Lamb observed that: When he was on the bench, he examined “exhibit “A” to the MOU because he wanted  to know the details behind the settlement and any surrounding circumstances in order to identify any possible issues.

Ed Welch of the Delaware Bar suggested that unlike other jurisdictions, in Delaware it is not enough to challenge price alone, but typically a successful case requires additional claims regarding process and proxy/disclosure claims. By comparison, claims in other jurisdictions that are not as “meritorious” and may only include a claim about the price of the deal, may have a better chance of prevailing. Thus, the issue about "cases involving Delaware law being filed elsewhere" is created due to the high standards that Delaware maintains, and by comparison the “lower” standards in some non-Delaware jurisdictions.

Betsy McGeever of the Delaware Bar discussed recent settlements of disclosure cases. Typically, this type of case settles shortly after the complaint is filed, but before a PI hearing, and all claims other than disclosure are waived. Often, settlements are based on minor additional financial details but merely confirm the fairness of the price (which claim is withdrawn). She said that “at least for now”, Chancery is still approving such settlements, but Vice Chancellors Strine and Laster have expressed concern and have reduced fees that were requested. For the most recent iteration of Delaware law on this topic, see here for a decision just published today, May 6, by Vice Chancellor Parsons in the case styled In Re Cox Radio Shareholders Litigation.

The recent Delaware Supreme Court opinion in Crown EMAK was discussed by Ed Welch. It was highlighted previously here. The whole panel exchanged views regarding the issue of separating voting rights and economic rights of stock. For example, if the “vote buyer” has an interest contrary to those who have economic rights then it would appear to be contrary to the alignment of such rights which is the policy basis on which voting rights were granted.

Bill Lafferty discussed the London v. Tyrell case, highlighted on this blog here. This case involved a Special Litigation Committee that the court found to be lacking. After a motion to dismiss was denied, a two-person Special Litigation Committee was formed. One of the two had a familial relationship with the CEO and the other had a prior business relationship with a director (who apparently felt some type of allegiance or gratitude for a prior deal.) The Court also dissected the report of the SLC and was critical of the lack of careful consideration of a claim to the extent it did not recognize that injunctive relief for a due care claim is not precluded by Section 102(b)(7). One of the points to take from this decision is to be 100% certain that the independence of any special litigation committee member is clear and that their report examines all the issues and applies all applicable law. Otherwise, the SLC may be a waste of time and effort. Also, notable is that the SLC has the burden to establish its independence.

VC Lamb said that one should read this London case and the Sutherland case and the Oracle case for guidance to be sure that an SLC is properly constituted.

VC Lamb also mentioned the new rules in the Court of Chancery that allow a case to be filed so that a member of the Delaware Court of Chancery will serve as an arbitrator. The hearing is to be scheduled within 90 days of filing the complaint and it will be done in confidence (at least prior to appeal). The expectation is that the appeal to the Supreme Court will not be de novo, but rather will be more limited and on a more expedited basis, although rules for appeals have not yet been published. Prior discussions of these new rules have appeared on these pages in the past. See, e.g., here.

——–
Professor Ann Conaway of Widener University School of Law briefly discussed Delaware law applicable to the duties of management in the context of a struggling company in distress.

When a company is insolvent, at that point the duties to shareholders are merely transferred to the creditors—who are then standing in the shoes of the shareholders. See, e.g., Nelson v. Emerson.

Contrary to the misreading by some commentators of Delaware law on this point, she emphasized that the “Zone of Insolvency” concept is dead. A creditor can only bring derivative claims against directors of a corporation and the duties to creditors arises when a company is insolvent and not prior to that moment in time.

As for alternative entity law, the LLC statute does not provide support for the view that fiduciary duties apply in the absence of an express contract provision. The good professor observed that there is a division among members of the Court of Chancery regarding whether common law fiduciary duties apply when a contract does not clearly address the issue.  Her analysis is consistent with remarks made at a recent seminar by Delaware Supreme Court Chief Justice Myron Steele that were highlighted here. (I understand that the Chief Justice and Professor Conaway will soon be publishing jointly a scholarly work on the latest developments in the law of alternative entities.)
 

Sutherland v. Sutherland, Del. Ch., No. 2399-VCL (April 22, 2009), read opinion here. This is a two-page letter decision that is part of a long line of cases in this ongoing internecine battle among shareholders in a family business. The seven (7) prior Chancery Court decisions in this case have been summarized on this blog here.

This ruling, in the context of a motion for clarification of a prior decision, addresses a limited issue: Whether a demand for books and records under DGCL Section 220 tolls the statute of limitations for claims brought after the documents are obtained. Answer: "It depends". See, e.g., Orloff v. Shulman, 2005 WL 3272355 at *10 (Del. Ch. Nov. 23, 2005). The specific basis for the motion was whether the prior ruling was limited to the context of the Rule 12(b)(6) motion, as opposed to ruling on the statute of limitations "on the merits". Bottom line: The issue will be addressed at trial.

Sutherland v. Sutherland, 2009 WL 750287 (Del. Ch., March 23, 2009).

Professor Larry Ribstein, a nationally recognized expert on LLCs, provides an analysis of this Chancery Court opinion which demonstrates how one can waive duties in the LLC format but such waivers are more limited in the corporate context.

Following is an excerpt from the good professor’s post.

The court refused to apply the provision  [in the parties agreement] to treat interested directors as disinterested for purposes of immunizing interested transactions from Delaware’s entire fairness analysis. The court said (emphasis added):

The question * * * is whether such a far-reaching provision would be enforceable under Delaware law. It would not. If the meaning of the above provision were as the defendants suggest, it would effectively eviscerate the duty of loyalty for corporate directors as it is generally understood under Delaware law. While such a provision is permissible under the Delaware Limited Liability Company Act and the Delaware Revised Uniform Limited Partnership Act, where freedom of contract is the guiding and overriding principle, it is expressly forbidden by the DGCL. Section 102(b)(7) of the DGCL provides that a corporate charter may contain a provision eliminating or limiting personal liability of a director for money damages in a suit for breach of fiduciary duty, so long as such provision does not affect director liability for “any breach of the director’s duty of loyalty to the corporation or its stockholders….

In other words, if you want to completely opt out, you have to use an uncorporation. In corporations, freedom of contract is not, by negative implication, the "guiding and overriding principle."

This is not form over substance because there are meaningful differences between uncorporations and corporations. Here’s more on that.

Read the whole post, and links to Professor Ribstein’s related writings on the topic, here.

Six other Chancery Court decisions involving the same (or affilated) parties as in this case, are collected and summarized here.

Sutherland v. Sutherland, 2008 WL 3021024 (Aug. 5, 2008).

This is an example of the Chancery Court’s practical side which allows it to cut to the chase and avoid unnecessary procedural entanglements. In this case, despite a Motion to Dismiss that was pending, and in light of the multiple proceedings that ensued after the motion was filed, in order to promote efficiency, the court allowed the plaintiff to amend his complaint.  Apparently a Brief was filed by the plaintiff in reply to the Motion to Dismiss and Chancery Court Rule 15(aaa) gives one a binary choice in light of a Motion to Dismiss: either amend the complaint or respond to the Motion to Dismiss. However, the rule also gives the Court flexibility to amend anyway when  (as here) dismissal "would not be just under the circumstances".

In the meantime, the court cited to several cases that address the procedural impact on a pending complaint based on actions taken by a special litigation committee, especially in terms of arguments about demand excusal under Chancery Court Rule 23.1.

There have been no less than five (5) prior decisions of substance that I previously summarized in this case, which provide the extensive background details regarding this intra-family, internecine warfare, and which are available here.

In Sutherland v. Sutherland, 2008 WL 2221770 (Del. Ch., May 29, 2008), read opinion here, the Delaware Chancery Court denied a motion to reargue its May 5 decision, pursuant to Chancery Rule 59(f), in which it rejected the report of a one-person Special Litigation Committee (SLC). The prior decision sought to be reargued was summarized on this blog here. In addition to the foregoing decisions, several other prior Chancery decisions involving these parties, which provide more background on this case, have been summarized on this blog and are linked here.

In the course of repelling the request by the nominal defendant company that the court second-guess its opinion, the Chancery Court recited well-settled law regarding the standard of review used by the court to evaluate the SLC’s conclusions and investigations as articulated in the seminal decision of Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), and the court provided examples of what an SLC should NOT do as well as reiterating precatory practices.

Initially the court quoted from its prior decision to emphasize that the SLC seeking to dismiss derivative litigation has the burden of proof, akin to a motion for summary judgment under Rule 56, as follows:

The SLC is not entitled to any presumptions of independence, good faith, or reasonableness. Rather, the corporation has the burden of proof under Rule 56 standards, which require the corporation to establish the absence of any material issue of fact and its entitlement to relief as a matter of law. In addition, as the court in Kaplan v. Wyatt noted, the motion must be supported by a thorough record. It seems … that what the Committee did or did not do, and the actual existence of the documents and the persons purportedly examined by it, should constitute the factual record on which the decision as to the independence and good faith of the Committee, and the adequacy of its investigation in light of the derivative charges made, must be based. Each side has the opportunity to make a record on the motion. If the court is satisfied with the SLC’s independence and good faith, and the reasonableness of its inquiry, the court may nonetheless exercise its own business judgment and deny the motion to dismiss. FN6

FN6. Sutherland v. Sutherland, 2008 WL 1932374, at *3 (Del. Ch. May 5, 2008) (citations omitted)[emphasis added].

Citing to prior cases (FN 7) comparing the need for a one-person SLC to be "above reproach, like Caesar’s wife",  the court noted that this rubric also applied to the evaluation of the SLC’s independence as well as its good faith and the reasonableness of its investigation and conclusions.

It did not help the SLC’s argument that the one-person SLC apparently "destroyed its original interview notes, after using them to prepare cursory and incomplete summaries of the interviews it conducted, which undermined the court’s confidence in the good faith and reasonableness of the SLC’s investigation."

NOTE TO FUTURE SLCs: Consider carefully, in light of this opinion, whether it is a good idea to destroy notes of interviews.

ANOTHER SUGGESTION: Don’t be too quick to omit reference to information about claims even if the SLC thinks the company has good defenses to assert against those claims.

The foregoing "suggestion" comes directly from the court’s criticism of the SLC’s omission from its report  of payments that related to the claims that the executives were using company assets for their personal benefit–inappropriately. The court reasoned that even if the SLC thought that there was a good statute of limitations defense to claims relating to that information: " a good faith effort to deal with the King payments issue necessarily required that the report both disclose the facts relating to the payments and present analysis of  Perry’s [the executive involved] defense".

LAST NOTE: Provide documentation to support the most important factual conclusions of the SLC’s investigation.  The court was not impressed, to say the least, with the lack of documentary support for key representations by the SLC that certain disputed benefits for the company executives were included in their W-2s. Compounding the inability of the company to satisfy its burden of proof was an incomplete review of the company ledger that admittedly failed to capture two large payments at issue in the case. [In the court’s prior opinion, the court noted that on the one day that the company’s record’s were reviewed, the review started late in the day, was interrupted by a leisurely lunch, and ended before the normal end of normal business hours.]

 

Sutherland v. Sutherland, 2008 WL 1932374 (Del. Ch., May 5, 2008), read opinion here.

[This is one of four opinions issued on May 5 by the Chancery Court, two of which were written by the same vice-chancellor. I hope to post on the other 3 opinions issued on May 5 by tomorrow.]

Factual background details can be obtained from the three prior decisions by the Chancery Court involving these parties, and summarized on this blog here, here and here. This latest opinion in this ongoing internecine Sutherland family squabble denied a motion to dismiss, despite the great weight often given to the recommendation of the Special Litigation Committee (SLC), on which the defendant companies relied for their motion to dismiss. The reason for rejecting the SLC’s conclusions: After having considered the briefs, affidavits, limited discovery and arguments of the parties, the Chancery Court reasoned that:

"the special litigation committee [consisting of one man] has not satisfied the court that it acted in good faith and conducted a reasonable investigation."

The opinion also discusses the issue of independence, the third requirement that the SLC needs to satisfy pursuant to the decision in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), as well as closely scrutinizing whether the SLC satisfied the other requirements of good faith and reasonable investigation.

One lesson from this opinion that can be learned by "negative example" is how "not to constitute"" an SLC (if one wants to have maximum "protection") , and how "not to conduct an SLC investigation" (if one wants to increase the odds of not  having the court disregard the SLC’s conclusions.)

The court noted that the SLC has the burden of establishing its good faith, reasonable investigation and independence, based on Rule 56 standards, although the review has some aspects of a Rule 12(b)(6) motion. The court also referred to the decision in Kaplan v. Wyatt , 484 A.2d 501, (Del. Ch. 1984), that requires the SLC’s conclusions to be supported by a "thorough record". The court may also apply its own business judgement to the conclusion of the SLC even if the SLC satisfied all other prerequisites.

A central theme in the complaint was that the directors were allegedly using the company’s assets for their own personal benefit via such things as personal use of the corporate jet, lavish personal expenses charged to the company for chartered private railroad cars, private parties, club memberships, expensive hotels, rental cars, and other examples of opulence not required by their position at the company.

The court provided reasoning and examples of why the one-man committee’s investigation was not adequate. He only spent  less than one full-day at the company’s office reviewing records. He arrived at 8:30 and then met with various accounting and management personnel before reviewing records. He took a one-hour lunch and then left at 3:30. The following quote from the opinion provides more details:

Perhaps more notable than what Jeffrey did is what Jeffrey [the one-man committee] did not do. Jeffrey testified at his deposition that, although he is a certified public accountant, he did not arrive at the companies’ offices with a plan for how he was going to conduct the review. He did not take any notes. Thus, there is no written record of what he did. Jeffrey testified that he did not review a statistically significant number of invoices when testing whether the accounting records were accurate. He did not verify that the vendor number he asked the accounting department to run was Perry’s only vendor number. And he conducted no search for payments the companies may have made to third parties on Perry’s behalf. For instance, if Perry used Maysville and Maysville then invoiced the companies rather than Perry, Jeffrey’s investigation would not have found the check sent to Maysville on Perry’s behalf.FN33  Nor, as Jeffrey testified, would he have found checks the companies made to credit card issuers on Perry’s behalf. Indeed, Jeffrey testified that his review of the ledgers would have failed to capture the two large payments made to King on Perry’s behalf.

In Sutherland v. Sutherland, 2008 WL 571253 (Del Ch., Feb. 2008), read opinion here, the Delaware Chancery Court examined the format and content of the report of a Special Litigation Committee (SLC) — noting the paucity of citation to source documents, for example, and observed the inauspiciousness of the SLC being composed of only one person (which of course makes it a greater challenge for the SLC to establish its independence, good faith and reasonableness under the Zapata standard.) This short letter opinion refused to allow the SLC to supplement the record with an appendix to the report due in large measure to the prejudice that would be suffered by the plaintiff in light of the lateness of the supplementation in terms of the amount of work and expense incurred to date based on discovery, briefing and argument that focused on the initial SLC report.

Two prior decisions in the case, that can be accessed here, provide more factual background.

In Sutherland v. Sutherland, 2007 WL 1954444 (Del. Ch., July 2, 2007), read opinion here, the Delaware Chancery Court denied in part a Motion for Protective Order,  and allowed more discovery than usually allowed into the basis for the decision of a Special Litigation Committee to dismiss a derivative action. More factual details about the internecine warfare among the shareholders of the family-owned business involved in this case are provided in a prior decision of this court in a Section 220 action that preceded the current litigation and that was summarized on this blog here [ including a link to the full prior decision, the citation for which is Sutherland v. Dardanelle Timber Co., 2006 WL 1451531 (Del. Ch., May 16, 2006).]  One of the reasons the court found (in the prior decision) a proper purpose and credible basis under Section 220, was that the directors–who were also the shareholders who controlled the corporation, approved their own compensation which was alleged to be excessive.

This opinion is full of useful insights into Delaware law regarding the selection of a Special Litigation Committee formed by a corporation as a response to a derivative action. The court noted that the corporation, in essence, lost its defense of the prior Section 220 action, but directors caused the company to spend "upwards of $500,000" in legal fees to defend the case. No indication in this opinion of the cost to the plaintiffs to pursue the Section 220 case, but this serves as an educational reminder of why those cases are not always simple affairs.

 I need to attend to paying clients, so allow me to summarize a few key points in as pithy a manner as possible, while encouraging you to read the whole opinion at the above link.

1. The complaint in this case was filed in September 2006.

2. After a hearing in December 2006, the court stayed this case pending an investigation by the special litigation committee ("SLC").

3. Important aspects regarding the SLC in this case are as follows: (i) the board was originally comprised of the 3 relatives of the plaintiff who are also named defendants; (ii) after suit was filed, they expanded the board and added a fourth board member named Bryan Jeffrey; (iii) Mr. Jeffrey was then appointed as the sole member of the SLC with final and binding authority with respect to the claims in the lawsuit; (iv) at the hearing in December 2006, the Chancery Court expressed "significant concerns about the lack of adequate disclosure of Jeffrey’s background and bona fides" [see footnotes 9 and 10 describing concerns and noting that a single member SLC should be like Caesar’s wife and "above reproach" (citing Kahn v. Tremont Corp., 694 A.2d422, 430 (Del. 1997)).];

4. In March 2007 Jeffrey filed his report with the court as well as a motion to dismiss the litigation. Shortly thereafter the plaintiff served somewhat extensive discovery requests.

5. Relying on the Delaware Supreme Court’s seminal decision in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), the corporation sought to limit the scope of discovery sought and bar any inquiry into the merits of the underlying derivative claims, as opposed to simply examining the independence and good faith of the SLC (in this case Jeffrey alone).

6. The court acknowledged that the Zapata decision controlled the scope of permissible discovery that a derivative plaintiff may take following the investigation and motion to dismiss of an SLC (citing also to Kindt v. Lund, 2001 WL 1671438 at *1 (Del. Ch.)), and observed that the court’s limited role at that stage is to:  "conduct both an inquiry into the independence and good faith of the committee’s members, and an examination of the objective reasonableness of the conclusions that the committtee ultimately reached in its report."

7. The court underscored its inherent equitable power to decide where to draw the line for "limited discovery" and based on the facts of this case a more expansive view of "limited discovery" was warranted–moreso "than might be appropriate in another context"–in light of the prior, expensive battle to obtain documents in the Section 220 case,  and a modus operandi which the corporation seemed to be pursuing in this case with continuing efforts to bar access to data.

8. Thus, in conclusion, the court allowed the following discovery of the SLC (and provided a good roadmap for practitioners to follow, subject to the particular facts of this case): (i) same documents that the SLC or its counsel or advisors reviewed during the investigation; (ii) documents related to the "selection, retention and compensation of [the sole SLC member], as well as his attorneys and advisors"; (iii) the deposition of the SLC member, his consultant and "representatives of the attorneys who advised Jeffrey in his work"; and (iv) replies to interrogatories that related to the scope of his work or the substantive tasks entrusted to him.   The court reasoned that this discovery related directly to the SLC’s diligence and independence.  However, the court disallowed other requests that went directly to the merits of the derivative claims, which otherwise would result in a loss of the "perceived efficiencies generated by a committee’s investigation."

The Chancery Court ruled in Sutherland v. Dardanelle Timber Company, download file, that a proper purpose under Section 220 includes investigation of possible self-dealing and that a credible basis for the claim existed due to the controlling shareholder establishing his own salary. In this 29-page decision that described in great detail the disagreements among the three family members who owned a very successful lumber yard business, the Court ruled that as long as the primary purpose is proper, secondary motives will not defeat the primary purpose, and in any event it would be very hard to prove “false pretenses” in such a context. The court determined that it could review de novo the report of the Master on the record alone without a new hearing.
The court also acknowledged as a proper purpose in a Section 220 demand for books and records the investigation of the possible breach of fiduciary duty as long as there was “some credible evidence to warrant further investigation.” Finally, the court also reiterated prior Delaware rulings that a parent corporation can only be forced to produce documents of a subsidiary if it controls that subsidiary.