Court of Chancery Issues Reminder Regarding Utility of Properly Formed SLCs in Resolving Pending Derivative Claims

For over 40 years, Delaware’s courts have recognized the special litigation committee (“SLC”) as an efficient means of judging the corporate interest served by a derivative suit when the full board is otherwise disabled by self-interest. Paired with that recognition, however, has been a longstanding skepticism of the structural biases that can affect SLC members. In the leading case of Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), the Delaware Supreme Court warned that courts should “be mindful that directors are passing judgment on fellow directors in the same corporation . . . . The question naturally arises whether a ‘there but for the grace of God go I’ empathy may not play a role. And the further question arises whether inquiry as to independence, good faith and reasonable investigation is sufficient safeguard against abuse, perhaps subconscious abuse.”

Recently, in Diep v. Sather, the Delaware Court of Chancery granted an SLC’s motion to dismiss a derivative lawsuit asserting insider trading claims, providing a helpful model to boards of directors and future special litigation committees for overcoming the courts’ skepticism of director impartiality. In that case, stockholders of restaurant chain El Pollo Loco (the “Company”) accused certain directors, as well as an acquisition vehicle of the private equity firm that took the chain public, of selling roughly $130 million in shares shortly after an earnings call during which alleged misrepresentations were made about the Company’s lagging first-quarter performance and outlook.

After the court denied the defendants’ motions to dismiss as to lead plaintiff Kevin Diep’s insider trading claim, the Company formed an SLC to investigate and evaluate the allegations and issues raised in the suit, along with related lawsuits and stockholder demands. The Company appointed three of its independent directors to the SLC, and the court stayed the suit pending the results of the SLC’s investigation.

After conducting an extensive document review and several interviews, and meeting regularly with counsel and as a committee, the SLC issued a 377-page report concluding that the Company should move to dismiss the suit in light of the litigation costs to the Company, the distraction from business operations, and the unnecessary focus of public relations efforts on what it determined to be meritless claims. Upon filing its report, the SLC moved to dismiss the suit. The day before oral argument, however, the parties filed a stipulation of settlement as to the individual defendants, leaving the acquisition vehicle and controlling shareholder as the only remaining defendant. The settlements, however, did not sway the court from finding that the SLC met its burden in moving to dismiss. In resolving the SLC’s motion, the court applied Zapata’s two-part test:

First, the court evaluated the SLC members’ independence, good faith, and bases for their recommendation, which required that the SLC provide a detailed report of its investigation, procedures, and findings. See Zapata, 430 A.2d at 788–89. Because none of the SLC members sat on the Company’s board at the time of the suspect trades or had any financial interest in the transactions at issue, the court’s analysis focused on whether the SLC members’ relationships with the defendants were such that they might have considered factors other than the best interests of the corporation in deciding to move for dismissal.

The court was primarily concerned with the SLC members’ relationships with David Keller, a director and one of the managing members of Trimaran Capital, L.L.C., which was the managing member of the defendant acquisition vehicle. The court ultimately recognized, among other things, that co-service on other boards of directors, innocuous statements regarding the litigation years earlier, and social relationships based largely around children did not vitiate director independence. Because the SLC members did not have relationships with interested parties that appreciably exceeded a kind of thin, social-circle friendship, they remained independent for purposes of the derivative suit.

Second, having impliedly concluded that the case involved nonfrivolous claims, see id. at 789, the court exercised its independent judgment to determine whether or not the corporate interest would be served by the derivative suit’s continuance. After having rejected the plaintiff’s challenges to the substance and scope of the SLC’s investigation, the court was quick to conclude that a disinterested and independent decision-maker for the Company, not acting under any compulsion and with the benefit of the information available to the SLC, could reasonably accept the SLC’s recommendation to dismiss the plaintiff’s claims. Therefore, the court granted the SLC’s motion.

The El Pollo decision is an important reminder to companies regarding the utility of SLCs in resolving pending derivative lawsuits, while also highlighting potential pitfalls.  First, companies should consider having multiple members on a SLC, or risk running afoul of the oft-repeated guidance in Lewis v. Fuqua, 502 A.2d 962 (Del. Ch. 1985) that where an SLC is composed of one member, that member should “like Caesar’s wife, be above reproach.”  Second, companies should prioritize carefully vetting any conflicts of interests to ensure the independence of SLC members.  Finally, companies should empower the SLC to conduct a careful, well-documented investigation of the claims sufficient to satisfy the “good faith investigation of reasonable scope” standard.  Properly formed, SLCs can offer a company significant power in determining the outcome of derivative claims.

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