13 July 2022

Don’t Let the Fox in the Henhouse: Lessons from the El Pollo Loco Decision on Special Litigation Committee Independence

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In a recent split decision in Diep v. Trimaran Pollo Partners LLC et al., the Delaware Supreme Court, sitting en banc, addressed the level of independence required of members of Special Litigation Committees recommending dismissal of shareholder derivative actions.

After a shareholder filed suit alleging that directors and officers of fast-casual restaurant chain El Pollo Loco, together with the company’s controlling shareholder, engaged in insider trading and breached their fiduciary duties, the defendants (including nominal defendant El Pollo Loco) moved to dismiss the action for failure to make a pre-suit demand and failure to state a claim. The Delaware Court of Chancery denied the motion, finding that the plaintiff had successfully pleaded insider trading claims, and also had shown that demand would be futile because a majority of the board faced a substantial risk of liability. The El Pollo Loco board subsequently designated a Special Litigation Committee (“SLC”) with exclusive authority to investigate and act on the shareholder derivative claims. Two of the three members of the SLC, William Floyd and Carol Lynton, were members of the El Pollo Loco board at the time the defendants moved to dismiss the derivative suit.

The SLC conducted what appeared to be an extensive investigation, culminating in a 377-page report, after which it moved to terminate the litigation. Applying the standard set forth in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981), which places the burden on the SLC to show that no disputed issue of material fact exists regarding the independence, good faith, or reasonableness of the SLC’s investigation and conclusions, the Delaware Court of Chancery granted the SLC’s motion and dismissed the case. On appeal, the shareholder plaintiff argued that the SLC lacked independence because, though none of the members of the SLC had been on the board during the period of alleged misconduct, a majority had participated in the decision to seek dismissal of the suit and thus had “prejudged” the claims.

In a majority opinion written by Chief Justice Seitz, the Delaware Supreme Court concluded that the company had met its burden under Zapata to establish the independence of the members of the SLC and affirmed dismissal. The majority was unpersuaded by the argument that Floyd and Lynton’s membership on the El Pollo Loco board at the time of the defendants’ motion to dismiss undermined their independence. Although Floyd and Lynton had attended a board meeting during which there had been an “update on pending litigation,” that alone was not sufficient to show that either individual “approved or participated in any substantive way” in the decision to file the motion on behalf of El Pollo Loco. The majority concluded that “mere familiarity with an issue does not compromise independence” in the absence of evidence that any SLC member had approved the filing of the motion to dismiss.

Justice Valihura authored the lone dissent. She inferred that the El Pollo Loco board had at least tacitly approved and authorized the filing of the motion to dismiss when El Pollo Loco affirmatively joined the motion to dismiss, and then took a “leading role” presenting argument on the motion, rather than remain neutral. Justice Valihura noted that this “was obviously authorized by someone,” and that the most likely “someone” was the El Pollo Loco board since “a corporation acts through its board.” In addition, because the motion went beyond technical or procedural arguments, and instead “challenged the substance of the very claims” that the SLC was later charged with investigating, Justice Valihura concluded that Floyd and Lynton’s membership on the El Pollo Loco board when the decision was made to file that motion cast doubt on their independence.

This split decision highlights the fact-specific nature of the Zapata independence inquiry; it defies sweeping generalizations, and instead requires consideration of the particular circumstances under which the SLC was formed. However, it remains clear that the decision to appoint an SLC, the timing of its formation, and the composition of its membership, are each decisions that can substantially alter the course of derivative litigation. A thoughtfully constituted SLC can take control of derivative claims and ensure these suits are managed in the best interest of the company — but only if the SLC can demonstrate that it is independent, objective, and capable of investigating the claims in good faith.