“Thick-As-Thieves” Narrative Persuades Court That Director Independence Is In Question in Carvana

The Delaware Court of Chancery recently denied a motion to dismiss stockholder derivative claims against Carvana Co. arising out of a stock offering Carvana announced in March 2020. The Court found that, based on the plaintiff’s allegations, it was reasonably conceivable that the stock offering had been orchestrated to take advantage of pandemic-related market volatility to benefit investors hand-selected by Carvana’s controlling stockholders. In doing so, the Court rejected the defendants’ arguments of demand futility and provided useful guidance regarding the types of allegations necessary to establish a director’s lack of independence.

The plaintiffs alleged that at the timing of the offering in late March 2020, Carvana, an e-commerce platform for buying and selling used cars, had no need to raise capital. Even though the company’s stock price had declined from a high of $110 in February 2020 to less than $30 on March 20, 2020, the complaint alleged that Carvana was well-positioned to withstand the challenges posed by the COVID-19 pandemic and could operate for a year without financing. Nonetheless, the plaintiffs claimed that the company’s CEO tried to take advantage of the low stock price by hastily arranging a stock offering to “handpicked” investors over a matter of days beginning on March 24, 2020. By March 29, the CEO informed the board that the company would sell $600 million in stock to certain investors at $45 per share, at the lowest price that the Board had authorized. The CEO and his father, who the plaintiffs alleged controlled the company through their control of the majority of the company’s voting stock, each invested $25 million in the offering, which closed on March 30, 2020.

A shareholder derivative action challenging the offering was filed on May 28, 2020. After an amended complaint was filed in August 2021, the CEO moved to dismiss, arguing that the plaintiffs had failed to plead demand futility and failed to state a claim. The Court rejected both arguments in denying the motion to dismiss and permitting the case to move forward.

First, the Court found that the plaintiffs had adequately pleaded that half of the six-member board of directors lacked independence. The Court’s inquiry focused on two directors who, although they were not interested in the offering or likely to face liability for approving it, allegedly were beholden to the CEO and his father.

The plaintiffs alleged that one director had a 30-year relationship with the CEO’s father during which he (i) had been employed by the CEO’s father, (ii) had been involved in a savings and loan scandal with the father that ultimately led to the father’s felony conviction, (iii) had been censured by the NYSE for actions taken on the father’s behalf, and (iv) had been involved in a series of business ventures wherein the CEO’s father was a co-owner or significant investor in the director’s businesses. The Court found that, based on this history, it was reasonably conceivable that the director “might be incapable of impartially considering a demand to sue the man who allegedly saved his career, helped generate his personal wealth, and financially shores his current livelihood.” Likewise, the Court found that the other director’s independence could be conceivably questioned based on allegations that the director had been the relationship banker for the CEO and his father’s companies for decades, during which time the director had served on the boards of three of their companies (earning more than $1 million in the four years prior to the offering), and had been given access to investment opportunities (not available to other directors) in Carvana affiliates wherein the director had made tens of millions of dollars.

Second, the Court found that the complaint had stated reasonably conceivable allegations against the CEO. The CEO argued that, because he had recused himself from the board decision on the offering, he could not be liable if it was wrongful. But the Court found that the CEO had played a role in negotiating, structuring, and approving the offering, and had set the price and led discussions at “every single board meeting.” The fact that the CEO had ultimately abstained from the final vote, the Court held, was not enough to establish abstention under Delaware law. The Court also rejected the CEO’s invocation of the business judgment rule, finding that the allegations of the benefit that inured to the CEO and the lack of independence of the board were sufficient to establish that the entire fairness rule would presumptively apply to the lawsuit.

The Carvana decision does not alter Delaware precedent holding that the allegations necessary to plead a director’s lack of independence must establish far more than professional relationships, personal friendships, or the potential for some financial benefit via stock ownership. The Court was careful to distinguish its decision in Zimmerman v. Crothall, where it rejected the argument that a director lacked independence because of a close friendship with the CEO and the fact that they had founded a start-up company together. The Court likewise found that its prior decisions rejecting similar arguments based on decades-long relationships or employment by the controlling shareholders were distinguishable. The Court ultimately determined that the Carvana plaintiffs’ allegations were able to survive the pleading standard set forth in its prior decisions because they alleged a “constellation of facts” demonstrating “far deeper” personal and financial relationships with the directors than those alleged in many of its prior cases. 2022 WL 2352457, at *12-15.

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