Carvana SLC Drives Away Derivative Case

On March 27, 2024, Chancellor McCormick granted the Carvana Special Litigation Committee’s motion to dismiss after finding no wrongdoing by the Company’s controlling stockholders in connection with its March 2020 direct offering and the controlling stockholders’ subsequent sale of Company stock for over US$1 billion. See https://courts.delaware.gov/Opinions/Download.aspx?id=362010.

Background:  Carvana – an e-commerce platform dedicated to selling used cars – conducted a direct offering in March 2020.  Controlling stockholders, Ernest Garcia II and Ernest Garcia III (the “Garcias”) participated in the direct offering. Later in 2020, Garcia II sold over US$1 billion of his Carvana shares. A derivative claim was filed accusing the Garcias of breach of fiduciary duty for allegedly enriching themselves through purchase at a depressed price in the direct offering. The Court of Chancery denied the Garcias’ motion to dismiss in August 2022 (that decision was discussed on this blog previously).

Carvana thereafter formed a two-director Special Litigation Committee (“SLC”). Over seven months and with the assistance of counsel and financial advisors, the SLC reviewed 18,000 documents, conducted 16 witness interviews, and issued a 170-page report concluding that there had been no wrongdoing by the Garcias and that the direct offering was entirely fair.

The SLC’s Motion to Dismiss and Zapata: Following conclusion of its process, the SLC moved to dismiss the derivative action and Chancellor McCormick granted the motion, finding that the SLC satisfied the two-step analysis called for in Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981). The court first considered whether the SLC members were independent and conducted a good-faith investigation of “reasonable scope that yielded [a] reasonable basis supporting its conclusions.” Order at 18 (citing Diep ex rel. El Pollo Loco Hldgs., Inc. v. Sather, 2021 WL 3236322, at *14 (Del. Ch. July 30, 2021)). For the second step, the court applied its own business judgment to the facts to determine if Carvana’s best interests would be served by dismissal of the derivative action.

To evaluate the SLC’s independence, the court considered if “for any substantial reason” the SLC members were incapable of making a decision in the sole best interests of the Company. Order at 20 (emphasis in Order). The court’s considerations included, for example, “lesser affiliations” that nevertheless could impair independence. Chancellor McCormick rejected each attack on the SLC’s independence:

• Management’s recommendation of the SLC’s law firm was insufficient to demonstrate improper influence on the SLC by outside counsel. Order at 21-22.
• The facts of two other pending securities and fiduciary lawsuits against the SLC members were unrelated to the instant litigation, and thus do not raise a question of independence. Order at 22-23.
• The SLC did not prejudice the investigation. Approval of the underlying transaction alone did not establish inability to be impartial as to the transaction later. Order at 24. And the SLC members’ “mere presence” on the board when it moved to dismiss the derivative action originally did “not create a disabling conflict.” Order at 25. The SLC members had not participated in a substantive way or voted to approve the motion to dismiss.
• The allegations of one SLC member’s prior business dealings with the Garcias did not describe the magnitude of those dealings or how they might have affected the member and thus were not significant. at 26.

Regarding the investigation itself, although the SLC’s investigation efforts “compare[d] favorably with SLC investigations upheld” by the court in the past, Plaintiffs attacked its thoroughness and scope and the reasonableness of its conclusions. Order at 30. The court was not persuaded. Of note, in considering the thoroughness of the SLC’s work, the Court acknowledged that comments by one SLC member that he was not “honored” to be on the committee and implying time constraints on his SLC work were “not helpful to an SLC’s cause.” Order at 31. Nevertheless, the court found no evidence that the lack of enthusiasm affected the member’s diligence. The court concluded that “none of Plaintiffs’ arguments raise a genuine question of material fact as to the thoroughness of the investigation, the reasonableness of the scope of the SLC’s investigation, or the presence of reasonable bases for the SLC’s conclusion.” Order at 40.

Having conducted a detailed review of the SLC’s process and conclusions, the court, without more, also was able to take the second step under Zapata and determine based on its own business judgment that dismissal was in the interest of Carvana. Order at 41 (“[t]hat analysis informed the conclusion that the recommended result is appropriate. At bottom, 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 Plaintiffs’ claims.”).

This post is as of the posting date stated above. Sidley Austin LLP assumes no duty to update this post or post about any subsequent developments having a bearing on this post.