Controller’s Ability to Appoint and Remove Directors at Will Insufficient to Establish Demand Futility
In Harrison Metal Capital, an investment fund with an 18% stake in a privately held company called MixMax, Inc. believed the CEO was committing financial improprieties, but found no legal recourse for its complaint. Although certain features of the case are unusual as a factual matter, the Court of Chancery’s analysis of demand futility in a company with a controlling stockholder will be applicable in more conventional derivative actions as well.
The claims of the investment fund, Harrison Metal Capital, arose during the first twelve months of the pandemic. During that period, the company received a federal Payroll Protection Plan loan but slashed its workforce. At the same time, the CEO nearly doubled his own salary. In soliciting investments under SAFE (Simple Agreement for Future Equity) contracts, the CEO made representations the Fund believed were false. The Fund also believed the company was recognizing revenue improperly during this period.
Under a series of agreements, the CEO controlled three of the five board seats and the Fund controlled one. Based on its concerns, the Fund made a Section 220 books-and-records demand through its board designee, followed by “what proved to be a contentious 220 Action.” In March 2022, the Fund filed an action under 8 Del. C. §205 seeking to invalidate stockholder ratification of the challenged salary increase. The defendants were the CEO and a second officer and director, whose salary had also been increased.
When the Fund brought its original complaint, only four of the five board seats were filled. The CEO had removed one of the three directors whose seats he controlled but had not appointed a replacement. Before the Fund filed an amended complaint, two things happened. The CEO filled the fifth seat, and the company restated its financial statements, after earlier telling the Fund it would not do so.
Against that background, the Fund filed an amended complaint. Unlike in its original Section 205 complaint, the Fund asserted derivative claims for breaches of fiduciary duty by the two officers-directors who had obtained salary increases.
The company moved to dismiss for failure to establish demand futility, and the court granted the motion. The court assumed that the two defendant directors could not impartially assess the claims asserted against them, and that the Fund’s designee could do so. That left the Fund with the burden of establishing that one or both of the remaining two directors lacked independence. The court held that the Fund failed to meet that burden.
Certain features of the case were unusual. Among other things, the proponent of the Section 220 demand was a director, who had greater inspection rights than a stockholder would have had — a fact the court remarked on (“Plaintiff here is not a typical stockholder derivative plaintiff”). But key aspects of the court’s analysis appear generalizable.
First, the case shows a very clear and simple application of the Delaware Supreme Court’s decision in Braddock v. Zimmerman, which governs the analysis of demand futility when board composition has changed between the filing of an original and an amended complaint. The rule under Braddock is that the court looks to board composition at the time of the amended complaint unless derivative claims were already “validly in litigation” at the time of the original complaint. That was clearly not the case here. The original complaint did not include derivative claims at all, but instead was an action to invalidate stockholder ratification under Section 205. The change in board composition appears to have been dispositive. Under the four-member board in place at the time of the original complaint, the Fund would have had to identify only two directors who lacked independence or were interested. The court was willing to assume the two director defendants fell into that category, and even without such an assumption, establishing that the directors were interested in the challenged salary increases would likely not have been a heavy lift for the Fund.
Second, the court’s decision reflects a rigorous application of the third prong of the Supreme Court’s Zuckerberg decision, under which demand is futile as to any director who
lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.
The court explained that under a series of decisions, the ability of a controller to appoint and remove a director does not in itself establish that director’s lack of independence. The Fund argued that more was at issue than simply the power to appoint and remove. According to the Fund, the CEO had removed one of the directors whose seat he controlled in retribution for that director’s opposition to certain of the CEO’s actions. Then, after the derivative action was filed, the CEO opportunistically filled the seat he had previously left vacant, which significantly increased the Fund’s demand futility burden. The Fund argued that the combination of retributive action and self-serving changes in board composition showed that the two directors at issue lacked independence from the controller.
The court rejected the argument and distinguished the Fund’s authorities. In the cases on which the Fund relied, the derivative plaintiffs were able to allege in detail a pattern of retributive actions by the controllers, or facts showing that a newly appointed director “might be an easy tool, deferential, glad to be of use.” The Fund had alleged no comparable facts. The allegations of retribution were conclusory, and the Fund did not show that the fifth director, appointed eight months after the derivative litigation commenced, had any incentive to defer to the CEO.
The court’s rigorous approach to independence may be helpful to companies seeking dismissal on demand futility grounds where members of the demand board have been designated or can be removed by particular corporate constituencies. For example, derivative plaintiffs often assume that CEOs will be deemed to lack independence for demand futility purposes because the board controls their tenure — particularly when the CEO is designated as lacking independence under stock exchange rules. Harrison Metal Capital should provide companies with an additional tool in arguing that control — even accompanied by such a designation — does not alone produce a lack of independence, and that courts should require factual allegations showing a misuse of control before concluding that an officer-director cannot be deemed impartial.
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.
