This synopsis was prepared by Mitchell Mengden, a law student at the Georgetown University Law Center.

A recent Delaware Court of Chancery opinion outlines the applicable standards when challenging a board’s decision to reject a pre-suit demand. In Busch v. Richardson, C.A. No 2017-0868-AGB, (Del. Ch. Nov. 14, 2018), the court upheld a board’s decision to refuse a pre-suit demand that the company pursue claims against its Chairman and CEO as well as others, in connection with a demand to unwind allegedly conflicted transactions. The plaintiff did not adequately demonstrate that a majority of the board was interested or lacked independence such that it would compromise their impartiality, nor did the plaintiff allege particularized facts that raise a reasonable doubt concerning the good faith or the reasonableness of the board’s investigation in connection with rejecting the pre-suit demand.

Brief Background:

A shareholder demanded that the company take action to unwind three transactions that the company did not originally disclose as related-party transactions. Two were a repurchase of the company’s stock from its Chairman and CEO, and one was a repurchase from a charity that the Chairman and CEO controlled. The shareholder involved also claimed that the company misled him with respect to the board’s independence.

In response to the pre-suit demand, the board formed a special committee, which ultimately concluded that there was no basis to initiate action against any officer or director. The shareholder involved subsequently filed this action, claiming breach of fiduciary duty by each of the five directors.

Analysis of the Court:

The court declined to apply the two-part test from Zapata Corp. v. Maldonado, because the approach in that case applies where a derivative suit is brought, demand is excused, and then the company attempts to cleanse conflicts by creating a special litigation committee to determine the course of the derivative litigation–which was not the case here. See footnotes 105-11 and accompanying text.

The court provided the following well-established pre-suit demand principles:

  • Demand can be excused where: (1) an adjudication is made that demand is excused; or (2) no motion to dismiss is filed under Rule 23.1 in the face of well-plead allegations that a majority of the board is conflicted. See footnote 106.
  • Under Delaware law, there are two different tests for determining whether demand may be excused: the Aronson v. Lewis test and the Rales v. Blasband test. See footnote 112 and accompanying text. The Aronson test generally applies when “a decision of the board of directors is being challenged in the derivative suit[,]” whereas the Rales test generally applies when “where directors are sued derivatively because they have failed to do something.” See footnotes 113-16 and accompanying text.
  • For a complaint to survive a Rule 23.1 motion to dismiss under Rales, it must “plead facts specific to each director, demonstrating that at least half of them could not have exercised disinterested business judgment in responding to a demand.” See footnote 121 and accompanying text.

In this matter, the court applied the demand refusal framework described in Spiegel v. Buntrock, in which the Supreme Court recognized the high hurdle a plaintiff faces when a pre-suit demand is made, because such a demand:  “tacitly concedes the independence of a majority of the board to respond.” In that situation, as our Supreme Court held in Spiegel v. Buntrock, the decision to refuse a plaintiff’s demand is afforded the protection of the business judgment rule. In addition, the court explained, if the board refuses the stockholder’s demand, “the only issues to be examined are the good faith and reasonableness of its investigation.” See footnote 73.

The Court in this matter concluded that: Under the Spiegel framework, a board’s decision to “refuse a plaintiff’s pre-suit demand is afforded the protection of the business judgment rule unless the plaintiff alleges particularized facts that raise a reasonable doubt as to whether the board’s decision to refuse the demand was the product of valid business judgment.” The Court also held that the plaintiff did not do so because he failed to “allege particularized facts that raise a reasonable doubt that (1) the board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; or (2) the board acted in good faith, consistent with its duty of loyalty.” See text accompanying footnotes 75 and 76.