Another shareholder derivative suit claiming diversity shortcomings within the company was dismissed last week: A judge in the Northern District of California dismissed allegations that Cisco Systems Inc. falsely and improperly represented itself as an industry leader in diversity.

Unlike other derivative complaints alleging corporate failure to foster a diverse corporate environment, however, this case was not dismissed for failure to make a demand on the board.  Rather, here, the plaintiff did make such a demand, but, after conducting an investigation of its allegations, the board rebuffed its claims. The plaintiff’s complaint alleged the board had wrongfully refused their demand, the company moved to dismiss under Rule 23.1, and the individual board member defendants filed a separate motion to dismiss on Rule 12(b)(6) grounds.

Cisco argued that the board formed a committee to investigate the demand letter, a fact not referenced in the complaint. Applying Delaware law, the court noted that when a demand on a board has been made and refused, the board’s decision is entitled to the presumption of the business judgment rule.  In such cases, the only issues to be examined are the good faith and reasonableness of the board’s investigation. Absent an abuse of discretion or particularized facts to create a reasonable doubt that the Board was informed and validly exercised its business judgment – both of which are the burden of the plaintiff to assert – a board’s decision not to pursue a derivative claim alleged in a demand letter is respected by the court.

Applying this standard, the court held that the complaint failed to allege Cisco’s board wrongfully refused the complaint, pointing to statements made in the motion to dismiss regarding the process and scope of the investigation conducted by the board’s demand review committee.  The plaintiff argued that the motion “revealed facts” that caused a reason to doubt the work of the committee – namely that (1) board retained ultimate decision-making authority over Cisco’s response to the demand, and (2) two of the committee members were named defendants.  The court rejected both of these arguments; neither the board’s ultimate retention of authority over the committee’s decisions, nor the two committee members’ interest in the outcome of the investigation were sufficient reasons to doubt the committee’s independence.

The court also granted the individual defendants’ motion to dismiss under Rule 12(b)(6). As we have previously discussed in this space, other courts that have dealt with diversity suits have dismissed cases without getting to the merits of the allegations. Here, however, the court held that the plaintiff failed to state a claim for a violation of Section 14(a) of the Exchange Act because “aspirational assertions” about diversity in Cisco’s proxy statements were non-actionable, and because the complaint did not allege that proxy statements were an essential link to a loss-generating corporate action.

Two lessons can be drawn from the court’s opinion. First, as other decisions from Delaware courts and elsewhere have noted, conducting a thorough and independent investigation is critical to addressing derivative allegations. Especially when a company receives a shareholder demand, a board’s best recourse may often be to retain independent counsel that can investigate and evaluate any allegations of wrongdoing, and then use the completeness of that investigation to insulate the company from future lawsuits.

Second, the essential link analysis could prove important for future diversity cases. Under the court’s reasoning, Cisco’s failure to nominate a black director was “too tenuous[ly]” linked to financial loss of the company. Under that reasoning, future plaintiffs may have to provide a more direct connection between the election of diverse executives and corporate profits, which could require complicated financial analysis or other detailed examples.

Check back here for further developments on this slew of board diversity cases.

Photo of Joseph Hartunian Joseph Hartunian

Joe Hartunian is an associate in the Litigation Department.

Joe earned his J.D. from the University of Michigan Law School, where he was an executive editor of the Michigan Journal of Law Reform. Joe previously served as a law clerk to the…

Joe Hartunian is an associate in the Litigation Department.

Joe earned his J.D. from the University of Michigan Law School, where he was an executive editor of the Michigan Journal of Law Reform. Joe previously served as a law clerk to the Honorable Peter W. Hall of the United States Court of Appeals for the Second Circuit.

Prior to law school, Joe served as a legislative aide for Senator Charles E. Schumer on the Senate Judiciary Committee, focusing on issues related to opioid abuse, telecommunications and gun safety. Upon graduation, he returned to the committee as an advisor to Senator Amy Klobuchar on the nomination of now-Justice Brett Kavanaugh to the Supreme Court.