Guidance on SLCs in Shareholder Derivative Litigation

An SLC must be formed with the utmost care to ensure that its members and advisers can, in appearance and fact, objectively evaluate the merits of a demand-excused suit and the best interests of the corporation when a disabled board cannot. It is frequently said that an SLC must be above suspicion—like Caesar’s wife Pompeia, whom he divorced on mere suspicion of indiscretion.¹ Memorable, but as a standard it lacks the particularity needed to provide predictable guidance to practitioners. Last month, the Delaware Court of Chancery issued a lengthy decision in London v. Tyrrell,² providing detailed guidance on how (i) a court examines the independence of the SLC and the process followed by the SLC in reaching its determination, and (ii) investigative lapses will undermine the court’s confidence in the SLC’s conclusion. The decision admonishes directors that “if the SLC process is to remain a legitimate mechanism,” SLCs must foreclose any reasonable basis to question whether non-merits factors operated in the SLC’s ultimate judgment.

‘Zapata’ Procedure

In shareholder derivative litigation, the shareholder plaintiff makes the threshold directional decision whether to (i) make a demand on the board of directors asking it to pursue the alleged claim, or (ii) purport to initiate litigation on behalf of the corporation and allege that pre-suit demand is excused as futile. If the shareholder makes a demand on the board (rather than alleges that demand is excused), in litigation challenging a subsequent demand refusal, the law deems the shareholder to have conceded that a majority of the board is disinterested and independent as to the underlying claims. Thus, once a shareholder makes a demand on the board, the implicit concession that a majority of the board is independent narrows the court’s inquiry to the board’s good faith and the reasonableness of the investigation, i.e., business judgment rule review.³ As one court observed, “[e]xcept in extraordinary cases…tendering a demand to the board puts the plaintiff out of court under Delaware law.”⁴ Not surprisingly, the difficulty in establishing wrongful refusal of a demand leads most plaintiffs to sue without making a pre-suit demand and litigate the futility of demand.