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Court of Chancery Questions Special Litigation Committee’s Independence and Investigation in Denying Recommendation to Dismiss Derivative Action

By Stephen B. Brauerman

In London v. Tyrell, C.A. No. 3321-CC (Del. Ch. March 11, 2010), the Court of Chancery denied a special litigation committee’s (“SLC”) motion to dismiss a derivative complaint arising out of the approval and implementation of an equity incentive plan (the “Plan”) because of concerns about the SLC’s independence and the reasonableness of the SLC’s investigation. Applying the Zapata Corporation v. Maldonado two-step analysis (mandatory review of the independence of SLC and reasonableness of the good faith investigation followed by discretionary application of Court’s business judgment of the best interests of the corporation) to the SLC’s recommendation, the Court found that the SLC had not met its burden to show its independence or that it had conducted a reasonable, good faith investigation and permitted the derivative plaintiffs to maintain their action against the directors who approved the Plan.

In reaching its decision, the Court contrasted the pre-suit demand independence inquiry under Aronson v. Lewis and its progeny with the independence analysis required by Zapata. After noting the procedural similarity of the analyses, the Court emphasized the dispositive placement of the burden of proof on the SLC in establishing its independence under Zapata. As the Court observed, the “SLC has the burden of establishing its own independence by a yardstick that must be ‘like Caesar’s wife’–‘above reproach.’” As a result of albeit tenuous familial and prior unrelated professional relationships between the members of the SLC and one of the defendant directors, the Court concluded that the SLC could not surmount Zapata’s more stringent independence inquiry.

While the independence of the SLC was a fairly close call that turned on the burden of proof, the Court had little difficulty identifying the deficiencies in the SLC’s investigation. Among other deficiencies, the Court identified the SLC’s (i) misapplication of law concerning the exculpatory provisions of the Corporation’s charter to claims seeking rescission of the Plan, (ii) willingness to accept at face value unconvincing explanations offered by the defendant directors, (iii) failure to investigate fundamental theories of recovery alleged in the derivative complaint, (iv) refusal to investigate ancillary actions challenged by the shareholder plaintiffs that would have shed light on the broader allegations in the complaint, (v) decision to ignore the circumstances surrounding the timing of plaintiffs’ removal from the corporation’s board of directors, and (vi) mistakes in the consideration of fundamental, undisputed facts.

Attorneys advising special litigation committees and corporations facing derivative suits will find the Chancellor’s analysis in Tyrell instructive, as it clarifies the minimum efforts a special litigation committee must take to ensure a reasonable, good faith investigation that will justify the Court’s adoption of the committee’s recommendations regarding the derivative suit.

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