Chancellor McCormick Provides Helpful Guidance on Pre-Suit Litigation Demands Under Delaware Law
Jul 7, 2021
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Last month, Delaware's new Chancellor Kathaleen S. McCormick issued a decision largely dismissing challenges to board action after finding that the plaintiff's emails to the board constituted pre-suit litigation demands, and thus the plaintiff was precluded from arguing that the director defendants were interested or lacked independence for purposes of considering a demand. 1 As a result, the Delaware Court of Chancery concluded the plaintiff's only option to pursue litigation was to allege that its demands had been wrongfully refused, which it had not done. The decision provided an opportunity for the court to weigh in on technical issues related to pre-suit demand under Court of Chancery Rule 23.1 that have not been discussed at length by the court in some time. The action arose from a 2019 software license agreement between UpCounsel, Inc. (the company) and LinkedIn Corporation (LinkedIn) pursuant to which the company agreed to wind down its business and dissolve and that would result in certain company employees, including two of the defendant directors, entering into employment agreements with LinkedIn. The company received written consents authorizing the transaction from stockholders holding more than 85 percent of the shares entitled to vote. The plaintiff stockholder refused to consent to the transaction and initiated an unsuccessful lawsuit for an injunction in California state court. Thereafter, the plaintiff's representative sent two emails to the company's board of directors demanding, among other things, that the company i) refrain from redirecting traffic to LinkedIn, ii) terminate the company's CEO Mason Blake and board Chairman Matthew Faustman, and iii) initiate litigation against Blake, Faustman, and LinkedIn. The second email even stated that "[t]his email serves as an Official Notice to the Board, per Rales v. Blasband … [and] serves as a former [sic] demand" by the plaintiff. When the board did not respond to those demands to the plaintiff's satisfaction, the plaintiff filed suit in the Court of Chancery against Blake, Faustman, and then-interim CEO Greg Rudin (who served for approximately one week), alleging claims for breach of fiduciary duty, unjust enrichment, and breach of Section 275 of the Delaware General Corporation Law (DGCL)—which governs dissolution. 2
Blake and Faustman moved to dismiss, arguing with respect to the breach of fiduciary duty and unjust enrichment claims that the plaintiff's emails to the board constituted pre-suit demand under Rule 23.1 and therefore the "tacit concession" doctrine barred the plaintiff from later alleging the board members were interested and lacked independence. The court took the opportunity to expound on the two options available to a stockholder seeking to bring a derivative action under Rule 23.1: either i) make a pre-suit demand on the board to pursue the claims; or ii) file a lawsuit and plead with particularity that demand would be futile because a majority of the directors is interested or lacks independence. The court explained that by choosing the first option, to make a pre-suit demand, a stockholder "tacitly concedes" the disinterest and independence of the board for purposes of considering the demand. If the board then decides to refuse the demand, a plaintiff's only option to pursue litigation is to show that the board wrongfully refused the demand under the more deferential business judgment rule standard of review. As the court summed: "the tacit concession doctrine is an aspect of the demand requirement procedurally embodied in Rule 23.1, which derives from the bedrock principle that the board of directors, rather than stockholders, manage the business and affairs of the corporation … [which] includes deciding to pursue or refrain from pursuing litigation on behalf of the corporation." 3
The plaintiff argued the court could not consider the email communications because they were not incorporated by reference in the complaint and that, in any event, the emails were not intended to be pre-suit demands. The court initially rejected the argument that it could not consider the pre-suit emails, explaining that a plaintiff could not "avoid the effects of the tacit-concession doctrine by omitting reference to pre-suit communications in the complaint." In considering whether the plaintiff's pre-suit email correspondence with the board constituted demands under Rule 23.1, the court considered the three criteria for a demand spelled out in Yaw v. Talley. 4 The Yaw factors look to whether the communications identify i) the alleged wrongdoers; ii) the wrongdoing and subsequent injury to the company; and iii) the legal action the plaintiff stockholder wants the board to take on behalf of the company. The court concluded that all of the Yaw factors were satisfied because the plaintiff's emails to the board i) clearly identified Blake and Faustman as the alleged wrongdoers, ii) asserted the alleged harm of re-directing traffic to LinkedIn and a resultant injury of diminished goodwill and decreased asset value, and iii) demanded Faustman and Blake's recusal (and removal) and that the company initiate a lawsuit against LinkedIn, Faustman, and Blake. The court also noted that both emails used the word "demand" multiple times, with one even citing the seminal Rule 23.1 decision, Rales v Blasband, further supporting that the communications were indeed demands. Because the complaint did not assert a claim for wrongful refusal, the court dismissed the claims for breach of fiduciary duty pursuant to Rule 23.1. The court also dismissed the claim for unjust enrichment, reasoning that it arose from the same subject matter as the demands and thus also must be dismissed under Rule 23.1. The court, however, denied the defendants' Rule 12(b)(6) motion to dismiss the plaintiff's direct claim for violation of Section 275 of the DGCL for allegedly enacting a plan of dissolution without a stockholder vote. The defendants argued that no plan of dissolution had been proposed to stockholders and relied heavily on exhibits that were not incorporated in the complaint. Based on that reliance, the court converted the motion to one for summary judgment under Rule 56 and granted the plaintiff leave to respond. Ultimately, Chancellor McCormick's decision serves as a useful primer on the paths available to a stockholder seeking to bring derivative claims challenging board conduct (and the consequences of each). For boards of companies faced with derivative litigation, the decision is an important reminder of the board's central role and authority to manage litigation on behalf of the corporation.  The decision is The Raj and Sonal Abhyanker Family Trust v. Mason Blake, et. al., C.A. No. 2020-0521-KSJM (Del. Ch. June 17, 2021).  The court dismissed the claims against Rudin because the complaint failed to allege any facts related to Rudin’s week-long stint as CEO and because the plaintiff’s attempt to simply lump him into the definition of “Defendants” amounted to impermissible group pleading.  The Raj and Sonal Abhyanker Family Trust, C.A. No. 2020-0521-KSJM, at 10.  Yaw v. Talley, 1994 WL 89019 (Del. Ch. Mar. 2, 1994).