The creation of a Special Litigation Committee (“SLC”) is a useful device for a corporation to address and dispose of litigation accusing the corporation and/or corporate insiders of misconduct. A recent decision by the Delaware Chancery Court provides significant guidance on the requirements for an SLC’s recommendation to dismiss litigation to pass muster with the court. In particular, the Chancery Court emphasized that an SLC’s investigation and decision-making must be reasonable, not perfect.
The Chancery Court’s decision in In re Carvana Co. Stockholders Litigation, No. 2020-0415-KSJM (Del. Ch. Mar. 27, 2024), arose from a direct stock offering by Carvana, an online used car retailer, in March 2020. The two controlling stockholders, Ernest Garcia II and Ernest Garcia III, participated in the offering and Garcia II later sold over $1 billion of his shares. The plaintiff-stockholder filed a derivative action on behalf of the company against the Garcias for breach of fiduciary duty, alleging that they enriched themselves through the offering by acquiring shares at a depressed price.
After Chancellor Kathaleen St. J. McCormick denied the defendants’ motion to dismiss, the Board of Directors formed a two-person SLC, which conducted a seven-month investigation, reviewing over 100,000 documents and interviewing 16 witnesses. The SLC retained outside counsel and an investment banker to assist the investigation. The SLC concluded in a 170-page report that no wrongdoing occurred and that terminating the lawsuit was in the company’s best interests. The SLC then moved to dismiss the lawsuit.
The Court evaluated the SLC’s motion to dismiss under Zapata v. Maldonado, 430 A. 2d 779 (Del. 1981). Under Zapata, the SLC first has the burden of proving its independence and that it acted in good faith in conducting an investigation of reasonable scope that provided a reasonable basis for its conclusion. The court then applies its own business judgment in determining whether the SLC’s recommendation falls within a range of reasonable outcomes that a disinterested and independent decision maker for the corporation could reasonably accept.
Independence of SLC Members
Plaintiffs’ opposition to the SLC’s motion to dismiss challenged the independence of the SLC members, Michael Maroone and Neha Parikh. Plaintiffs asserted that these directors were not independent because they voted to approve the direct offering transaction and discussed the motion to dismiss the underlying lawsuit. But a director’s approval of a transaction does not establish the director’s inability to impartially consider the merits of the transaction at a later time. And because the Board did not vote on filing the motion to dismiss, the SLC members did not participate in a substantive manner in the decision to file the motion. Nor was their independence compromised because they considered management’s recommendation on the choice for outside counsel or because they were named as defendants in lawsuits filed after the direct offering transaction.
Investigation Was Reasonable and Good Faith
The SLC bears the burden of proving that it acted in good faith and conducted a reasonable investigation. First, plaintiffs argued that the SLC relied too much on the work of outside counsel. But the court held that reliance on independent, competent outside counsel was typical and reasonable. A key fact for the court was that the SLC members met formally nine times and informally many times; participated in decisions regarding document collection and other matters; and attended critical witness interviews. The SLC members’ lack of memory concerning details of the investigation was not relevant because “that is why humans write things down.” The SLC’s report was exhaustive, well-documented and included the relevant facts. Although Maroone expressed a lack of enthusiasm about serving on the SLC and described it as a “part-time responsibility,” there was no evidence that such views compromised his diligence. The failure to collect text messages from some individuals paled in comparison to the extensive document collection. In summary, the record amply demonstrated the SLC’s good faith efforts to thoroughly investigate the allegations through a reasonable interview process.
Scope
The court rejected plaintiffs’ contention that the SLC failed sufficiently to consider Garcia II’s stock sales. The SLC found that there was no basis for knowing that Carvana’s stock price would increase after the stock offering and the stock that Garcia II sold was not purchased in the offering but came from stock he had owned since Carvana’s initial public offering. The investment bank retained by the SLC found that there was sufficient liquidity and volume to allow non-participating Carvana stockholders to purchase shares. The investment bank concluded that the economic dilution suffered by the Garcias far outweighed any benefit they received from the offering and in fact they were diluted more than any other stockholder on an absolute dollar basis. The SLC investigated the conduct of two directors and found that although neither were independent as a matter of law, they acted properly with respect to the stock offering. Other flaws alleged by plaintiffs were minimal and did not affect the SLC’s conclusions.
In short, the SLC met its burden and established that its conclusions were the product of a good faith, reasonable investigation. Plaintiffs failed to raise a genuine question of material fact as to the thoroughness of the investigation, the reasonableness of the scope or the reasonableness of the SLC’s conclusions.
The Court’s Examination
The court’s task in exercising its own business judgment was “to determine whether the SLC’s recommended result falls within a range of reasonable outcomes that a disinterested and independent decision maker for the corporation, not acting under any compulsion and with the benefit of the information then available, could reasonably accept.” The court concluded that based on that standard, it accepted the SLC’s recommendation to dismiss the derivative action.
Conclusion
The Carvana decision illustrates how an SLC, if utilized properly, provides a basis for dismissing a derivative action. But it is essential that certain fundamental principles be followed: the SLC members must be independent; competent outside counsel (and an investment bank, if needed) should be retained; the SLC members should actively participate in the investigation; all important issues should be investigated; the findings and conclusions should be well-documented; and the SLC’s conclusions must have a reasonable basis.
For more information regarding Alto Litigation’s litigation practice, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, or Joshua Korr.
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