United States: Chancery Court Rules For First Time On An Issue Of Evenly-Divided Corporate Board. Gives Clear Guidance To Bar And Boards.

A key issue for all Delaware corporations has been decided and guidance for Delaware lawyers has been provided on the following topic: Whether pre-suit demand, in a derivative action, will be excused when a board of directors is evenly-split between impartial and interested directors. This issue was squarely addressed by the Delaware Court of Chancery in the recent decision of Beneville v. York and CARNET Holding Corp., Del. Ch., C.A. No. 17638, Strine, V.C. (July 10, 2000). The answer is that demand will be excused.

The complaint in Beneville alleged that from late 1997 through 1998 , director defendants York and Dabich, without the knowledge, participation or approval of CARNET's full Board, caused a subsidiary that they secretly formed for CARNET to enter into a License and Marketing Agreement ("the Agreement") for valuable CARNET software with a subsidiary they also formed of SYNERGY 2000, Inc. ("SYNERGY"), a publicly-traded company controlled by York and Dabich. During a meeting of CARNET's Board, it was alleged that York presented the Agreement merely as a "proposal", when the Agreement had been a fait accompli several months earlier.¹ The full CARNET Board of Directors never approved the transaction with SYNERGY's subsidiary.

The Court found in Beneville, after oral argument on a motion to dismiss, that a claim could be made that York and Dabich committed breaches of their fiduciary duty of loyalty by dictating the terms of a self-interested transaction in which they stood on both sides of the disputed transaction.² In a shareholder derivative action, brought under Chancery Court Rule 23.1,³ demand will be excused where the plaintiffs set forth in their complaint particularized, nonconclusory facts showing why demand on the board would be futile.⁴ In Beneville, the plaintiff did not make a pre- suit demand on CARNET's Board because he argued that one of the two directors on the Company's Board at the time the original complaint was filed, defendant York, suffered from such a disabling self-interest in the challenged transaction as to render demand futile, and therefore excused.⁵

Plaintiff alleged specific facts that demand should be excused since defendant York, the Chairman of CARNET's Board, and who himself constituted 50% of that Board, could not have considered plaintiff's demand on its merits by exercising his disinterested business judgment.⁶

Applying Rales⁷, because there was no board decision,⁸ and in light of particularized allegations of York's partiality due to his personal interest in the challenged transaction,⁹ the Court found that defendant York had a classic self-dealing conflict that rendered him interested for demand purposes.¹⁰

Traditionally, the requirement of a pre-suit demand in a derivative case is excused if there does not exist a majority of disinterested directors to receive the demand. Here, however, there was no unequivocal authority to determine how that majority requirement would apply to an evenly- divided board--especially one composed of two members. In Beneville, the Court reasoned that it "makes little sense to find that demand is required in an evenly-divided situation"¹¹, because the majority requirement was based on the reality that a majority of eligible directors is required in order to cause the corporation to take action on a demand.¹² Nor would the protection of the business judgment rule apply without such a majority.¹³

Defendants appeared to suggest that no board consisting of only two directors could ever satisfy the tests of demand futility.¹⁴ As the Court stated : "the defendants cling to the life raft of a literal reading of Supreme Court case law, which has often stated that a stockholder must show that a 'majority of the board of directors either has a financial interest in the challenged transaction or lacks independence . . . ."¹⁵

The Court reasoned that it was more logical and coherent to hold that demand should be excused as futile when the board is comprised of an even number of interested and disinterested directors, including, as here, one interested and one disinterested board member. In Katell,¹⁶ a derivative case involving a limited partnership, the limited partner plaintiffs alleged that one of two general partners, Morgan Stanley, breached its fiduciary duty of loyalty to the limited partnership by entering into a self-interested transaction that unfairly benefitted Morgan Stanley's affiliates and from which Morgan Stanley profited through transaction fees. In their complaint, plaintiffs alleged that Morgan Stanley could not be presumed to be disinterested because it appeared on both sides of the challenged transaction.¹⁷ Plaintiffs further alleged in Katell that the other general partner, CIGNA, was disinterested.¹⁸ Defendants moved to dismiss on the grounds that plaintiffs failed to make pre-suit demand. In response, plaintiffs alleged that they were excused from making a demand upon Morgan Stanley due to its self-interest which impeded its ability to evaluate the demand.¹⁹ Denying defendants' motion to dismiss, now-Chancellor Chandler initially noted in Katell that demand and demand futility were equally applicable to corporate and partnership derivative actions.²⁰ For a two-person board, the usual requirement would become a unanimity requirement which would not be equitable and would be inconsistent with practical realities and elementary mathematics.

Just as in Katell, where the court rejected blind adherence to the semantics of a majority of the two-person board (i.e., a unanimous vote), here the Court agreed that demand was excused because the disinterested director at the time the original complaint was filed simply could not act alone on a demand made upon CARNET's two director Board without the agreement of the interested director, defendant York.

Vice Chancellor Strine reasoned that in a two-person conflicted board the interested director still possessed the blocking power to prevent the other disinterested director from accepting the demand.²¹ The Court added that "the impartial directors do not have the power unilaterally to cause the corporation to act on the demand."²² The Court, relying on Levine, further elucidated its ruling by observing that "it may be inferred that the board is incapable of exercising its power and authority to pursue the derivative claims directly.²³

Defendants took the position that derivative "plaintiffs should make demand if there is a potential that a corporate anomaly should transpire: namely, that corporate policy would be set not by a board resolution, but by a board minority."²⁴ However, the Court emphasized that case law does not require the plaintiffs to test whether a corporate board will act in such an unusual manner. Instead the Court ruled that "it is enough for a plaintiff to show that there is an absence of impartial board members necessary to cause the corporation to accept demand."²⁵

To have held otherwise would lead to situations where demand could never be excused in cases involving two-director boards since no majority mathematically could ever exist without a unanimous vote that would include the disqualified director who was not disinterested.

In an instructive footnote that is of great importance to all Delaware corporations and Delaware lawyers, the Court took the opportunity to discuss the possibility that there may be situations when less than a board majority may suffice. The Vice Chancellor theorized that corporations may choose, for example by charter or bylaws, to create standing litigation committees comprised of independent non-management directors who have the authority to accept derivative action demands without the participation of the full board.²⁶ Delaware law allows such committees of disinterested directors.²⁷ This independent committee may be given the authority to accept or deny derivative action demands. However in Beneville, no such committee was ever created. Had such a committee been created, denied the demand, and then it was proven that the committee composed of independent and disinterested directors conducted a proper review of the matters before it, considered a variety of factors and reached in good faith, a business judgment that the action was not in the best interest of the corporation, the result in Beneville may have been different.²⁸ Vice Chancellor Strine assumed in a footnote "that Delaware courts would give careful consideration to a claim by the defendants that demand must be made in such circumstances."²⁹

1 See generally, Delaware jurisprudence holding that directors owe a fiduciary duty of candor to disclose "fully and fairly all material information within the board's control." Stroud v. Grace, Del. Supr., 606 A.2d 75, 84 (1992). Delaware directors must also avoid misleading partial disclosures. Arnold v. Society for Sav. Bancorp., Del. Supr., 650 A.2d 1270, 1280 (1994). Most recently, in In re Marriott Hotel Properties II, L.P., Del. Ch., C.A. No. 14961, 2000 WL 128875, Lamb, V.C. (Jan. 24, 2000), in the context of defendants' disseminating a false and misleading offer to purchase in connection with a tender offer, the court explained: "Where, as here, the lone source of disclosure is a fiduciary having a conflicting interest, an obligation of complete candor is imposed on the fiduciary and judicial scrutiny of the disclosure is more exacting." Id. at *11.

2 Beneville v. York, Del. Ch., C.A. No. 17638, n. 2, Strine, V.C., ( July 10, 2000).

3 Rule 23.1 provides in pertinent part: "The complaint shall...allege with particularity the efforts, if any...to obtain the action the plaintiff desires from the directors...and the reasons for the plaintiff's failure to obtain the action or for not making the effort."

4 Brehm v.Eisner, Del. Supr., 746 A.2d 244, 254 (2000); Grimes v. Donald, Del. Supr., 673 A.2d 1207, 1216 (1996).

5 See, e.g., Mizel v. Conelly, Del. Ch., C.A. No. 16638, 1999 WL 550369, at *4, Strine, V.C. (Aug. 2, 1999) (demand excused where directors possessed either disabling self-interest or were beholden to other directors who did possess such self-interest).

6 Brehm, 746 A.2d at 254.

7 Rales v. Blasbad, Del. Supr., 634 A.2d 927, 934 (1993).

8 The proper time to measure demand futility is as of the date the original complaint was filed. Harris v. Carter, Del. Ch., 582 A.2d 222, 228 (1990). At the time the original complaint was filed the CARNET Board was comprised only of two persons, including defendant York.

9 Rales, 634 A.2d at 934.

10 Beneville at 6-7.

11 Id. at 11.

12 Id.

13 Aronson v. Lewis, Del. Supr., 473 A.2d 805, 815 (1984).

14 R.F. Balotti and J. Finkelstein, Del. Law of Corps. & Bus. Orgs., 3d ed. § 13.13 (2000 supp.) (citing Katell v. Morgan Stanley Group, Inc., Del. Ch., C.A. No. 12343, 1993 WL 10871, Chandler, V.C. (Jan. 14, 1993) (applying corporate principles to limited partnership case, finding demand to be excused where complaint alleged that one of two 50-percent general partners was self-interested). See also D. Wolfe and M. Pittenger, Corporate and Commercial Practice in the Delaware Court of Chancery § 9-2(c)(1), at 607 (1998) (citing Katell).

15 Beneville at 8 (citing Levine v. Smith, Del. Supr., 591 A.2d 194, 205 (1991)).

16 Katell v. Morgan Stanley Group, Inc., Del. Ch., C.A. No. 12343, 1993 WL 10871, at *1, Chandler, V.C. (Jan. 14, 1993)

17 Id. at *5.

18 Id.

19 Id.

20 Id. In this regard, the Katell court's reasoning is consistent with other decisions equating the pre-suit demand analysis in corporate and partnership derivative actions. See Litman v. Prudential-Bache Properties, Inc., Del. Ch., C.A. No. 12137, 1993 WL 5922, at *3, Chandler, V.C. (Jan. 4, 1993) (holding duties of general partner and a director are very similar and demand futility issue in the partnership context is the same as in the corporate context); see also Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., Del. Ch., C.A. No. 15754-NC, 1998 WL 832631, at *5, Steele, V.C. (Nov. 10, 1998); Seaford Funding Limited Partnership v. M&M Associates II, L.P., Del. Ch., 672 A.2d 66 (1995).

21 Beneville, at n.9.

22 Id. at 11.

23 Id. (quoting Levine, 591 A.2d at 205.)

24 Id. at 13.

25 Id. at 13-14.

26 Cf. Kahn v. Tremont, Del. Ch., C.A. No. 12339, mem. op. 1992 WL 205637, Allen, C. (Aug. 21, 1992) & C.A. No. 12339, mem. op., 1994 WL 162613, at *1 & n.2, Allen, C. (Apr. 21, 1994, rev. Apr. 22, 1994) (citing Zapata Corp. v. Maldanado, Del. Supr., 430 A.2d 779, 778 (1981), rev'd on other grounds, Del. Supr., 694 A.2d 422 (1997)).

27 8 Del. C. section 144.

28 See Zapata Corp. v. Maldanado, Del. Supr., 430 A.2d 779, 787 (1981), rev'd on other grounds, Del. Supr., 694 A.2d 422 (1997).

29 Beneville at n. 16.