United States: Shareholder's Challenge To Smith & Wesson SLC's Independence Misfires In The First Circuit

Last Updated: February 16 2015
Article by Lily Becker

On February 4, 2015, the First Circuit affirmed the summary dismissal of a shareholder derivative suit, which brought Nevada state claims for breach of fiduciary duty, waste of corporate assets, unjust enrichment, and entitlement to contribution or indemnification against Smith & Wesson and its officers and directors. Plaintiff alleged Smith & Wesson made false and misleading statements when it overstated its sales projections and earnings guidance while demand collapsed and the Company had excessive inventory. During the course of the litigation, the suit was transferred to the federal District Court of Massachusetts, which granted summary dismissal, upholding the independence of a Special Litigation Committee and the reasonableness of its conclusion not to pursue a claim against defendants. Because Nevada adopted Delaware state law, the First Circuit applied Delaware law to make its ruling.

Before the litigation, in response to multiple demands on the board, Smith & Wesson formed a Special Litigation Committee ("SLC") to investigate the validity of the allegations. The SLC was comprised of three directors, two of whom were outside directors and members of the Audit Committee. The SLC engaged outside counsel and concluded that there was insufficient evidence to substantiate the allegations and that it was not in the best interest of the company to pursue the suit. Plaintiff subsequently pursued the derivative claim and the SLC moved for summary dismissal, which, under Delaware law, is a motion to terminate a derivative suit because the SLC recommended against filing any claims. To succeed on a motion for summary dismissal, the corporation must show the SLC's independence and good faith, and a reasonable basis for its conclusions.

In his appeal, Plaintiff challenged the lower court's finding that the SLC was independent, arguing that the SLC could not make an independent decision since its members were defendants. Additionally, Plaintiff argued that the SLC members were not independent since two of them were members of the Audit Committee, and thus reviewed and approved the alleged misstatements.

The First Circuit rejected Plaintiff's arguments, noting that Delaware has no per se rule that "an SLC's independence is destroyed by either naming a member as a defendant or as member's past approval of a disputed statement," and that Plaintiff must "show more" to suggest that an SLC member's board position influenced his decision as a member of the SLC. The Court reasoned that such a per se rule would be impractical since a plaintiff could manipulate the process by naming a member of the SLC as a defendant after the committee's formation, thereby "undercutting the legitimacy of its conclusions." Additionally, most corporations have small boards and thus an SLC will frequently have at least one member who approved the relevant transaction.

Applying the principle that "a director is independent when he is in a position to base his decision on the merits of the issue rather than being governed by extraneous considerations or influences," the Court found the SLC to be independent since it was comprised of three experienced directors, two of whom were outside directors on the independent Audit Committee, and Plaintiff did not bring any evidence to suggest the SLC's bias. The Court found that the SLC did not draw any formal conclusions before its investigation and that even though evidence showed that the SLC had preliminary views, this did not by itself constitute prejudgment on the issue. This opinion further confirms the interpretation of Delaware law in the First Circuit, and thus can provide guidance to companies and outside counsel when forming an SLC in response to demands on the board.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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