FLI Deep Marine LLC v. McKim; the Futility of Claiming Demand Futility After a Demand Has Been Made

Much of the law can be a trap for the unwary. This is particularly true with procedure. Even experienced counsel can blow it. Such appears to have been the case with plaintiffs’ counsel in this derivative action. By his letter opinion of April 21, 2009 (2009 WL 1204363) Vice Chancellor Noble dismisses this derivative action for plaintiffs’ failure to allow the board of directors of Deep Marine Holdings, Inc. (“DMT”) adequate time to respond to plaintiffs’ litigation demand.

A. Plan Ahead

Plaintiffs complained that DMT had been looted for personal gain for some four years by its controlling shareholders, acting through their controlled directors, also named as defendants in the lawsuit. But plaintiffs filed their action after plaintiffs’ counsel had demanded of the board that it take remedial action and appoint a special litigation committee to investigate the alleged breaches of duty. In response to the demand, the board established a special litigation committee, comprised of two of the defendant directors.

Notwithstanding the making of their demand, in their post-demand lawsuit, plaintiffs alleged that demand on the board was futile and should be excused, notwithstanding that they had already made one!

B. The Law Is the Law

Chancery Rule 23.1 requires that a shareholder seeking to assert a claim on behalf of a Delaware corporation to first make demand on the directors to obtain the action desired, or “state with particularity the reasons for the shareholder’s failure to make such effort.” Letter Opinion at 6-7.

The action of a board in responding to a demand is generally subject to review under the “deferential” business judgment rule, “which presumes that a board is independent, and acts reasonably and in good faith.” Letter Opinion at 7. Where a derivative plaintiff seeks to avoid demand and proceed directly with litigation on behalf of the corporation, then the inquiry focuses on “director independence” and “disinterestedness,” which plaintiff can rebut by alleging particularized facts challenging the independence of the directors and creating “a reasonable doubt that the challenged conduct was a valid exercise of business judgment.” Id.

However, where a shareholder chooses to make a demand upon a board, then the shareholder “concedes the independence of a majority of the board.” Id. at 8. In such circumstances, the Chancery Court “only examines the good faith and reasonableness of the board’s investigation.” Because plaintiffs in this action made a pre-suit demand upon DMT’s board of directors, “they have conclusively conceded the independence of the Board, and are precluded from now arguing that demand should be excused because the directors are conflicted.” Id. at 8. The Vice Chancellor reaches this conclusion notwithstanding plaintiffs’ pleas that, given the makeup of the special committee appointed to respond to their demand, the exercise would be a “mockery,” “contrived,” and a “farce.” While, based upon the allegations of the complaint, plaintiffs might well be correct, too bad: the Court “cannot diverge from settled law.” Id. at 9.

In words that undoubtedly cause plaintiffs’ counsel considerable heartburn, the Vice Chancellor observes that, yes, their demand may very well have been a misstep:

“In light of these facts [plaintiffs’ allegations of the lack of independence of the board], the Plaintiffs’ decision to make a demand upon the Board appears inprovident. The Plaintiffs ask the Court to undo the consequences of their demand; this Court will not part ways with established Delaware law to grant the Plaintiffs relief from a strategic decision they now regret.”

Id. at 10.

C. Spiegel v. Buntrock

This has happened before. It seems to be a habit of derivative plaintiffs. In a similar vein, the Delaware Supreme Court, in Spiegel v. Buntrock, 571 A.2d 767 (1990), likewise concluded that, when a shareholder makes a pre-suit demand, the shareholder “tacitly concedes the independence of a majority of the board to respond.” 571 A.2d at 777. The facts of Spiegel were even more dramatic: Spiegel first filed his derivative action. When respondents protested that he had not made a pre-suit demand, Spiegel dutifully responded by filing a demand! Gotcha! Once such demand is made, then the business judgment rule applies to the board’s response to the demand, and the issues on review of any board decision “are solely the good faith and reasonableness of the committee’s investigation.” 571 A.2d at 778, citing Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (1981). The focus is on process, not the ultimate decision, since that decision is not subject to judicial review. Id.

So it’s back to the drawing boards for plaintiffs in this case. If defendant DMT’s advisors have any brains, the special committee will follow accepted practice, appoint one or more disinterested directors, advised by special counsel, and reach the inevitable decision not to litigate. Only if DMT is foolish enough to leave the decision on how to respond to the demand in the hands of directors who are alleged, through particularized pleading, to have engaged in misconduct, would plaintiffs have a shot at claiming the board’s response was not one made in “good faith.”