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New Delaware Guidance on SLCs

In Sutherland v. Sutherland, Delaware Vice Chancellor Stephen Lamb has provided important guidance on the use of special litigation committees to resolve shareholder derivative litigation. (HT: Pileggi)

First, with respect to the composition of the committee:

At the time the SLC was formed, the court agreed to impose a brief stay of proceedings to permit the SLC to do its work without the interference that would be caused by the simultaneous conduct of discovery by the plaintiff. The court did so reluctantly, and only after observing that the use of a one-person SLC in the context of these closely held corporations pressed the theory of Zapata to the extreme. The court made it plain that both the independence of the SLC and the good faith of its inquiry would be the subject of close scrutiny if the investigation resulted in a recommendation that the litigation be dismissed.

This makes sense. It’s important to remember that we’re dealing eher with demand excused cases. As such, a majority of the board of directors has been disabled by conflicted interests or some other equally serious ground. Because the members of the committee typically are appointed by the defendants to the derivative litigation, there is a natural concern that the persons selected will be biased in favor of the defendants. We know from research on group decision making that one advantage of group over individual decision making is that group members monitor one another’s effort and good faith. Because a one person committee lacks that internal constraint, more intrusive external judicial review seems warranted.

Second, with respect to the format of the SLC report, Lamb wrote:

The Report summarizes the investigation done and factual conclusions reached by the SLC in a format that entirely omits any record citation, either to documentary evidence or to the witness summaries the SLC’s counsel prepared in the course of its investigation. The Report does contain an appendix but it is limited to certain analyses of one particular aspect of the complaint. None of the source documents or testimonial evidence is found therein. Nonetheless, as sometimes happens in situations of this kind, the Report is relied upon by the nominal defendants as if it were itself evidence of both the good faith of the SLC’s investigation and the factual conclusions it reached. This shortcoming was the central argument around which the plaintiff developed her opposition brief. ...

Although the SLC argues that a report need not cite to documents entered into the record, such citations would undoubtedly aid the court’s evaluation of the report.

Lamb refused to allow the SEC to submit a supplemental materials. This highlights the need for the SLC to clearly document its conclusions.

Lamb’s criticism of the report’s failings seems well founded. Under Zapata, tn deciding whether to dismiss the action, the court is to apply a two-step test: (1) The court should inquire into the independence and good faith of the committee. The court also should inquire into the bases supporting the committee’s recommendations. The corporation will have the burden of proving independence, good faith, and a reasonable investigation. (2) If the first step is satisfied, the court may but need not go on to apply its own business judgment to the issue of whether or not the case is to be dismissed.

Under the first step, a Delaware court looks not only at the procedures used, but also at the reasonableness of the basis for the committee’s decision.  In other words, Delaware judges make sure the investigative results support the committee’s conclusions. A committee that fails to facilitate that process by providing adequate citation and documentation is asking for trouble.