On April 2, 2020, Vice Chancellor Slights dismissed a derivative lawsuit that alleged that a Company’s Board breached its fiduciary duties by rushing to pay an “excessive” severance fee in order to facilitate the CEO’s separation from the Company, and as a means to cover up the Board’s slow and inadequate response to the CEO’s pattern of wrongful conduct. According to the Court of Chancery, Plaintiff’s claims were betrayed by the Complaint’s failure to demonstrate demand futility under either prong of the standard described in Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
Of note in this decision is that the Court of Chancery affirms the principle that, under typical circumstances, a general release provision in a settlement agreement (including the release of claims against directors) cannot form the basis of allegations that a board engaged in an “interested transaction.” That is especially true, where, as in this case, the claim purportedly avoided is one that is so weak that the Plaintiff elected not to bring it and raised it only in an effort to identify the Board’s interest in the Separation Agreement under the first prong of Aronson.
Background – CEO Behaves Poorly and is Terminated Pursuant to a Separation Agreement
The Complaint alleged that the CEO created a toxic culture, including by expressing views of male superiority and filling “the Company’s high-level executive positions with men,” turning the executive team into a boy’s club. Plaintiff further alleged that the CEO dated one of the Company’s designers and gave her preferential treatment. Once the Board became aware of the CEO’s conduct, it denounced the conduct and voted not to renew the CEO’s contract beyond 2017. Following the Board’s response, the CEO engaged in two additional instances of inappropriate behavior. After receiving notice of Incidents 1 and 2, the Board decided to investigate the CEO and hired outside counsel to do so. Based on outside counsel’s Report, the Board immediately began to negotiate the terms of the CEO’s separation from the Company.
Given that the CEO engaged in Incidents 1 and 2, after the Board declined to renew his contract, Plaintiff contends that the Board could have terminated the CEO “for cause,” precluding the CEO from receiving a severance. Instead, just one week after receiving outside counsel’s Report, the Board agreed to pay the CEO $5 million if he would, among other things: (1) release any and all claims he might have had against the Company; (2) resign from his position quietly and without disparaging the Company; and (3) extend the non-solicitation period in the Employment Agreement. The CEO agreed to these terms, and after entering into the Separation Agreement, the Company announced that the CEO “fell short of the Company’s standards of conduct” and had been removed from his role with the Company.
Procedural Posture – Plaintiff Files Suit Against the Board for Breach of its Fiduciary Duty by Approving the Separation Agreement
In response to the Board’s approval of the Separation Agreement, Plaintiff filed a derivative lawsuit, asserting that the Board breached its fiduciary duty by approving the Separation Agreement, and as a result, the CEO received unjust enrichment.
Plaintiff’s theory appeared to be that the Board acted in its own interest by approving the Separation Agreement because doing so allowed the Board to quickly sweep the CEO’s conduct under the carpet in order to avoid potential liability. According to Plaintiff, the Board’s self-interest caused it to overpay the CEO to separate from the Company.
Defendants moved to dismiss Plaintiff’s complaint for failure to establish demand futility. As the parties were briefing that motion, Plaintiff disavowed any attempt to plead a Caremark claim — i.e. that the Board failed to exercise appropriate oversight.
Analysis – Plaintiff Failed to Establish Demand Futility
Whenever a plaintiff elects not to make a pre-suit demand on the board, the related complaint must contain particularized facts supporting the conclusion that the pre-suit demand would have been futile because (i) a majority of the board is interested in the challenged decision, or (ii) the challenged decision was not a product of valid business judgment. The Court of Chancery found that Plaintiff’s complaint failed to satisfy either element of this Aronson test.
Under Aronson’s first prong, the Board could not be considered “interested” unless the Complaint contained particularized facts supporting the reasonable inference that at least 5 of the Board’s 10 directors appeared on both sides of the Separation Agreement, derived a personal financial benefit from the Separation Agreement, or were beholden to an interested person. The Court of Chancery found that the Complaint could not support any of the inferences necessary for demand futility.
First, the Board cannot be found to have benefitted from the Separation Agreement because the purported “benefit” was avoiding a Caremark claim that was so weak that Plaintiff decided not to bring it and represented to the Court that Plaintiff had no intention of raising such a claim in this litigation.
Second, general release language obtained by a board in a settlement cannot be the basis for an “interested party transaction,” except in “egregious” circumstances that did not exist in this litigation.
Third, Plaintiff does not identify any claims the CEO might have against the Board, or indicate whether the CEO’s claims would have been subject to the general release.
Fourth, the allegation that two directors worked for an entity that owned the Company’s stock does not render those two directors “interested” in the Separation Agreement in a manner inconsistent with the interests of the minority stockholders. To the contrary, this stake in the Company aligned the directors’ interests with the Company and its stockholders because a stockholder-director is more likely to act in the best interests of the Company.
To satisfy Aronson’s second prong, the Complaint needed particularized facts supporting the reasonable inference that the Board’s decision to enter into the Separation Agreement was “inexplicable with reference to business judgment.” Since the Company’s charter exculpates duty of care claims, Plaintiff could satisfy this prong of Aronson only with allegations that the Separation Agreement is so egregious on its face that the Board’s approval of it cannot meet the test of business judgment. No such allegations existed in this case.
Plaintiff also alleged that the Separation Agreement constituted corporate waste. The Court of Chancery disagreed because in exchange for the severance payment, the Company received (1) a release of claims against it; (2) the CEO’s commitment to a non-solicitation provision with an extended term; (3) liberation from the CEO’s troublesome tenure; and (4) the opportunity to correct a toxic workplace environment.