SLCs and Responding to Shareholder Demands: How to Investigate Alleged Director Misconduct

This article is the second in a two part series. Part 1 explains the underlying reasons for SLCs, the lawsuits in which SLCs are involved, the powers of the SLC and the process the SLC must undertake to remain independent and disinterested in the process. This installment explores the investigation process an SLC undertakes; the SLC decision-making process; the options available to the SLC including dismissals, settlements and pursuing litigation; and how company insurance can play in. Overall, this two-part series is designed to provide a high-level overview with key insights to directors on what they need to know when facing the question – what does it mean to be a member of an SLC?

The Investigation

The purpose of the SLC’s investigation is to determine whether the claims asserted have merit and whether it is in the best interest of the company to pursue those claims. The thoroughness and good faith of the investigation may be used to challenge the SLC’s conclusions. Thus, it is important to undertake a formal, well-documented, and extensive investigation. This will allow you to understand the circumstances and context behind the events or transactions at issue and better decide the outcome. When courts examine the good faith and reasonableness of the investigation, some factors they may consider include:

• The use of capable counsel.[1] Courts will likely look to the use of capable counsel as an indicator of a good faith investigation.

• The duration of the investigation.[2] There is no magic number for the duration of the investigation. The reasonableness of the duration of the investigation is proportional to the subject matter.

• The SLC’s meetings.[3] Much like the duration of the investigation, there is no magic number of times the SLC must meet. However, the SLC should meet regularly and maintain meeting minutes.

• Document review.[4] The SLC should collect and review relevant documents including corporate documents and communications (i.e., emails) if necessary. The SLC may rely on law firms to assist with large document review but should be involved in the process and review key documents.

• Interviews.[5] The SLC may rely on counsel to lead interviews but should at a minimum attend key interviews and/or review interview summaries for interviews they do not attend.
• The SLC’s final report.[6] The SLC’s final report should thoroughly document the investigation process and conclusion.

The SLC’s Decision

At the conclusion of its investigation, the SLC will determine that it is in the best interest of the company to dismiss, settle or pursue the claims involved in the demand.[7] The SLC’s report should support this conclusion. If a lawsuit has been filed, the SLC report is generally provided to the court and the shareholders who provided the demand. In assessing the determinations of the SLC, the court will assess whether the SLC was in fact independent and disinterested, acted in good faith in its analysis and investigation and whether its investigation was sufficient in light of the demand.

• Request to dismiss the entire action. If the SLC determines that dismissal is appropriate, the shareholders will likely contest the decision. To defeat the contest, it is imperative to have a well-documented review process to show the court that the investigation was reasonable and conducted in good faith. To avoid a courtroom battle, it may be helpful to maintain contact with the shareholder’s counsel throughout the investigation that helps show good faith and reasonableness of investigation. We would anticipate the shareholder’s counsel will likely not be cooperative or agreeable on the SLC’s determination, at least initially. From our experience, it is important to communicate with the demand shareholders’ counsel for a number of reasons, including ensuring the court understands that the SLC has undertaken all reasonable review of relevant information, which likely should include the views and alleged evidence of the demand shareholders and their counsel.
• Request to settle some or all of the claims as to some or all of the officers/directors or other defendants in a derivative lawsuit. In some instances, likely more than most people expect, an SLC may determine that there are viable legal claims against some and/or all of the officers, directors or other potential parties. In these instances, there are number of factors to consider in determining whether to pursue and/or settle a matter including without limitation: (1) the costs/benefits of proceeding with litigation vs. settlement; (2) how insurance may play into any such decision, claim or judgment and/or settlement (insurance discussed further below); and (3) assessing how, if at all, the demand shareholders and their counsel view the settlement and whether they will attempt to oppose such a settlement and/or seek attorney’s fees claiming their involvement and that of their clients provided value to the company. The settlement analysis can be complex, and it is important to consider all issues above as well as other issues that may apply, such as SEC reporting obligations and any ramifications that may result from such a disclosure. For the SLC, the key component is again whether pursuing and/or settling any claim is in the best interest of the company.
• Pursue litigation. Should the SLC seek to pursue claims, and should the court approve, claims will then proceed as requested by the company. In this instance, the company can be the party to bring the action against the defendants on behalf of the company. This may require the company to again seek counsel to purse the claims. Another option is to consider whether the demand shareholders’ counsel may continue its lawsuit as to the claims and defendants the SLC determines are appropriate.

Settlement/Dismissals Generally

As noted above, contrary to general belief, many SLCs decide to either settle or pursue derivative claims. In fact, a 2009 study published in the Indiana Law Journal debunked the hypothesis that special litigation committees invariably decide to dismiss shareholder derivative litigation. Using data from public filings at the time, the study found that approximately 40 percent of the time, SLCs either settled claims or pursued them against one or more defendant.[8]

After the SLC concludes its investigation, the parties will likely attempt to settle. A shareholder derivative action may not be settled without the approval of the court.[9] Notice to shareholders is also required.[10] The court will hold a fairness hearing to determine whether the settlement and/or dismissal as requested by the SLC is appropriate. Shareholders may oppose the SLC’s decisions as they deem appropriate.

Generally, if the court renders an order accepting the conclusions of the SLC and ordering dismissal, partial dismissal, settlement and/or partial settlement, that decision will receive res judicata effect. Res judicata, means that any effort by another shareholder or shareholders to pursue the same or similar action should be dismissed, providing the company with a level of certainty that once settled or dismissed, other shareholders cannot bring the same claims again and the matter is concluded.

Navigating Indemnity and D&O Insurance

One of the considerations for the SLC is the role of indemnity agreements and D&O insurance.

In order to encourage individuals to serve in corporate governance, companies often agree to indemnify directors and officers against lawsuits brought against them. This indemnity typically extends to advancement of costs of defense. These indemnity agreements are backed by the company’s assets. Thus, when directors and officers are accused of wrongdoing and the SLC begins its investigation, the company’s assets may already be depleting. Advancement of expenses may be conditioned upon the eventual repayment if the director or officer is held liable. However, at the end of the litigation, the directors and officers may be unable to repay the advances. Thus, it is important to monitor advancements and the coverage available under insurance.

Tip: Assess advancement of costs of defense early on and analyze whether the directors and officers will have to repay those costs and under what conditions that repayment obligation is triggered. You should also assess whether the directors and officers will be financially capable of repaying these costs.

D&O insurance is liability insurance purchased by a corporation to protect its officers, directors and its own assets against liability claims. In recent years, D&O insurance has increased in price due to increased shareholder and derivative litigation.[11]

Standard D&O policies provide a single policy limit that is shared among three types of coverage: “‘Side A,’ for the directors and officers when they are not indemnified by the company or not otherwise insured; ‘Side B,’ for reimbursement of the company when it indemnifies directors and officers; and ‘Side C,’ for certain claims against the company itself.’”[12]

As a general matter, one consideration for the SLC is whether the claims and any settlement and/or possible judgment are eligible for coverage.

The key issues to consider are the coverage limits and coverage exclusions.

Coverage Limits

Coverage under D&O policies has limits. A company can have one carrier provide insurance or have a tower of insurance who participate in a tiered risk structure known as a coverage stack. The primary carrier will be first in line to pay from its insurance policy, which generally covers cost of defense (legal fees and expenses).

Coverage Exclusions

D&O policies typically have coverage exclusions. On the more obvious end of the spectrum, D&O policies are not designed to cover intentional criminal acts. But what about “gross negligence” or even terms as plain as “misconduct”? These types of exclusions require more extensive review and analysis. It is important to get out in front of these issues. If you conduct the investigation first, spend months on document review and interviews and then decide to pursue litigation without assessing how (if at all) D&O insurance may play into the action, you have left an important hole in your analysis.

Further into the forest, a policy exclusion that may have unique application in derivative litigation is known as the “insured vs. insured” exclusion. This exclusion generally excludes coverage for claims brought between insured persons, which may affect insurance for derivative litigation. Furthermore, there may be an exclusion specifically discussing derivative claims. Assessing the language early on is important.

There are a number of factors to consider and assess. With indemnification, it is important for the company to understand whether the officers and directors it is considering pursuing in litigation will seek indemnification for the claims to be made against them. Furthermore, it is important to assess and understand how potential D&O insurance may apply for such claims. These factors all play into an assessment of what steps are in the best interest of the company.

Conclusion

A properly authorized and constructed SLC that diligently investigates shareholder demands in good faith can efficiently resolve shareholder disputes in the best interest of the company. However, directors are not given a playbook on how best to approach their newfound role of SLC member. We hope that this article provides prospective and current SLC members useful insights into the questions and issues each SLC member will face and what steps they should consider as they take on this important role for the company they serve.

Authors’ note: This article is the second in a two-part series designed to provide a high-level overview with key insights to directors on what they need to know when facing the question: what does it mean to be a member of an SLC? Part 1 provides an introduction explaining the underlying reasons for SLCs; the lawsuits in which SLCs are involved; the powers of the SLC; and the process the SLC must undertake to remain independent and disinterested in the process. Part 2 explores the investigation process an SLC undertakes; the SLC decision-making process; the options available to the SLC including dismissals, settlements and pursuing litigation; and how company insurance can play in.

[1] Katell v. Morgan Stanley Group, Inc., 1995 WL 376952, *10 (Del. Ch. 1995) (good faith investigation found where SLC “selected capable counsel to assist their investigation and relied heavily on that counsel”); Grafman v. Century Broadcasting Corp., 762 F. Supp. 215, 220 (N.D. Ill. 1991) (“Another indicia of good faith and reasonableness of the investigation is the use of capable counsel.”)

[2] See Strougo v. Bassini, 112 F. Supp. 2d 355, 365 (S.D. N.Y. 2000) (applying Maryland law) (holding that five-month period between the commencement of document assembly and the time the draft report was filed was not an unreasonable time); see also Spiegel v. Buntrock, 571 A.2d 767, 772, (Del. 1990) (affirming dismissal of derivative complaints based on report that followed five-month investigation).

[3] See Scalisi v. Grills, 501 F. Supp. 2d 356, 363 (E.D.N.Y. 2007).

[4] See Johnson v. Hui, 811 F. Supp. 479, 489, (N.D. Cal. 1991) (approving SLC’s reliance on counsel to gather documents and interview witnesses where this did not affect “independence of the SLC, the reliability [of the] SLC’s evidence gathering, or the reasonability of the SLC’s analysis”)

[5] See Strougo, 112 F. Supp. 2d at 360 (noting favorably that both members of SLC participated in majority of witness interviews and reviewed and approved counsel’s interview summaries); see In re Take-Two Interactive Software, Inc. Derivative Litigation, 2009 WL 1066251, *7 (S.D. N.Y. 2009), certification denied, 2010 WL 882987 (S.D. N.Y. 2010) (where Plaintiffs failed to “proffer evidence that [counsel] conducted the interviews in an unreasonable manner…. It was … not unreasonable, as a matter of law, for the SLC to rely on competent counsel as its agent in conducting the interviews.”).

[6] Grafman v. Century Broadcasting Corp., 762 F. Supp. 215, 220 (N.D. Ill. 1991) (“The report included an exhaustive review of over 20,000 documents, evaluation of financial transactions, and interviewing of 20 witnesses. The court is satisfied that the investigation was thorough. …”).

[7] Minor Meyers, The Decisions of the Corporate Special Litigation Committees: An Empirical Investigation 1309, 1332, Indiana Law Journal (Vol. 84:1309, 2009) (“Contrary to the predominant view in legal scholarship, SLCs do not invariably move to dismiss litigation. Instead, approximately forty percent of the time SLCs either settled claims or pursued them against one or more defendants.”).

[8] Id.

[9] Fed. R. Civ. P. 23.1(c) (“A derivative action may be settled, voluntarily dismissed, or compromised only with the court’s approval. Notice of a proposed settlement, voluntary dismissal, or compromise must be given to shareholders or members in the manner that the court orders.”).

[10] Id.

[11] Sarah Downey, Rising Insurance Prices and Intensifying Risks: 5 D&O Priorities for 2021.

[12] Sarah H. Mitchell, Current Trends in Directors and Officers Liability Insurance (Dec. 20, 2018).