After the filing of a derivative lawsuit, it is common for the board of the company at issue to form a special litigation committee that will move to stay the action while it evaluates whether to pursue the derivative claims. More often than not, the Delaware Court of Chancery will grant that motion. But, in circumstances where the special litigation committee receives its mandate from a lone general partner, who has "a disabling interest for pre-suit demand purposes," the Court of Chancery will decline to recognize the committee's authority, including to investigate the derivative claims or to move to stay. See Wenske v. Blue Bell Creameries, (Del. Ch. Aug. 28, 2019).
In Wenske, two limited partners of Blue Bell Creameries (Blue Bell or the partnership) filed suit against the partnership's sole general partner, Blue Bell Creameries (BBGP), for failing to operate Blue Bell in compliance with the limited partnership agreement (the LPA). In particular, the plaintiffs asserted that BBGP's mismanagement caused "widespread contamination at Blue Bell's ice cream production facilities, a listeria outbreak infecting scores of Blue Bell customers, a temporary shutdown of Blue Bell's operations, and hundreds of millions of dollars of lost profits." The defendants moved to dismiss the plaintiffs' claims, but the Court of Chancery denied the motion, finding that "demand upon BBGP was excused because BBGP, as an entity, faced substantial likelihood of liability for breach of the LPA."
Almost one year later, BBGP created a special litigation committee (SLC) "to investigate all matters at issue in the derivative litigation and determine whether it is in the best interests of Blue Bell and its limited partners to pursue the claims." The SLC then moved to stay the derivative action to give it time to reach conclusions about the viability of the plaintiffs' claims. The Court of Chancery denied the SLC's motion to stay after finding that the SLC lacked independence. The court reasoned that a stay would serve no rational purpose since it was "clear that [the court] will never be able to defer to a decision by the [SLC]."
Although it declined to do so in this situation, the Court of Chancery typically will stay a lawsuit to afford a special litigation committee time to determine whether the underlying derivative action should be prosecuted. That is because special litigation committees exist to "promote confidence in the integrity of corporate decision-making by vesting the company's power to respond to accusations of serious misconduct by high officials in an impartial group of independent directors." Where, however, the special litigation committee appears to lack impartiality or independence, Delaware courts will decline to recognize the committee's existence. A special litigation committee may be found to lack impartiality when the body that created the committee faces a substantial likelihood for liability in the underlying derivative lawsuit.
A cornerstone of Delaware corporation law is that the board has sole authority to manage the affairs of the corporation, including the authority to delegate decision-making. Leaning on that logic, the Delaware Supreme Court, in Zapata v. Maldonado, 430 A.2d 779 (Del. 1981), held that a conflicted board can assume control over a derivative lawsuit by establishing a committee of independent directors to investigate the claims and determine whether to prosecute them. While this very concept applies in the partnership context, the analysis focuses on the general partner who, like a corporation's board, has broad authority to manage the business and affairs of the limited partnership. Where there is just one general partner, and it has been found to be conflicted, the general partner retains no authority to investigate and evaluate a derivative claim, or to appoint new board members to assume the investigatory responsibilities. Allowing a conflicted general partner to select a special litigation committee to serve at the general partner's pleasure would be tantamount to allowing the conflicted partner to investigate itself.
Given that reality, the Court of Chancery concluded that BBGP, as Blue Bell's lone general partner, could not avail itself of the special litigation committee and its benefits. There was no question that BBGP had a legal basis to appoint an SLC. Indeed, Section 6.1(a) of the LPA vested in BBGP the "exclusive right and full authority to manage, conduct, control and operate the partnership's business." "And, as permitted by 6 Del. C. Section 17-403(c), Section 6.11(c) [of the LPA] authorizes the general partner to appoint an agent to act as if it were the general partner. Thus, in the ordinary course, BBGP could delegate its authority to manage litigation claims, including the investigation of a putative or asserted derivative claim." Still, the Court of Chancery found BBGP too disabled by conflict to be tasked with making decisions about the plaintiffs' derivative claims. The same would be true of any agent to whom BBGP might delegate the duties of an SLC. BBGP's substantial likelihood of liability in the derivative action created the risk that BBGP might exert influence over the SLC in order to serve BBGP's interests to the detriment of Blue Bell and its limited partners. In short, "a special litigation committee that cannot act without the looming influence of the conflicted general partner is not legitimate under Zapata."
Since the court refused to recognize the SLC that BBGP created, it held that there was no rational purpose for a stay since the sole purpose of the stay was to allow the SLC determine the fate of the claims at issue.
Takeaway
Under Zapata, a general partner may create a special litigation committee to manage and determine whether to pursue derivative claims. If the general partner is found to be conflicted, it no longer has the authority to delegate control over the partnership's derivative actions to a special litigation committee. Moreover, since the general partner as an entity, not the board, has the authority to and responsibility of managing the partnership, issues of conflict cannot be cured simply by adding members to the partnership's board.
This case further suggests that a partnership concerned that it may have to cede control over litigation to derivative plaintiffs, instead of a special litigation committee, can address that issue in one of two ways. If the partnership has multiple entities serving as general partner, the nonconflicted entities could create a special litigation committee that is impartial on its face. The general partner also could amend the partnership agreement to include language triggering the creation of an independent special litigation committee in the event of a derivative lawsuit. For instance, the partnership agreement could call for the creation of a special litigation committee comprised of representatives selected by certain limited partners.
Reprinted with permission from Delaware Business Court Insider, © ALM Media Properties LLC. All rights reserved.
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