In the decision of Harrison Metal Capital III, L.P., v. Mathé, et al., C.A. No. 2022-0261-PAF (Del. Ch. Mar. 27, 2024), the Delaware Court of Chancery considered whether plaintiff adequately plead demand futility under Rule 23.1 in its suit alleging that defendants, who were directors and officers of the company, breached their fiduciary duties by increasing their salaries and engaging in other harmful conduct to the company. This decision provides a helpful roadmap for properly alleging demand futility where a plaintiff chooses not to make a pre-suit demand upon the board.
Factual Background
Plaintiff Harrison Metal Capital III, L.P. ("Plaintiff" or "Harrison Metal") filed a complaint seeking to invalidate ratifications of corporate actions under Delaware law by alleging Defendants Olof Mathé and Bradford Vogel ("Defendants") breached their fiduciary duties owed to Plaintiff in their capacities as directors and officers of Mixmax, Inc. ("Mixmax" or the "Company"). Plaintiff alleged the Defendants inappropriately used Paycheck Protection Program (PPP) loan funds provided to the Company. Specifically, in their PPP loan forgiveness application, Defendants certified the funds would be used to retain employees, but Defendants instead laid off those employees and used the money for their own salary increases. Plaintiff further alleged other accounting irregularities, such as improperly counting voided invoices as income and purportedly making false representations to induce investments.
Analysis
Defendants moved to dismiss Plaintiff's Amended Complaint under Rule 12(b)(6) for failure to state a claim upon which relief can be granted, and under Rule 23.1 for failure to adequately plead demand futility. The Court of Chancery granted the motion for failure to plead demand futility.
Under Delaware law, in order for a stockholder to assert a claim on behalf of a corporation without board consent, plaintiff must "state with particularity: (A) any effort by the derivative plaintiff to obtain the desired action from the entity; and (B) the reasons for not obtaining the action or not making the effort." Ct. Ch. R. 23.1.
Here, Plaintiff did not make a demand upon the Company. Therefore, Plaintiff was required to adequately demonstrate that three of the five board members would be unable to impartially and fairly consider the demand to bring a claim against the Defendants.
Vice Chancellor Fioravanti noted that, under Delaware law, demand is futile if at least half of the members of the board are unable to consider the demand for one of the three reasons outlined in United Food & Com. Workers Union v. Zuckerberg, 262 A.3d 1034 (Del. 2021):
- [T]he director received a material personal benefit from the alleged misconduct that is the subject of the litigation demand;
- [T]he director faces a substantial likelihood of liability on any of the claims that would be the subject of the litigation demand; [or]
- [T]he director lacks independence from someone who received a material personal benefit from the alleged misconduct that would be the subject of the litigation demand or who would face a substantial likelihood of liability on any of the claims that are the subject of the litigation demand.
Id. at 1059. The Court further noted that "[t]o comply with Rule 23.1, the plaintiff must meet 'stringent requirements of factual particularity that differ substantially from . . . permissive notice pleadings.'" Id. at 1048.
In assessing whether the Amended Complaint adequately plead demand futility, the Court assumed that demand was excused as to Defendants Mathé and Vogel. In addition, it was undisputed that board member Dearing, the principal of Plaintiff, was capable of considering the demand. Therefore, Plaintiff was required to show that either of the remaining board members, Bar-Cohen or Fritjofsson, were incapable of considering the demand. Plaintiff argued that demand was excused because Fritjofsson and Bar-Cohen each lacked independence.
As to Bar-Cohen, plaintiff relied on 1) Mathé's prior removal of another board member as a director, Ritz, which according to Plaintiff showed that Mathé is willing to take retributive action against directors who disagree with him, and 2) the timing of Bar-Cohen's appointment by Mathé during this litigation. Relying upon the Delaware Court of Chancery decisions Ezcorp and Viacom, the Court found that a director's appointment by an interested controller who previously removed directors is not, by itself, dispositive. In re Ezcorp Inc. Consulting Agreement Deriv. Litig., 2016 WL 301245 (Del. Ch. Jan. 25, 2016); see also In re Viacom Inc. S'holders Litig., 2020 WL 7711128 (Del. Ch. Dec. 29, 2020), as corrected (Dec. 30, 2020).
The Court found that the allegations seeking to undermine Fritjofsson's independence were event weaker. Plaintiff argued that Fritjofsson acted to advance Mathé's self-interest by voting for and not objecting to the conduct Plaintiff challenged. But as Zuckerberg made clear, a director's participation in events giving rise to a derivative claim does not necessarily render the director incapable of considering the demand.
The Vice Chancellor found that three board members were capable of fairly considering a demand, and thus plaintiff was unable to persuade the Court that demand should be excused as futile. Accordingly, the Court dismissed the Amended Complaint.
Key Takeaway
This decision illustrates the necessity of adequately pleading demand futility under Rule 23.1 where a plaintiff strategically chooses not to make a pre-suit demand upon the corporation's board. Simply arguing that a director was appointed by an interested board member, or voted in favor of the conduct being challenged, is not by itself sufficient to adequately allege demand futility.
Originally published May 12, 2024
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