Corporate Governance

Plaintiffs and Prolixity: Wood v. Baum (Part 2)

By J. Robert Brown

We did an earlier post on Wood v. Baum, a recent Delaware Supreme Court upholding the dismissal of a derivative claim, emphasizing the unnecessary decision to accuse the plaintiff of engaging in "prolixity."  As is often the case, however, the tone telegraphs the outcome.  The "prolix" plaintiff lost. But let's see how the Court got there.

The Company, an LLC, “provides debt and equity financing to various parties, invests in tax-exempt bonds and other housing-related debt and equity investments, and is a tax credit syndicator that acquires and transfers low-income housing tax credits.”   Plaintiff alleges that the Company engaged in a number of improper practices, including improper valuation of assets, improper charitable contributions, improper related party transactions and inadequate internal controls.

The Company has certainly had some problems.  It has indicated that it would restate earnings. See Form 8-K filed April 2008 ("In September 2006, we determined that we had to restate our financial statements for 2005 and 2004 and for the first quarter of 2006. We are in the process of completing our financial statements at December 31, 2006 and for the year ended on that date, and our restated financial statements at December 31, 2005 and for the years ended December 31, 2005 and 2004."). It was also, apparently, delisted from the NYSE for failing to meet a deadline for filing audited financial statements for 2006 and now trades in the Pink Sheets.

The case came before the Chancery Court for disposition pursuant to a motion to dismiss for failing to make demand.  Demand excusal turned on whether the facts were sufficient to allege that the board's decision was not "the product of a valid exercise of business judgment."  The relevant standard, however, also confronted the Company's waiver of liability provision.  Delaware allows broad (indeed almost total) waiver of liability for directors/managers of LLCs (the authority is much broader than in the corporate context).

In this case, the operating agreement waived liability "except in the case of fraudulent or illegal conduct of such person." As a result, the case turned on whether the facts alleged behavior that would be sufficient to this type of behavior or to show bad faith (managers of LLCs are subject to a duty of good faith and fair dealing).  As the Court noted: 

• Where, as here, directors are exculpated from liability except for claims based on “fraudulent,” “illegal” or “bad faith” conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had “actual or constructive knowledge” that their conduct was legally improper. Therefore, the issue before us is whether the Complaint alleges particularized facts that, if proven, would show that a majority of the defendants knowingly engaged in “fraudulent” or “illegal” conduct or breached “in bad faith” the covenant of good faith and fair dealing. We conclude that the answer is no.

Plaintiffs, of course, had to do more than allege that bad things occurred inside the company. Instead, they had to tie the board to the behavior. The involvement centered on the signing of false reports, the authorization of certain transactions allegedly involving self dealing, membership on the audit committee and the disregard of red flags.

The rest of the opinion is a unilateral dismissal of each allegation, addressing each allegation seriatim as if they stood alone.  With respect to the contention that the board approved some of the improper transactions, the Court concluded that "Delaware law on this point is clear: board approval of a transaction, even one that later proves to be improper, without more, is an insufficient basis to infer culpable knowledge or bad faith on the part of individual directors."  Fair enough.  But the broad platitude in no way took into account that the board was approving self interested transactions and that the plaintiff alleged that there were red flags concerning the transactions.  In other words, the plaintiff did not assert that demand should be excused solely because of board approval. 

Moreover, this was an opportunity for the Court to set out some standards that boards must follow when addressing conflict of interest transactions (i.e. executive compensation).  The failure to do so is typical but is also an explanation for why there is increased federalization of fiduciary obligations (the movement towards say on pay the best current example).  If Delaware won't, the federal government increasingly will. 

Primary materials from the Chancery Court can be found at the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on July 16, 2008 (boomark / email).