The derivative action report: more trouble than it's worth?

• Author: Mrachek, L. Louis

When a plaintiff files a derivative action on behalf of a corporation, the board of directors of that corporation has the right to appoint an individual, the independent investigator, or a group of individuals, the Special Litigation Committee (SLC), to review the derivative action and to recommend if that litigation should be dismissed. If the investigator or the SLC (collectively the "reviewer," for want of a better term) recommends in a written report that the derivative action be dismissed, the corporation may file a motion seeking to dismiss, with prejudice, the derivative action. This written report, together with the legal and practical problems it creates both for the corporation and the lawyers advising the corporation, is the subject of this article.

On its face, although the process is subject to a number of contingencies, it would seem that the corporate decision to seek such a report is a no-brainer. That is so because, according to Florida law, the court may dismiss the case if 1) the report recommends dismissal; 2) the reviewer was "independent"; 3) the investigation leading to the report was reasonable and performed in good faith, and, therefore, is entitled to the deference given to corporate decisions by the business judgment rule; and 4) the court concludes that it would have resolved the issue, using its independent business judgment, (1) just as the reviewer did (an issue that the court may, but does not have to, consider). (2) Dismissal of the derivative action is the best that can result from the report, but dismissal is far from a certainty and problematically, along the way, there are any number of detriments that can result from the preparation of the report, and those detriments can easily outweigh the possibility of any dismissal.

Who Makes the Report

F.S. [section]607.07401(3)(a) and (b) provides that the board of directors may appoint either of the following to review the derivative action: 1) a committee consisting of two or more independent directors (the SLC); or 2) a panel of one or more independent persons appointed by the court upon motion by the corporation (the independent investigator).

SLCs and independent investigators by their evaluation of the derivative action:

serve to balance the rights and duties of the board and the dissenting shareholder by providing the corporation with "an important tool to rid itself of meritless or harmful litigation" while preventing directors from using the committee "to wrest control of bona fide derivative claims away from well-meaning plaintiffs." (3)

The statutory requirements for the appointment of the reviewer are straightforward, but for two issues: 1) the independence requirement discussed below; and 2) whether the independent investigator can be a sitting member of the board of directors of the corporation on whose behalf the derivative action is brought. If that were the case, in effect, there could be an SLC of one director, when the statute requires two or more directors. In fact, some states, but not Florida, would seem to permit SLCs of one director. (4) But in none of those cases is the one member a sitting member of the board, and in all of those cases the sole reviewer is subjected to the increased scrutiny given to the independence of the reviewer, the smaller the size of the committee. (5) "If a single member committee is to be used, the member should, like Caesar's wife, be above reproach." (6)

If a corporation is willing to run the risk of the heightened scrutiny given to an independent investigator who is a sitting member of the board, there appears to be no absolute bar to such an appointment. However, that individual, as any independent investigator, would be subject to judicial review of its independence prior to appointment by the court, unlike an SLC, whose independence is reviewed by a court only if and when the SLC submits a written report recommending dismissal and the corporation moves to dismiss the derivative action based on that report. This is the only significant difference between an SLC and an independent investigator.

There is one less significant difference between an SLC and an independent investigator and that is that the corporation has an absolute right to appoint an SLC, there being no statutory requirement of judicial appointment, whereas a corporation does not have the absolute right to the appointment of an independent investigator. Although the issue seldom comes up, appointment of an independent investigator is a matter of discretion for the court, and there are cases in which motions to appoint an independent investigator have been denied. (7)

Independence

The most important and heavily ligated requirement of the reviewer is that of independence. (8) Courts look at the "totality of the circumstances" to determine if the reviewer "is in a position to base his decision on the merits of the issue rather than being governed by extraneous considerations or influences." (9) A number of factors are usually considered: "(1) a [reviewer's] status as a defendant, and potential liability; (2) a [reviewer's] participation in or approval of the alleged wrongdoing; (3) a [reviewer's] past or present business dealings with the corporation; (4) a [reviewer's] past or present business or social dealings with the individual defendants; (5) the number of directors on the [reviewer]; and (6) the 'structural bias' of the [reviewer]." (10)

Simply because a reviewer is a defendant, and particularly one with nominal liability, does not necessarily mean that a reviewer lacks independence. Courts have been relatively generous to the reviewer on this point, the logic being that "[t]o allow one shareholder to incapacitate an entire board of directors merely by levying charges against them gives too much leverage to dissident shareholders." (11) Other courts also have noted that business or personal relationships between the reviewer and the derivative defendants, standing alone, do not indicate anything inappropriate or suggest that the reviewer would not faithfully discharge its duties. "[I]t would be a strained and artificial rule which required a director to be unacquainted or uninvolved with fellow directors in order to be regarded as independent." (12)

Some courts, (13) although a small minority, (14) have held that SLCs may not be utilized at all because of the structural bias inherent where a majority of the directors, because they are named as defendants, could not terminate a derivative action, yet could appoint a committee of their fellow directors who would have that power. (15) Other courts have noted that "[s]tructural bias exists because the ... members [of the committee] have backgrounds and expertise that are similar to that of the defendant directors" and, accordingly, "this commonality of experience translates into a sympathetic analysis by the ... [committee] of the defendant directors' decisions." (16) Obviously, those courts holding that an SLC of two or more disinterested directors cannot be used because of the threat of structural bias, would use the same logic to reject an independent investigator who also was a sitting director of the board that had nominated him or her. (17) However, the vast majority of courts have not rejected the usage of SLCs on account of structural bias, but rather have scrutinized carefully the report rendered by such SLCs in light of the potential for structural bias in any given situation. (18)

Florida courts and those courts interpreting Florida law have been as strict as any courts in scrutinizing the independence of the reviewer. One court rejected the motion to terminate the litigation based upon the SLC's report because there were questions of material fact as to the independence and good faith of the SLC, when the SLC consisted of two sitting members of the board while the defendant was the only other member of the board and exercised voting control over the corporation. (19) In another case, the court denied the corporation's motion to dismiss because the SLC consisted of two sitting members of the board, who were also defendants in the derivative action and themselves faced possible substantial liability because the indemnification policy that the corporation contended rendered them independent was limited to $10 million, while the claimed damages were between $63 and $210 million. (20) Finally, in a case in the Southern District of Florida, the court denied the corporation's motion to dismiss, in part, because the corporation failed to meet its burden by the preponderance of the evidence to prove that the reviewers were independent. (21) In that case, the court reviewed the independence of both the "evaluation committee" and the 10 directors who collectively voted to terminate the derivative action, because the board reserved unto itself the right to review the decision of the evaluation committee. The court noted that the directors, even if they are nominal defendants, might be independent, but when the liability is direct and substantial, for that reason alone the directors' independence was suspect.

The Investigation

The general requirement is that as a predicate for any report, the reviewer must "conduct a thorough and careful analysis regarding the plaintiff's derivative suit." (22) Florida courts have required the investigation to be "reasonable and objective." (23) "Some of the factors relevant to the adequacy of the committee's investigation may include the length and scope of the investigation, the use of experts, the corporation or defendant's involvement, and the adequacy and reliability of information supplied to the committee." (24) To assist the reviewer in meeting these standards, the reviewer typically hires its own legal counsel and then hires experts (CPAs, investment bankers, compensation experts, etc.) if and as appropriate.

The reviewer is statutorily charged to decide whether the maintenance of the derivative action is...