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Delaware Supreme Court Reaffirms High Standard for Pleading Demand Futility in a Director Oversight Case

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In an opinion released December 15, 2017, the Supreme Court of Delaware reiterated the state’s high standards for pleading demand futility in shareholder derivative suits. The Court affirmed a Chancery Court decision requiring plaintiffs alleging demand futility based on a Caremark violation to show scienter—that the board members knew they were breaching a fiduciary duty.

In City of Birmingham Retirement and Relief System v. Good, 2017 WL 6397490 (Del. Dec. 15, 2017), shareholder derivative plaintiffs brought breach of fiduciary duty claims against members of the board of directors of Duke Energy Corporation after the company pled guilty to environmental regulation violations. Duke Energy is an electricity provider based in Charlotte, North Carolina. After a pipe owned by Duke Energy ruptured, releasing 27 million gallons of coal ash slurry and wastewater into the Dan River, Duke Energy pled guilty to nine misdemeanor criminal violations of the Federal Clean Water Act. The company paid $102 million in fines, and agreed to restitution, community service, and mitigation. The shareholder derivative plaintiffs alleged that the company’s directors breached their fiduciary duties because they knew of, but disregarded, Duke Energy’s Clean Water Act violations.

Under Delaware law, a company’s board of directors has control over legal actions asserting rights held by the corporation. A shareholder seeking to usurp this authority first must either demand that the board bring such a suit or allege with particularity why making demand upon the board would have been futile. A plaintiff arguing demand futility bears a heavy burden.

When the alleged violation is of the board’s oversight duties, the plaintiff “must plead particularized facts raising reasonable doubt of the board’s independence and disinterestedness when the demand would reveal board inaction of a nature that would expose the board to a substantial likelihood of personal liability.” Id. at *5 (quotations omitted). When the board is protected from due care violations by an exculpatory provision, as was the board in Good, the plaintiff must allege particularized facts showing that the directors “acted inconsistent[ly] with [their] fiduciary duties and, most importantly, that the director[s] knew [they were] so acting.” Id. In Good, the plaintiffs had to demonstrate that “a majority of Duke Energy directors face[d] a substantial likelihood that they [would] be found personally liable for intentionally causing Duke Energy to violate the law or consciously disregard[] the law.” Id. at *13 (emphasis added). The Supreme Court of Delaware found, as the Court of Chancery did, that the plaintiffs failed to meet this pleading requirement.

As evidence that the Duke Energy directors knew about the Clean Water Act violations, the plaintiffs pointed to several presentations on environmental regulations given to the board before the pipe ruptured. One presentation highlighted proposed changes in EPA regulations and steps Duke Energy was taking to mitigate risks. A second presentation was a comprehensive review of the history of coal ash ponds and environmental regulation, on-going litigation, and steps Duke Energy was taking to mitigate financial and environmental risks at its own ash ponds.

The Court found that the board presentations showed that the board exercised oversight—not that it consciously disregarded its responsibility by purposefully ignoring environmental concerns. The Court concluded that the plaintiffs “conflate[d] the bad outcome of the criminal proceedings with the actions of the board.” Id. at *8.

The plaintiffs also alleged that the directors colluded with a regulator—the North Carolina Department of Environmental Quality (DEQ). The plaintiffs pointed to the relatively small fine the DEQ levied against Duke Energy after its initial investigation, the regulator’s purported overall lack of aggressiveness, and a federal court decision in a separate matter finding that the DEQ was not diligently prosecuting its case against Duke Energy.

Finding this evidence insufficient to excuse demand, the Court stated that to show demand futility, “it is not enough to allege cooperation with what plaintiffs describe as a too-friendly regulator. Instead, the plaintiffs must allege in sufficient detail that Duke Energy illegally colluded with a corrupt regulator. And then, plaintiffs must tie the improper conduct to an intentional oversight failure by the board.” Id. at *9 (emphasis added). The Court concluded that the DEQ’s relatively small fine, supposedly unaggressive compliance schedule, and allegedly business-friendly policies were insufficient to alert Duke Energy’s directors to corrupt activities between the company and the regulator. The Court further found that although the federal court’s ruling may show that the DEQ was not diligent in pursuing litigation with Duke Energy, it did not lead to a reasonable inference that the DEQ was corrupt and colluding with Duke Energy, and that the board knew about and consciously ignored the corruption.

Justice Strine authored a dissenting opinion. He agreed that the plaintiffs had to “plead facts supporting an inference that Duke consciously was violating the law, taking steps that it knew were not sufficient to come into good faith compliance, but which it believed would be given a blessing by a [corrupt] regulatory agency.” Id. at *14. He believed, however, that the plaintiffs had met this standard. In reaching this conclusion, Justice Strine emphasized that at the pleading stage, the plaintiffs did not need to have conclusive proof of all their contentions.

This case reaffirms the high standard a shareholder derivative plaintiff must meet to prove demand futility in a director oversight case when the board is protected by an exculpatory provision. Delaware courts will not allow a shareholder derivative action to proceed against a board in such a situation unless the shareholder pleads particularized facts showing that the directors intentionally disregarded their oversight responsibilities such that their dereliction of fiduciary duty rose to the level of bad faith.

 

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