Case background
A stockholder-plaintiff filed a lawsuit in the Delaware Court of Chancery asserting derivative claims against directors and officers of UpCounsel, Inc. (the Company), a Delaware corporation. Specifically, the stockholder-plaintiff alleged three of the Company’s fiduciaries, Messrs. Faustman, Blake, and Rudin, breached their fiduciary duties and were unjustly enriched through an agreement to license UpCounsel’s intellectual property to a third party and then dissolve the Company.
In September 2019, following a sale process, the Company’s board of directors proposed a transaction in which the Company would license its intellectual property to a non-party and redirect traffic from its website to the non-party’s website. In connection with the proposed transaction, the Company would wind down its business within 120 days and dissolve “as promptly as practicable.” The Company also agreed to use commercially reasonable efforts to ensure that employees, including Messrs. Faustman and Blake, accept employment with the non-party licensee. The transaction was approved by holders of 85 percent of the Company’s stock. Thereafter, the Company notified its stockholders, including the plaintiff, that the Company’s assets would be insufficient to satisfy the preferred stockholders’ liquidation preference and that common stockholders, like the plaintiff, would receive nothing in connection with the dissolution.
On January 25, 2020, the stockholder-plaintiff sent the Company an email titled “URGENT NOTICE - Minority Shareholder NOTICE to UpCOUNSEL board ->>>> Notice of Objection to Prospective Action by UpCounsel, Inc. & [non-party licensee].” The stockholder-plaintiff’s January 25 email asserted that redirecting traffic to the non-party licensee would cause irreparable harm. The stockholder-plaintiff wrote in his email that redirecting the website traffic would constitute “a gross breach of [the board’s] fiduciary duties” and would “give rise to . . . a shareholder derivivitive [sic] lawsuit.” The stockholder-plaintiff demanded in the January 25 email that Messrs. Faustman and Blake recuse themselves from any board decision regarding redirection and that Blake be removed as CEO.
Two days later, on January 27, 2020, the stockholder-plaintiff sent a second email to the Company titled “Immediate Demand to Act, UpCounsel, Inc. Board.” The January 27 email demanded the board terminate Messrs. Faustman and Blake from their directorships and file an action against them for “breaching their fiduciary duties, and unjust enrichment and self-dealing.” The stockholder-plaintiff wrote that the January 27 email was intended to serve as an Official Notice to the Board, per [Steven M. Rales, et al. v. Alfred Blasband, No. 210, 1993, opinion (Del. Dec. 22, 1993; rev. Dec. 23, 1993)].” The stockholder-plaintiff characterized the January 27 email as “a former [sic] demand” to terminate Messrs. Faustman and Blake and sue them for breach of fiduciary duty. The defendants took none of the actions the stockholder-plaintiff demanded and the stockholder-plaintiff filed suit in the Delaware Court of Chancery in June 2020.
The defendants moved to dismiss the derivative claims under Court of Chancery Rule 23.1 on the ground that the stockholder-plaintiff’s January 25 and January 27 emails constituted a litigation demand and, thus, the stockholder-plaintiff conceded the board’s disinterest and independence for the purposes of deciding whether to pursue litigation on the Company’s behalf. The stockholder-plaintiff argued that the January 25 and January 27 emails were not referenced in the complaint and, therefore, may not be considered on a motion to dismiss. The stockholder-plaintiff further argued that even if they could be considered, the emails did not constitute a litigation demand.
The court’s decision
The Court of Chancery granted the defendants’ motion with respect to the fiduciary duty and unjust enrichment claims. The court held, among other things, that the stockholder-plaintiff may not avoid a Rule 23.1 motion by failing to reference its pre-litigation communications in the complaint and, when considered, the January 25 and January 27 emails constituted a litigation demand, which left the stockholder-plaintiff with only the ability to bring a claim for wrongful demand refusal, which it did not do.
The court first discussed the “tacit concession doctrine,” which deems a stockholder who made demand on a board to pursue claims on the corporation’s behalf to have conceded that the board was disinterested and independent with respect to the demand. The tacit concession doctrine prevents the demanding stockholder from pursuing derivative claims concerning the demand’s subject matter. The doctrine, as explained by the court, is embodied in Court of Chancery Rule 23; and, if the doctrine applies, the demanding stockholder is only able to pursue a claim for wrongful refusal if the board rejects the demand, and the claim is subject to Delaware’s deferential business judgment rule:
The tacit concession doctrine is an aspect of the demand requirement procedurally embodied in [Court of Chancery Rule 23.1], which derives from the bedrock principle that the board of directors, rather than stockholders, manage the business and affairs of the corporation. A board’s authority to manage the business and affairs of the corporation includes deciding to pursue or refrain from pursuing litigation on behalf of the corporation.
As part of this board-centric model, Rule 23.1 presents a stockholder wishing to bring a derivative action with two options. Either the stockholder makes a pre-suit demand that the board of directors pursue the claims at issue, or the stockholder must plead with particularity that it would have been futile to present the matter to the board.
Of the two potential routes presented by Rule 23.1 – pleading demand excusal with particularity or making a pre-suit demand – the former is a steep road, but the latter is “steeper yet.” By making a pre-suit demand, a stockholder “tacitly concedes” the disinterest and independence of a majority of the board to respond to the demand, as the Delaware Supreme Court held in [Ted Spiegel v. Dean L. Buntrock, et al. [Waste Management], No. 86, 1989, opinion (Del. Mar. 19, 1990)].
By operation of the tacit-concession doctrine, a board’s decision to refuse a demand is subject to the business judgment rule. After making a pre-litigation demand, a stockholder plaintiff may not pursue claims challenging the subject matter of the demand; the stockholder is limited to a claim that the board wrongfully refused the demand.
The court rejected the stockholder-plaintiff’s argument that the court could not consider pre-litigation communications—which were cited by the defendants but not incorporated into the complaint—cited by the defendants as constituting a pre-litigation demand. The court explained a stockholder-plaintiff may not avoid the argument that a litigation demand tacitly conceded board disinterest and independence by omitting reference to pre-litigation communications from the complaint.
The court explained that the party arguing a pre-litigation demand was made bears the burden of establishing that the stockholder communication at issue qualifies as a demand and, under Delaware law, whether a pre-litigation stockholder communication constitutes a demand is a fact-driven determination. The court discussed the three-part test set forth in Robert E. Yaw, II v. William W. Talley, II, et al. and RAMCO Holding Corp., C.A. No. *12882-VCJ (Del. Ch. Mar. 2, 1994), which provides that a pre-suit communication is a demand for the purposes of Rule 23.1 if it provides “(i) the identity of the alleged wrongdoers, (ii) the wrongdoing they allegedly perpetrated and the resultant injury to the corporation, and (iii) the legal action the shareholder wants the board to take on the corporation’s behalf.” The court explained that “[a]lthough the test contains three parts, it calls for a holistic analysis of the nature of the communication, asking whether the communication substantively places a board on notice of the claim to be pursued.”
The court held that the defendants met their burden and established, under the Yaw factors, that the January 25 and January 27 communications constituted pre-litigation demands for the purposes of Court of Chancery Rule 23.1:
The pre-suit communications in this case constitute pre-suit demands under Yaw.
As to the first Yaw factor, [plaintiff’s] January 25 email to [defendants] specifically charges them with ‘a gross breach of [their] fiduciary duties.’ [Defendants] are therefore identified as alleged wrongdoers in the communication. [Plaintiff’s] January 27 email likewise is sent to [defendants], who are again charged with ‘breaching their fiduciary duties.’ The first Yaw factor, that pre-suit communications identify the alleged wrongdoers, is thus satisfied.
As to the second Yaw factor, the communications identify the wrongdoing that [defendants] allegedly perpetrated and the resultant injury to [nominal defendant]. [Plaintiff’s] January 25 email asserts that [approving a challenged transaction] would be ‘a gross breach of [their] fiduciary duties’ and would cause [nominal defendant] to be harmed due to ‘diminished’ goodwill, revenue diverted . . . , and its asset value decreasing. [Plaintiff’s] January 25 email notes [the challenged transaction] would ‘give rise to . . . a shareholder derivative lawsuit’ due to the resulting harm to [nominal defendant]. The January 27 email also charges the board members with ‘breaching their fiduciary duties . . . and self dealing [sic].’ The second Yaw factor, that the pre-suit communications identify the wrongdoing allegedly perpetrated by the wrongdoers and the resultant injury to the corporation, is also satisfied.
As to the third Yaw factor, both pre-suit communications identify the legal action that [plaintiff] urges the Board to take on [nominal defendant’s] behalf. In his January 25 email, entitled ‘URGENT NOTICE - Minority Shareholder NOTICE to [nominal defendant] board - >>>> Notice of Objection to Prospective Action by [nominal defendant] & [a third party],’ [plaintiff] made a ‘demand that [defendants] recuse themselves from ANY and ALL decisions’ regarding [the challenged transaction]. He also ‘demand[ed] that [one defendant] be removed as the ‘part time CEO’’ of [nominal defendant] and demanded that the Board not [approve the challenged transaction]. Furthermore, in [plaintiff’s] January 27 email entitled ‘Immediate Demand to Act, [nominal defendant] Board,’ he asserts that ‘this email serves as a former [sic] demand’ . . . for [nominal defendant’s] Board to ‘[i]mmediately terminate . . . [defendants] from the [nominal defendant] board . . . and sue them for breaching their fiduciary duties . . . and self dealing [sic].’ In the event the Board refused such action, [plaintiff] next demanded that the Board ‘[i]mmediately file a Third Party Interference of Contract claim against [third party], [defendants].’
The third Yaw factor, that the pre-suit communication contains legal action the stockholder wants the board to take on the corporation’s behalf, is therefore also satisfied.
Moreover, in his two emails, [plaintiff] said ‘demand’ multiple times and made various demands upon the Board. Furthermore, in his January 27 email, [plaintiff] cites [Steven M. Rales, et al. v. Alfred Blasband, No. 210, 1993, opinion (Del. Dec. 22, 1993; rev. Dec. 23, 1993)], noting that ‘[t]his email serves as an Official Notice to the Board, per Rales v. Blasband.’ It would be an unreasonable contortion of these communications to conclude that they were anything other than a demand for the purposes of Rule 23.1.
The court explained that its determination that the January 25 and January 27 emails constitute demands materially limited the stockholder-plaintiff’s ability to pursue the derivative claims against the Company’s fiduciaries. Under Delaware law, “‘a judicial determination that a plaintiff has made a demand carries with it significant legal consequences.’ Delaware courts have toed a hard line against stockholder plaintiffs attempting to game the tacit concession doctrine, applying the doctrine to bar all derivative claims arising from the subject matter of the demand, even legal theories not expressly identified by the stockholder or considered by the board.” Specifically, the court explained that, because of the pre-suit demands, the stockholder-plaintiff is limited to claiming that the Company’s board “wrongfully refused the demands.”
The stockholder-plaintiff in Blake, however, did not assert a claim for wrongful refusal in the complaint. The complaint only pleaded that any demand on the board would be futile, despite making multiple, actual demands on the Company’s board. Even if the stockholder-plaintiff alleged wrongful refusal, the board’s decision to refuse the demand would be reviewed under the business judgment rule since, by making the pre-litigation demands, the stockholder-plaintiff had implicitly conceded the board’s independence to consider the demand. Because the stockholder-plaintiff conceded that any demand on the board would not be futile , and otherwise did not allege wrongful refusal of the demand, the court dismissed the breach of fiduciary duty claim under Court of Chancery Rule 23.1. Based on the same reasoning, the Court of Chancery also dismissed the stockholder-plaintiff’s unjust enrichment claim, which arises from the same subject matter as the January 25 and January 27 demands:
Plaintiff’s unjust enrichment claim arises from the subject matter of the demands and thus must . . . be dismissed under [Court of Chancery Rule 23.1]. The unjust enrichment claim arises from [the challenged transaction]. Plaintiff alleges that [defendants] were unjustly enriched because the [challenged transaction] was a ‘sweetheart deal’ for them. According to Plaintiff, [defendants] ‘worked together to approve [a plan to wind-down nominal defendant]’ in connection with the [challenged transaction] because it would result in increased compensation for them. If there were any doubt that the unjust enrichment claims were part and parcel of the pre-suit communications, [plaintiff’s] January 27 email eliminates it by specifically charging [defendants] with ‘unjust enrichment.’
Because Plaintiff’s unjust enrichment claims arise from the subject matter of the pre-suit demands, Plaintiff is limited to claiming that the Board wrongfully refused the demands. . . . [H]owever, the Complaint does not do so. Accordingly, [plaintiff’s unjust enrichment claim] is . . . dismissed pursuant to Rule 23.1.”
Key takeaways
- It is a bedrock principle of Delaware law that the board of directors, rather than the stockholders, manage the business and affairs of the corporation.
- A stockholder of a Delaware corporation who makes a pre-suit demand on the board (or certain board members) tacitly concedes the disinterestedness and independence of a majority of the board to respond to the demand.
- After making a pre-litigation demand, a stockholder plaintiff may not pursue claims challenging the subject matter of the demand; the stockholder is limited to a claim that the board wrongfully refused the demand.
- A board’s decision to refuse a demand is subject to the Delaware law’s “business judgment rule.”
- Stockholders of Delaware corporations should engage legal counsel with subject-matter expertise before taking steps to pursue, or even investigate, claims against directors and/or officers of Delaware corporations, and failing to do so could be fatal to a stockholder’s claims.
Client Alert 2021-185
