Background

This was a stockholder derivative action. Kevin Diep, a stockholder of El Pollo Loco Holdings, Inc., filed derivative claims against some members of the board and management as well as a private investment firm. The suit was filed in the Delaware Court of Chancery. Diep’s lawsuit focused on two acts of alleged wrongdoing: (1) concealing the negative impact of price increases during an earnings call and (2) selling company stock while in the possession of material nonpublic financial information.

After the Court of Chancery denied the defendants’ motion to dismiss, the board appointed a special litigation committee with exclusive authority to investigate the derivative claims and to take whatever action the SLC determined to be in the company’s best interests. The SLC consisted of three directors, all three of whom had joined El Pollo Loco’s board after the alleged wrongful acts at issue. Two of the SLC members had various social and business connections to one of the board member defendants, centering in one case around their joint service on the Board of Overseers at the University of Pennsylvania School of Nursing and, in the other case, around the social relationship between their now-adult children.

The SLC undertook an “extensive investigation,” under the guidance of counsel whose independence Diep did not challenge. It reviewed over 249,000 documents that included board materials, financial updates and reports, internal governance and company polices, and business and personal emails. The SLC met formally 16 times between December 2017 and February 2019. Diep’s counsel and counsel for other stockholders were invited to participate in the SLC investigation, but failed to do so.

In its 377-page report, the SLC addressed both of the alleged acts of wrongdoing: the claim of insider trading and the claim for breach of fiduciary duty for failing to disclose material information on the earnings call.

An insider trading claim under Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949), requires (1) that there existed material, nonpublic information, and (2) evidence that the parties were motivated to trade by that information. Regarding the Brophy claim, the SLC found that the insider information was not material and may have also been public, given that the underlying data had been disclosed on the earnings call. Regarding the breach of fiduciary duty claim, the company’s certificate of incorporation contained an exculpatory provision such that the directors could only be held liable if they were “grossly negligent” or “had acted in bad faith.” The SLC found that the directors were not grossly negligent in choosing not to disclose potentially unreliable data and projections, and that there was no evidence that any of the defendants had acted in bad faith.

The SLC moved to terminate the litigation on the grounds of its findings. Before the Court of Chancery reviewed the SLC’s motion, all of the defendants, with the exception of the private investment firm, settled. Diep opposed the SLC’s motion, challenging the SLC’s independence and the reasonableness of its investigation. Diep argued in the alternative that the Court of Chancery should apply its own business judgment and find that even if the SLC investigation was adequate, it would still be in the company’s best interests for the lawsuit to proceed.

The Court of Chancery granted the SLC’s motion to dismiss, applying the familiar two-step test under Zapata v. Maldonado, 430 A.2d 779 (Del. 1981). The Court of Chancery first reviewed the SLC’s motion (and Diep’s objections thereto) under the first prong of Zapata. The analysis under the first prong of Zapata is “not a typical motion to dismiss,” but rather an analysis of “the reasonableness of dismissing the complaint prior to trial without any concession of liability on the part of the defendants and without adjudicating the merits of the cause of action itself.” To dismiss the action, the court must be satisfied that “no disputed issues of material fact exist about the independence, good faith, and reasonableness of the SLC’s investigation and whether the SLC had reasonable bases for its conclusions.” Thus, the inquiry is not on the merits of the underlying case, but on the independence of the SLC and the adequacy of its investigation. The second discretionary prong of Zapata allows the court to review, in its business judgment, whether dismissal or some other course of action is in the company’s best interests.

Under the first prong of Zapata, the Court of Chancery considered whether the SLC members’ ties to any of the defendants rendered them, “for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind.” Diep had argued that two of the three SLC members lacked independence because of their relationships with a defendant director and because they “prejudged Plaintiff’s claim” by sitting on the company’s board when the company joined the filing of the motion to dismiss in this case. On the first point, the Court of Chancery found that none of the members’ social or business ties were sufficient to create a conflict. On the second point, the Court of Chancery interpreted Diep’s argument as essentially that merely sitting on the board when the motion to dismiss was made was sufficient to disqualify the SLC members, a conclusion the Court of Chancery rejected. The Court of Chancery further found that the SLC had “conducted a reasonable investigation of the matters alleged in the complaint in good faith.”

Under the second prong of Zapata, the Court of Chancery found that the SLC’s recommendation “falls within a range of reasonable outcomes that a disinterested and independent decision maker for the corporation, not acting under any compulsion and with the benefit of the information then available, could reasonably accept.”

On appeal, Diep challenged the Court of Chancery’s decision on multiple grounds, including alleging that there were disputed issues of material fact concerning the independence of the SLC members and the reasonableness of their investigation. Diep further argued that the Court of Chancery had abused its discretion when it found that the SLC’s conclusions were reasonable and that the court had erred in applying the second prong of the Zapata test.

Analysis

The first prong of Zapata is subject to a summary judgment standard and is reviewed de novo. The second prong of Zapata is reviewed for abuse of discretion. These were the standards that the Delaware Supreme Court applied on appeal.

Under the first prong of Zapata, the majority agreed with the Court of Chancery that the SLC members were adequately independent, had conducted a reasonable investigation, and had reached reasonably supported conclusions. Regarding independence, the majority explained that this is a fact-specific determination made in the context of a particular case. The majority rejected any suggestion that the SLC members must be strangers, explaining that it 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.” Instead, the inquiry is “whether the SLC member would be more willing to risk her reputation than the personal or professional relationship with the director subject to investigation.”

In this case, it was undisputed that one of the three SLC members was independent. Concerning the remaining two SLC members, the state supreme court majority agreed with the Court of Chancery that (1) the fact these two SLC members served on the board when the company joined the motion to dismiss in this case did not mean that they had “prejudged” the merits, (2) their business and personal connections with the defendant director did not affect their independence or the reasonableness of the SLC’s conclusion, and (3) the SLC had conducted a reasonable investigation and had reasonable bases for its conclusion.

On the first point, the majority pointed out that the record “does not show that [the two SLC members] approved or participated in a substantive way in the decision to file the motion on [the company’s] behalf.” Instead, “at most, the record shows they attended a board meeting when the motion was discussed.” Neither of the two SLC members recalled any substantive discussion about the motion. One of them testified at deposition that he was “sure” there “would have” been a “litigation update” and “discussion” on the subject, but he “did not recall the details of it.” The majority held that these facts did not raise a material question as to whether the two members had prejudged the merits where they were only “exposed to a litigation review that included a less than in-depth discussion of the motion to dismiss.”

On the second point, the majority similarly found that the SLC had met its burden in showing that the personal and professional relationships between the two members and the defendant director did not impede SLC independence. Even though the personal and professional relationship between one of the members and the defendant director was “closer than what one would ordinarily expect of SLC members” (where their families had socialized and shared meals over the years), several other factors showed that, overall, the SLC members were capable of acting independently. These factors included: the SLC members were individuals “with significant backgrounds in business with prominent company positions and industry experience”; none of the SLC members were defendants, nor had they been on the board at the time of the alleged wrongful actions; and the SLC members disclosed upfront their personal and professional connections to the defendant director. Overall, the majority agreed with the Court of Chancery that the SLC members “were unlikely to sacrifice their personal and professional reputations for their relationship with [the defendant director] and his family.”

On the third point, the majority explained that the plaintiff’s appeal misunderstood the nature of the supreme court’s review. Diep had argued that the Court of Chancery “improperly resolved disputed questions of material fact” about “the negative impact of higher prices,” “defendants’ scienter,” and “deterioration in 2015 Q2 Company [sales].” But, as the court explained, “the question [on appeal] is not whether there were disputed issues of material fact about the three merits-based issues raised by Diep.” Instead, the issue is simply “whether disputed issues of material fact were raised about the scope of the investigation and the reasonableness of the SLC’s conclusions.” The majority agreed with the Court of Chancery that the SLC had conducted a reasonable investigation and had reasonable bases to support its conclusions.

Finally, concerning Zapata’s second prong, the majority found that the Court of Chancery did not abuse its discretion by declining to continue the litigation “in the company’s best interests.” The supreme court held that the record “did not reveal any unusual concerns about the merits of the claims, the committee’s process, or matters of law and public policy such that the court should have intervened and refused to dismiss the derivative suit as a matter of its own business judgment.”

The dissenting opinion took issue with the independence of two challenged SLC members – specifically related to their role on the board at the time the company joined the motion to dismiss. The dissent argued that the motion to dismiss “did not merely raise technical or procedural arguments as to why the derivative claims should be dismissed” but instead “affirmatively argued the very substantive issues that the SLC would later be tasked with independently investigating.” The dissent found that the record in this case shows more than just the SLC members’ “mere presence” on the board at the time the motion was filed. The record reflected that the motion was discussed by the board, and that no director objected. One of the two SLC members in question specifically testified that he did not object to the filing. The dissent argued that “[t]he logical conclusion is that the Board, at least tacitly, approved and authorized filing” after that discussion. And, given that “[a]n important aspect of a board’s managerial decision-making is whether to initiate, or refrain from initiating, litigation on the corporation’s behalf,” the decision on whether or not to join the motion to dismiss would have been “an important decision.” The dissent concluded: “The 2016 Motion was obviously authorized by someone. Given that a corporation acts through its board of directors, and given that the motion was the subject of a Board discussion, the record suggests that the Board authorized it.”

Takeaways

• Under Zapata, the court’s review of an SLC’s motion to dismiss does not directly concern the underlying merits of the allegations. Instead, the review is of the independence of the SLC, the adequacy of the SLC process, and the reasonableness of the SLC’s conclusions.
• For special litigation committee members to be found independent, it is not necessary that they have no connection to defendant directors. Rather, the inquiry is “whether the SLC member would be more willing to risk her reputation than the personal or professional relationship with the director subject to investigation.”
• Depending on the specific facts, the presence of an SLC member on the company’s board at the time of a motion to dismiss does not necessarily mean that the SLC member cannot independently evaluate the claims within the context of the SLC process.

Client Alert 2022-205