Sarnacki v. Golden: Smith & Wesson Rely On Special Litigation Committee Report To Dismiss Derivative Suit

In Sarnacki v. Golden, et al, Docket No. 14-01414 (1st Cir. Apr 14, 2014), Aaron Sarnacki, a citizen of Maine, filed a derivative suit against Smith & Wesson, a gun manufacturer, as well as its current and former directors and CEO (collectively “Defendants”). The suit asserted state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. 

Sarnacki alleged that in 2007, Smith & Wesson made false public statements about the demand for their products in an attempt to sell excessive inventory by raising both sales and earnings projections.  The Plaintiff further asserted that some of the Defendants did so while selling millions of Smith & Wesson shares. Following a reduction in projected net income, Smith & Wesson’s share price dropped 40 percent. In December of 2007, the company again reduced its projections before finally withdrawing them altogether in January of 2008.

Sarnacki filed a derivative suit in Massachusetts state court. The suit was dismissed in January 2009 for failure to make a pre-suit demand on the board. Shortly after the dismissal, Smith & Wesson received two demand letters from other shareholders. The board formed a special committee to evaluate the claims.  The special committee consisted of three outside directors, including two who also served on the Audit Committee.  The committee hired independent outside counsel.   

Some months later, Sarnacki sent Smith & Wesson a letter demanding an independent investigation of the board’s 2007 actions. Counsel for Smith & Wesson informed Sarnacki of the special committee and requested proof that Sarnacki held shares during the relevant periods.  In October 2010, Sarnacki again filed suit, this time, in Federal District Court in Arizona, and alleged Nevada state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. Two months later, the special committee concluded a lack of evidence existed to prove that the directors committed any breach of fiduciary duty and issued a report recommending that the claims not be pursued.

In January 2011, both parties consented to a transfer of the case to the Federal District Court in Massachusetts, and in July 2011, Smith & Wesson filed a motion to dismiss based on the special committee’s findings. The motion was denied, and the court ordered limited discovery on the sufficiency of the special committee’s report. Following discovery, Smith & Wesson moved for summary dismissal based on the special committee’s report. The court granted the dismissal in March 2014.

Sarnacki then appealed to the US Court of Appeals for the First Circuit. Both parties agreed that Delaware law, as adopted by Nevada, applied. The law requires a court to conduct a two-prong test after a corporation has moved for summary dismissal based on a special committee report in a shareholder suit. The first prong requires the corporation to prove the special committee’s independence and that the decision was supported by good faith and a reasonable basis. Even where, however, the standard has been met, the court retains the discretion to apply its own “independent business judgment rule” where the company’s actions met the test but do not “appear to satisfy its spirit.”

On appeal, Sarnacki challenged the independence of the special committee for two reasons. First, Sarnacki argued that two of the three directors were not independent because they were members of Smith & Wesson’s audit committee in 2007 when the alleged misstatements occurred.  Moreover, the Audit Committee directly dealt with the financial misrepresentations made by Smith & Wesson. Next, he argued a lack of independence because members of the audit committee were defendants in the present action.

The First Circuit, however, disagreed with Sarnacki and held that status as a defendant to an action or approval of the relevant transactions did not establish a lack of independence. The court also noted the Audit Committee was never accused of wrongdoing in any demand letter or suit and Sarnacki provided no evidence of bias by the special committee.

The court also rejected a Sarnacki’s argument that the district court erred by failing to consider his arguments alleging a lack of independence as a whole.  Finally, Sarnacki argued it was not his burden to prove independence. The First Circuit agreed with Sarnacki, but determined that Smith & Wesson satisfied the burden.

In determining the good faith and reasonableness standard, the First Circuit focused on the process rather than the conclusion of the special committee. It concluded Sarnacki did not provide evidence that the process used by the special committee was inadequate. Accordingly, the First Circuit Court of Appeals found Smith & Wesson satisfied both prongs and affirmed the lower court’s judgment.

The primary materials for this case can be found on the DU Corporate Governance website

Patrick Rohl