Taneja v. Familymeds Group, Inc. and the Importance of Process

Delaware has a reputation for producing management-friendly decisions in the corporate governance area.  The evidence can be seen from the jurisprudence emanating from the state, but it also can be seen from the fact that plaintiffs increasingly seek to litigate governance issues in other jurisdictions.    The thinking, presumably, is that they will get a better result in other states, even when the courts are applying Delaware law.  

A possible example of this occurred in Taneja v. Familymeds Group, Inc., 2012 Conn. Super. LEXIS 2127 (Conn. Aug. 21, 2012).  Shareholders brought a derivative action against the board, essentially alleging mismanagement.  The business mostly operated in Connecticut but was incorporated in Nevada.  The court noted that Nevada, in the absence of controlling law, viewed Delaware as persuasive.  As a result, the court found itself interpreting Delaware law.   

In the derivative action, defendants were represented by a law firm ("Law Firm").  The original case was dismissed for failure to make demand.  Plaintiffs thereafter made demand.  The directors were represented by the same Law Firm.  The Law Firm conducted an investigation into the allegations and ultimately issued a report concluding that "the allegations of the plaintiffs' demand were not substantiated."  The report was approved by the two directors "not subject to a conflict because of the pending demand allegations."  

Plaintiffs challenged the board's decision to reject demand.  The court noted that, under Delaware law, it was limited to "an analysis of the board's good faith and the reasonableness of the board's investigation of the demand." The court concluded that the designation of the Law Firm to undertake the investigation had not been done in good faith.  

The court essentially found that the Law Firm wore two hats:  Independent investigator and advocate for defendants.  The two positions could not be reconclied. 

At the time of the delegation, the directors were not disinterested. The assumption and the expectation were that the investigation's conclusion was predetermined, and that it was to be in the board's favor. The obligation of [the Law Firm] was to defend their client first and foremost. The undertaking of the investigation commenced while this purpose was in mind. This "asks too much of human nature . . ."  

Nor did approval by the disinterested directors change the outcome.  "The two remaining directors who voted . . . 'controlled neither which facts they heard nor the legal guidance given to them to put the evidence into the proper context.'" So long as the decision was based upon "the report of a conflicted law firm, then their conclusions are not entitled to the presumption that they were reasonable."

In the area of demand refusal, courts primarily rely on process to protect shareholders.  In this case, the court did not really question the quality of the investigation.  It was enough that the integrity of the process was in doubt.  Would Delaware courts have agreed?  Plaintiffs avoided having to find out by maintaining the action in Connecticut. 

J Robert Brown Jr.