Tola to receive CA citation for putative shareholder claims
In Tola vs Bryant, #16150, 2022 Cal. App. LEXIS 241 (Cal. App. March 24, 2022), the First constituency of appeal of California Court of Appeals applied Delaware’s new wording of the test for determining whether a shareholder has standing to assert derivative claims on behalf of a corporation. According to the test articulated by the Supreme Court of Delaware in United Food and Commercial Workers Union c. Zuckerberg262 A.3d 1034, 1058 (Del. 2021), a shareholder of a Delaware corporation has standing to assert derivative rights where the shareholder can plead particular facts, director by director, showing that at least half advice in place at the time of filing the complaint:
received a material personal benefit from the alleged misconduct that is the subject of the dispute;
faces a substantial likelihood of liability on asserted claims; or
lack independence from someone who received a material personal benefit from the alleged misconduct or someone who would face a substantial likelihood of liability on any of the claims.
The shareholder requesting Tola did not meet this standard. the Tola decision is expected to help corporate lawyers advise clients facing derivative lawsuits filed as a result of operational issues.
Intel Corporation (“Intel”) is a Delaware corporation headquartered in California that designs and manufactures microprocessors. An Intel shareholder filed a derivative complaint alleging that Intel management knew of two security vulnerabilities in its microchips, but kept that information secret for six months, until they finally disclosed the vulnerabilities in response to media reports by discussing. The plaintiff alleged that Intel’s late disclosures harmed the company because they caused the price of Intel shares to decline by $4, which was equivalent to more than $20 billion in lost market capitalization.
The plaintiff alleged that five out of ten Intel directors could not independently or disinterestedly review a request, rendering the prior request to the board futile. The plaintiff argued that the claim was futile with respect to the managing directors (CEO and CFO) because they allegedly received a “material benefit” as a result of the impugned conduct by selling Intel stock after became aware of the security vulnerabilities, but before these issues were made public. . With respect to the other three outside directors and the CEO, the plaintiff argued that the request was frivolous because they allegedly did not implement any controls to report cybersecurity issues to the board. The trial court upheld the defendants’ objection, without leave to amend, finding that even if a claim was frivolous as to the CEO and CFO, the other board members were not disqualified from considering a claim. request. The plaintiff appealed.
The Court of Appeal confirmed. The Court began by citing the seminal Delaware Court of Chancery decision in In re Caremark International Inc., 698 A.2 959 (Del. Ch. 1996), to note that plaintiff’s “supervisory failure” theory was “probably the most difficult theory in corporate law upon which a plaintiff could hope to obtain a judgement”. Under Delaware law, a director is only liable for damages to the corporation if he acts in bad faith by “failing to act in the face of a known duty to act.” Thus, the plaintiff was required to rely on a “sustained or systematic failure of the board of directors to exercise oversight” to support an inference of bad faith. The plaintiff shareholder’s claims failed because the complaint admitted that Intel had controls in place to monitor the company:
Tola does not allege, for example, that . . . Intel did not have an audit committee, that Intel’s audit committee met only infrequently, or specific facts suggesting that Intel’s board of directors knew that monitoring cybersecurity vulnerabilities was essential to Intel’s operations, but simply chose to ignore the need for board-level reporting.
Plaintiff’s complaint was also insufficient as he conceded that Intel immediately began attempting to address the security vulnerabilities, such as forming a “problem response team” shortly after becoming aware of the issue. Additionally, when the potential security vulnerabilities became public knowledge, Intel’s board immediately acted by calling a meeting to discuss the issue, engaging the audit committee to investigate the issue, and creating a sub – board committee responsible for cybersecurity. There were simply no detailed allegations to support the conclusion that the security risks were serious and that the board had ignored them in bad faith for an extended period. Because plaintiff, at most, pleaded facts that called into question the impartiality of only two of Intel’s ten directors, it lacked standing to pursue the company’s claims.
It is a fundamental tenet of Delaware corporate law that the board of directors – not the shareholders – have the authority to pursue corporate litigation. The decision in Tola demonstrates the difficulties plaintiff shareholders face when attempting to usurp the board’s prerogative to scrutinize corporate claims, particularly when proceeding on the basis of a supervisory failure theory . Since many California-headquartered companies are incorporated under Delaware law, we expect Tola will receive frequent subpoenas by California attorneys defending derivative claims from putative shareholders. Furthermore, the decision in Tola should serve as a practical roadmap for lawyers seeking to advise board clients on how to respond to unexpected business challenges and operational issues.
Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XII, Number 96