CURRENT MONTH (November 2019)

Business Litigation

Chancery Finds Stockholder’s Request for “Corrective Action” to be a Litigation Demand, Dismisses Stockholder Derivative Claims for Failure to Plead Wrongful Refusal

By K. Tyler O’Connell

Under the Delaware Supreme Court’s decision in Spiegel v. Buntrock, 571 A.2d 767 (Del. 1990), a stockholder-plaintiff who makes a pre-suit demand upon the board to address potential wrongdoing concedes that the board may properly decide whether to cause the corporation to bring suit.  That concession makes it more difficult to satisfy pleading standards in a later derivative suit.  In Solak v. Welch, 2019 WL 5588877 (Del. Ch. Oct. 30, 2019), Vice Chancellor Kathaleen S. McCormick reviewed the law in this area and concluded that – despite a disclaimer to the contrary – the plaintiff’s pre-suit letter was a litigation demand.

The writing at-issue “suggest[ed] … corrective action” for alleged excessive director compensation, including mid-six-figure payments to outside directors.  It cited Delaware case law addressing fiduciary duty claims for directors’ compensation decisions, and warned that the company was “more susceptible than ever to shareholder challenges” in this area.  It requested remedial measures, including setting limits for overall compensation.  It stated that, absent a satisfactory response, the plaintiff would consider “all available shareholder remedies.”  On the specific issue of whether it was a litigation demand, a footnote disclaimed “nothing contained herein shall be construed as a pre-suit litigation demand…”

The Court explained that Rule 23.1 gives stockholders with potential derivative claims two “mutually-exclusive” options: (i) making a pre-suit demand on the board, or (ii) filing suit and claiming that such a demand would be futile.  Where a stockholder makes a demand and therefore tacitly concedes that the board is capable of addressing the demand in a disinterested and independent manner, the plaintiff must allege that the refusal is wrongful.  That requires particularized facts supporting that the board engaged in a grossly negligent decision making process, or that its refusal amounted to intentional wrongdoing. 

Reviewing the letter, the Court reasoned that the “footnote disclaimer does not obviate the Court’s review of the [l]etter’s substance for obvious reasons” – including that a plaintiff is not permitted to “cover all the bases” by demanding remedial actions while also purporting to reserve the right to bring suit.  Instead, the Court evaluates the “substance of the communication objectively” to assess whether it gives notice of potential wrongdoing sufficient to allow the recipient to take corrective corporate action.  While the plaintiff argued that the letter did not actually request that the board file suit, no such specific request was necessary.  In addition, the remedies the plaintiff requested “resemble therapeutic benefits commonly achieved in derivative lawsuits challenging non-employee director compensation.”  In addition, the Court reasoned, the letter was “nearly a carbon copy” of the plaintiff’s subsequent complaint, which also was prepared to provide notice of wrongdoing. 

The Court concluded that the complaint failed to allege wrongful refusal.  It did not mention the demand letter or the company’s response.  The latter indicated that the board, with the help of counsel, had conducted an investigation, including review of pertinent documents and interviews.  The company’s response also provided merits-based reasons for not taking further action, and cited additional supporting considerations.  Accordingly, the Court granted the defendants’ motions to dismiss for failure to plead wrongful refusal. 

First Circuit Rules That Parents’ Payment of Adult Child’s College Tuition is Subject to Claw Back

By Edward M. Fitzgerald

In individual bankruptcy cases where the debtor has made college tuition payments on behalf of an adult child, trustees will often attempt to recover those tuition payments from the college under the theory that they are constructively fraudulent transfers.  11 U.S.C. § 548(a)(1) allows trustees to avoid transfers made by insolvent debtors within two years preceding their bankruptcy filings if the debtors did not receive “reasonably equivalent value” in return.  The underlying concept behind these trustee avoidance actions against colleges and universities is that the debtor’s estate received nothing of direct value for the tuition payments, and the payments depleted the estate of assets that could have otherwise been distributed to creditors.  In opposition, the colleges and universities targeted by these claims argue that the debtor parents do receive value from the payments in that paying for their child’s college education enhances the child’s financial well-being, which in turn confers an economic benefit on the parent.  This issue has divided several courts, and now the First Circuit Court of Appeals has officially entered the debate with its decision in DeGiacomo v. Sacred Heart University (In re Palladino), 2019 WL 5883721 (1st Cir 2019), which gives a favorable ruling for trustees and holds that a debtor’s pre-bankruptcy payment of college tuition for an adult child is subject to avoidance as constructively fraudulent transfer.  In this case, the daughter of the debtors attended Sacred Heart University.  From March 2012 through March 2014, the debtors paid approximately $65,000 in tuition payments to Sacred Heart University on her behalf.  In April 2014, the debtors filed their chapter 7 bankruptcy petition.  In 2015, chapter 7 trustee , Mark G. DeGiacomo, filed an adversary proceeding against Sacred Heart University seeking to claw back the debtor’s tuition payments as fraudulent transfers.  The bankruptcy court granted summary judgment in favor of Sacred Heart, ruling that a financially self-sufficient daughter offered the debtors an economic benefit, and then certified its own decision on the issue to the First Circuit Court of Appeals.  In issuing its ruling, the First Circuit rejected the bankruptcy court’s opinion that the tuition payments conferred a benefit on the debtors.  The First Circuit stated that “the tuition payments here depleted the estate and furnished nothing of direct value to the creditors who are the central concern of the code provisions at issue.”  Relying on statutory textualism, the First Circuit found that the tuition payments could not have conferred any value under 11 U.S.C. Section 548(d)(2)(A), i.e. that there was no exchange of property, payment of a current or prior debt, or collateralization of a current or prior debt.  This decision will no doubt be cited by trustees across the country in support of future similar avoidance actions against colleges and universities. 


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