Court Finds Board of Directors Not Entitled to Benefit of Business Judgment Rule

In Brining v. Donavan , Civil Action No. 16-3422-BLS1, 2017 WL 4542947 (Sup. Ct. Mass. Sept. 14, 2017), a court denied a motion to dismiss filed by a corporation and, thus, denied its board of directors the benefit of the business judgment rule because the board’s decision not to pursue litigation or a derivative action against a former director who also was managing the company “raise[d] serious questions . . . concerning the independence of the [b]oard and the good faith of its decision to seek no redress for the serious financial improprieties” reported by an independent accounting firm.

Jennifer Brining was a shareholder in Sendletter, Inc. (“Sendletter”), an internet-based company. Although Brining was a minority shareholder owning approximately 11% of the company, her investment made her the largest shareholder in the company. Brining alleged that nearly all the money invested in Sendletter was taken by John Donovan, who was a director and effectively the manager of Sendletter, for personal use, not for the benefit of the company. Brining at one point sent a letter to Sendletter’s Board of Directors (“Board”), seeking redress of Donovan’s alleged misconduct. The Board removed Donavan as a Board member and assured Brining that Donovan no longer had control over Sendletter funds. The Board also retained AlixPartners, LLP, a forensic accounting firm, to investigate the transactions involving Donovan. At the time that AlixPartners issued its report on April 18, 2017, the Board composition had changed, as the Board members at that time were John Rose, Nadir-Yohan Zohar (who became President of Sendletter as of February 1, 2017), and Bhaskar Panigrahi.

The AlixPartners report found that Sendletter had essentially no internal controls as of December 2016. Donovan and his wife did not invest any cash in Sendletter, but they loaned “Sendletter Entities” $202,074, which was documented in a note signed by Zohar on March 30, 2017. The report did not explain why Zohar signed loan documents on loans made before he became President or what Zohar did to confirm the amounts, sources, and use of the funds received. The report found there were lease obligations to Donovan related entities for $363,970, but the estimated value of the lease obligations was only $192,206. There were a number of other odd findings and conclusions in the report, including the fact that of $2,846,276 disbursed by Donovan on behalf of Sendletter, $1,274,506 “appear[ed] . . . related to the business activities of Sendletter[,]” “$800,018 [was] not related to Sendletter business activity[,]” and $771,552 of disbursements “cannot be determined based on the scope of work performed.” The report also concluded that “[d]ocuments regularly included handwritten modifications of dates, interest rates, and loan amounts; [m]etadata indicated that documents were created or modified days, months and years after the date on the face of the document; . . . [m]ultiple versions of documents contained materially different terms and varying dates; . . . and [d]ating and amounts on the documents are inconsistent within the document.”

The Board, however, chose not to pursue action against Donovan because any judgment against Donovan “would not be of substantial value.” The Board also determined that litigation would be expensive, distract employees and management, negatively affect partnership and investment opportunities, and adversely affect the company’s public image and share price (to which the court noted that there does not appear to be a market for the company’s shares). The Board further concluded Brining had “demonstrated that her values and motivation are not aligned with this Board and are not compatible with the success of the company.” As a result of the Board’s decisions, Brining pursued legal action on her own.

After addressing choice of law issues, the court examined the independence of the Board. The court noted that, under Delaware law, a director generally is deemed independent “only when the director’s decision is based entirely on the corporate merits of the transaction and is not influenced by personal or extraneous considerations.” The court further noted that there is no bright line rule for determining when a director breaches the duty of independence through self-interest to rebut the presumption of the business judgment rule. Despite this high burden, the court found there were “certain confounding factors presented in this case.” First, the court noted that the Board composition had changed from when the issue was first presented to the Board and when the report was issued for the Board to decide whether to pursue action against Donovan. In this regard, the court questioned the appropriateness of Donovan selecting individuals with whom he had a prior relationship to serve on the Board when those individuals were being asked to make a determination about pursuing claims against him. Second, the court noted when Board independence is questioned, a special litigation committee often is formed to consider the potential claim, but no such committee was formed here. Third, the court questioned the independence of the Board as a result of Zohan signing loan documents for loans that pre-dated his appointment as President, particularly while AlixPartners was investigating the proprietary of those transactions.

The court then proceeded to analyze the business judgment rule, stating that, if one assumes the Board is functionally independent of Donovan as it relates to the decision not to pursue litigation against him, the Board’s decision should receive the benefit of the business judgment rule. Under the business judgment rule, the decision not to pursue a claim or permit a derivative action against Donovan would be binding unless sufficient facts raise a reasonable doubt that the Board adequately investigated the claims or acted in good faith, consistent with its duty of loyalty. Stated differently, the business judgment rule would apply and protect the decision of the Board unless the decision “is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.” The court found that a reasonable investigation was conducted, as evidenced by the Board retaining AlixPartners, but there was reasonable doubt as to whether the Board acted in good faith based on the Board’s conclusions.

The court questioned the Board’s decision in a number of respects. For example, the court found that there was no evidence in the Board minutes to support its conclusion that any judgment against Donovan would not be of substantial value. In fact, the court found that the AlixPartners report indicated there was a “strong likelihood of obtaining a substantial judgment against Donovan” (and the court proceeded to dissect many aspects of the report to support this conclusion). While the court acknowledged that a judgment may not be of substantial value if the judgment debtor did not have sufficient assets to satisfy a judgment, the court noted that the Board minutes do not suggest the Board gave any consideration to this issue. The court also examined the potential harm the lawsuit against Donovan would cause to Sendletter achieving its business objectives, but the court once again noted that Board minutes did not specify any transactions that would be jeopardized, whether they be partnering arrangements, investments, or other transactions. Additionally, in light of new management, the court could not find any reason based on the information presented why a potential individual or entity would not want to do business with Sendletter as a result of such a lawsuit against Donovan. Moreover, the court questioned the Board’s decision not even to attempt to negotiate a settlement with Donovan and recoup some of the funds without the cost of litigation. Based on these and other factors the court discussed, the court found that there were “serious questions . . . concerning the independence of the Board and the good faith of its decision to seek no redress for the serious financial improprieties” the Board discovered.

The court’s decision in Brining is significant for companies and their boards of directors. While the business judgment rule is applied broadly and often protects many decisions of boards, even questionable decisions, the protections afforded by the rule are not unlimited. As illustrated in Brining , although a board may reach certain conclusions, the basis for those conclusions should be sufficiently investigated and significant factual developments cannot simply be ignored. When a board fails to exercise reasonable care in evaluating courses of action and analyzing data presented to it, the board faces potential legal action and it will not necessarily be protected by the business judgment rule. Each board decision should be evaluated on its own merits, but, when it comes to decisions about taking legal action against a current or former officer or director, boards at a minimum should evaluate such decisions with the assistance of counsel.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

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