Special Litigation Committee Investigations: London v. Tyrell
May 3, 2010
In London v. Tyrell, C.A. No. 3321-CC (Del. Ch. Mar. 11, 2010), the Court of Chancery denied a special litigation committee’s (“SLC”) motion to dismiss, finding that there were material questions of fact regarding the SLC’s independence and the reasonableness and good faith of its investigation.
This action, brought by two former directors individually and derivatively on behalf MA Federal, Inc. (“iGov”), alleged several violations of fiduciary duty in connection with the enactment of the company’s Executive Incentive Plan (“EIP”). Specifically, the complaint alleged that the defendants, the iGov directors responsible for approving the EIP, manipulated financial projections in order to obtain an artificially low valuation of the company. This, according to the plaintiffs, allowed the defendants to receive underpriced shares and options.
Though not enacted by the iGov board until January 2007, the EIP was proposed and developed over the summer of 2006. In connection therewith, the board retained Chessiecap Securities, Inc. to determine the equity value of the company as of July 31, 2006. To develop its valuation, the company provided Chessiecap with the “Original Chessiecap Forecast,” a fiscal year 2007 revenue projection reflecting EBITDA of approximately $3 million.
In October 2006, Chessiecap returned a draft valuation, showing iGov’s equity value at $5.5 million, to Michael Tyrell, the company’s CFO. After reviewing the draft valuation, Tyrell sent Chessiecap an email expressing his belief that the draft valuation overstated the value of iGov. In support of this position, Tyrell pointed to several specific line items that he believed were no longer accurate. Tyrell also sent Chessiecap the “Revised Chessiecap Forecast,” which reduced the projected revenue of the company in several areas and reflected EBITDA of $1.8 million. The final valuation received from Chessiecap, after consideration of the revised forecast, reflected a lower equity value of $4.7 million.
As of January 1, 2007, the plaintiffs comprised one-half of the iGov board; two of the defendants, Nevan and Hupalo, comprised the other half. After delivery of the final valuation, the plaintiffs requested, and received, the Revised Chessiecap Forecast. After reviewing the underlying financials, the plaintiffs objected to using Chessiecap’s final valuation for purposes of the EIP because it was based on outdated and unreliable information. The plaintiffs asserted that while the Revised Chessiecap Forecast incorporated negative developments in the company’s financial prospects after July 31, 2006, it failed to include material positive developments that occurred after the valuation date. Moreover, the plaintiffs pointed out that several of the company’s internal valuations from that period projected EBITDA of at least $3 million.
After it became clear that the plaintiffs would not approve the EIP, defendants Nevan and Hupalo, along with an otherwise uninvolved iGov officer, executed written stockholder consents removing the plaintiffs from the board and electing Tyrell as a director. Several weeks later, the newly-comprised board adopted the EIP. The defendants were awarded 60 percent of the options available under the plan.
By the time the plaintiffs brought suit, the iGov board had been expanded with the addition of Vincent Salvatori and John Vinter. After the Court concluded that the amended complaint “easily survived” the defendants’ motion to dismiss, the iGov board formed a two-person SLC comprised of the two new directors. The committee conducted a four-month investigation which concluded that the board had employed a fair process and that the exercise price of the options was within the range of fair market value. The SLC’s report also found that maintaining the suit was not in the best interests of the company.
Chancellor Chandler began his analysis by reiterating the well-known, two-step Zapata standard applied where an SLC evaluates a pending lawsuit and recommends its dismissal. First, the Court evaluates the committee’s independence and considers whether the SLC conducted a good-faith investigation — reasonable in scope and revealing a reasonable basis for its recommendation. Second, the Court may, in its discretion, apply its own independent business judgment to evaluate the best interests of the corporation.
The Court determined that both members of the SLC had relationships with Tyrell that raised a material question as to their independence. Vinter’s wife was Tyrell’s cousin, and although Tyrell and his cousin were not “close,” the Court concluded that “appointing an interested director’s family member to an SLC will always position a corporation on the low ground.” Salvatori, on the other hand, had hired Tyrell as a consultant for his own business several years earlier. Salvatori credited Tyrell with allowing him to sell that business at a significant profit. Thus, it was conceivable that Salvatori would feel a sense of obligation towards Tyrell. This, according to the Court, raised a material question with regard to his independence.
The Court also found that the SLC had failed to conduct a good-faith, reasonable investigation. Addressing the duty of care claims, the SLC based its recommendation to dismiss on the iGov charter’s Section 102(b)(7) exculpatory provision. However, under Delaware law, an exculpatory provision only precludes a court from entering judgment for monetary damages. Here, where the plaintiffs sought rescission of the EIP, a Section 102(b)(7) provision would not preclude relief. Moreover, the Court explained that the company’s exculpatory provision does not shield the defendants from liability where they “derived an improper personal benefit” from the questioned transaction. Thus, the Court found that it was unreasonable to conclude, solely based on the charter’s Section 102(b)(7) provision, that the duty of care claims should be dismissed.
With regard to its analysis of the duty of loyalty claims, the Court criticized the SLC’s narrow focus and its persistent failure to examine critically the defendants’ version of disputed facts. In its report, the SLC concluded that it was permissible for Tyrell to maintain and employ different revenue forecasts for different purposes. The Court, however, took issue with the scope of the SLC’s investigation, concluding that it had failed to deal with the issue of fair process raised by the claims fully. For example, the SLC did not investigate why the company’s other internal projections all showed EBITDA of approximately $3 million. Additionally, the SLC accepted Tyrell’s representation that the Revised Chessiecap Forecast was the company’s most accurate FY07 forecast without asking why it was never used in any other context. After listing numerous similar examples, the Court found that such an inadequate investigation could not provide a reasonable basis for recommending dismissal of the duty of loyalty claims.