ROBERT J. SHELBY, District Judge.
Before the court is a motion to dismiss shareholder derivative claims. Plaintiff Marc Schenkel brought the claims on behalf of Xyngular Corporation against members of its board of directors. This motion is part of a broader lawsuit involving Mr. Schenkel, Xyngular, members of Xyngular's board, and a number of third-party defendants. Xyngular moves to dismiss Mr. Schenkel's derivative claims. For the reasons stated below, the court grants Xyngular's motion.
Mr. Schenkel is a cofounder and shareholder of Xyngular, a network marketing company that distributes health supplements. The company was incorporated in Delaware in 2009. Mr. Schenkel was also a member of the board of directors, along with Rudy Revak, Mary Julich, and Steve Kole. Shortly after Xyngular's formation, Mr. Schenkel's business relationship with the other board members began to deteriorate and the parties resorted to litigation. Part of that litigation includes derivative claims Mr. Schenkel brought on behalf of Xyngular. Below, the court summarizes the facts relevant to those claims.
In September 2011, Mr. Schenkel sent a demand letter to Xyngular in which he demanded that the board investigate and pursue claims against Mr. Revak, Mr. Kole, and Ms. Julich for "misappropriation of corporate assets, corporate waste, self-dealing, and usurpation of corporate opportunities." Mr. Schenkel alleged in the demand letter that
Days after receiving the demand letter, Xyngular responded to Mr. Schenkel by stating that the board "disagrees with [Mr. Schenkel's] claims of self-dealing, mismanagement and retaliatory behavior and believes it has acted, and continues to act, in the best interests of its shareholders." The letter further denied any allegations that the commercial relationship between Xyngular and GVMS was inappropriate. Xyngular also stated that it was "willing to confirm this conclusion through a form of independent review." To conduct the independent review, Xyngular planned to add to its board "at least two individuals with significant experience in the networking marketing industry who have no ownership or business interest" in Xyngular or GVMS. These new board members would investigate Mr. Schenkel's letter and determine whether the board should pursue derivative claims.
In September 2012, Xyngular filed this suit, seeking a declaratory judgment that Mr. Schenkel had breached his obligations to the company. Xyngular then further responded to Mr. Schenkel's demand letter in October 2012, stating that the company appointed three new independent board members (Jim Northrop, Dan Murphy, and Russ Fletcher) to investigate the matter. The letter generally addressed Mr. Schenkel's allegations by stating that
In sum, the new board members investigated the allegations in Mr. Schenkel's demand letter and decided against pursuing derivative claims.
Mr. Schenkel responded to Xyngular's Complaint by filing counterclaims and third-party claims against Xyngular directors. Mr. Schenkel also brought derivative claims on behalf of Xyngular. These claims, numbered eleven through fifteen in Mr. Schenkel's Complaint, include breach of contract, breach of covenant of good faith and fair dealing, promissory estoppel, unjust enrichment, and breach of fiduciary duty. Mr. Schenkel filed his Complaint after the Xyngular board had informed him that it declined to pursue derivative claims.
In his Complaint, Mr. Schenkel makes several allegations about the adequacy of the Xyngular board's investigation of his demand letter. In relevant part, Mr. Schenkel makes the following allegations:
Federal Rule of Civil Procedure 23.1 requires a shareholder derivative complaint to "state with particularity any effort by the plaintiff to obtain the desired action from the directors or comparable authority" and "the reasons for not obtaining the action or not making the effort."
Delaware courts have clarified that under Rule 23.1, a plaintiff wishing to bring a claim for a wrongful refusal of demand "must allege with particularity facts raising a reasonable doubt that the corporate action being questioned was properly the product of business judgment."
The board of directors decides whether to pursue claims on behalf of the corporation.
The parties dispute two issues: (1) whether Mr. Schenkel conceded the independence of the board when he made his demand and (2) whether the complaint alleges sufficient facts that the board wrongfully refused to bring the derivative claims. The court considers these issues in turn.
Mr. Schenkel contends that the Xyngular board is not independent and that he did not concede its independence by making a presuit demand. To support this contention, Mr. Schenkel makes three arguments: (1) he did not concede the independence of the new board members because he did not know their identities when he sent the demand letter; (2) the board conceded its lack of independence when it appointed new board members to investigate the allegations; and (3) Xyngular waived its defense by failing to raise it at an earlier stage of the litigation.
It is well established under Delaware law that a shareholder who makes a demand on a board before filing suit "tacitly concedes the independence of a majority of the board to respond."
Mr. Schenkel then contends that the new board members lacked independence based on their preexisting friendships and business relationships with the original board members. But Mr. Schenkel conceded the independence of the original board members when he made a presuit demand. Accordingly, the original board members were independent and therefore could not destroy the new board members' independence.
Mr. Schenkel next argues that the board conceded its lack of independence by delegating the investigation of his allegations to new board members. Generally, the traditional business judgment rule applies when a board delegates authority to investigate a demand letter to a special litigation committee.
In Abbey, the board formed a special litigation committee and delegated the power to not only investigate the shareholder's demand letter, but to also make all decisions on the potential lawsuit.
The Delaware Supreme Court found that "by divesting itself of any power to make a decision on the pending suit, and by adding a new and independent director and by designating him as a Special Litigation Committee of one with the final and absolute authority to make the decision on behalf of the corporation, the incumbent board of directors, in effect, conceded that the circumstances alleged in the complaint justified the initiation of the suit by the plaintiff."
But Abbey is limited. The Delaware Supreme Court has warned that the case does not "stand for the proposition that a board of directors, ipso facto, waives its right to challenge a shareholder plaintiff's allegation that demand is excused by the act of appointing a special litigation committee and delegating to that committee the authority to act on the demand."
Unlike Abbey, the Xyngular board never fully divested itself of its decision-making power in this lawsuit.
Lastly, Mr. Schenkel argues that Xyngular waived its demand defense by raising it nine months after filing the suit. But that is incorrect. Mr. Schenkel filed the derivative claims on October 22, 2012. On November 30, 2012, as part of Xyngular's timely Answer to Mr. Schenkel's counterclaim, Xyngular asserted the business judgment rule as a defense.
Even when a shareholder makes a presuit demand, he can still bring derivative claims if he can show that the board wrongfully refused to bring the claims.
When a shareholder makes a presuit demand and that demand is refused, the court reviews the board's decision under the business judgment rule.
The business judgment rule is a "presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting the presumption."
The board's investigation was predetermined by Global Venture Partners: Mr. Schenkel argues that the new board members' investigation was predetermined. He first points the court to the allegation that "[w]hile Mr. Murphy and Mr. Fletcher were attempting to improperly enrich themselves with their new business partners, Mr. Schenkel received no response from the board regarding their purported investigation into his demand letter."
Next, Mr. Schenkel states that the new board members appeared to communicate about the demand letter only six days before they sent their final response outlining the findings of the investigation. To support this argument, Mr. Schenkel points to an email sent from Mr. Northrop's office to Mr. Murphy and Mr. Fletcher on October 2, 2012 that stated, "Jim [Northrop] would like to have a call today to discuss the proposed letter to Marc Schenkel."
Lastly, Mr. Schenkel alleges that Global Venture Partners (a company owned by Mr. Revak, Ms. Julich, Mr. Kole, and Mr. Jensen) forced Xyngular to file the lawsuit.
The new board members failed to reasonably investigate the claims: Mr. Schenkel next argues that the board members failed to reasonably investigate the demand.
Mr. Schenkel's contention rests on several allegations. First, Mr. Schenkel alleges that board members did not talk with Xyngular's COO Mr. Oliver about the IT issues in the demand letter and relied on GVMS to justify its own fees rather than do an independent evaluation. But the investigating board members were not required to speak with Mr. Oliver or make an independent evaluation of the GVMS fees. The response letter specifically addresses these issues, stating, "We spent a significant amount of time evaluating your claims about deficient IT support for Xyngular and the costs for providing proper support."
Second, Mr. Schenkel argues that Xyngular failed to investigate whether Symmetry misappropriated Xyngular's top selling product, Xyng.
Third, Mr. Schenkel appears to allege that Mr. Murphy's involvement with Uppercase Living results in interestedness on the part of the board.
The response to the demand letter contains false and misleading information: Lastly, Mr. Schenkel argues that the response to the demand letter contained false and misleading information.
In sum, corporate directors have limited time and ample discretion. Here, Mr. Schenkel's allegations do not overcome the presumption of good faith. Perhaps the board's investigation could have been more thorough or effective. Perhaps Xyngular could have made better business decisions. But these are not the questions the court considers under the business judgment rule. Mr. Schenkel has not alleged egregious actions that rebut the presumption of deference to corporate directors' business judgment.
For these reasons, the court GRANTS Xyngular's Motion to Dismiss Derivative Claims and DISMISSES WITH PREJUDICE Mr. Schenkel's eleventh through fifteenth causes of action.
SO ORDERED.