A recent decision from the Business Litigation Session of the Massachusetts Superior Court serves as a powerful reminder to corporations of all sizes of the vital importance of commissioning timely, thorough, and independent investigations of shareholder derivative suit allegations—or for that matter, serious internal allegations of any kind, whether brought by shareholders, policyholders, or employees. In Boylan v. Boston Sand & Gravel Co.,1 Judge Ralph Gants—who at the time of this writing was slated for promotion to the chief administrative judge of the BLS upon Judge Allan van Gestel’s retirement in January 2008—allowed a shareholder derivative suit to survive summary judgment because the board of directors failed to conduct an adequate investigation of the shareholders’ claims.2 Significantly, Gants closely scrutinized the corporation’s decision to refuse the shareholder demand even though the vote to do so was made by a group of disinterested directors acting as a de facto special litigation committee.3
The law in most states requires a careful, comprehensive evaluation of shareholder claims even for a majority-disinterested board enjoying the protection of the highly deferential business judgment rule.4 Indeed, the duty to investigate any claim relating to the business of the corporation is a bedrock principle underlying a director’s fiduciary duty. In Massachusetts, the Supreme Judicial Court has held that a “lack of investigation into the demand” neutralizes the protection of the business judgment rule.5 Moreover, under the law of several states—including Massachusetts, and even more dramatically in Delaware—courts employ a heightened standard requiring corporations to employ even greater investigative diligence when the board of directors is not comprised of a majority of disinterested directors. Where corporations cannot demonstrate such diligence to a court, the derivative suit survives and is able to proceed to trial, causing, at best, distraction, uncertainty, legal expense and a weakened settlement position, and, at worst, an eventual verdict against the corporation for significant money damages, court-ordered dismantling of corporate transactions and an overall erosion of marketplace confidence in the company. Corporations can forestall this range of unpalatable possibilities by undertaking a thorough and independent investigation of the shareholder demand as soon as it is made. This is most effectively done through an unbiased special litigation committee (“SLC”) that is aided in its investigation by outside counsel.
ALI guidance for an effective investigation of derivative actions
The American Law Institute has outlined the steps corporations should take to conduct an effective investigation of a derivative action. The Massachusetts Supreme Judicial Court, while not formally adopting the entire ALI provision on this subject, has embraced its spirit as well as several of its specific recommendations.6 Specifically, the ALI guidance states that corporate boards of directors should do the following when faced with a derivative demand:
Background of the Boylan decision
- appoint an SLC comprised of at least two members, each of whom should be disinterested and objective;
- employ counsel and other such necessary professionals to assist the SLC;
- ensure that the SLC has made determinations that are supported by a careful review and evaluation of the facts and relevant law; and
- if the SLC determines that refusal or dismissal of the demand or action is the appropriate course of action, prepare a detailed report to be filed in court justifying its determination.7
The consequences of a poor internal investigation are brought to life in the recent Boylan decision. There, a long-running schism in a family business led to the estate of one shareholder (Dan Boylan, the deceased older son of the company founder) bringing suit against the corporation, the ready-mix concrete supplier Boston Sand & Gravel, which was under the majority ownership of the company founder’s other son, Dean Boylan Sr., and his two children, Dean Boylan Jr. and Jeanne-Marie Boylan. Dean Sr., Dean Jr. and Jean-Marie also served as directors of BS&G, along with four other individuals who were not members of the Boylan family.8 The suit alleged that Dean Jr. and Jean-Marie breached their fiduciary duty by entering into an agreement whereby a separate company owned by them leased a parcel of land in New Hampshire—for well below market value, the Dan Boylan Estate contended—from a wholly owned BS&G subsidiary.9 The agreement included a three-year option to purchase.10 The lawsuit sought rescission of the agreement as well as damages for Dean Jr. and Jeanne-Marie’s alleged misappropriation of a BS&G corporate opportunity.11
After the Dan Boylan Estate filed suit, the BS&G board of directors voted unanimously to ratify the lease/option agreement.12 Voting in favor of ratification were Dean Sr., Dean Jr. and Jeanne-Marie, admittedly interested directors; a third director, longtime counsel for BS&G who Gants found also was interested based on the circumstances; and three directors who Gants determined were disinterested.13 The ratification of the agreement by the three disinterested directors was the functional equivalent, Gants found, of a disinterested SLC voting not to prosecute the estate’s ongoing derivative suit.14 “Demand excused” cases are a dying breed in Massachusetts but the heightened standard of judicial scrutiny that governs them still lives
Because the Estate had not presented a formal demand prior to filing suit, the Boylan case presented a “demand excused” type of case. Such cases occur where the shareholder alleges that a majority of directors is interested and therefore making a demand on the board prior to filing suit would be futile.15 In these cases, as in Boylan, the corporate board may still vote whether or not to join the suit after it is filed. The other type of shareholder derivative action is referred to as “demand refused,” that is, a case which proceeds in court following the shareholder’s pre-complaint presentation of his demand to the board and the board’s refusal to litigate the demand on behalf of the corporation. By statute, after June 30, 2004 all shareholder derivative lawsuits filed in Massachusetts courts must have been first presented to the board for action.16 This made Massachusetts one of at least 23 “universal demand” states,17 and has made every viable shareholder derivative suit filed in the state after June 30, 2004 a “demand refused” case.
So the Boylan case, commenced in 2002, may be one of the last “demand excused” decisions to come out of the Massachusetts courts. However, the standard under Massachusetts law governing the judicial evaluation of corporate decisions not to join (and instead to seek to dismiss) “demand excused” cases, set forth in the Supreme Judicial Court decision Houle v. Low,18 is equally applicable to “demand refused” cases in which there is not a majority of disinterested directors on the board.19 In such cases, even where the board delegates the litigation decision to a disinterested SLC, “a good deal of judicial oversight is necessary,”20 to temper the “structural bias” that may permeate a board when most of its members are interested and those who are not may be inclined to protect their fellow directors from liability.21 Houle’s heightened standard of judicial scrutiny of Massa-chusetts SLCs
The Houle standard, employed by Gants in Boylan, calls for a searching review that asks, in essence, whether the decision of the SLC—or, if no SLC, that of the voting disinterested directors—was “reasonable and principled.”22 To answer that question, Houle sets forth a three-tiered test, well described by Gants in Boylan as follows:
- whether the SLC (or other directors making the decision) was “independent, unbiased, and [acted] in good faith,” and, if so,
- whether the SLC/independent directors conducted “a thorough and careful analysis,” and, if so,
- whether the decision was “contrary to the great weight of the evidence.”23
Applying the facts of Boylan to this heightened standard, Gants found that BS&G’s de facto SLC had fallen short on the first two tiers of the test, which made an in-depth analysis on the final tier, whether the merits of the corporate decision were “contrary to the great weight of evidence,” unnecessary.24 On the first inquiry regarding the de facto SLC’s independence and lack of bias, Gants pointed out that these concepts are not the same as mere disinterest: A director may not meet the definition of being interested under the particular factual circumstances, yet may be susceptible to “pressures … to recommend dismissal of the [shareholder] action” that may raise questions of bias and lack of independence25 and therefore, “‘call for scrutiny of … members of a litigation committee.’”26 On the second inquiry, whether the de facto SLC conducted a “thorough and careful analysis,” Gants answered flatly, “no,” because the evidence BS&G could muster supporting a diligent investigation was virtually non-existent.27 Harhen’s more deferential standard of judicial oversight of Massachusetts SLCs appointed by disinterested boards: diligent investigation is still required
In the widely-known Harhen decision of the Supreme Judicial Court, a case involving a group of policyholders’ derivative action against certain directors of the John Hancock Mutual Life Insurance Company, the court set forth the standard of judicial oversight applicable to a refusal of a shareholder demand when the SLC is comprised of disinterested members and is appointed by a board on which there is a majority of disinterested directors. As discussed above, in such cases, Massachusetts law treats the SLC decision to refuse the demand as a business decision that is protected by the business judgment rule.28 Therefore, unlike in cases governed by the heightened Houle standard, Massachusetts courts will not delve into all the particulars of the SLC’s investigation, nor question whether the merits of the SLC’s decision was supported by sufficient evidence. However, as Gants pointed out in his Boylan decision, Harhen does require that a disinterested SLC appointed by a disinterested board still conduct a good faith investigation of some kind, lest the SLC and the board be deprived of the protections of the business judgment rule and face far more intense judicial scrutiny into their demand refusal decision.
Consequently, even a board in the comfortable position of facing a shareholder derivative demand that brings with it no hint of potential director interest or the taint of “structural bias” should not allow overconfidence, nonchalance or undue delay to pervade its internal investigation of the allegations. A timely, thorough and independent inquiry, conducted or aided by outside counsel and other such necessary professionals (e.g., independent accountants, appraisers, computer forensics experts), will buttress an already strong position enjoyed by the disinterested board and create a nearly impenetrable business judgment.Delaware standard of judicial scrutiny of SLCs
Given the vast number of corporations maintaining a principal place of business in one state but incorporating in Delaware, it is worth summarizing the standard under Delaware law governing the adequacy of SLC investigations.29 As enunciated in the seminal case Zapata Corp. v. Maldonado,30 Delaware has adopted a more intense standard of judicial oversight than even the heightened Houle standard in Massachusetts.
Specifically, an SLC must conduct an “objective and thorough investigation” into the claims of the derivative suit, and if the SLC determines that the action is not in the corporation’s best interests, it may file a motion to dismiss. The reviewing court then:
- inquires into the independence and good faith of the committee and the bases supporting its conclusions. The corporation holds the burden of showing independence, good faith and a reasonable investigation; then, additionally, and at the court’s discretion,
- applies its own independent business judgment to determine whether the motion to dismiss should be granted.31
In short, for Delaware corporations facing derivative suits, the importance of commissioning a diligent and independent investigation aided by outside counsel is even more acute than for corporations chartered in Massachusetts.Benefits of a timely, thorough, Independent internal investigation
Besides the direct benefit in the shareholder derivative context of winning a court’s assent to the board’s business judgment, a timely, thorough and independent internal investigation brings several other benefits in situations where allegations are lodged against (usually from within) a company.
When planned and executed properly, an internal investigation can accomplish the following results:
- head off civil liability exposure to directors who might otherwise be alleged to have shirked their fiduciary duties;
- eliminate or reduce the scope of potential government investigations (by the Securities and Exchange Commission, for example) into alleged wrongdoing;
- minimize potential criminal liability for certain offenses by self-reporting violations (a factor considered under the Federal Sentencing Guidelines); and
- win the external public relations battle by highlighting to the media the company’s proactive approach.
As most recently highlighted by the Massachusetts Superior Court Business Litigation Session in the Boylan decision, there is no substitute for a timely, comprehensive and independent investigation when a corporation is faced with a shareholder derivative claim, or any internal allegation of fiduciary breach or other wrongdoing. Such internal investigations are best discharged with the prompt creation of a wholly independent SLC aided by outside counsel. Following this course of action will not only help the company fully understand the validity of allegations lodged against it, but also will bring immeasurable value in protecting against a later attack on the adequacy of its internal investigation. Endnotes
1. Boylan v. Boston Sand & Gravel Co., No. 02-2296-BLS2, 2007 WL 836753 (Mass. Super. Mar. 16, 2007) (Gants, J.).
2. Id. at *13.
3. Id. at *10-*11.
4. Massachusetts, adopting the relevant provisions of American Legal Institute’s Principles of Corporate Governance, defines, in short, an “interested” director as one who (a) is a party to the transaction or conduct at issue; (b) has a financial or familial relationship with such party that would reasonably be expected to affect the director’s judgment in a manner adverse to the interests of the corporation; (c) has associates who have a financial interest in the transaction at issue that would reasonably be expected to affect the director’s judgment; or (d) is subject to a “controlling influence” on the board that could reasonably be expected to affect the director’s judgment in a manner adverse to the corporation. See Harhen v. Brown, 431 Mass. 838, 842-43, 843 n.5 (2000); Boylan, 2007 WL 836753 at *9; ALI Principles of Corporate Governance: Analysis and Recommendations §§ 1.15, 1.23 (2006).
The Massachusetts Supreme Judicial Court has described the business judgment rule as “afford[ing] protection to the business decisions of directors, including the decision to institute litigation, because directors are presumed to act in the best interests of the corporation.” Harhen, 431 Mass. at 845.
5. Id. at 847.
6. Houle v. Low, 407 Mass. 810, 819-20 (1990).
7. See ALI Principles of Corporate Governance: Analysis and Recommendation § 7.09 (2006).
8. Boylan v. Boston Sand & Gravel Co., No. 02-2296-BLS2, 2007 WL 836753, *1, *6 (Mass. Super. Mar. 16, 2007).
9. Id. at *1.
10. Id. at *1.
11. Id. at *1.
12. Id. at *6.
13. One of those disinterested BS&G directors was former Red Sox great Dom DiMaggio, a lifelong friend of Dean Boylan, Sr. Id. at *5. In his decision, Gants could not resist the aside that “my father-in-law still believes that Dominic was a better defensive outfielder than his more famous brother, Joe.” Id. at *5 n.6.
14. Id. at *11.
15. See Harhen v. Brown, 431 Mass. 838, 844 (2000). At an earlier stage of the case, the defendants’ unsuccessful motion to dismiss, the Superior Court excused the Dan Boylan Estate’s lack of pre-filing demand based on its having properly alleged self-interest by the directors. Boylan v. Boston Sand & Gravel Co., No. 02-2296-BLS2, 2007 WL 836753, *11 (Mass. Super. Mar. 16, 2007).
16. Mass. Gen. Laws ch. 156D, § 7.42 (2004).
17. Other “universal demand” states (i.e., where “demand excused” cases are no longer permitted) include each of the New England states except Vermont, as well as Arizona, Florida, Georgia, Hawaii, Idaho, Iowa, Michigan, Mississippi, Montana, Nebraska, North Carolina, Pennsylvania, South Dakota, Texas, Utah, Virginia, Wisconsin, and Wyoming. See Boland v. Engle, 113 F.3d 706, 712 (7th Cir. 1997); In re Guidant Shareholders Derivative Litigation, 841 N.E.2d 571, 574 (Ind. 2006).
18. Houle v. Low, 407 Mass. 810 (1990).
19. Harhen, 431 Mass. at 847.
20. Houle, 407 Mass. at 822.
21. Though not dispositive on the question of whether a majority of a board of directors is interested, close corporations (i.e., closely-held (often family-held), non-public corporations) are likely to be hindered by a judicial assumption that they are ruled by an interested board. “The factors which contribute to making a corporation a close corporation may … bear on the independence and good faith of an [SLC] in such a corporation. To that end, a reviewing court should consider those factors in its inquiry.” Id. at 824, 825 n.11.
22. Id. at 824.
23. Boylan v. Boston Sand & Gravel Co., No. 02-2296-BLS2, 2007 WL 836753, *13 (Mass. Super. Mar. 16, 2007).
24. Id. at *12.
25. Id. at *13.
26. Id. at *13 (quoting Houle, 407 Mass. at 823).
27. Id. at *13.
28. Harhen v. Brown, 431 Mass. 838, 847 (2000).
29. Like most states, Massachusetts case law “adhere[s] to … [the] policy that the State of incorporation dictates the choice of law regarding the internal affairs of a corporation,” including shareholder actions. Harrison v. NetCentric Corp., 433 Mass. 465, 471 (2001).
30. Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).
31. Id. at 787-89.