Chancery Court Dismisses Derivative Action Alleging Caremark Claims
By: Scott Waxman and Zane Madden
In In re Lendingclub Corp. Derivative Litigation, C.A. No. 12984-VCM (Del. Ch. October 31, 2019), the Delaware Court of Chancery (the “Court”) granted the defendants’ motion to dismiss the plaintiffs’ consolidated supplemented complaint (the “complaint”) for failure to adequately plead demand futility. After analyzing the allegations in the complaint, the Court concluded that plaintiffs’ claims failed because the facts alleged did not demonstrate at the dismissal stage that a majority of the board of directors (the “Board”) could exercise independent and disinterested judgment with regard to a litigation demand as required under In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996).
LendingClub Corporation (“LCC”) operates an online platform that facilitates loans issued by third parties. Borrowers apply for loans through LCC’s website. LCC’s bank partners issue the loans, which are purchased by LCC. LCC then resells the loans to specific institutional investors based upon each investor’s desired loan and credit characteristics.
In March and April 2016, LCC incorrectly sold $22 million worth of near-prime loans to an investor despite the loans not meeting the investor’s stated preferences. Once the Board became aware of the mistake, an internal investigation ensued. In addition to the aforementioned incorrect sales, the investigation uncovered several instances of corporate malfeasance. Two directors, including the CEO/Chairman of LCC, failed to disclose interests held in a company prior to LCC’s $10 million dollar investment in the company. Additionally, one of LCC’s wholly owned subsidiaries, a registered investment advisor called LC Advisors, made valuation adjustments inconsistent with GAAP. Due to these incorrect valuation adjustments, one fund’s investment parameters were exceeded.
Upon discovery, LCC immediately reported the misconduct to the SEC and began remediation efforts. The SEC subsequently issued a cease-and-desist order, but praised LCC for its self-reporting and corrective efforts. As part of the remediation, the Board secured the resignation of the offending employees, bifurcated the CEO and Chairman position, ratified the $10 million dollar investment and disclosed all of the transactions on its financial statements related to the invested-in company as related party transactions. The Board also publicly disclosed its internal investigation and its results via multiple filings of Forms 8-K and 10-Q.
Two groups of stockholders filed suit based upon the misconduct of LCC, the two board members, and its subsidiary. The first case was filed in the Northern District of California and alleged violations of Section 11 of the Securities Act of 1933. The suit was premised upon alleged misstatements contained in LCC’s 2014 Registration Statement. The California litigation was settled in May 2018. A second and third group of stockholders filed derivative actions in the Delaware Chancery Court claiming LCC’s Board breached its fiduciary duties. Those actions were consolidated in October 2017. The plaintiffs in that case asserted two claims for breach of fiduciary duties under Caremark. Boiled down, each count contended that the Board did not make a good faith effort to put a system of internal controls in place to avoid misconduct and/or the directors consciously failed to monitor LCC’s operations such that the Board was disabled from being informed of problems.
The defendants moved to dismiss the complaint for failure to plead demand futility. The plaintiffs’ argued that a pre-suit demand to the Board would have been futile because a majority of the Board at the time the first complaint was filed in 2016 were compromised due to the substantial likelihood of liability relating to the subject matter of the California and Delaware lawsuits.
The Court began its analysis by determining which of two standards would govern the demand futility inquiry: one which generally applies in the demand futility arena or another which is an exception to the general rule. The exception was applicable here, because the plaintiffs’ claims alleged violations of the Board’s oversight duties. In order for plaintiffs’ to meet their burden under this standard, they were required to plead particularized facts which raised a reasonable doubt that a majority of the Board at the time the complaint was filed could exercise independent and disinterested business judgment with regard to a pre-suit litigation demand.
The plaintiffs’ claimed that a majority of the Board were incapable of exercising disinterested business judgement due to eight of the nine Board members facing a substantial likelihood of liability from the Delaware and California lawsuits. The plaintiffs’ first claim encompassed three separate allegations, which the Court addressed in turn.
Plaintiffs’ first allegation maintained that the directors breached their fiduciary duties by failing to implement controls necessary to prevent the public dissemination of false and misleading information. The Court rejected the argument, stating that plaintiffs were required to plead that the Board, in bad faith, failed to implement a system of controls. However, as the Court noted, LCC implemented such a system in the form of its Audit Committee. The Court accordingly found that the complaint contained no allegations of bad faith and LCC implemented a system meant to prevent the misconduct described.
Plaintiffs’ second allegation pertained to the $10 million related-party investment by LCC. The plaintiffs asserted that the Board’s inability to prevent harm to the Company via this investment represented a conscious failure to monitor the operations of LCC. The plaintiffs bolstered this argument by alleging that LCC’s Risk and Audit Committees approved the investment without investigating the propriety of the action. The Court rejected this argument as well, stating that the complaint failed to outline any facts indicating that the Risk or Audit Committees knew or should have known about the Board members’ individual investments. Accordingly, a majority of the Board did not face a substantial likelihood of liability with regard to this claim.
Plaintiffs’ third allegation similarly charged the Board with a conscious failure to monitor the activities of LCC resulting in the sale of non-conforming loans to an investor. The Court repudiated this argument by quoting a portion of the complaint that conceded there was an information security program, complete with procedures for safeguarding the integrity of information, established by the Board. While the Court found that this program had its shortcomings, deficiencies alone did not amount to an outright oversight failure.
Plaintiffs’ second claim comprised of a single allegation averring that LCC utterly failed to properly monitor LC Advisors’s risk management and compliance with applicable laws. The claim was entirely premised upon the cease-and-desist order issued by the SEC. After analyzing the SEC order, the Court found that it failed to mention the Board or its members, except to mention that the Board undertook remedial measures. Additionally, the Court noted, the complaint conceded that the Board established an Investment Policy Committee to specifically monitor the type of misconduct that occurred. The Court consequently dismissed the plaintiffs’ claim after concluding that the complaint lacked sufficient facts to demonstrate a substantial likelihood that a majority of the Board faced liability.
The plaintiffs also asserted that the Board could not be impartial regarding a litigation demand due to the threat of liability posed by the California litigation. Because the California litigation proceeded upon the same basic facts as plaintiffs’ first cause of action, plaintiffs argued a majority of the Board faced a substantial likelihood of liability sufficient to satisfy the applicable standard for demand futility. The Court rebuffed this argument by finding that the California litigation had not yet survived a motion to dismiss at the time the 2016 complaint was filed in the Delaware litigation. Further, the Court distinguished the characteristics of the two lawsuits. While the California suit set forth Section 11 securities violations requiring no showing of scienter, the Delaware litigation required a showing of bad faith by the Board. Thus, in the Court’s view, a majority of the Board could not have viewed the California litigation as presenting an opportunity for substantial liability because Section 11 liability would not have demonstrated bad faith on the part of the Board.
Lastly, the Court considered the independence prong of the applicable standard. To satisfy this requirement, the plaintiffs were required to plead facts that supported a reasonable inference that a majority of the Board was so under the influence of others as to sterilize their independence. To demonstrate this point, the plaintiffs claimed the Board members were compromised for a variety of reasons, including that: 1) one board member had previously acted as the boss of another, 2) two board members sat together on another company’s board of directors, and 3) the entire Board lacked independence because it failed to exclude one of the board members with an undisclosed interest in the related-party investment transaction. The Court declined to adopt this reasoning. Instead, the Court held that the complaint lacked particularized facts necessary to establish that any of these relationships exhibited the level of control necessary to establish sterilization of independence. As pleaded by the plaintiffs, the Court disagreed that these relationships compromised a majority of the Board.
Having concluded that the plaintiffs failed to demonstrate that a majority of the Board members faced a substantial likelihood of liability rendering them impartial to the consideration of a litigation demand, the Court dismissed the plaintiffs’ claims.