Chancery Court Holds More than Red Flags Required to Allege Demand Futility in a Derivative Suit

By:  Annette Becker and Will Smith

In In re Qualcomm Inc. FCPA Stockholder Derivative Litigation, C.A. No. 11152-VCMR (Del. Ch. June 16, 2017), the Delaware Court of Chancery granted a motion to dismiss brought by defendants for failure to state a claim and for failure to make demand or to allege demand futility with sufficient facts, dismissing the plaintiff-stockholders’ derivative action on Court of Chancery Rule 23.1 grounds. The court held that the plaintiffs failed to support the inference that the board acted in bad faith pursuant to a Caremark claim for breach of fiduciary duties and found that the plaintiffs’ proffered documentary evidence suggested that the defendant-directors had yielded to—rather than charged after—red flags raised about the Qualcomm’s compliance with federal anti-bribery laws.

Plaintiff stockholders of Qualcomm Inc. (“Qualcomm”) asserted claims for breach of fiduciary duty, waste, and unjust enrichment against Qualcomm’s directors and chief financial officer in a derivative action.  The claims in the case arise from a determination by the Securities and Exchange Commission (“SEC”) that Qualcomm violated the Foreign Corrupt Practices Act (“FCPA”) from 2002 through 2012. The SEC issued a cease-and-desist order on March 16, 2016 detailing and settling Qualcomm’s FCPA violations. Qualcomm paid a penalty of $7.5 million and agreed to provide periodic reports to the SEC.  The plaintiffs alleged that the Qualcomm board knew of several red flags concerning FCPA reporting problems in China and Korea before the issuance of the cease-and-desist order, including direct reports of FCPA violations to the audit committee and whistleblower allegations in 2009 and 2010. The board consciously disregarded these red flags, the plaintiffs alleged, to pursue an expansionary business plan in the Asia Pacific region.

The defendants moved to dismiss the claims under Court of Chancery Rule 23.1 for failure to make demand or allege demand futility, and also under Rule 12(b)(6) for failure to state a claim. The court’s analysis concentrated on the demand requirement imposed by Rule 23.1 for stockholders asserting derivative claims. To satisfy the demand requirement, stockholders must either make a demand on the board of directors or allege that a demand would be futile. Where stockholders wish to challenge a board’s inaction, the requirements for alleging demand futility are set by the Rales test. Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993) (requiring that a derivative stockholder compliant allege particularized facts sufficient to “create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand”). A plaintiff satisfies this demand futility criterion when a complaint demonstrates a “disabling interest” such that a majority of the board faces a “substantial likelihood” of personal liability.

The court focused on the claim brought by plaintiffs for breach of fiduciary duty for improper oversight, known as a Caremark claim. The plaintiffs sought to establish the directors’ liability for “consciously” failing to monitor or oversee the reporting controls or information systems implemented by the board, “thus disabling themselves from being informed of risks or problems requiring their attention” (Quoting Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006)). A Caremark claim must allege that the directors acted in bad faith by failing to prevent or remedy legal violations by the corporation. An allegation of bad faith requires that a plaintiff plead particularized facts from which the court may reasonably infer that “the board consciously disregarded its duties by intentionally failing to act in the face of a known duty to act” (internal brackets omitted). The Court indicated “conscious disregard” means “intentional dereliction of duty,” not mere inattention, failure to be informed of material facts, or poor business judgment.

The plaintiffs claimed that the directors’ knowledge of certain “red flags” indicative of corporate misconduct amounted to a conscious disregard of the board’s duty to address such misconduct. The Court found, however, that the complaint failed to allege that the board consciously disregarded the plaintiffs’ purported red flags as such. The Court noted that many of the documents cited as red flags by the complaint also set forth the board’s planned remedial efforts or corrective actions, and that these responses indicate that the board changed course in light of the problems reported. As a result, the board did not act in bad faith because it reacted to the red flags as warnings of unacceptable corporate behavior. Rather than buttress the plaintiffs’ position, the documentary evidence indicated that the board did not believe “Qualcomm could continue to violate the FCPA without consequences.”

Ultimately, the Court held that the plaintiff failed to meet the Rales test on each count: the complaint did not contain particularized facts sufficient to show that the board was incompetent to decide whether to bring the claim alleged because of a substantial likelihood of personal liability for a majority of the board. As to the breach of fiduciary duty claim, the Court concluded that the compliant failed to establish bad faith because the plaintiffs failed to plead adequately the board’s intentional dereliction of duty. Simply asserting a statutory violation of the FCPA does not establish director liability: that standard is set by Delaware law, and is not met by a conclusory allegation that illegality occurred under a federal statute. The Court ruled in favor of the defendants on the motion to dismiss.

In re Qualcomm Inc. FCPA Stockholder Derivative Litigation letter opinion 170616

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>

Copyright © 2024, K&L Gates LLP. All Rights Reserved.