Failure to Make Demand on Board Prior to Commencing Derivative Action Not Excused When Plaintiff Did Not Demonstrate that Demand Would Have Been Futile Because Directors Acted in Bad Faith by Knowingly Breaching their Oversight Responsibilities
By: Eric E. Freedman and Serena M. Hamann
In Juan C. Rojas derivatively and on behalf of J.C. Penney Company, Inc. v. Marvin R. Ellison, et al, C.A. No. 2018-0755-AGB (Del. Ch. July 29, 2019), the Delaware Court of Chancery dismissed with prejudice a derivative claim brought against J.C. Penney Company, Inc. (“J.C. Penney,” or the “Company”) and current and former members of the Company’s board of directors (the “Board”), on the grounds that the failure of plaintiff Juan Rojas (“Rojas”) to make a demand on the Board prior to filing suit did not satisfy the requirements of Delaware law for excuse from the requirement to make such a demand. The Court held that Rojas had failed to allege facts from which the Court could reasonably infer that any of the Board members had acted in bad faith by knowingly failing to exercise their oversight responsibilities, and that Rojas therefore had not demonstrated that a demand on the Board would have been futile.
Rojas’ derivative action asserted that J.C. Penney’s directors breached their fiduciary duty of loyalty by consciously disregarding their responsibility to oversee J.C. Penney’s compliance with California laws governing price-comparison advertising. Specifically, Rojas alleged that the directors failed to exercise appropriate oversight to ensure that the Company abided by the terms of a 2016 California class action litigation settlement, thus leading to additional litigation over the Company’s pricing practices. The 2016 class action litigation settlement and other later lawsuits filed between 2016 and 2018 concerned J.C. Penney’s alleged use of “false reference pricing,” a practice involving labeling an advertised product with a “reference” price higher than the true sales price, making an advertised discount appear larger than the actual discount.
The defendants moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure to make a demand on the Board before filing suit. Under Rule 23.1, a plaintiff wishing to assert a derivative claim on behalf of a corporation must allege with particularity the reasons for the plaintiff’s failure to make an effort to obtain the relief the plaintiff desires from the corporation’s board. Delaware law provides two tests for determining whether making a demand on a corporation’s board of directors to pursue a claim may be excused as futile. When the derivative suit alleges that the board of directors breached its fiduciary obligations by failing to act, as opposed to taking inappropriate action, the Court applies the test for futility outlined by the Delaware Supreme Court in Rales v. Blasband, 634 A.2d 927 (Del. 1993). Under Rales, demand on the board of directors is excused only if at the time the complaint was filed there were reasonable grounds for doubt that the board could have properly exercised its independent and disinterested judgment in responding to the demand. Rojas’ sole justification for his failure to make a demand on the Board was his assertion that at least nine of the eleven Board members faced a substantial likelihood of personal liability with respect to the claims he asserted because they were members of the Board when the alleged failures in Board oversight occurred. Citing the standards for oversight liability established by In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996), Rojas argued that the directors were exposed to liability either because they utterly failed to implement a system of controls to ensure good pricing practices or because they consciously failed to monitor an appropriate system of controls.
The Court noted that Delaware law imposes oversight liability on directors only if the directors acted in bad faith, meaning that the directors must have known they were not discharging their fiduciary obligations or must have consciously disregarded their responsibilities such as by failing to act in the face of a known duty to act. The Court found that Rojas failed to allege facts sufficient to show that the directors were exposed to a substantial likelihood of liability for failing to implement an appropriate system of controls following the Company’s 2016 class action settlement. To the contrary, the Court observed, the Board had implemented various Board-level systems of monitoring and oversight, including the audit committee and protocols requiring reports about risks and the use of third-party monitors and consultants.
The Court also found that Rojas failed to prove the directors faced liability for consciously failing to monitor. In order to succeed on such a claim, a plaintiff must typically show the directors were alerted to evidence of illegality or a “red flag.” As such, Rojas was required to show that, having implemented an appropriate system of controls, the directors knew the Company was nonetheless violating the law and that they acted in bad faith by failing to prevent or remedy those violations. Rojas argued the 2016 class action settlement was the ultimate “red flag,” putting the directors on notice that the Company’s price-comparison policies violated California Consumer Protection Laws. However, the Court agreed with the defendants’ contention that Rojas failed to plead particularized facts supporting the inference that 2016 class action settlement put directors on notice of ongoing violations of the law. In fact, Rojas failed to allege facts giving rise to an inference that the J.C. Penney directors were aware the Company violated any pricing laws at any time before or after the settlement. The 2016 class action settlement included an express acknowledgement that the Company was not violating the law, and the Company actively implemented pricing policies to maintain compliance. The Court concluded that this case was different from prior cases in which settlements constituted a “red flag” because the Company’s 2016 class action was a purely civil matter and was not brought against the backdrop of clear, repeated violations of the law.
The Court found that Rojas failed to plead with particularity that the J.C. Penney directors acted in bad faith by consciously allowing J.C. Penney to violate price-comparison laws, and therefore faced a substantial likelihood of oversight liability. Accordingly, Rojas did not raise reasonable doubt as to the disinterest of the J.C. Penney directors, and failed to demonstrate that it would have been futile to make a demand on the Board prior to filing his derivative suit.