For many years, the special litigation committee (“SLC”) was a nearly forgotten device in derivative litigation in the Delaware Court of Chancery. Chastened by a string of decisions rejecting SLCs’ motions to terminate,[1] boards facing derivative litigation in Delaware almost always chose to litigate on the merits. During that same period, the Delaware plaintiffs’ bar became a serious threat to wayward fiduciaries, extracting billions of dollars in settlements in high-value derivative actions.

Recently, however, the SLC has experienced a dramatic revival. After an eighteen-year drought—from 2003 to 2021—in which there was not a single written opinion granting an SLC’s motion to dismiss, SLCs are now routinely being formed in strong derivative cases, they are routinely moving to dismiss, and their motions are often granted.[2]

The SLC’s newfound popularity has bred deep cynicism and skepticism amongst shareholder advocates. As attorneys who typically represent public stockholders, we are far from alone in observing an increasingly common phenomenon: seemingly results-driven SLC investigations that appear designed to terminate meritorious claims. These “investigations” generally downplay contemporaneous evidence in favor of unsworn, after-the-fact witnesses’ explanations that are neither recorded nor transcribed.  They then culminate in a report in support of a motion to terminate that reads more like standard defense-side advocacy than an objective assessment of all relevant evidence.

Unsurprisingly, SLC counsel disagree with this view and often express great offense at the temerity of plaintiffs’ counsel who express skepticism about the good faith of the committee’s efforts. The result is usually months of hotly contested discovery, followed by briefing where plaintiffs ask the Court to draw inferences about the incompetence of the SLC’s investigative efforts from a patchy record. The lawyers are unhappy and the Court is put in an awkward position.

The status quo isn’t working for anyone. We believe it’s time for a refresh and a return to the principles first established by the Delaware Supreme Court in Zapata Corp. v. Maldonado.[3] There, the Supreme Court directed that “[t]he Court should apply a two-step test” to an SLC’s motion to terminate.[4]

“First, the Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions.”[5] The SLC bears “the burden of proving independence, good faith and a reasonable investigation, rather than presuming independence, good faith and reasonableness.”[6] “If … the Court is satisfied under Rule 56 standards that the committee was independent and showed reasonable bases for good faith findings and recommendations, the Court may proceed, in its discretion, to the next step.”[7]

At the second step, “[t]he Court should determine, applying its own independent business judgment, whether the motion should be granted. This means, of course, that instances could arise where a committee can establish its independence and sound bases for its good faith decisions and still have the corporation’s motion denied.”[8] Although the Supreme Court framed the second step as an exercise of discretion, it also emphasized that the second step was the “essential key in striking the balance between legitimate corporate claims as expressed in a derivative stockholder suit and a corporation’s best interests as expressed by an independent investigating committee.”[9]

We believe that current SLC doctrine has drifted from the key principles of Zapata in two key respects. Fixing that drift will help correct an untenable status quo and restore the SLC to its proper role of filtering out “meritless or harmful litigation and strike suits” while ensuring that “bona fide derivative actions” brought by “well-meaning derivative plaintiffs” continue to operate as an effective “intra-corporate means of policing boards of directors.”[10]

1. The Court Should Require More Transparency From SLCs

At the first step, SLCs are supposed to bear the “burden of proving independence, good faith and a reasonable investigation, rather than [the Court] presuming independence, good faith and reasonableness” under Rule 56 standards.[11] SLCs in theory are required to show their work, but that is not happening as a practical matter. A series of discovery rulings have increasingly led to a world where SLCs’ motions to terminate are decided based on a record that is prepared and curated entirely by the SLC’s counsel. In particular, the Court of Chancery has tended to hold that plaintiffs are entitled only to the documents that the SLC relied on, not those that it merely reviewed.[12] As a consequence, plaintiffs are forced to defend against an SLC’s motion to dismiss using a lawyer-drafted SLC report and the lawyer-selected exhibits to that report, lawyer-drafted SLC minutes, and lawyer-drafted interview memoranda. This rule means that SLCs are also incentivized to shield potentially damaging documents by declining to rely on them. It also incentivizes cherry-picking in SLC reports, because once an SLC determines to seek dismissal of derivative litigation, the SLC’s counsel is obligated to advocate for dismissal through the SLC’s report and motion practice. Think about this procedural anomaly. Allowing the litigant facing a summary judgment burden to pick and choose what evidence to disclose to the non-movant and to the Court is truly bizarre. The simple and cost-free[13] fix is to require SLCs to produce all documents the SLC receives during the course of its investigation (from the company, defendants, and third parties) on a rolling basis, subject to privilege issues which can be dealt with under Rule 510(f). Adding greater transparency to the process—by requiring SLCs to produce to plaintiffs the same documents they receive in their investigation—would correct this procedural anomaly, incentivize more objective drafting and use of the evidence, ensure that real investigatory work is done, and promote confidence in the SLC mechanism.

In the same vein, SLCs should also be required to record or transcribe their witness interviews. At a recent Weinberg Center panel, SLC and defense counsel suggested that recording or transcribing SLC interviews could chill discussion or prevent witnesses from speaking openly.[14] The suggestion seems to be that witnesses are saying things in SLC interviews that they would not say under oath or while being recorded. But why should the Court trust what witnesses tell an SLC if they are unwilling to say it while under oath or while being recorded?

Notably, the Court of Chancery allows objectors to class action and derivative settlements to gain access to the full discovery record, including documents and deposition transcripts.[15] An objector is granted such access in order to test “the competence of the settlement,” including “the timing of the settlement in the context of the litigation” and “the soundness of [plaintiff’s counsel’s] judgment to settle the case.”[16]

This is a valuable tool. In Prime Hospitality, Chancellor Chandler reviewed transcripts of deposition testimony before rejecting a proposed disclosure-only settlement, finding that the original plaintiff’s counsel had “engaged in a discovery process that was long on style and short on substance.”[17] After objectors’ counsel took over, the case settled for $25 million.[18]

More famously, in the Rural/Metro case, the original lead plaintiff proposed a settlement with broad, intergalactic releases in exchange for supplemental disclosures.[19] Objectors’ counsel obtained access to emails and deposition transcripts from the discovery record and relied heavily on those materials in framing its objection.[20] The Court rejected the proposed disclosure-only settlement, finding that the original plaintiff’s counsel had failed to provide adequate representation. Vice Chancellor Laster grounded his ruling on a close reading of the deposition transcripts:

I do not have a sufficient degree of confidence based on the record that was created. It’s not clear to me that there was sufficient adversarial discovery at the document stage. I have read all four of the depositions that were taken. It’s not clear to me at all that there was sufficient thoroughness and vigor in those depositions. It’s not — we’re not just asking you to check boxes and take depositions. And I didn’t have a lot of comfort from reading those depositions.[21]

Years later, after objectors’ counsel took over the case, the Court rendered a post-trial judgment in favor of the stockholder class, holding that it had suffered over $91 million in damages.[22]

In the settlement context, objectors get access to “all discovery that has already been taken” precisely because “it is not … a sufficient safeguard to absentees that the representative plaintiff has proceeded in good faith; it is also important to such persons that the class representative has proceeded competently.”[23] So too in the context of an SLC’s motion to dismiss.

Increasing transparency through these two tweaks—requiring production of all documents and transcribing witness interviews—will improve the reliability of the SLC process by enabling plaintiffs’ counsel and the Court to understand what the SLC actually did and deemphasize a fight over the inherent credibility of SLC counsel. Transparency will also influence the work of SLCs and their counsel in a positive way, by incentivizing the SLC to create a genuine record of independence, diligence, objectivity, and reasonableness. Put differently, if SLCs and their counsel understand from the outset that the Court and the plaintiff will have access to the full documentary and testimonial record, they will be incentivized to conduct investigations in a way that obviates suspicions regarding the SLC’s thoroughness, diligence, and objectivity. Conversely, transparency disincentivizes gamesmanship and will help bring SLC procedures in line with Zapata’s goals of “safeguarding against abuse, perhaps subconscious abuse.”[24]

2. The Court Should Revive Zapata’s Second Prong

The second concerning trend is that Zapata’s second prong seems to be withering away. In AmerisourceBergen, Vice Chancellor Glasscock suggested that “where … the stockholder-Plaintiffs have not only pointed to substantial corporate trauma but have withstood the rigors of a motion to dismiss under Rule 23.1,” it is “incumbent upon the Court … to go beyond a review of independence and reasonableness of the scope of the investigation and the bases for its conclusion,” to “apply its own judgment of the reasonableness of the special litigation committee’s conclusions.”[25] Vice Chancellor Glasscock suggested, however, that the Court could do so either “implicitly in its prong one analysis or explicitly via prong two[.]”[26] Other members of the Court have given equally short shrift to prong two. In Carvana, Chancellor McCormick’s prong two analysis consisted of a few sentences essentially incorporating the prong one analysis.[27] The Chancellor offered a similar analysis in Diep v. Sather.[28] In Baker Hughes, Vice Chancellor Will expressly declined to conduct a prong two analysis.[29]

The de-emphasizing of prong two—particularly in strong cases—seems inconsistent with Zapata, which described prong two as “the essential key in striking the balance between legitimate corporate claims as expressed in a derivative stockholder suit and a corporation’s best interests as expressed by an independent investigating committee.”[30] Zapata emphasized that while prong two was discretionary, it was important. Prong two was designed to “thwart instances” where an SLC’s recommendation met “the criteria of step one” but would “prematurely terminate a stockholder grievance deserving of further consideration in the corporation’s interest … when faced with a non-frivolous lawsuit.”[31] The withering away of prong two has also forced plaintiffs into a situation where their best hope of defeating an SLC’s motion to dismiss is attacking the reasonableness of its investigation, which puts the Court in the awkward position of second-guessing the SLC’s lawyers.

The Court should resurrect Zapata’s second prong—especially in cases that have already withstood a motion to dismiss or were filed based on a complete Section 220 investigation—which the Zapata Court described as the “essential key in striking the balance” between legitimate derivative actions and a committee’s ability to determine what’s best for the corporation.[32]

A faithful application of Zapata’s second prong should require the Court to meaningfully consider the type of claim being investigated and the likelihood of a beneficial recovery if the claims were prosecuted by plaintiffs’ counsel. For instance:

• Are the claims challenging a controller self-dealing transaction where defendants will likely bear the entire fairness burden through trial, or small compensation-related claims that do not stand to generate a material benefit for the company?
• Are they oversight claims buttressed by facts developed in government investigations, guilty pleas, and civil settlements, or oversight claims premised upon theoretical and speculative future harm?  
• Was the SLC formed pre-motion to dismiss, or did the plaintiff overcome a Rule 23.1 motion by pleading particularized facts/conflicts to establish demand futility?

The prong two analysis can be analogized to the “give/get” analysis in the settlement approval context.  When an SLC moves to terminate derivative litigation, it is recovering nothing for the company in exchange for effectively releasing the claims against the defendants.  There is no doctrinal reason that a Court that carefully scrutinizes settlements and releases, should not conduct the same level of scrutiny under Zapata’s second prong.