The business judgment rule did not shield a company board’s vote not to pursue a derivative suit demanded by a shareholder as there was evidence that the vote was not taken in good faith, a judge in the Business Litigation Session in Boston has decided.
The judge also pointed to evidence that the board may not have been independent from the defendant, a former corporate officer who had allegedly converted company funds.
Normally, a decision not to pursue litigation — even litigation with a reasonable likelihood of success — would benefit from the protection of Massachusetts’ business judgment doctrine, Judge Mitchell H. Kaplan wrote.
While the board in the case before him “adequately investigated” the shareholder’s demand, as the business judgment rule requires, its response to an accounting firm’s report, which seemed to validate the shareholder’s allegations, was one of a number of red flags, according to Kaplan.
“This case appears to present a situation in which the Board’s conduct is so different from what an independent Board would be expected to do when confronted by the Report that it can raise reasonable doubt concerning the Board’s good faith,” he said.
Kaplan said the board perhaps revealed its true motive by deciding that litigation against the officer should not be pursued “at any point now or in the future,” a stance made more extreme because Brining’s derivative claim against the officer appeared to be the company’s “only significant asset.”
Under the circumstances, an independent board might have been expected to attempt to settle the claims against the former director or at least negotiate a tolling agreement, allowing the claims to be pursued when a suit would no longer impair the company’s business prospects.
The decision not to do so “raises serious questions both concerning the independence of the Board and the good faith of its decision to seek no redress for the serious financial improprieties at least strongly suggested by the Report,” Kaplan wrote.
The 19-page decision is Brining v. Donavan, et al.
Not an ‘insuperable hurdle’
The shareholder’s attorney, Michael C. Gilleran of Boston, said the decision shows that while the business judgment rule, G.L.c. 156D, generally is “pretty impenetrable,” it is possible to parry back its invocation. That is particularly true if a board’s position merely contains “bromides and platitudes,” Gilleran said, quoting Kaplan’s comments at the hearing on the motion to dismiss.
Boston attorney Stephen D. Riden said one obvious takeaway of the case is that the board should have elaborated further on its decision not to allow the shareholder to pursue the claims, if it wanted its judgment to be upheld.
Of particular note was Kaplan’s description of the benefits of using a “special litigation committee” to validate the independence of the board’s decision. Following that course could have provided the board with some cover, Riden said.
Kaplan meticulously went through the board’s “laundry list” of justifications in a way Riden said he had never seen before.
“The big picture here is the court found that the board’s resolution was not grounded in reality,” he said.
While Riden agreed that courts are loath to go around the business judgment rule, he suggested that anybody involved in a case with similarly egregious facts “should read this case and see what it looks like when a court doesn’t give the board the benefit of the doubt.”
According to Boston attorney Paula M. Bagger, Kaplan’s decision involved a relatively straightforward application of G.L.c. 156D.
“One thing that is always important to remember is that the business judgment rule is a presumption, not a defense,” she said.
The requirement that a board act in good faith is a low bar to ask directors to meet, she added.
One of the defendant company’s attorneys, Boston’s Joseph J. Laferrera, declined to comment.
The docket reflects that Laferrera and his co-counsel filed an unopposed motion to withdraw on Sept. 28. The same day, Boston attorneys Luke T. Cadigan, Timothy Cook and Michael Welsh filed a similar motion to withdraw as counsel for the defendant director and his business. That motion was allowed only with respect to the director, whom the docket indicates will proceed pro se until the appearance of successor counsel.
Cadigan, Cook and Welsh did not respond to requests for comment.
“One thing that is always important to remember is that the business judgment rule is a presumption, not a defense.”
— Paula M. Bagger, Boston
Internal controls absent
Plaintiff Jennifer Brining supplied about $1.3 million of the approximately $2.5 million raised by Sendlater, an internet-based business designed to arrange for cards, gifts and other items to be delivered over extended periods, presumably to family and friends, even after the sender died. The company planned to forge partnerships with retailers, florists, greeting card companies and other businesses.
Despite her sizable investment, Brining owned only 11 percent of Sendlater as of May 2017.
Brining came to believe that nearly all the money that had been invested in Sendlater found its way into accounts or businesses controlled by a director and president of the company, John J. Donovan, or his wife.
The company founders had been introduced to Donovan by their Vermont attorney and were “unaware of Donovan’s somewhat checkered past,” Kaplan noted in a footnote. Kaplan was referring to, among other things, a Boston Globe story headlined, “Father of Trump Deputy Treasury Pick at Center of Family Dispute.”
According to the Globe story, Donovan in 2005 had accused his son, a Goldman Sachs banker, of hiring Russian hitmen to shoot him. However, investigators found that the senior Donovan — an entrepreneur and former MIT professor — had orchestrated the incident and shot himself in the stomach.
Brining first brought suit directly against Donovan but was eventually prompted to make a demand to bring a derivative suit against Donovan on Sendlater’s behalf.
Sendlater’s board responded by reporting that Donovan had been removed from the board and no longer had control over Sendlater’s funds. The board further reported that it had retained a nationally recognized forensic accounting firm to investigate transactions between Donovan and the company.
While Donovan drew upon the accounting firm’s preliminary analysis of his transactions with Sendlater to oppose Brining’s motions, BLS Judge Edward P. Leibensperger “found that it actually supported Brining’s contentions that Donovan had misused corporate assets,” Kaplan wrote.
The report suggested that Donovan may have benefitted from operating within a company that “essentially had no internal controls” until December 2016.
“Not only did it not prepare financial statements, it did not even record transactions,” Kaplan said.
Two days after the accountants completed their report, the board voted on April 20 not to pursue legal action against Donovan “at any point now or in the future, or to permit claims to be pursued on its behalf.”
Based on that vote, Sendlater filed a motion to dismiss Brining’s derivative claims. Kaplan heard oral arguments on Aug. 8.
Independence also questioned
The new members who were invited onto the board by Donovan and then voted not to pursue the suit against him had longstanding relationships with Donovan but had not invested their own cash in the company and thus lacked “skin in the game,” according to Kaplan.
Standing alone, such factors would be insufficient to establish that the board members had a “disabling interest,” he added.
But the case also presented “certain confounding factors,” Kaplan continued.
One of those was that Donovan had selected the board members only after the shareholder had made her litigation demand. Kaplan wrote that he questioned whether it was appropriate for Donovan to select people with whom he had pre-existing relationships as members of the company’s board, “when the principal business question facing the corporation is whether to pursue a claim” against him.
For that reason, a special litigation committee would have been particularly helpful, Kaplan said.
The auditors unearthed a number of curious transactions, including an alleged loan of more than $200,000 from Donovan to “Sendlater Entities” that a board member appointed by Donovan only memorialized with notes created long after the fact. That, too, called the board’s independence into question, according to the judge.