Last month, we tackled Pennsylvania’s “universal” demand requirement. As a refresher, unlike many states, Pennsylvania will not excuse the shareholder of a company who wants the company to sue its executives or directors from making a written demand on the company’s board of directors prior to filing a lawsuit even when doing so would be futile. “Futility” means that the composition of the company’s board makes it incapable of impartially deciding whether to bring suit on behalf of the company based on the wrongful conduct alleged by that shareholder in their demand. Normally, if such a demand would be futile, a would-be shareholder-plaintiff can skip the written demand and move straight to filing their lawsuit.
As I explained in that blog post, this “universal demand” requirement makes sense in Pennsylvania because the Commonwealth’s laws allow a company’s board to appoint a special litigation committee (known in legal circles as an “SLC”) composed of independent third-party members to investigate the complaining shareholder’s allegations and determine whether bringing a potential lawsuit based on those allegations would be in the best interests of the company. A demand in Pennsylvania should never, strictly speaking, be futile because it is always possible for a board to take good faith action in response to a demand, even if the entire board is conflicted.
Not every company jumps at the chance to commence these investigations, especially a closely held company that might not have the cash flow or balance sheet needed to fund one. But there may be a way for closely held companies to carry out these investigations and reap the benefits of doing so without breaking the bank.
Spend money on an investigation now, save money on litigation later
In publicly held companies and private companies with many shareholders, it is common for a board of directors to appoint an SLC after receiving a shareholder’s complaint. Usually, the SLC then retains an outside law firm to help it investigate the complaint. Most times, those law firms will thoroughly and independently investigate the complaint and issue a report, dozens of pages long, explaining why the shareholder’s allegations are without merit, and thus why the board should not file the lawsuit the shareholder is asking it to file.
The boards at these companies know that whatever they pay for the investigation and report —likely anywhere from the low six figures to the high seven figures—will provide a meaningful return on investment on the backend. That’s because the investigation and report could be a proper basis, according to a court, on which a board can rely to not pursue a lawsuit against its own company, thus putting an early end to litigation over the shareholder’s complaints. The cost to the company of litigating the shareholder’s complaints to the bitter end would inevitably be multiples of what that investigation and report cost.
But when it comes to closely held companies, in my experience, the controlling owners/shareholders rarely appoint an SLC to investigate a complaining shareholder’s claims. The funny thing is, they probably should. By not doing so, they are missing an opportunity to show Pennsylvania courts that a complaining shareholder’s allegations of wrongdoing were investigated by a law firm and found to be without merit, and thus related litigation should be dismissed as early as possible. Moreover, the cost of most litigation means that disputes over relatively small amounts (500k to 2 MM) would not be in a company’s best interests, thereby creating an additional justification for dismissal of a plaintiff’s claim. The board of a closely held company that fails to appoint an SLC misses these opportunities to end litigation early and the potentially significant ROI that an SLC’s investigation can bring.
So why don’t more closely held companies appoint SLCs to investigate a complaining shareholder’s allegations of wrongdoing?
It might seem to closely held companies that the cost of conducting such an investigation would be prohibitive. The price to hire an outside law firm to conduct this kind of investigation at a closely held company likely begins in the mid-five figures and tops out in the mid-six figures.
But Pennsylvania courts have held that a board’s decision to not pursue litigation against its own company is subject to the business judgment rule (under which a court will uphold a board’s decisions if they are made in good faith, using reasonable care, and with the best interests of the company in mind). The business judgment rule focuses on process. Therefore, how the board of a closely held company arrived at its decision not to pursue litigation against its company regarding a complaining shareholder’s allegations of wrongdoing is what counts, not necessarily who its SLC hired to help it investigate those allegations.
So how can a closely held company’s SLC investigate these allegations without breaking the bank? A 2008 Pennsylvania appellate court suggests a path worth following.
LeMenestrel v. Warden: A roadmap for DIY SLC investigations
The dispute at the center of LeMenestrel v. Warden, 964 A.2d 902 (Pa. Super. Ct. 2008) is common amongst closely held companies. The LeMenestrel siblings, who were minority shareholders of Superior Group, brought a breach of fiduciary duty claim in a derivative action against the company’s SLC, controlling shareholders, and controlling officer. The SLC was formed in response to a demand letter sent by the LeMenestrels regarding losses to some of Superior Group’s subsidiaries, and business decisions by the majority shareholders relating to the sale and liquidation of other subsidiaries. The LeMenestrels also claimed that the SLC breached its fiduciary duty to Superior Group’s shareholders in its investigation of the self-dealing allegations.
The trial court granted the defendants’ motion to dismiss the lawsuit. The court held that the SLC formed by Superior Group’s board of directors in response to the LeMenestrels’ demand letter “was disinterested, independent, impartial and adequately informed in reaching its good faith conclusion that it was not in the best interests of [Superior Group] to proceed with the LeMenestrels’ shareholders’ derivative suit.”
The LeMenestrels appealed that decision to the Pennsylvania Superior Court. In its decision, the Superior Court upheld the trial court’s decision.
LeMenestrel is one of the few Pennsylvania court cases that evaluated the actions of an SLC. In its decision, the Pennsylvania Superior Court explained why Superior Group’s SLC’s deference to its attorney was proper and why the committee was “adequately informed” when it decided not to pursue the LeMenestrels’ lawsuit. The court focused on the work of the committee’s lawyer, John G. Harkins, Jr.:
- Harkins was independent, had no conflict of interests, and was “an eminently qualified practitioner” who conducted an “extensive investigation”;
- He developed an investigation plan and met regularly with the committee to discuss matters regarding the investigation, including the scope of the investigation, the general procedures to follow, the kinds of claims raised in the demand letter and which claims could be subject to a lawsuit based on particular legal theories;
- He reviewed thousands of documents, including deposition transcripts from a related litigation and documents provided by the LeMenestrels’ lawyer;
- He interviewed at least eight witnesses knowledgeable about facts relevant to the LeMenestrels’ claims;
- He interviewed the LeMenestrels’ lawyer, met with him regarding the scope of the investigation to ensure that it considered issues his clients felt were significant, and tailored the scope of the investigation after talking with the lawyer; and
- His investigation took five months, resulting in a 106-page final report that explained “in a thorough, evenhanded manner, the background and events leading up to the LeMenestrels’ claims, the response of Superior Group’s board and formation of the committee, the scope of the investigation, and findings and recommendations in light of the fiduciary duties owed by the defendant directors and officers.”
Following the roadmap without paying a fortune
Based on the LeMenestrel court’s description of the Superior Group’s SLC’s investigation, the company probably spent somewhere between $200,000 and $400,000 on it. That cost was likely justified by the fact that potentially tens of millions of dollars were at stake.
But rarely is that amount of money at stake in legal disputes between the shareholders of closely held companies. In those disputes, a more likely amount at stake is $500,000 to $2 million. At those amounts, a $200,000 to $400,000 investigation does not make much financial sense. But a $20,000 or a $40,000 investigation might.
If that’s the case, how could a budget-minded SLC at a closely held company conduct a process-driven and thorough investigation like John Harkins did for Superior Group that is strong enough to pass judicial muster and serve as the appropriate basis for the dismissal of a shareholder’s lawsuit early in the litigation process?
Here’s one possible way: hire “an eminently qualified” lawyer to lead the investigation and be the “quarterback” of it, but assign company personnel and other qualified non-lawyers the brunt of the legwork. That will cut down on the fees charged by a lawyer because it reduces the time they will spend investigating.
To be clear, an SLC should hire a lawyer to lead the investigation. Only a lawyer can determine, based on what the investigation finds, whether the SLC and ultimately its company’s board should agree to the shareholder’s demand to bring a derivative lawsuit on behalf of the company. This decision will be a result of the facts uncovered during the investigation and the law of the company’s jurisdiction regarding whether those facts constitute legal wrongdoing. That is the exclusive domain of a lawyer.
But uncovering the facts is not. If we look at the aspects of the Superior Group’s SLC’s investigation that the LeMenestrel court lauded, we see many tasks that can be delegated to non-lawyers partially or entirely, including directors on the SLC, disinterested executives, and disinterested third parties:
- Developing an investigation plan;
- Meeting with the SLC to update them on the investigation;
- Reviewing documents, including deposition transcripts;
- Interviewing witnesses; and
- Drafting a final report
Surely, the lawyer hired by the SLC will be intimately involved with the investigation, guiding the non-lawyer(s) and assisting them. But the lawyer need not be the person sitting for an interview with a witness—they can help the interviewer prepare for one. Same thing for the first draft of a final report. Merely by reducing the amount of “doing” by a lawyer while maintaining the same amount of strategic thinking they provide, SLCs at closely held companies can reduce the cost of an investigation of a shareholder’s demand. This cost reduction could lead to a wider adoption of investigations at these companies, which as I mentioned above, would generally be a good thing for them.
A few dollars of prevention is worth exponentially more of cure
When faced with shareholder demands regarding significant alleged wrongdoing at their companies, the boards of Pennsylvania closely held companies may be doing themselves and all of their shareholders a disservice when they fail to convene an SLC to investigate the allegations. An SLC’s investigation and subsequent report can provide the means to an early exit from what could end up being a costly lawsuit.
If cost is a factor, the LeMenestrel case provides a roadmap for closely held companies to follow that could help them obtain the litigation benefits of an SLC without breaking the bank.