$850 Million Settlement of $175.3 Million Financial Statement Liability Can Support Inference of Breach of Duty of Loyalty When a corporation suffers
$850 Million Settlement of $175.3 Million Financial Statement Liability Can Support Inference of Breach of Duty of Loyalty When a corporation suffers
harm, the board of directors is the actor
empowered to determine what remedial action the corporation should take. If the board is unable or unwilling to act, a shareholder may pursue a derivative suit on behalf of the corporation, in appropriate circumstances. Ordinarily, the shareholder must first demand that the board pursue the action. However, a shareholder is excused from making the demand if it would be futile.
A demand is futile when: (i) the director received a material personal benefit; (ii) the director faces a substantial likelihood of liability, and (iii) the director lacked independence.
The second factor—whether a director faces a substantial likelihood of liability—often times depends on whether grounds exist to rebut the business judgment rule. Such standard of review can be rebutted if the plaintiff pleads facts sufficient to support an inference that the director acted in bad faith, which can implicate a breach of the duty of loyalty.
In a recent case out of the Delaware Court of Chancery, the court concluded that the plaintiff—a shareholder of GoDaddy Inc.—pled sufficient facts to support an inference that some of the corporation’s directors and officers acted in bad faith when they pursued and approved a transaction with the entity’s founders. As a result, a demand to the directors would have been futile.
In summary, the transaction consisted of a buyout of a liability that GoDaddy owed to some of its founders if it was able to reduce its taxable income by using tax assets generated by the founders. Although the nominal liability owed by GoDaddy to the founders could have been as high as $1.8 billion (if the tax assets were fully used), GoDaddy valued the liability in its financial statements at $175.3 millions based on the amount of the tax assets that would likely be used by the company.
The board eventually approved a settlement of such liability for $850 million. For the court, the disparity between the amount paid by GoDaddy and the amount at which the company valued the liability in its financials was sufficient to support a claim of waste and hence an inference of bad faith on that basis alone.
The court also found additional facts that supported an inference of bad faith, including: (1) the CFO’s conflicting representations with respect to the probability that GoDaddy would generate enough taxable income to use all of the founder’s tax assets; (2) the failure to consider GoDaddy’s M&A-based business model and its effect on GoDaddy’s ability to use the tax assets; (3) that the director’s approved the transaction in a thirty-minute meeting, and (4) that the transaction involved counterparties that management and the directors had reason to favor.