In a ruling interpreting Delaware law on shareholder derivative suits, the Sixth Circuit held that a partial recusal by a member appointed to a special litigation committee (“SLC”) created by a corporation compromises the independence of such committee.  In Booth Family Trust v. Jeffries (6th Cir. 09-3443) [PDF], a divided panel found that where an SLC member “recused himself from considering the claims against [one of the named defendants in the derivative suit] he effectively admitted that he was not independent.”  On that basis, the Court reversed the district court’s dismissal of the derivative suit.

In Booth Family Trust, shareholders filed a derivative suit on behalf of clothier Abercrombie & Fitch Co. against the company’s board of directors  The plaintiffs claimed that Abercrombie’s executives developed a business model of selling low-cost products at high retail prices through advertising that “trained” customers not to expect sales or markdowns by the retailer but, rather, to pay its higher prices.  With this in mind, the plaintiffs claimed that Abercrombie issued reports showing strong denim sales when, in fact, there was an inventory in surplus of such volume that it would require markdowns to liquidate, clashing with the company’s business model.  When the reality became known, plaintiffs alleged, the stock price of the company fell.  After the derivative suit was filed, Abercrombie invoked a procedural mechanism available under Delaware law by appointing an SLC to investigate the plaintiffs’ claims.  If the claims are found lacking, the SLC directs the corporation to move to dismiss the action.  Under Delaware law, “[i]f a court finds that a corporation’s special litigation committee was independent, conducted its investigation in good faith, had reasonable bases for its conclusion and the decision to dismiss the lawsuit is not inconsistent with business judgment, the court will dismiss the derivative action” (citing Zapata Corp. v. Maldonado, 430 A.2d 779, 788-89 (Del. 1981)).  Abercrombie created a two-person SLC, initially appointing two board members, Daniel Brestle and Allan Tuttle.  Brestle later resigned and was replaced by board member Lauren Brisky.  After a 16-month investigation, the SLC produced a 144-page report concluding that there was no evidence to support the plaintiffs’ claims and recommending that Abercrombie seek dismissal of the case.  Abercrombie moved to dismiss, which, after applying the Zapata test, the district court granted.

Writing for himself and Judge Patrick J. Duggan, U.S. District Judge for the Eastern District of Michigan, sitting by designation, Judge Martin reversed upon de novo review, ruling that the district court wrongly determined that the SLC had been independent.  Observing that, under Delaware law, an SLC had to be “‘like Caesar’s wife’ — ‘above reproach,'” the majority found that Tuttle’s decision to recuse himself from consideration regarding allegations against named defendant Robert Singer, Abercrombie’s Chief Operating Officer, had fatally compromised the SLC’s independence.  Tuttle partially recused himself because he and Singer were friends and had a longstanding personal relationship, predating their time together at Abercrombie.  The majority acknowledged that Delaware corporate law was “relatively flexible and will not find that directors are incapable of exercising independent judgment even if they are friends,” but, owing to the relatively undeveloped state of Delaware law as to SLC independence, it found that it was “unclear” whether the law governing an SLC’s independence “would be quite as accepting.”  Because of the general flexibility of Delaware law as to officers’ friendships, the majority stated that “[h]ad Tuttle not recused himself from considering the claims against Singer, we might agree with the district court that he was independent.  However, because Tuttle, for whatever reason or no reason at all, recused himself from considering the claims against Singer he effectively admitted that he was not independent.”  The majority also rejected the argument that, even with Tuttle’s partial recusal, a one-person SLC was acceptable under Delaware law.  While that may be true, the majority pointed out that the board resolution creating the SLC called for it to have two members.  The majority took pains to state that it was not accusing Tuttle of being a “bad person” or committing any offense, but rather that Tuttle’s recusal “le[ft] us with serious doubts as to his independence.”  Because the majority found that the SLC was not independent, it did not need to reach the other elements of Delaware’s Zapata test and reversed the district court, remanding for further proceedings.

Finding that the majority conclusion was “inconsistent with Delaware law,” Judge Griffin dissented. Rather than compromising the independence of the SLC, Judge Griffin found that, “through his partial recusal, Tuttle attempted to expel any doubt regarding the independence of the SLC.”  The dissent noted that it had found no caselaw supporting the proposition that recusal could serve as an admission of bias, and it observed that “had Tuttle not recused himself and fully addressed all issues presented to the SLC, there would be little doubt regarding the committee’s independence.  In my view, Tuttle’s partial recusal does not alter this result.”  Judge Griffin would have found that the SLC was independent, that the other elements of the Zapata test were also met, and that the district court therefore ruled properly.  (Given the important of this decision, it may well attract en banc attention.)

Because many companies are incorporated in Delaware, and given the expected rise in the number of derivative lawsuits, this decision is important.  The composition of the SLC, the board resolution authorizing the appointment of the SLC, and the decision-making process of the SLC will likely all be under a microscope if, in the end, the SLC decides not to pursue a derivative suit.  Tread carefully, and think twice before making any recusal decision.