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Editor: D. A. Jeremy Telman
Valparaiso Univ. Law School

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Tuesday, November 18, 2008

business Associations Limerick of the Week: Auerbach v. Bennnett

Tootsie_popsOur last Business Associations Limerick introduced the concept of demand in shareholder litigation. We now move on to the next option for boards seeking to stave off shareholder derivative litigation. If demand might well be excused as futile (which, interestingly enough, was more or less assumed in Auerbach v. Bennett, even though it's hard to see why it would be), the Board has the option of setting up a Special Litigation Committee (SLC) made up of disinterested (or brand new) directors who can then make a recommendation to the Board as to whether or not to permit the litigation to proceed. SLCs generally recommend dismissal of the suit, and the question here (under New York law) is what amount of deference is due to such an SLC recommendation. The answer, in New York, is that so long as the members of the SLC are not interested in the challenged transaction and undertook a thorough investigation, their recommendation will be accorded the benefits of the business judgment rule.

In this case, the shareholder derivative litigation related to allegations that GTE was engaged in foreign bribery. Its Board established an audit committee and found that there had indeed been bribery and took measures to prevent a recurrence. In response to a shareholder derivative suit, the Board formed an SLC which recommended dismissal of the suit. The court limited its review to the SLC's procedures and found the SLC both independent and sufficiently thorough. The standard for thoroughness is that the investigation was not a sham.

The interesting thing about this standard is that it would require a court to dismiss a suit based on the SLC's recommendation regardless of he underlying conduct. In this case, the court assumed that demand was excused, which would mean either that the majority of the Board was alleged to have been engaged in culpable conduct or that the Board was captured by those who were. Still, if the SLC was not personally compromised and they really investigated, the court would have to dismiss.

In short, an SLC is like the hard candy shell of a tootsie pop. So long as the shell is independent and its investigation is not a sham, the court will not break through the the gooey center.

Note, this is the rule for New York. Playing against type, Delaware courts are far less deferential to the recommendations of SLCs.

Auerbach v. Bennett

The Board's business judgment prescribed
That foreign officials be bribed.
If the Lit. Comm.'s disinterested
The court won't be interested
In shareholder rights circumscribed.

[Jeremy Telman]

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