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Appellate decision makes defending derivative suits harder in Maryland

Posted: 04/09/2012

By Charles O. Monk, II, Marshall B. Paul and Joshua W. Richards

Summary

In the wake of the Maryland Court of Appeals' decision in Boland v. Boland Trane, Maryland boards of directors may find that defending a shareholder derivative suit is more difficult and complicated than ever before.

It may be "hard to stop a Trane," as the TV commercial says, but in Maryland, it's even harder to stop a shareholder derivative suit.

As a result of an opinion rendered by the Maryland Court of Appeals in the case ofBoland v. Boland Trane, 21 A.3d 529 (Md. 2011), defending a derivative suit is now much harder — and more complicated — for Maryland boards of directors than ever before. Boland involved an intra-family dispute over the affairs of two companies that had relationships with the Trane Company, a manufacturer of heating, ventilating and air conditioning equipment. All family members were stockholders, but only three of them held board seats.

After making a demand that the director family members take action to redress wrongs allegedly committed by them against the corporations, the non-director family members filed derivative suits on behalf of the corporations. In response, the corporation’s board appointed a special litigation committee ("SLC") to investigate the issues presented in the complaints. After a five-month investigation, the SLC, in a lengthy and detailed report, recommended that the derivative actions be dismissed, and the corporations filed motions to that effect, which were denied by the trial court. The corporations appealed.

On appeal, Maryland's highest court remanded the cases to the trial court for additional testimony, noting that the corporations had failed to plead facts demonstrating the independence of the members of the SLC and had failed to demonstrate the "methodology" applied by the SLC in reaching its dismissal recommendation.

Requiring that a corporation bear the burden of demonstrating that SLC members are independent is nothing new. This is a requirement under both Auerbach v. Bennett, 393 N.E. 2d 994 (N.Y. 1979) and Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1980), seminal cases taking distinctly different approaches to the role of the court in assessing whether to accept an SLC's recommendation. The AuerbachCourt prefers a limited role for the trial court, while Zapata allows trial courts to exercise more subjective judgment in determining whether to accept an SLC's recommendation.

Where Boland breaks new ground is with respect to the level of scrutiny afforded trial courts overseeing, and some might say micromanaging, the work of SLCs. InBoland, the Maryland Court of Appeals directed the lower court to require that the corporation demonstrate, in explicit detail, not only the independence of the members of the SLC, but also the process used by the SLC, and the standard of review under which the SLC analyzed the Board's decision. According to Boland, the SLC may not apply a business judgment standard to the board’s decision at issue, but rather must place itself in the shoes of the directors and make an independent judgment based on all the facts known by the Board. Boland, 31 A.2d at 568.

More difficult to understand, however, is the requirement that the Court's inquiry include a detailed factual examination of the nuts-and-bolts methodology and processes the SLC applied. Under Boland, a court must undertake its own analysis of whether the SLC's methodologies were "reasonable," and, that analysis must be considerably more comprehensive than courts have previously required.

Moreover, the Boland Court does not explain what "reasonableness" means in the selection and application by the SLC of methodologies to make an independent decision. While perhaps it previously was sufficient in Maryland to demonstrate only that the SLC did more than "rubber stamp" the board's decision, Boland suggests that an SLC must engage in (and scrupulously document) a depth of analysis that, although perhaps heralded by Auerbach, appears not to have previously been required by a high court in any jurisdiction.

The unfortunate result is that in Maryland, SLCs may have difficulty satisfying this new approach using current practices. Because the Maryland Court of Appeals seems prepared to treat all SLC methodologies with skepticism until proven otherwise, Boland appears to direct the trial court to place the burden squarely on the corporation to prove that an SLC's methodology was objectively reasonable. Moreover, the inquiry sanctioned by the Boland opinion appears to give a defendant no choice but to rigorously document all stages of the SLC's investigation, a practice that may prove to be problematic should other litigation alleging securities fraud be lurking.

While the authors do not recommend that the Court should endorse a rule that permits an SLC to "rubber stamp" the decisions of a corporation's board of directors, we hope that further case law will provide greater clarity for corporate directors.

If you have any questions about this emerging area of the law in Maryland or would like further detail about the topics addressed in this alert, please do not hesitate to contact the authors.

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