Kandell v. Niv et al., C.A. No. 11812-VCG (Del. Ch. Sept. 29, 2017) (Glasscock, V.C.)
In this memorandum opinion, the Court of Chancery denied in significant part defendants’ motion to dismiss derivative claims brought on behalf of FXCM, Inc. (“FXCM”) seeking to recover losses associated with the “flash crash” triggered by the unexpected decoupling of the euro and the Swiss franc. Most notable in the Court’s claim-by-claim demand futility analysis is the conclusion that, based on the “unusual facts” alleged in the complaint, FXCM’s directors faced a substantial threat of personal liability for knowingly permitting FXCM to violate the law.
FXCM is a foreign exchange broker. Its business model primarily involved highly leveraged trades on behalf of retail customers. As its marketing materials emphasized, FXCM had a policy of not pursuing customers for additional amounts owed if losses exceeded a customer’s initial investment. As a result, FXCM, rather than the customer, would bear those losses.
This policy presented both legal and business risks. The legal risk arose from a CFTC regulation prohibiting foreign exchange brokers from representing that they would limit clients’ trading losses. The business risk manifested in January 2015, when the Swiss National Bank unexpectedly announced that the Swiss franc would no longer be pegged to the euro. This led to extreme volatility in the euro/Swiss Franc exchange ratio, and ensuing market illiquidity prevented FXCM from liquidating its customers’ positions before incurring substantial losses.
The result was disastrous for FXCM. Within days of the crash, and facing extreme pressure from its regulators, FXCM agreed to accept a $300 million loan from Leucadia at an annual interest rate starting at 10% and increasing quarterly to 20.5%. The loan included a “value-sharing arrangement” in which, once the loan was paid, Leucadia would be entitled to 50% of the next $350 million of sale proceeds or dividends, and an even greater percentage of any additional amounts. In March 2016, FXCM entered into a Memorandum of Understanding to amend the loan to, among other things, provide that FXCM management would receive between 10% and 14% of FXCM’s post-loan proceeds.
FXCM implemented other changes in the wake of the crash. In January 2015, the board adopted a “Rights Plan” designed to reduce the likelihood of a hostile takeover of FXCM. The Rights Plan initially had a 10% ownership trigger, which was reduced the following year to 4.9%. In March 2015, FXCM announced amended compensation arrangements that effectively doubled executive compensation and doubled severance payments owed if an executive were fired.
In December 2015, an FXCM stockholder filed a complaint in the Court of Chancery seeking to pursue claims derivatively on behalf of FXCM regarding the crash and ensuing events. Following several amendments, the operative complaint alleged, among other things, breach of fiduciary duty and waste.
The plaintiff did not make a litigation demand on the FXCM board. Pursuant to Court of Chancery Rule 23.1, the Court was therefore required to dismiss the complaint unless it alleged particularized facts showing that demand would have been futile. The Court referred to the well-known tests for evaluating demand futility in Aronson v. Lewis and Rales v. Blasband as “complementary versions of the same inquiry,” namely whether the board is capable of exercising its business judgment in considering a demand. The Court evaluated each claim based on the board in place when the complaint first asserting that claim was filed.
The Court divided the claims into four categories for purposes of the demand futility analysis. First, demand was excused with respect to claims regarding the Leucadia loan because it was not approved by a board with a majority of disinterested and independent directors. Of the 11 directors on the board (i) defendants did not argue that the five employee directors were disinterested with respect to the loan and (ii) an additional director, who had expressed desire to participate in the loan from the lender’s side, abstained from the vote. The Court therefore held that entire fairness review would likely apply and that demand was excused because the board would be unable to exercise its independent business judgment in considering a demand.
Second, demand was not excused with respect to claims regarding the Rights Plan because the plaintiff had not pled particularized facts supporting an inference that the board adopted it to entrench themselves. The Court rejected the complaint’s entrenchment allegations as “conclusory,” noting that the Rights Plan just as easily could have served the valid corporate purpose of preventing an undervalued hostile takeover in the wake of the crash, even though there was no evidence of a specific takeover threat. The Court further found that there was no allegation of an accumulation of shares that would threaten to trigger the Rights Plan, or any request for a waiver of the plan, and that the plaintiff could not point to any threatened liability that would compromise the board’s ability to consider the demand.
Third, demand was not excused with respect to claims regarding the amended executive compensation arrangements because the plaintiff had not alleged facts supporting an inference that the outside directors, who constituted a majority of the board, were “dominated and controlled” by the employee directors who received the challenged compensation. Although the employee directors collectively controlled 27.7% of FXCM’s voting power, the Court held that the complaint did not include particularized factual allegations detailing how the employee directors exerted control over the disinterested directors. Further, because the complaint revealed a rational business purpose for the compensation arrangements—retaining top executives at a time of great difficulty—the Court rejected the plaintiff’s claim that those arrangements constituted waste that excused demand under the second prong of Aronson.
Fourth, demand was excused with respect to the claim that defendants knowingly caused or permitted FXCM to violate the law. Because the plaintiff did not contend that a majority of the board was interested or lacked independence, the relevant question was whether the defendants faced a substantial likelihood of liability from the claims. As a result of the exculpatory provision in FXCM’s charter, the directors would face liability only if they knowingly caused or permitted FXCM to violate the law. In that regard, the Court concluded that the relevant CFTC regulation “clearly prohibits touting loss limitations to clients,” that FXCM had an established policy of doing precisely that, and that there was a strong inference that the directors knew that FXCM’s policy violated the regulation. The Court concluded that demand was excused under the “highly unusual” facts alleged in the complaint because the directors faced a substantial threat of liability that rendered them incapable of disinterestedly evaluating a demand.