Diep v. Sather et al., C.A. No. 12760-CM (Del. Ch. July 30, 2021) (McCormick, C.)
In this memorandum opinion, the Delaware Court of Chancery granted a special litigation committee’s motion to dismiss a “Brophy” claim for insider trading against a controlling stockholder. The stockholder-plaintiff alleged that the company’s controlling stockholder, along with several officers and directors, sold stock in 2015 while in possession of material non-public information regarding the company’s projected sales. The director and officer defendants settled just prior to a hearing on the motion to dismiss. The Court evaluated the remaining claim against the controlling stockholder under the rubric set forth in Zapata Corporation v. Maldonado and evaluated the independence of the special litigation committee and the good faith of its investigation. Having found that the special litigation committee was independent and performed the investigation thoroughly and in good faith, the Court determined the special litigation committee had a reasonable basis to seek dismissal.
El Pollo Loco Holdings, Inc. (the “Company”) is a “fast-casual” restaurant chain. The defendants included Trimaran Pollo Partners, LLC (“Pollo Partners”), which acquired the Company in 2005 and remained a majority stakeholder after taking the Company public in 2014, as well as members of the executive management team and the board of directors. The Company maintained a policy on insider trading. Under that policy, if the insider did not possess material non-public information and received approval from the Company’s general counsel, then the insider could trade during a specified window in each fiscal quarter that opened two days after the Company’s earnings call.
In 2014 and early 2015, the Company raised prices incrementally on a large number of menu items. The resulting market data showed that these price increases potentially were depressing sales growth. However, many on the management team believed the data was incomplete or that other factors explained the indications of depressed sales. The lowered sales expectations were presented to the board at successive board meetings in May 2015. Days after the board meetings, the Company faced its first quarter earnings report. The Company wanted to lower expectations for the second quarter without setting a precedent for offering guidance in earnings calls. Ultimately, the Company noted that the second quarter was expected to be “closer to the low end of the range” for the annual growth projections. The stock price fell from $29.06 the day of the earnings call to $24.07 two days later, when the insider trading window opened. When the trading window opened, Pollo Partners and three officers joined in a block sale of nearly six million shares, and two directors separately sold more than one hundred thousand shares. Second quarter results were even lower than expected, and the stock dipped to $14.56.
Several lawsuits asserting derivative claims for breach of fiduciary were filed in the Court of Chancery. After the Court denied the defendants’ motion to dismiss, the board formed a three-member special litigation committee (the “SLC”) to investigate the claims on the Company’s behalf. After an investigation, the SLC released a 377-page report recommending the dismissal of all claims. After the SLC published the report, a federal court approved a $20 million settlement of a related federal securities action. The director and officer defendants settled the Delaware action for $625,000, leaving Pollo Partners as the sole defendant.
The Court examined the standards for reviewing a special litigation committee’s motion to dismiss, as articulated by the Delaware Supreme Court in Zapata v. Maldonado, 430 A.2d 779 (Del. 1981), noting that it was a “procedural standard akin to a summary judgment inquiry” that required the SLC to demonstrate the absence of any material issues of fact. The Court would engage in a two-step analysis: first, the Court would review the independence of the SLC and consider whether it conducted a good faith investigation of reasonable scope yielding results to support its conclusions; second, the Court would apply “its own business judgment to the facts to determine whether the corporation’s best interests would be served by dismissing the suit.” The Court noted that the SLC was not entitled to any presumptions and that it was the SLC’s burden of proof to demonstrate its independence and good faith investigation.
First, the Court examined the independence of the SLC members. Because no SLC member had a financial interest in the transaction, the Court analyzed whether the members were independent from Pollo Partners and its founder, Dean Kehler. The plaintiff alleged that the SLC’s second member, Floyd, lacked independence because he pre-judged the litigation based on the fact that he sat on the board when the defendants filed their initial motion to dismiss. The Court found this insufficient. The Court also examined Floyd’s personal relationship with Kehler. While the Court noted that they served together for sixteen years on a board of trustees, there was no indication that Floyd and Kehler had any personal relationship. The Court then examined Lynton’s independence. Lynton attended Harvard with Kehler’s wife, and she also worked with Kehler for two years after college—though not closely. Lynton’s and Kehler’s children also overlapped at school, and Lynton dined with the Kehlers approximately twenty times in thirty-five years, though less so after their children were grown. In addition, Lynton had approached Kehler for business advice at least once, and they had each donated money to the other’s charities. The Court found that the business advice and the charities were not significant enough to call Lynton’s independence into question. Regarding the personal ties, the Court noted their relationship centered on their children, and that, unlike the facts of a prior case cited by the plaintiff, Lynton did not have the sort of close relationship that would make future encounters with Kehler awkward in the absence of a dismissal recommendation.
Second, having found the SLC members independent from Kehler and Pollo Partners, the Court evaluated the investigation. It found that the SLC had considered all relevant facts, including the settlements, and that it had evaluated all claims under the correct standards of law. The Court then found that the SLC had reasonable bases for its conclusions, including that lower projections withheld on the earnings call were immaterial and that the timing of the trades did not indicate that any defendant acted with the scienter necessary to establish a claim for insider trading.
The Court reached the final step of the Zapata analysis, in which it would substitute its business judgment for that of the SLC and evaluate whether the SLC’s recommendation fell within a range of reasonable outcomes. The Court concluded that the SLC’s recommendation was reasonable and granted the motion to dismiss.