A shareholder typically brings a derivative suit on behalf of a corporation against the company’s current or former officers or directors in one of two contexts:  either after the shareholder has demanded that the board cause the company to bring suit on its own and the board refuses, or when the shareholder brings the suit directly on the basis that demand on the board would have been futile because a majority of the board is not sufficiently disinterested to make the decision as to whether to sue.  In either case, the company’s board (or board committee, such as a special litigation committee, exercising the board’s authority) generally can cause the suit to be dismissed on a motion to dismiss if, after an investigation, it has determined that prosecution of the claims would not be in the best interests of the company and its shareholders.  The company’s motion to dismiss may be defeated, however, if the board or committee was assisted in its investigation by a law firm that, because of relationships the firm has or had with the company or the individual defendants, did not have the ability “to exercise independent professional judgment, free of any bias.”  Stepak v. Addison, 20 F.3d 398, 405 (11th Cir. 1994) (applying Delaware law).

What relationships will lead to the denial of a company’s motion to dismiss on the ground that the law firm conducting the investigation was not sufficiently “independent”?  In Part I of this article, we discuss cases where outside counsel had a prior professional relationship with the individuals whose conduct was under investigation by the board or committee.  In Part II, we discuss the more complicated—and more common—situation of outside counsel having a prior professional relationship with the company itself.

Turning over prosecution of the company’s claims to the shareholder and its lawyers is generally the worst possible outcome for the company on a motion to dismiss a derivative suit.  Yet, that would be the result if the investigating board or committee retains outside counsel that is not sufficiently “independent.”  Although some courts have granted motions to dismiss notwithstanding that outside counsel had a prior professional relationship with the individuals or the company, the safest course of action is for the board or committee to hire outside counsel having no prior relationship with either the individuals or the company itself.

 Outside Counsel’s Relationship with the Individuals Under Investigation

In an investigation of current or former officers or directors, may the board or board committee conducting the investigation retain a law firm that has a prior professional relationship with those persons?  In the leading case of Stepak v. Addison, the U.S. Court of Appeals for the Eleventh Circuit, applying Delaware law, held that the law firm’s independence would be compromised if it previously represented those persons concerning “the very subject matter of the [shareholder] demand.”  20 F.3d at 407.  The court partly based its ruling on the “strong possibility that a ‘lingering allegiance’ toward the insider defendants will color or otherwise bias counsel’s investigation of the allegations against its former clients, as well as any legal advice counsel provides to the corporation about the matter.”  Id. at 405.

While Stepak’s ruling is expressly limited to instances where the prior representation concerned “the very subject matter of the [shareholder] demand,” other courts have cautioned more broadly against retaining outside counsel with “any ties” to the individuals under investigation.  See In re Oracle Sec. Litig., 829 F. Supp. 1176, 1189 (N.D. Cal. 1993) (board was required “to retain counsel with no prior ties to the individual defendants or the corporation”); Dalrymple v. Nat’l Bank & Trust Co., 615 F. Supp. 979, 986 (W.D. Mich. 1985) (outside counsel should have “no previous professional relationship with either the corporate entity or its directors”); Messing v. FDI, Inc., 439 F. Supp. 776, 782 (D.N.J. 1977) (outside counsel must be “unshackled by any ties to the directors”).

Many law firms qualified to conduct investigations into the actions of corporate officers and directors have no prior relationships with those persons.  To avoid questions about the integrity of the board’s or committee’s investigation, outside counsel should be as far removed from the individual directors or officers as possible.

Outside Counsel’s Relationship with the Company

A trickier situation arises where, as is often the case, outside counsel to the board or committee conducting the investigation has a prior professional relationship with the company itself.  Frequently, the law firms the board or committee wishes to consider are the company’s usual outside counsel and firms previously retained by the company in prior, unrelated actions that were able to resolve the actions favorably for the company.

Several courts have articulated, or at least suggested, a per se rule rejecting the independence of the board or committee conducting an investigation of derivative claims if its outside counsel had any prior professional relationship with the company.  For example, in In re Oracle Securities Litigation, the U.S. District Court for the Northern District of California, applying Delaware law, stated that outside counsel must have “no prior ties” to the company.  829 F. Supp. at 1189.  The U.S. District Courts for the Western District of Michigan, applying Michigan law, and Southern District of New York, applying New York law, have made similar statements.  See Dalrymple, 615 F. Supp. at 986 (“The role of the Special Litigation Committee is anomalous, as it involves an ostensibly independent investigation by directors of their colleagues’ and their own, misconduct, assisted by an attorney selected precisely because he had no previous professional relationship with either the corporate entity or its directors.” (emphasis added)); Lewis v. Schaffer Stores Co., 218 F. Supp. 238, 240 (S.D.N.Y. 1963) (“[I]t would be wise for the corporation to retain independent counsel, who have had no previous connection with the corporation, to advise it as to the position which it should take in this controversy.” (emphasis added)).  The Georgia Court of Appeals, moreover, has suggested that, if counsel for the investigating committee has ever “represented any party having an interest in or obtaining a direct benefit” from the transaction the committee investigated, any motion to dismiss made on the basis of the committee’s recommendations should be denied.  Goldstein v. Wells, 673 S.E.2d 325, 326-27 (Ga. Ct. App. 2009).

Not all courts espouse the per se rule, however.  For example, the U.S. District Court for the Eastern District of Michigan, applying Michigan law, ruled that a committee’s outside counsel’s prior representation of the company, alone, was insufficient grounds to deny the company’s motion to dismiss derivative claims on the basis of the committee’s investigation.  In re Consumers Power Co. Derivative Litig., 132 F.R.D. 455, 478 (E.D. Mich. 1995).  In that case, the committee’s outside counsel had defended the company in a breach-of-contract action related to the same facts, occurrences and persons that were the subject of the committee’s investigation.  The court first stated the general rule that “the integrity of a special litigation committee can be undermined if the attorneys representing and advising it have a sufficient conflict of interest to taint the committee’s investigation and decision-making.”  Id. at 474.  The court found no such conflict and granted the company’s motion to dismiss the derivative complaint, ruling that the committee’s decision-making process was not “taint[ed]” since outside counsel previously represented only the corporation, not the individual executives being investigated:

[The law firm’s] client in the [prior] case, in the present case, and in their representation of the Advisory Committee is one and the same—Consumers Power.  The [law firm] only represents Consumers Power.  It does not represent any of the individual defendants in the present case or any other matters.

Id. at 476.  The court stated that the shareholder had pointed “to no facts that would suggest that at any time [the lead lawyer from the outside law firm] abandoned his loyalty and commitment to serving the interest of his sole client, Consumers Power.”  Id. at 478.

Nevertheless, even those courts that reject the per se rule against prior representation of the company still view that prior representation as a factor weighing against granting a company’s motion to dismiss, although the company may nevertheless succeed on its motion if the prior contacts are sufficiently minimal.  In General Electric Co. v. Rowe, the U.S. District Court for the Eastern District of Pennsylvania, applying New York law, granted a motion to dismiss made by General Electric despite the fact that the board’s special litigation committee, which investigated claims made in a shareholder demand letter, was represented by a law firm that previously represented GE in other matters.  1992 U.S. Dist. LEXIS 15036, at *23 (E.D. Pa. Sept. 30, 1992).  As in Consumers Power, the court acknowledged the general rule disfavoring such prior connections, but explained why, based on the size of GE, GE’s associations with numerous law firms and GE’s minimal prior relationship with this particular law firm, the firm was sufficiently “independent”:

GE is one of the largest companies in the world and has 19 directors who sit on various other boards and are often officers of other major entities.  Given these realities, there are probably few firms capable of supervising a special litigation committee in a matter like this that have not had some contact with GE or its directors.  As a result, the relatively minimal contact between GE and [the law firm] cannot support the assertion that the committee was a sham.

Id. at *18.  The court stated that (a) the law firm generally had “performed only a minor role in GE’s general legal affairs,” (b) the fees paid to the firm by GE were “less than one percent of the money GE paid for outside legal services,” and (c) “over the last four years, fees from GE have never been more than one half of one percent of [the law firm’s] annual revenues.”  Id. at *17-*18.

This somewhat quantitative approach has been endorsed by other courts as well.  For example, the Delaware Chancery Court has suggested that a relatively “modest” amount of legal work performed by a law firm in a prior representation of the company will not adversely affect the independence of a committee, represented by that same firm, investigating a shareholder demand or derivative suit.  See In re Oracle Corp. Derivative Litig., 824 A.2d 917, 925 (Del. Ch. 2003) (committee’s counsel “had not performed material amounts of legal work for Oracle or any of the individual defendants before its engagement” (emphasis added)).

Conclusion

No company or law firm wants the plaintiff shareholder and its lawyers given access to the amount of their legal fees and the portions attributable to one law firm or one client.  The focus should properly be on the results of the board’s or committee’s investigation, not the persons or law firms conducting the investigation.  Nevertheless, as reflected in General Electric, an inquiry into the firm’s or company’s fees may be necessary if the board or committee hires outside counsel that has a prior professional relationship with the company or the individuals under investigation.  To avoid this outcome, the board or committee should retain as its outside counsel a law firm having no prior professional relationships with either the company or the individuals.