Over at Law & Liberty (here), John Berlau has posted a comment on Jarkesy v. SEC, in which the Fifth Circuit recently ruled that “(1) the SEC’s in-house adjudication of Petitioners’ case violated their Seventh Amendment right to a jury trial; (2) Congress unconstitutionally delegated legislative power to the SEC by failing to provide an intelligible principle by which the SEC would exercise the delegated power, in violation of Article I’s vesting of ‘all’ legislative power in Congress; and (3) statutory removal restrictions on SEC ALJs violate the Take Care Clause of Article II.” Jarkesy v. Sec. & Exch. Comm’n, 34 F.4th 446, 449 (5th Cir. 2022). What follows is a brief excerpt from Berlau’s post, but please go read the whole thing.

Critics and proponents of the ruling by the U.S. Court of Appeals for the Fifth Circuit in Jarkesy v. SEC have called revolutionary the new limits it places on federal regulatory agencies’ use of administrative law judges, a core tool of the administrative state…. Jarkesy is indeed revolutionary—both in the jurisprudence it could usher in limiting the power of the administrative state and in its concern for issues involved in the American Revolution. The ruling “has taken what could be a historic step toward restoring the Constitution’s checks and balances,” predicts Mario Loyola, professor at Florida International University and … [a] senior fellow at the Competitive Enterprise Institute (CEI), writing for the Wall Street Journal.

These checks and balances—including the right to a jury trial for common law offenses and a separation of powers of the different branches of government—came about due to the abuses the Founding generation suffered at the hands of Great Britain. Documents of the Founding era from the writings of George Washington to the Declaration of Independence itself list as grievances the quasi-courts created by the British to prosecute tax and trade offenses. These courts, which bypassed jury trials and due process for the colonists, and were under the rhetorical thumb of the British officials prosecuting the alleged offenses, bear a striking resemblance to the administrative venues run by regulatory agencies today.

The Delaware Supreme Court just decided an interesting new case, Diep v. Trimaran Pollo Partners et al., on director independence, over the dissent of Justice Valihura. 

El Pollo Loco is a publicly-traded restaurant chain controlled by Trimaran Pollo Partners, a holding company, which itself is controlled by private equity firm Trimaran Capital Partners, founded in part and controlled in part by Dean Kehler.  The plaintiff filed a derivative action alleging that after the IPO, El Pollo Loco received unfavorable news about the effects of certain price increases, and before this news was made public, several officers and directors – and Trimaran Pollo Partners – were permitted to sell stock.  Trimaran in particular did not receive written preclearance, in violation of the company’s insider trading policy.

After a different, earlier derivative action concerning the same events was filed, Kehler invited two new independent directors to join the board, Floyd and Lynton. Kehler had prior relationships with each – especially Lynton, with whom he had longstanding social ties – and when interviewing each, he mentioned the pending litigation.

Once they were on the board, the Diep case was filed, and the earlier derivative action voluntarily dismissed.  The company and the other defendants filed motions to dismiss the Diep action, both for failure to make a demand under Rule 23.1, and for failure to state a claim under Rule 12(b)(6).  Floyd and Lynton, as newly-added directors, were not personally named as defendants. 

Chancery denied the motions, finding, among other things, that the board was majority conflicted due to the number of board members who were personally accused of wrongdoing.

El Pollo Loco sought to appoint an SLC to investigate the claims, and the case was stayed.  The SLC consisted of Floyd and Lynton, and one additional director who joined the board after the motion to dismiss was denied, Babb.  Eventually, the SLC produced a report concluding that the case was not worth pursuing; the insiders had not acted with scienter, and there was little to be gained from further litigation.  The SLC moved to dismiss the action and, while that motion was pending, the individual defendants settled, leaving only the claims against Trimaran Pollo Partners.

The Chancery Court concluded that the SLC was independent and had acted reasonably and in good faith, in accordance with the Zapata standard, and dismissed the action.  The plaintiff appealed, and most of the arguments turned on Floyd’s and Lynton’s independence.

The main issue concerned the effects of the original motion to dismiss, prior to the formation of the SLC.  Since Floyd and Lynton had both been on the board at that point – and the company had filed a motion to dismiss, which contained many of the same arguments that ultimately were made by the SLC – could it be inferred that Floyd and Lynton had prejudged the case’s merits, before joining the SLC, such that they were biased from the outset?

The majority of the Delaware Supreme Court said no.  The evidence that the board, including Floyd and Lynton, had given any thought to the motion to dismiss was scant; though some kind of litigation update was mentioned in the board minutes, neither could recall much discussion about it.  Justice Valihura, by contrast, believed that it was a fair inference that the board as a whole – including Floyd and Lynton – had authorized the filing.  Given that the SLC had the burden of proving its independence, Floyd and Lynton were charged with showing they had not prejudged the allegations, and simply claiming ignorance of the original motion to dismiss – which, by hypothesis, they had authorized – was not sufficient to meet that burden.

So, just to spin this out: Valihura based her opinion on a kind of presumptive set of board responsibilities, which included having a basic familiarity with serious and credible claims against the company, as well as the company’s responses to those claims.  The majority, by contrast, did not really … weigh in … on what the board’s actual responsibilities were with respect to authorizing litigation filings; instead, it accepted evidence that the board in fact had little role, and from there concluded Floyd and Lynton were untainted.  One cannot help but wonder if the majority believed that Floyd and Lynton’s purported ignorance of litigation, and company filings in its own defense, was sufficient to meet their own duty of care with respect to company litigation – it wasn’t the subject of the plaintiff’s claims, and so the majority did not have to address it. 

You see this a lot in the securities fraud space.  Company statements are false; a corporate officer is accused of intentionally defrauding investors; the critical question is whether the officer knew of the underlying facts that made the statements false, giving rise to an inference of scienter.  In that scenario, the corporate officer usually claims ignorance – “you can’t prove I was actually competent at my job,” argues the officer, “and it’s a stronger inference that I was simply uninformed of corporate shenanigans, than that I was in fact fulfilling my basic work responsibilities and therefore must have known about them.”

Doctrinally, federal courts are usually bound to accept this argument; they must, in practical effect, presume the corporate officer was negligent in order to defeat inferences of scienter.

(They don’t say that explicitly, of course; doctrinally, the concept is known as the “core operations” inference.  Plaintiffs may not rely on a presumption that corporate officers knew of internal facts about the corporation simply by dint of their positions with the company – they must specifically show the officers were informed of those facts – unless the facts concerned huge and central “core operational” matters.  It’s a crap shoot whether any particular facts are huge and central enough to count as “core operations,” and many courts won’t accept the inference altogether, no matter how central the facts were.)

In any event, it seems a majority of the Delaware Supreme Court, too, is willing to presume something like director negligence in order to defeat an inference of director bias.  So, may plaintiffs bring a claim alleging that a particular corporate decision was so damaging that it must have been the product of a lack of care? No; their claims will be dismissed on the presumption that directors acted on an informed basis.  But, may plaintiffs presume that directors act on an informed basis in order to allege bias?  Also no. 

Leaving that aside, though, what actually stood out for me was something else, the “dog that didn’t bark,” if you will.  Notice the timeline here: Both Floyd and Lynton were acquaintances/friends of the controlling shareholder’s controller (Kehler), and were invited to join the board at a time when litigation was pending.  Kehler also likely knew that Floyd and Lynton would play important roles in that litigation as “independent” directors, though there was no discussion of SLC service at the time they joined.  The third member of the SLC, Babb, was specifically invited to join the board with the knowledge he would be an SLC member (Valihura infers that Babb was invited because the board was concerned the SLC lacked independence, see Op. at 14 n.62)

In other words, all three members of the SLC were invited to join the board by the defendants with the knowledge they would likely play key roles in passing judgment on the defendants’ conduct, and neither the majority, nor the dissent, took issue with that fact.  This has come up before; I flagged it when I posted about Flood v. Synutra, and the WeWork litigation; I’m sure there are other examples.  In both cases, new board members were recruited in contemplation of blessing tainted transactions, by the conflicted persons themselves, and yet no one cast doubt on their impartiality.  VC Laster has recently begun to raise concerns about activists who have repeat ties to purportedly “independent” directors who do their bidding, but this is a slightly different scenario, and I have to say, Delaware’s assumption that the newly-recruited board members will be impartial under these circumstances is somewhat, umm, heroic.