Egelhof v. Szulik, et al., 2006 NCBC 4.
STATE OF |
IN THE GENERAL COURT OF JUSTICE |
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SUPERIOR COURT DIVISION |
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FILE NO. 04 CVS 11746 |
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ANDREW EGELHOF, Derivatively on Behalf of Red Hat, Inc. Plaintiff, vs. MATTHEW J. SZULIK, KEVIN B. THOMPSON, PAUL J. CORMIER, TIMOTHY J. BUCKLEY, MARK H. WEBBINK, ALEX PINCHEV, ROBERT F. YOUNG, EUGENE J. McDONALD, F. SELBY WELLMAN, MARYE A. FOX, WILLIAM S. KAISER, DR. STEVE ALBRECHT and H. HUGH SHELTON Defendants. |
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ORDER AND OPINION
{1}
This case arises out of
Plaintiff Andrew Egelhof’s shareholder derivative
claims brought on behalf of Red Hat, Inc. (“Red Hat”, “The Company”) against
Defendants Matthew J. Szulik, Kevin B. Thompson, Paul
J. Cormier, Timothy J. Buckley, Mark H. Webbink, Alex
Pinchev, Robert F. Young, Eugene J. McDonald, F.
Selby Wellman, Marye A. Fox, William S. Kaiser, Dr.
W. Steve Albrecht, and Gen. H. Hugh Shelton, in their capacities as officers
and/or members of Red Hat’s Board of Directors.
Specifically, Plaintiff asserts claims for insider selling and
misappropriation of information, breach of fiduciary duty, abuse of control,
gross mismanagement, waste of corporate assets, and unjust enrichment. Red Hat is named as a nominal defendant. This matter comes before the Court on
Defendants’ motion to dismiss.
{2}
After considering briefs and
oral arguments, the Court GRANTS Defendants’ motion to dismiss on the grounds
that the Amended Complaint does not establish demand futility under
Womble
Carlyle Sandridge & Rice, PLLC by
I.
PROCEDURAL BACKGROUND
{3}
This shareholder derivative
action was filed in Wake County Superior Court on August 18, 2004. The case was designated complex business and
assigned to the undersigned Special Superior Court Judge for Complex Business
Cases by order of the Chief Justice of the Supreme Court of North Carolina
dated December 29, 2004. Plaintiff’s
Amended Shareholder Derivative Complaint (“Amended Complaint”) was filed on
July 21, 2005.
{4}
Defendants filed a motion to
dismiss on September 9, 2005, asserting that Plaintiff’s claims should be
dismissed for failure to make demand on the corporation prior to filing
suit. The Court heard oral arguments on
the motion on February 2, 2006.
{5}
Several related class actions
have been filed in the Eastern District of North Carolina against Red Hat, Inc.
and Matthew J. Szulik, et al., alleging violations of
the Securities Exchange Act of 1934.
Those actions remain pending.
II.
FACTUAL BACKGROUND
A.
THE PARTIES
{6}
Plaintiff Andrew Egelhof was at one time a common stock shareholder of Red
Hat. At oral argument Plaintiff’s
counsel did not know how many shares Egelhof owned;
nor did he have any other knowledge about Plaintiff, whose only contact appears
to have been with the “shareholder relations” department of Robbins, Umeda & Fink.
Subsequent to the hearing, plaintiff’s counsel contacted the Court to
give notice that, sometime in the previous year, Mr. Egelhof
had in fact sold his shares of stock.
{7}
Nominal Defendant Red Hat is a
corporation organized and existing under the laws of the state of
{8}
Defendant Matthew J. Szulik (“Szulik”) is, and at all
relevant times has been, President and Chief Executive Officer of Red Hat and
Chairman of the Company’s Board of Directors.
{9}
Defendant Kevin B. Thompson
(“Thompson”) was Executive Vice President, Chief Financial Officer (“CFO”), and
Treasurer of Red Hat until he resigned on June 14, 2004.
{10}
Defendant Paul J. Cormier
(“Cormier”) is, and at all relevant times has been, Executive Vice President of
Engineering at Red Hat.
{11}
Defendant Timothy J. Buckley
(“Buckley”) was, at all relevant times hereto, the Executive Vice President and
Chief Operating Officer (“COO”) of Red Hat until 2004.
{12}
Defendant Mark H. Webbink (“Webbink”) is, and at
all relevant times has been, the Senior Vice President, Secretary, and General
Counsel of Red Hat.
{13}
Defendant Alex Pinchev (“Pinchev”) is, and at
all relevant times since April 2003 has been, the Executive Vice President of
Worldwide Sales and has been the President of International Operations of Red
Hat.
{14}
Defendant Robert F. Young
(“Young”) is, and at all relevant times has been, a member of the Board of
Directors of Red Hat.
{15}
Defendant Eugene J. McDonald
(“McDonald”) is, and at all relevant times has been, a member of the Board of
Directors of Red Hat.
{16}
Defendant F. Selby Wellman
(“Wellman”) is, and at all relevant times has been, a member of the Board of
Directors of Red Hat.
{17}
Defendant Marye
Anne Fox (“Fox”) is, and at all relevant times since December 2002 has been, a
member of the Board of Directors of Red Hat.
{18}
Defendant William S. Kaiser
(“Kaiser”) is, and at all relevant times since July 2003 has been, a member of
the Board of Directors of Red Hat.
{19}
Defendant Dr. W. Steve
Albrecht (“Albrecht”) is, and at all relevant times has been, a member of the
Board of Directors of Red Hat.
{20}
Defendant Gen. Henry H. “Hugh”
Shelton (“Gen. Shelton”) is, and at all relevant times has been, a member of
the Board of Directors of Red Hat.
{21}
At the time the original
complaint was filed, the Red Hat Board of Directors thus consisted of one
insider—Szulik—and seven outside directors—Young,
McDonald, Wellman, Fox, Kaiser, Albrecht, and Gen. Shelton.
B.
OVERVIEW OF THE FACTS
{22}
Plaintiff alleges the
following facts, which, for the purposes of this motion to dismiss, will be
treated as true. Plaintiff’s claims
center around Red Hat’s decision in July 2004 to modify its long-standing
method of reporting revenue generated by software subscription agreements.
{23}
Red Hat, which was formed in
1993, is a software company that is headquartered in
{24}
Red Hat introduced the first
enterprise-class operating system, originally named Red Hat Advanced Server, in
March 2002.
{25}
On July 13, 2004, Red Hat
announced a plan to modify its method of revenue recognition for those
subscription agreements and to restate its financial statements over a two-year
period to reflect that change. Red Hat,
with the approval of its outside accountants, PriceWaterhouseCoopers
(“PWC”), had previously reported revenue from its subscription agreements on a
monthly basis. In June 2004, the Company
met with its new audit partner, who took over under the normal rotation of
auditing partners at PWC. The new auditing
partner advised that the Company should begin recognizing revenue from its subscription
agreements on a daily rather than a monthly basis. Red Hat opted to follow the new auditing
partner’s advice and begin recognizing that revenue on a daily basis.[2] Financial statements from the fiscal years
ending February 28, 2002, February 28, 2003, and February 29, 2004, were
restated to reflect the change.
{26}
The day Red Hat announced its
plan to restate earnings, its stock dropped to as low as $15.59 per share and
closed at $15.73 per share. The stock
eventually fell to as low as $14.77 per share.
As of the date of this opinion, however, Red Hat’s stock had climbed to
$27.46 per share.[3]
C.
IMPROPER REVENUE RECOGNITION
{27}
Plaintiff alleges that Red Hat
misled investors and violated Generally Accepted Accounting Principles (“GAAP”)
and federal securities laws and regulations by reporting revenue from its
subscription agreements on a monthly rather than a daily basis. It alleges that the individual defendants
disregarded their duty to maintain oversight over the Company’s accounting
practices by allowing it to do so.
(Amended Compl. ¶¶ 58-59.)
{28}
Before the Company altered its
accounting practices on July 13, 2004, whenever it signed a one-year
subscription agreement with a customer, it would report 1/12 of the revenue for
that contract in the month in which the agreement was made—regardless of which
day of the month the contract was formed.
For instance, if a customer purchased a one-year subscription to Linux
Enterprise or signed a contract for services on August 28, instead of reporting
four days of income for that month, Red Hat would record a full month of
revenue, or 1/12 the total revenue associated with the contract. (Amended Compl. ¶¶
60-61.) This specific example is
particularly notable because, plaintiff argues, given that August is the final
month of the Company’s second fiscal quarter, the practice had the effect of
exaggerating the earnings that Red Hat reported in its quarterly financial
statements. (Amended Compl.
¶ 61.) The effect was not to report
earnings that the company would never receive but to report earnings in the
first month of a given contract that would not actually be received until
later. When earnings were restated,
therefore, earnings for some quarters were restated slightly higher and some
slightly lower.
{29}
All parties agree that GAAP
rules specify that revenue must be recognized “ratably.” Plaintiff gives no indication, however,
either in his Amended Complaint or in his brief filed in response to the
defendants’ motion, that GAAP rules ever define the term “ratably” to
specifically require that revenue be reported daily rather than monthly. Evidently the two different partners at PWC
who advised Red Hat on the issue interpreted “ratably” differently under GAAP
rules.
{30}
The Amended Complaint alleges
that the defendants “knew or should have known” that the practice was improper
and should have acted to prevent it.
Plaintiff complains that the problem could easily have been solved by
merely having someone “push a button” causing the figures to be tallied on a
daily basis rather than a monthly basis.
(Amended Compl. ¶ 64.) The Amended Complaint suggests, but does not
state outright, that the practice was fueled by a desire by Red Hat’s
management and directors to manipulate sales figures to meet the Company’s
unreasonable financial objectives for each quarter by causing a large “spike”
in business late in the last days of each month and quarter. Plaintiff contends that the individual
defendants “could easily manipulate” the recognition of revenue in order to
“hit particular revenue targets and enjoy bonuses and other incentive
compensations that were approved by the Compensation Committee.” (Amended Compl. ¶
64.)
{31}
The effect of the earnings
restatement was to shift some earnings from earlier months to later
months. For each one-year subscription,
a portion of what was reported for the first month was shifted to the twelfth
month. The result was that some quarters
were restated slightly higher than originally reported and some slightly
lower. The total shift in revenue for
the entire period was less than one-half of one percent (approx. .37%). See Red Hat 10Q for 1Q of FY 2005, at
21 (Defendants’ Brief in Support of Motion to Dismiss (“Defendants’ Brief”),
Ex. B); Red Hat 8K for 2004, at Ex. 99.2
(filed June 17, 2004) (Defendants’ Brief, Ex. C); Red Hat 10K/A for FYE Feb.
29, 2004, at 57, 70-71 (Defendants’ Brief, Ex. D); Red Hat 10K for FYE Feb. 29,
2004, at 65-66 (Defendants’ Brief, Ex. E); Red Hat 10K for FYE Feb. 28, 2003,
at 15, 62-63 (Defendants’ Brief, Ex. F).
{32}
Plaintiff claims that defendants misled
investors by failing to adopt sufficient internal controls, which allowed the
Company to improperly inflate the percentage of customers who were going to
renew their subscriptions, in turn motivating it to manipulate its accounting
practices in order to keep sales figures in line with those unreasonable
forecasts of renewal rates. (Amended Compl. ¶¶ 66-76.)
Defendant Thompson allegedly involved himself directly in the
dissemination of false subscription information to investors and the public at
large by threatening the jobs of any members of the sales staff who did not
“produce rosy sales forecasts.” (Amended
Compl. ¶¶ 74-75.)
Defendant Szulik is also alleged to have been
involved in the subscription renewal process.
{33}
Red Hat’s lack of internal
controls also allegedly led to manipulation of the Company’s quarterly earnings
estimates with respect to consulting services offered to its customers. The Amended Complaint alleges that “a large
quantity of revenues were being recognized in association with consulting hours
that had not actually been worked,” causing Red Hat to be “‘stuck’ with a
‘bunch of work’ for the consultants to do and no budget with which to
compensate the consultants.” (Amended Compl. ¶ 77-78.) The
individual defendants are also alleged to have orchestrated an “atmosphere of
fear and intimidation” which ultimately led to much of the activity about which
plaintiff complains. (Amended Compl. ¶¶ 79-88.)
However, no restatement of income by Red Hat was based upon charges for
consulting services.
D.
INSIDER TRADING
{34}
Plaintiff’s Amended Complaint
alleges insider trading by several of Red Hat’s officers and directors, only
two of whom, Defendants Szulik and Kaiser, are
members of the Board of Directors.
Specifically, Defendants Szulik, Buckley,
Thompson, Kaiser, Cormier, and Webbink are alleged to
have sold shares of Red Hat stock while in possession of undisclosed material
adverse information. (Amended Compl. ¶¶ 14-19, 24, 119.)
{35}
Plaintiff does not indicate
what non-disclosed material information any of the defendants possessed at the
time of any particular sale. Nowhere in
the Amended Complaint does plaintiff allege the existence of any specific
knowledge on the part of any of the insider trading defendants at the time of
any specific sale; nor does Plaintiff point to any specific sources of such
information. The extent of plaintiff’s
allegations of insider trading is that five of Red Hat’s officers and two directors
owned and sold stock during a three-year period and that because of their
positions in the company they must have known some adverse non-public
information at some unstated time during the same period. (Amended Compl. ¶¶
14-19, 24, 119.)
E.
THE MISSTATEMENTS
{36}
In addition to allegations of
improper revenue recognition and insider trading, the Amended Complaint alleges
a failure of the Board of Directors to properly supervise the conduct of and
statements made by company officers during the period between December 17,
2002, and September 20, 2004. The
Amended Complaint includes a 19-page long string of press releases, articles
from TheStreet.com, and one SEC filing, all of which include allegedly
improper statements made by Red Hat officers.
The only defendants to whom any of the statements are directly
attributed are Defendants Thompson and Szulik. (Amended Compl. ¶¶
89-109.) None of the statements are
attributed specifically to any of the outside directors.
{37}
Most of the press releases
pasted into the Amended Complaint were issued by the Company prior to the
restatement of earnings, and Plaintiff claims that they include false
statements of exaggerated earnings and earnings estimates generated by Red
Hat’s faulty revenue reporting practices.
A press release issued on July 13, 2004, was entitled “Red Hat Announces
Plan to Change Method of Revenue Recognition for Subscription Agreements and to
Restate Financial Statements to Reflect Change.” In that press release, Red Hat explained the
nature and background of its decision to modify its revenue reporting practices
and informed the public of its plan to restate its financial statements for the
fiscal years ending in 2002, 2003, and 2004 and for the fiscal quarter ending
May 31, 2004. The press release stated
that the Red Hat’s independent auditors advised the Company that it should
consider the change on June 16, 2004, and that the Company had decided to act
on that suggestion. (Amended Compl. ¶ 104.)
{38}
On August 6, 2004, Red Hat filed
a Form 10-K/A with the SEC restating its earnings for fiscal year 2002 through
fiscal year 2004. The restatement sought
to bring the Company’s financial earnings for that time period in line with its
recently adopted practice of recognizing income from subscription agreements on
a daily basis. The filing stated that
“[t]he effect of using the new method on our previously reported financial
statements is to defer a portion of the revenue that had been previously
recognized in the month of commencement of a subscription to the month in which
the subscription ends.” (Amended Compl. ¶ 108.)
{39}
On August 18, 2004, just 36
days after Red Hat announced its decision to restate earnings, plaintiff filed
suit alleging that, in adopting and failing to timely correct the Company’s
prior reporting methods, the director and officer defendants named in this
lawsuit disrupted corporate controls, caused inflation in the company’s billing
and consulting services, and breached their fiduciary duties owed to the
corporation. At no time prior or
subsequent to the filing of the Amended Complaint did Plaintiff conduct any
inspection of the books and records of Red Hat or make any demand for any
action or information from the Board or the Company.
III.
MOTION TO DISMISS
{40}
This matter comes before the
Court on the defendants’ motion to dismiss.
Defendants argue first that the Amended Complaint should be dismissed
because Plaintiff has failed as a matter of law to adequately plead demand futility. Second, Defendants argue that Plaintiff has
failed to state any claim which sufficiently alleges damages which are not
premature, speculative, or defectively conclusory. Because Plaintiff has failed to make a demand
on the Company before filing suit or to adequately plead demand futility, the
Court does not need to reach the defendants’ second argument.
{41}
Defendants’ motion to dismiss
centers largely around Plaintiff’s failure to make a demand on the corporation
prior to bringing this derivative action.
Because Red Hat is a
{42}
Plaintiff concedes that he did
not make a demand on the corporation before filing suit. (Amended Compl. ¶
123.) Therefore, he may only proceed if
he can adequately demonstrate that demand would have been futile here.
B.
DEMAND FUTILITY
{43}
“Pleadings in derivative suits
. . . must comply with stringent requirements of factual particularity that
differ substantially from . . . permissive notice pleading.” Brehm v.
Eisner, 746 A.2d 244, 254 (Del. 2000).
Under Delaware law, in order for a derivative plaintiff to survive a
motion to dismiss in a case where demand is not first made on the corporation,
he must plead facts with particularity that demonstrate the reasons why
demand would have been futile. Aronson,
473 A.2d 805, 8115 (Del. 1984); Brehm, 746
A.2d at 254. If that heavy burden is not
satisfied, the complaint must be dismissed, regardless of the strength of his
claim on the merits. Brehm,
746 A.2d at 249.
{44}
As this Court discussed in its
earlier decision in
{45}
Under the Rales
analysis, the court asks “whether or not the particularized factual allegations
of a derivative stockholder complaint create a reasonable doubt that, as of the
time the complaint is filed, the board of directors could have properly
exercised its independent and disinterested business judgment in
responding to the demand.” Rales, 634 A.2d at 934 (emphasis added). The focus of the Rales
test is on “the disinterestedness and the independence of a majority of the
board of directors in responding to a demand.”
Rattner v. Bidzos,
2003 WL 22284323, at *8 (Del. Ch. Oct. 7, 2003). Demand futility is analyzed with a reasonable
doubt standard, but a derivative plaintiff must plead particularized facts to
support that reasonable doubt. Grimes
v. Donald, 673 A.2d 1207, 1217 (Del. 1996); Grabow
v. Perot, 539 A.2d 180, 186-87 (Del. 1988).
{46}
Therefore, in analyzing
plaintiff’s demand futility allegation the Court asks whether plaintiff has
pled particularized facts which raise a reasonable doubt that a majority of Red
Hat’s Board of Directors at the time the original complaint was filed would
have been sufficiently disinterested and independent to adequately consider a
demand had one been made. See Pozen, 2005 NCBC 7, at ¶ 51. For the purposes of this opinion only, the
Court considers the only inside director, Defendant Szulik,
to be interested. Plaintiff does not
allege that any of the directors here lacked the independence to properly
consider demand; plaintiff focuses instead on the directors’ lack of
disinterest. Therefore, to survive the
motion to dismiss, the Amended Complaint must raise a reasonable doubt, based
on particularized facts, as to the disinterest of at least three of the seven
outside directors.
{47}
Under Rales,
in order to properly allege that a director is “interested,” a plaintiff must
establish with particularized facts that (1) the director “will receive a personal
financial benefit from a transaction that is not equally shared by the
shareholders” or (2) the decision to bring suit would “have a materially
detrimental impact on a director, but not on the corporation and the
stockholders.” Rales,
634 A.2d at 936. Plaintiff seeks to
establish directorial interest by launching a laundry list of arguments. Plaintiff challenges the disinterestedness of
the members of Red Hat’s Board of Directors on the following grounds[4]:
1. Defendant Kaiser himself committed acts
of illegal insider trading while in possession of material, non-public
information (Amended Compl. ¶ 123(a));
2. Five of the directors, Defendants
Wellman, McDonald, Kaiser, Fox, and Albrecht, are members of the Audit
Committee, which was responsible for exercising oversight over the company’s
independent auditors and reviewing the audited financial statements and other
disclosures, and which also recommended that the Board include improper
statements of Red Hat’s earnings in statements to both the SEC and the
Company’s shareholders (Amended Compl. ¶ 123(d));
3. All of the outside directors receive
annual cash fees and annual grants of stock options for their services as
members of the Board of Directors (Amended Compl. ¶
123(f) & (k));
4. Defendants Albrecht and McDonald
possess specialized financial expertise, creating a heightened duty to insure
the accuracy and fairness of the Company’s financials (Amended Compl. ¶ 123(g) & (h));
5. All of the board members approved,
permitted, or participated in the wrongs complained of by failing to prevent
and correct the improper financials (Amended Compl. ¶
123(f), (l), (n), & (o)). Also, five
of the directors, Defendants Wellman, Kaiser, McDonald, Albrecht, and Gen.
Shelton, as members of the Compensation Committee, directly permitted or
condoned the Company’s unlawful practices by approving incentive compensation
for the director defendants and unduly compensating its officers (Amended Compl. ¶ 123(e));
6. In order to bring suit, the directors
would be forced to sue themselves (Amended Compl. ¶
123(m));
7. Any suit brought by Red Hat’s Board of
Directors would expose those directors to liability elsewhere (Amended Compl. ¶ 123(p) & (r));
8. Red Hat’s directors have to date failed
to bring the action themselves despite having knowledge of the claims raised by
plaintiff (Amended Compl. ¶ 123(q) & (t));
9. The Company’s liability insurance
policy does not cover suits brought by the Company against the directors
directly. Therefore, if the directors
were to authorize suit, they would open themselves up to uninsured liability
(Amended Compl. ¶ 123(s)).
{48}
These arguments very closely
resemble those made and rejected by this Court in Pozen. They are similarly rejected here.
{49}
Insider Trading. Plaintiff’s argument that Defendant Kaiser is
too interested to properly consider demand on the grounds that he participated
in alleged insider trading during the relevant period fails for lack of
particularized pleading. To establish
demand futility on the personal culpability of one or more of a board’s
directors, a plaintiff must demonstrate through particularized pleading that
the director or directors face a “substantial likelihood” of personal
liability—not just a “mere threat” of liability. Rales, 634
A.2d at 936 (citing Aronson, 473 A.2d at 815). Under
{50}
The Amended Complaint does not
state what insider information Kaiser possessed at the time he sold Red Hat
stock—only that because of his position in the Company, he was in a position to
know insider information. Plaintiff does
not tie either of Kaiser’s two alleged trades to any specific knowledge on his
part or even state that the transactions were based on or motivated in any way
by such knowledge. Plaintiff merely
alleges that Kaiser generally possessed material non-public information at the
time of each sale. Moreover, plaintiff
fails to give any indication of the size of the two sales relative to his total
ownership of Red Hat stock. Plaintiff
would ask this Court to adopt a rule that the act of selling company stock
would render any director so interested that he or she could not adequately
consider demand, regardless of the point in time at which the sale took place,
no matter what the size of the sale, and without any question as to what
specific knowledge the selling director may have had at the time of the
sale. Plaintiff’s insider trading claim
does little more than suggest a “mere threat” of liability for Defendant
Kaiser. It certainly doesn’t rise to the
level of a “substantial likelihood of liability” required by Rales and Aronson.
{51}
Audit Committee. Plaintiff alleges that five of the eight
directors are rendered interested by their roles on the Board’s Audit
Committee. Plaintiff charges that they
breached their fiduciary duties by failing to regulate the Company’s internal
controls with regard to its financials, recommending that the Company include
improper audited consolidated financial statements in its filings with the SEC,
and approving quarterly and interim earnings estimates that were published to
the investment community.
{52}
A Board of Directors’ duty
with regard to a system of internal controls is to “exercise a good faith
judgment that the corporation’s information will come to its attention in a
timely manner as a matter of ordinary operations.” In re Caremark Deriv.
Litig., 698 A.2d 959, 970 (Del. Ch. 1996). In order to adequately plead demand futility
on the ground that the directors failed to fulfill their fiduciary duties to
regulate the company’s system of internal controls, a plaintiff must allege
particularized facts that point to “red flags” that should have alerted the
board to any wrongdoing. See In re
Caremark, 698 A.2d at 969-70; Guttman
v. Huang, 823 A.2d 492, 507 (Del. Ch. 2003) (demand not excused where the
complaint included no “well-pled factual allegations—as opposed to wholly conclusory statements—that the [defendant] directors
committed any culpable failure of oversight under the Caremark
standard”).
{53}
Plaintiff’s argument boils
down to an assertion that these directors are interested merely because of
their status as members of the Board’s Audit Committee. The Amended Complaint indicates that the
Audit Committee relied on the Company’s outside auditor’s determination that
income on the subscription agreement should be recorded on a monthly basis and
that once the auditor suggested that it should change that practice it acted
quickly to adopt that change and restated its earlier financial statements to reflect
the change. Plaintiff does not point to
any specific facts indicating the existence of “red flags” which would have
suggested to the members of the committee that there were problems with Red
Hat’s financials prior to June 2004 or of any conscious decision not to take
action despite any such red flags.
Plaintiff merely argues that because members of the committee had
general access to “internal corporate documents,” were included in
“conversations,” and attended various “meetings,” they “knew or should have
known” that the Company’s internal controls were a “complete mess.” (Amended Compl. ¶
10.)
{54}
As noted by this Court in Pozen, the effect of such a ruling would be to make
it virtually impossible to find a disinterested board of directors anywhere because
audit committee members would be considered interested simply on account of
their membership on the committee—a conclusion entirely inconsistent with the
requirement that companies select disinterested and independent directors to
serve on the committee. See Pozen, 2005 NCBC 7, at ¶ 59. Were the Court to recognize demand futility
on the grounds asserted by plaintiff, the demand requirement would be rendered
void in all cases where a company opts to restate earnings. Such a ruling would be inconsistent with the
public policy that corporations act diligently to correct reported earnings
when mistakes or inconsistencies are discovered or where current accounting
practices dictate a change in reporting practices. Plaintiff’s conclusory
demand futility arguments with respect to the five members of the Audit
Committee are insufficient for the Court to find that his failure to make
demand is excused.
{55}
Director Compensation. Plaintiff alleges that demand is excused here
because all of Red Hat’s outside directors received compensation for their
services on the Board of Directors.
Plaintiff argues that in approving director compensation in the form of
annual fees and stock options at the time of the alleged wrongdoing, defendants
engaged in self-dealing which disqualifies them from properly considering any
demand. The Supreme Court of Delaware
has held that a director’s disinterest is not impeached by the mere fact that
he received compensation for his services.
Grobow v. Perot, 539 A.2d 180,
188 (Del. 1988). Other courts applying
{56}
Specialized Expertise. Plaintiff alleges that because Defendants
Albrecht and McDonald possess unique financial expertise, they owe a heightened
duty to safeguard the Company’s financials.
Plaintiff essentially takes the position that merely because Red Hat
sought and obtained the services of two professionals whom plaintiff claims are
experts in their field, those two professionals are then incapable of
objectively considering demand as a matter of law when the wrongful conduct
alleged involves a matter within that area of expertise. Plaintiff’s conclusory
allegation is insufficient to excuse failure to make pre-suit demand.
{57}
Approval of or Participation
in the Wrongs Alleged. Plaintiff also contends that the Board of
Directors as a whole lacks disinterest because it approved, permitted, or
participated in the wrongs alleged. As
this Court recognized in
{58}
Plaintiff asserts a blanket Caremark
claim that the director defendants “knew or should have known” of the wrongful
conduct alleged and that they breached their fiduciary duties by failing to
have internal controls in place that would have worked to prevent or correct
that misconduct. Plaintiff has failed,
however, to point to any specific facts that brought or should have brought any
wrongdoing to the directors’ attention—the “red flags” required by Caremark. See supra, at ¶ 52. Plaintiff also fails to plead facts that
would call into question the good faith efforts of the directors to have
systems in place that would prevent or correct such wrongdoing. The Board’s action in promptly responding to
a suggestion from its ouside auditors demonstrates
good faith—not bad faith or callous indifference.
{59}
Plaintiff attempts to bolster
his argument by asserting that the five members of the Compensation Committee
are interested because they “directly contributed to the unlawful practices
herein” by approving incentive compensation packages for Red Hat’s
officers. This assertion, though more
specific, is also unsupported by particularized facts that would tie the
incentive-based compensation plan to the wrongs alleged or that would show that
any “red flags” existed which would alert the Board to any such
connection. Given that plaintiff relies
on mere conclusions, this Court rejects this argument as it did in Pozen.
{60} &nb