In re InfoSonics Corp. – Backdating, Demand Futility, and the Internal Affairs Doctrine

In re InfoSonics Corp., 2007 U.S. Dist. LEXIS 66043 (S.D. Cal. Sept. 4, 2007) involves a derivative lawsuit brought by the shareholders of InfoSonics Corporation against the Board of Directors and several officers arising out of claims of backdating. Incorporated in Maryland but based in California, InfoSonics provides wireless handsets to Latin America and the United States.

Plaintiffs alleged, among other things, that Defendants breached their fiduciary duties and violated the Sarbanes-Oxley Act of 2002 when they approved backdated stock options, misclassified stock warrants, and issued misleading SEC filings. These acts artificially inflated InfoSonics’ stock price, which fell by twenty-eight percent when InfoSonics began to correct the problem. In response to Plaintiffs’ claims, Defendants filed motions to dismiss for (1) failure to make a demand on the Board of Directors, (2) lack of standing, and (3) failure to state a claim.

The court granted Defendants’ motion to dismiss for failure to make demand on the Board of Directors. Relying on Maryland law, the court had to determine whether the plaintiffs met the strict test for demand futility, something it described as "very limited." Plaintiffs argued they did not make demand because the Board could not have responded to their demand in good faith since three of the five board members approved issuing the stock options and that all of the Board members received the stock options. They relied on Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), the back dating case out of Delaware, to support their position. The court, however, noted that the case was inapplicable. "Ryan does not govern this Court's decision because it applied Delaware law. Delaware's requirements for demand futility are more permissive than Maryland's, requiring only that the facts alleged create a 'reasonable doubt' that the directors are disinterested and independent."

The court also concluded that there was no implied right of action for violations of Section 304 of SOX (15 USCS § 7243), the provision that governed the forfeiture of compensation by the CEO and CFO following certain restatements by the company. Plaintiffs argued that Congress considered and rejected language that would have expressly limited enforcement of the provision to the SEC. The court, however, concluded that if Congress had intended a private right of action under section 304, Congress "could have included language doing so." The court's reasoning was consistent with the opinion in Kogan v. Robinson, 432 F. Supp.2d 1075 (S.D. Cal. 2006).

The court did allow a claim for insider trading. In so doing, the opinion rejected Defendant's claim that, under the internal affairs doctrine, California Law did not apply to insider trading claims. The court rejected the argument, relying heavily on Friese v. Superior Court, 134 Cal. App. 4th 693, (2005) (holding claims for insider trading under California Corporate Securities Law of 1968 serve broad public interests rather than the narrow interests of a corporation's shareholders, and thus are not governed by the internal affairs doctrine). Under Friese, California law, not Maryland law, governed Plaintiffs’ claim. As such, the court found Plaintiffs stated a claim for relief under California Corporate Securities Law, and denied Defendants’ motion to dismiss.

The case illustrates that Delaware is not the only jurisdiction that imposes very high standards for demand excusal. Moreover, it further illustrates the practical difficulty in bringing derivative suits arising out of alleged backdating.

For the opinion and primary materials from this case, go to the DU Corporate Governance website.