Plaintiffs and Prolixity: Wood v. Baum (Part 3)

We are discussing Wood v. Baum, a recent Delaware Supreme Court upholding the dismissal of a derivative claim. Plaintiff alleged demand excusal because the directors signed false reports, authorized certain self interested transactions, served on the audit committee, and ignored certain red flags.

We have already noted that the case is little more than a summary dismissal of plaintiff's allegations (on a motion to dismiss, before discovery occurs), with each allegation dismissed seriatim and no effort to consider them in toto. Thus, the Court notes that the "Board’s execution of MME’s financial reports, without more, is insufficient to create an inference that the directors had actual or constructive notice of any illegality." Similarly, the Court describes plaintiff as asserting "that membership on the Audit Committee is a sufficient basis to infer the requisite scienter. That assertion is contrary to well-settled Delaware law."

But of course, plaintiff doesn't allege that mere membership on the audit committee is enough. Instead, it's about what the directors learned by virtue of their position on the audit committee. Thus, in the opposition to the motion to dismiss at the Chancery Court, plaintiff noted: "While the entire Board was apprised of virtually all alleged actions and inactions because of their related party nature, the Audit Committee also was apprised of failures to take other-than temporary impairment charges on non-related party transactions and assets as well as the gross accounting incompetence and mismanagement."  In other words, a far cry from membership alone is enough.

Similarly, plaintiff alleges that the board "ignored red flags." The Court did not discuss the red flags that the board allegedly missed but merely noted that "the Court of Chancery correctly concluded that there were no cognizable 'red flags' from which it could be inferred that the defendants knew that FAS 115 was being improperly applied, or that the defendants otherwise consciously and in bad faith ignored the improprieties alleged in the complaint."  It was a thin discussion of an important issue.

So what were these undiscussed red flag? A list from the opposition to the motion to dismiss at the Chancery Court include the following:

• The timing of foreclosure/resale transactions of non-performing assets with related parties that served to smooth and inflate earnings;
• The issuance of dividends unsupported by actual operating cash flow and despite the poor performance of a material amount of the Company’s assets;
• The maintenance of under-performing assets held by related-parties despite deteriorating performance and market conditions, precluding redeployment of corporate assets;
• The Company’s payment of charitable contributions to borrowers in order to keep loans of the Company in current status;
• The repeated transfers by deed in lieu of foreclosure transactions from one Joseph-controlled entity to another accompanied by the Company’s obligation to make delinquent debt service payments;
• The routine positive statements issued concerning the Company’s performance despite the severe issues with its portfolio of loans;
• The failure to properly value non-performing assets pursuant to the Company’s own valuation policies as well as accounting guidelines, including insisting on the
• Company’s ability and intent to hold assets when the Company had, in fact, relinquished both ability and intent through its syndications;
• The results from the MMA Portfolio Offering, the subsequent cancellation, and the failure to disclose this material information to shareholders which indicated
• the Company was significantly over valuing a material portion of its assets;
• The Company failing to establish and enforce adequate accounting controls and procedures that have resulted in serial restatements, investigations and review by the SEC and NYSE, with the Company having to halt substantial business operations and lose access to important sources of capital;

Perhaps these were insufficient, although at least a few of them seem serious (the payment of charitable contributions to borrowers in order to keep loans current) but they deserved more than a summary statement that the Chancery Court was right (the Chancery decision, by the way, was issued from the bench and was not reduced to a written opinion, so the more extended reasoning of the trial judge is not readily available). 

The case does little to address the standards that boards ought to employ in making decisions.  And, rather than address difficult issues head on the opinion mostly ignored plaintiff's arguments, refashioning them into something approaching a caricatures. 

We've got one more post on this case.  Primary materials from the Chancery Court can be found at the DU Corporate Governance web site.