Wednesday, October 11, 2017

REIT merger challenge dismissed again for lack of presuit demand

By Anne Sherry, J.D.

For the second time, the Delaware chancery court has dismissed a lawsuit alleging that a REIT overpaid for assets. The New Residential Corp. stockholder failed to establish that demand on the board was futile, either by casting doubt on the directors’ disinterestedness or independence or by challenging their exercise of business judgment in approving the merger (Chester County Employees’ Retirement Fund v. New Residential Investment Corp., October 6, 2017, Montgomery-Reeves, T.).

The New Residential Corp. stockholder alleged that the board, along with other entities, caused the REIT to overpay for the assets of Home Loan Servicing Solutions, Ltd., in order to advantage commonly owned real estate assets and maximize fees. Last October, the chancery court dismissed the original complaint with leave to amend, reasoning that the dual-natured derivative and direct action should be treated as derivative for purposes of the demand requirement. While the plaintiff did plead that at least half of the New Residential directors were beholden to the REIT’s controller, Fortress, it did not establish that Fortress had a material interest in the challenged transactions. The complaint also failed to adequately allege how the New Residential directors were incentivized to overpay for the assets.

Aronson analysis. After the court denied the plaintiff’s motion for reargument, the plaintiff filed the second amended complaint, again without first making demand on the board. The court again concluded that demand was not excused. Under Aronson v. Lewis, demand is futile if the plaintiff alleges particularized facts to raise a reasonable doubt either that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. Demand was not excused under the first prong because the plaintiff failed to create a reasonable doubt as to the independence of four of the seven New Residential directors.

For example, a director’s receipt of indemnification and exculpation rights did not cast doubt on his independence and disinterestedness; Delaware law holds as much because indemnification has become commonplace in corporate affairs and does not increase a director’s wealth. The plaintiff alleged that another director had “several years of social connections” with two individuals with key positions at Fortress, but failed to plead particularized facts from which the court could infer the director and Fortress officials had a close personal friendship. Finally, the court would not rule that another director’s board compensation was material simply because he was retired; this would amount to a blanket determination that all retired board members lack independence.

Demand was also not excused under Aronson’s second prong. Demand is not futile even if Fortress is a controlling stockholder of New Residential and was interested in the challenged transactions. Although entire fairness would potentially apply if that were the case, the argument that demand is thus futile is inconsistent with Delaware case law. The focus of the demand futility analysis is whether the plaintiff’s allegations raise a reasonable doubt as to the impartiality of a majority of the board. Nor could the plaintiff rest demand futility on its “Monday morning quarterbacking” of the board’s business decision. This was not one of the rare cases in which a transaction is so egregious on its face that board approval cannot meet the test of business judgment.

The case is No. 11058-VCMR.