By Anne Sherry, J.D.
The district court in Chicago dismissed a derivative suit arising out of the 2015 merger between Kraft Foods and Heinz. While the Kraft Heinz shareholders took issue with cost-cutting measures the company took after the merger, the complaint did not plead any misleading disclosures. Accordingly, it in turn did not plead a non-exculpated claim sufficient to establish demand futility (In re Kraft Heinz Shareholder Derivative Litigation, March 31, 2023, Alonso, J.).
After the merger, majority interest in Kraft Heinz was owned by Berkshire Hathaway and the private equity firm 3G. The latter is known for its cost-cutting strategies, particularly “zero-based budgeting.” The complaint alleged that the director and officer defendants were either directly affiliated with 3G or were close business associates of the 3G-affiliated defendants. Although 3G’s zero-based budgeting strategy had worked at other companies, it did not work at Kraft Heinz, the plaintiffs alleged. Instead, the new cost constraints tanked the value of the company’s brands, and the procurement division misstated the terms of supplier contracts.
Despite these issues, the defendants caused the company to file reports with the SEC that showed no impairment of goodwill or events that were likely to impair goodwill. When they reported weakness in their controls, they omitted to disclose the fallout of the cost-cutting measures or improper recording by the procurement division. Eventually, the company did recognize impairments to goodwill, but the plaintiffs alleged that these disclosures did not reveal the full extent of the problem. When Kraft Heinz announced a $15.4 billion impairment in early 2019, along with an SEC investigation into the procurement division’s accounting, its stock price plummeted.
Demand futility. The plaintiffs did not make a pre-suit demand and thus had to show that demand was excused as futile. Under Delaware’s universal test for demand futility, this requires an inquiry as to whether each director: (i) received a material personal benefit from the alleged misconduct; (ii) faces a substantial likelihood of liability on the claims; or (iii) lacks independence from someone in one of the above categories. If at least half of the members of the demand board check one of these boxes, demand is excused as futile.
Furthermore, Kraft Heinz’s certificate of incorporation exculpates directors for breach of fiduciary duty to the full extent permitted by Delaware law. Taken together with the demand futility test, this means that the plaintiffs needed to plead that a majority of the director defendants faced a substantial likelihood of liability for breaching their duty of loyalty, acting in bad faith, committing intentional misconduct, or knowingly violating the law. The plaintiffs attempted to do so by focusing on the directors’ exposure to personal liability.
The plaintiffs’ demand futility argument failed because they did not plead a non-exculpated claim with particularity. The complaint included no allegations suggesting what facts, arising at what time, should have put the directors on notice that the company’s cost-cutting was hurting it and would result in an impairment to goodwill. A 2018 presentation to the board gave some suggestion that the company’s brands was weakened, but the company then disclosed some impairments to goodwill and risks of further impairment. Even assuming the defendants were aware of some warning signs, it did not follow that they failed to disclose them in bad faith.
Furthermore, the argument that the defendants who sat on the Audit Committee should have known of the looming impairment to goodwill “is a non-starter under well-settled Delaware law.” Membership on a committee is not sufficient to infer knowledge. While the court found it unclear if the plaintiffs were advancing a Caremark theory for failure of oversight, if so, this claim was doomed for the same reason that the plaintiffs did not allege the defendants’ scienter.
The remaining claims were no help to the plaintiffs either. Although they alleged that a proxy statement was false, and there is no need to prove scienter to advance such a claim under the Securities Exchange Act, this is a derivative action and not a securities fraud action. The company’s exculpation provision meant that any claim in the derivative action had to incorporate the requisite state of mind. While certain other demand futility allegations were made as to individual directors, they did not account for half the board. The court accordingly dismissed the action in its entirety.
The case is No. 20-cv-02259.