In In Re Cognizant Technology Solutions Corporation Derivative Litigation, the United States Court of Appeals for the Third Circuit, under a newly adopted de novo standard of review, affirmed the District Court of New Jersey’s dismissal of a shareholder derivative suit against eleven board members and five current and former officers of Cognizant Technology Solutions Corporation (Cognizant) for breach of fiduciary duties, corporate waste, unjust enrichment, and contribution and indemnification.
From 2010 to 2015, Cognizant’s Board of Directors (the Board) received several updates indicating that Cognizant’s anti-corruption processes and controls in India were inadequate. Management also informed the Board that “[a] program is underway to ensure that disciplinary actions in India come into closer conformance with the rest of the countries, and that [c]ompliance is providing continuing examples from other countries to support the desired result in India.” In 2015 and 2016, with Board sign-off, Cognizant published two Sustainability Reports. In those reports, Cognizant disclosed that there were no reports of corruption in 2014 or 2015. At the end of 2016 and into early 2017, Cognizant began publicly disclosing the India bribery scheme, and the Board notified the DOJ and the SEC.
Plaintiffs filed this derivative action against the Board and certain current and former Cognizant officers in July 2017, without first making a pre-suit litigation demand on the Board. All defendants moved to dismiss the complaint for failure to plead demand futility, which the District Court granted.
The threshold question addressed by the Third Circuit on appeal was the appropriate standard of review to apply when evaluating a district court’s decision to dismiss a shareholder derivative action for failure to plead demand futility. Since its decision in Blasband v. Rales, 971 F.2d 1034 (3d Cir. 1992), the Third Circuit has applied the deferential “abuse of discretion” standard in reviewing dismissals of shareholder derivative actions for failure to plead demand futility. Since that time, other Circuits and state supreme courts have revisited the appropriateness of this standard and many, including the First, Second, Seventh, Eighth, and Tenth Circuits and the Delaware Supreme Court have adopted de novo review for these cases. The Third Circuit determined that in light of this trend, re-evaluation of Blasband would be appropriate.
The Third Circuit applied the U.S. Supreme Court’s Pierce v. Underwood test for determining whether deferential or de novo review is appropriate, which considers: (i) whether one judicial actor is better positioned than another to decide the question; (ii) the non-amenability of the problem to rule, because of the diffuseness of circumstances, novelty, vagueness, or similar reasons that argue for allowing experience to develop; (iii) the language and structure of the governing statute; and (iv) whether the decision under review ordinarily has such substantially consequences that one might expect it to be reviewed more intensively. The Third Circuit found that each of the factors weighed in favor of de novo review, reasoning that: (i) a district court is not better positioned than an appellate court to assess demand futility because demand futility is a pleading issue; (ii) “the doctrines of demand futility are reasonably uniform and amenable to general rules that cover a wide range of circumstances, making de novo review especially appropriate;” (iii) the text of Rule 23.1 or any applicable state law does not indicate a preference for a trial court decision; and (iv) demand futility arises frequently in and has substantial consequences on shareholder derivative suits.
Applying the de novo standard, the Third Circuit affirmed the District Court’s dismissal, finding that the plaintiffs did not allege that at least half the Board (1) “individually face a substantial likelihood of liability on one or more of the claims presented,” or (2) “lack independence from a director who faces a substantial likelihood of liability.”
First, the Third Circuit found that Plaintiffs failed to sufficiently plead that at least half the Board faced a substantial likelihood of liability. For the breach of duty claim, the Third Circuit concluded that the complaint did not allege the Board members knew about the alleged bribery scheme, “nor that [they] knew they were otherwise participating in wrongdoing by publishing the” Sustainability Reports, and therefore the Board did not know “they were disseminating false or misleading information to have violated their fiduciary duty of loyalty.” For the corporate waste claim, the court found that Plaintiffs failed to allege facts showing that the Board did not earn their compensation during the relevant period and therefore Plaintiffs “have not plausibly alleged that the Director Defendants face a substantial likelihood of liability for engaging in corporate waste.”
Second, the Third Circuit found that – even if Plaintiffs were correct that three directors lacked independence from a director who faced a substantial likelihood of liability – Plaintiffs still fell well short of the six directors they needed.
Authored by Allison Wuertz, Ann Kim, Jordan Teti, and Raman Kulkarni.
