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Jacobi v. Ergen

United States District Court, D. Nevada

March 30, 2015

Greg Jacobi, Plaintiff,
v.
Charles W. Ergen, et al., Defendants.

ORDER DISMISSING COMPLAINT FOR FAILURE TO DEMONSTRATE DEMAND FUTILITY [# 17] WITH LEAVE TO AMEND

JENNIFER A. DORSEY, District Judge.

This shareholder-derivative action challenges the EchoStar Corporation's compensation committee's decision to award its board chairman and principal shareholder Charles Ergen options for 1.5 million shares of stock-700, 000 more than the annual cap set by the company's stock-incentive plan. Without first making a demand on EchoStar's current board of directors, shareholder Greg Jacobi sued EchoStar, Ergen, and several of EchoStar's directors alleging that the award, and particularly the 700, 000 excess shares over the annual cap, was a "fundamentally unfair, " ultra vires act permitted by fiduciary breaches and resulting in Ergen's unjust enrichment. I find that Jacobi has failed to plead with sufficient particularly facts that show his pre-suit demand on the EchoStar board of directors was excused as futile, and I dismiss this action with leave to amend.

Background[1]

EchoStar is a Nevada holding company whose wholly-owned subsidiaries design and distribute digital set-top boxes for satellite TV service providers and cable companies, and provide digital broadcast and satellite services to DISH Network and other satellite services.[2] Ergen has been Chairman and a director of EchoStar since 2007, he is the company's majority shareholder, and he served as EchoStar's CEO until 2009.[3] Ergen no longer has managerial responsibility for EchoStar; "his only role is now to provide guidance' to management in his capacity as Chairman."[4] Ergen is also the majority shareholder and Chairman of the Board of EchoStar's spinoff company, DISH Network, which is also one of EchoStar's primary customers.[5]

On March 31, 2011, EchoStar's three-member compensation committee, consisting of Tom Ortolf, C. Michael Schroeder, and Joseph Clayton, awarded Ergen 1.5 million stock options to purchase EchoStar's Class A common stock, valued at $21.6 million.[6] Jacobi alleges that the award violated the limitations of EchoStar's shareholder-approved Amended and Restated 2008 Stock Incentive Plan (the "SIP"), which provides, "no Participant may be granted Awards... in the aggregate in respect of more than 800, 000 Shares in any one calender year...."[7] He characterizes the award as "not in fact compensation' at all, but rather a stealth dividend issued to the controlling shareholder."[8] And he contends that the award of options for the excess 700, 000 shares two years after Ergen stepped down as CEO was an ultra vires act, and that the sheer size of the entire 1.5 million-option award "was fundamentally unfair to the Company for a host of reasons."[9]

Jacobi sues the board of directors at the time of the award (Ergen, Ortolf, Schroeder, Michael Dugan, R. Stanton Dodge, Joseph Clayton, and David Moskowitz) for fiduciary breaches and corporate waste, and he sues Ergen separately for fiduciary breaches and unjust enrichment-all derivatively on behalf of EchoStar.[10] "Derivative suits allow shareholders to compel the corporation to sue' and to thereby pursue litigation on the corporations behalf against the corporation's board of directors and officers."[11] "But because the power to manage the corporation's affairs resides in the board of directors, a shareholder must, before filing suit, make a demand on the board, or if necessary, on the other shareholders, to obtain the action that the shareholder desires."[12] At the time Jacobi filed suit, EchoStar's board of directors consisted of Ortolf, Schroeder, Ergen, Dodge, Dugan, Anthony Federico, and Pradman Kaul.[13] Jacobi did not make a pre-suit demand on the board to challenge the award, and he alleges that demand would have been "a futile and useless act because the Current Board is incapable of making an independent and disinterested decision to institute and vigorously prosecute this action."[14]

Defendants move to dismiss Jacobi's shareholder-derivative action, arguing that, "[h]ad [p]laintiff done what the law requires him to do-make a pre-suit demand-this litigation and the expenses associated with it would have been avoided" because the award of the excess 700, 000 options was canceled immediately after the lawsuit was filed.[15] They contend that Jacobi has not sufficiently pled demand futility as required to permit him to maintain this action on behalf of EchoStar and, regardless, each of his claims should be dismissed under FRCP 12(b)(6) for failure to state a viable claim. The parties agree that the cancellation moots Jacobi's claim for corporate waste, but they disagree on the sufficiency of his other claims and demand-futility allegations. Having thoroughly considered the parties' extensive briefing and arguments at the hearing on this motion, I find that Jacobi's allegations do not sufficiently establish that a pre-suit demand would have been futile, and I dismiss his complaint with leave to amend.

Discussion

A. Demand futility

Shareholder derivative suits are anathema to the general rule that "a corporation's board of directors has full control over the affairs of the corporation, '" which includes the decision "whether to take legal action on the corporation's behalf."[16] Before a shareholder can file suit on the company's behalf, he must first demand that the board obtain for the company "the action that [he] desires."[17] The pre-suit demand requirement is excused only if the plaintiff demonstrates in his complaint that the demand would have been futile.[18] To determine demand futility, the district court applies the law of the state of incorporation-in this case, Nevada.[19] When a shareholder files derivative claims without a pre-suit demand, he must plead "with particularity... the reasons for not obtaining the action or not making the effort."[20] The relevant facts "must be put forth in the complaint and not merely in subsequent briefs."[21] This heightened pleading burden "is... more onerous than that required to withstand a Rule 12(b)(6) motion."[22]

1. Aronson or Rales ?

Nevada courts apply one of two tests developed by the Delaware courts to evaluate the plaintiff's allegations to determine whether demand is futile and thus excused.[23] As the Nevada Supreme Court explained in Shoen v. SAC Holding Corp ., "in those cases in which the directors approved the challenged transaction[], " the court applies the test from Aronson v. Lewis . [24] The two-pronged Aronson test "applies to determine if a complaint has created a reasonable doubt as to whether the directors, having made a business decision, were disinterested and independent, or likely entitled to the business judgment rule's protection."[25] But "where the contested corporate transaction is not the result of director action, " the test from Rales v. Blasband applies, and "the demand futility analysis is limited to whether a majority of the directors had a disqualifying interest in the matter or were otherwise unable to act on the demand with impartiality."[26]

All of Jacobi's claims challenge a single transaction: the compensation committee's March 31, 2011, award to Ergen of 1.5 million EchoStar stock options to purchase EchoStar's Class A common stock.[27] Jacobi attempts to tie the board of directors into this action by vague allegations that "the Board granted" these stock options and "breached their fiduciary duties by authorizing, approving, and/or by abdication of duty permitting stock option grants in violation of the terms of the Incentive Plan."[28] But these generalized statements do not square with the more particularly pled facts in the verified complaint that the decision was made exclusively by the three-member compensation committee.[29]

For example, Jacobi states in paragraph 10 that "the Board allowed its compensation committee, the members of which are effectively controlled by Ergen, to determine his compensation."[30] And although Jacobi highlights a number of things he alleges the board did not do, ("[t]he Board did not engage in arms-length negotiations when determining the amount of compensation to award Ergen, " or "seek the guidance of any consultants or advisors to determine what a fair award should be"[31]), the well-pled facts reflect that all affirmative action taken with respect to this stock-option award was performed by the compensation committee alone. ("On March 31, 2011, the Compensation Committee awarded Ergen 1.5 million stock options... under the Incentive Plan, " which Jacobi alleges is administered by the Compensation Committee[32]; "the Compensation Committee did not negotiate for and/or receive adequate consideration (if any at all) in return" for the award[33]; "the Compensation Committee did not consult any advisors or consultants, " though it "engaged a compensation consultant... after the 2011 compensation decisions were already made"[34]; and "[t]he Compensation Committee's actions in violating the express terms of the Incentive Plan by definition could not have been a good faith exercise of business judgment"[35]). Based on the totality of these allegations, the only fair reading of the complaint is that Jacobi's challenge relates to a single transaction: the compensation committee's award of the stock options to Ergen.

Because this challenged transaction was not the result of an affirmative vote by the board itself or an action by a majority of the board members, [36] all of Jacobi's claims must be evaluated under the Rales test for demand futility.[37] I thus consider whether Jacobi's "particularized factual allegations... create a reasonable doubt that, as of the time the complaint [wa]s filed, [a majority of] the board of directors could have properly exercised its independent and disinterested business judgment in responding to" Jacobi's demand.[38] I "accept as true each of the complaint's particularized factual allegations and draw every fair factual inference flowing from those particularly alleged facts in favor of" Jacobi.[39]

2. Jacobi's allegations do not create a reasonable doubt that a majority of the board of directors lacked the ability to exercise independent and disinterested business judgment to consider his pre-suit demand.

Under the Rales test, "directors' independence can be implicated by particularly alleging that the directors' execution of their duties is unduly influenced, manifesting a direction of corporate conduct in such a way as to comport with the wishes or interests of the person doing the controlling.' A lack of independence also can be indicated with facts that show that the majority is beholden to' directors who would be liable or for other reasons is unable to consider a demand on its merits, for directors' discretion must be free from the influence of other interested persons."[40]

Nobody disagrees that Ergen is neither independent nor disinterested; and there is no debate that Federico, who joined the board after the subject stock-option award, is disinterested and independent. This leaves me to consider only whether Jacobi's complaint satisfies the Rales test for at least three of the other board members: compensation committee members Ortolf and Schroeder, and the remaining board members Dodge, Dugan, and Kaul, such that Jacobi's pre-suit demand was excused as futile.

a. Ortolf

To create a reasonable doubt that Ortolf was capable of a disinterested and independent consideration of his demand, Jacobi alleges that Ortolf, as a member of the compensation committee that granted the stock options, faces "a substantial likelihood of liability" rendering him "incapable for objectively considering a demand."[41] He further alleges that Ortolf "has a long and substantial relationship with Ergen, " first from 1988-1991 and later beginning in 2005, having put Ortolf in executive positions and on boards.[42] He concludes that this history renders "Ortolf... incapable of making an independent and disinterested decision to institute and vigorously prosecute this action."[43]

Ortolf's membership on the committee when it made the stock-option-grant decision is not enough to demonstrate that he was incapable of exercising independent judgment in evaluating Jacobi's demand. Numerous courts have rejected the argument that "the mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge the disinterestedness of directors."[44] As the Third Circuit expressed during its consideration of the Rales facts, a plaintiff may not "bootstrap allegations of futility" by pleading that "the directors participated in the challenged transaction or that they would be reluctant to sue themselves."[45] And the Nevada Supreme Court recognized in Shoen that "[a]llegations of mere threats of liability through approval of the wrongdoing or other participation... do not show sufficient interestedness to excuse the demand requirement."[46] A director's misconduct must rise at least to the level of gross negligence to state a breach-of-the-fiduciary-duty-of-due-care claim, or involve "intentional misconduct, fraud, or a knowing violation of the law, " to state a duty-of-loyalty claim-standards the Nevada Supreme Court characterized in Shoen as a "difficult threshold to meet."[47]

Jacobi characterizes the stock-option grant as a violation of the SIP, "extravagant, "[48] "fundamentally unfair to the company, "[49] and not "in good faith, "[50] but his allegations do not rise to the level necessary to plead interestedness through potential liability. As the district court reasoned in In re Computer Sciences Corp. Derivative Litigation when finding that shareholders failed to plead with sufficient particularly facts excusing their pre-suit demand before challenging compensation-committee actions, alleging merely that some directors are responsible for errors made is not enough.[51] "In a derivative case like this one, a board of directors is entitled to a presumption that they can and should be allowed to manage the business affairs of a corporation, including the decision of whether and how to investigate errors like these and whether ultimately to bring claims on the corporation's behalf."[52] "Absent particularized allegations showing the board is unworthy of this deference, a derivative plaintiff must first make a demand on the board to investigate its claims."[53]

Nor does Ortolf's history of business relationships with Ergen excuse the demand. "When lack of independence is charged, a plaintiff must show that the [b]oard is either dominated by an officer or director who is the proponent of the challenged transaction or that the [b]oard is so under his influence that its discretion is sterilize[d].'"[54] The Aronson court clarified that "a plaintiff charging domination and control of one or more directors must allege particularized facts manifesting a direction of corporate conduct in such a way as to comport with the wishes or interests of the corporation (or persons) doing the controlling.' The shorthand shibboleth of dominated and controlled directors' is insufficient."[55] Even allegations of friendship or affinity are insufficient to rebut the presumption that a director acts independently.[56]

Jacobi's allegations do not demonstrate Ortolf is so beholden to Ergen that his discretion could not be independently exercised. The closest he gets is alleging that Ortolf "has set compensation for Ergen for two separate companies, both of which are under Ergen's control, " but he does not even insinuate that Ortolf did so in a way that suggests that Ortolf is somehow beholden to, or under the control of Ergen.[57] Jacobi's allegations that (1) because Ergen is EchoStar's controlling shareholder and (2) because Ergen is also the "controlling stockholder and Chairman of DISH Network, " the company from which EchoStar derived more than half its revenue from 2011-2013, all of the EchoStar board members "must act to appease Ergen and [are] incapable of acting independently"[58] are purely conclusory and lack any factual support. Jacobi simply has not satisfied his FRCP 23.1 burden of pleading demand futility with respect to Ortolf.

b. Schroeder

Jacobi's allegations of Schroeder's interestedness are even less compelling. He alleges merely that "Schroeder served on the Board of" DISH Network's predecessor company from 2003 until it became EchoStar and Ergen elected Schroeder "to continue to serve on the Board ever since."[59] He further alleges that Schroeder, like Ortolf, faces "a substantial likelihood of liability and [was] therefore... incapable of objectively considering a demand."[60] Just as these allegations were inadequate to satisfy Rales for Ortolf, they are inadequate to demonstrate a lack of independence on the part of Schroeder.

c. Dugan and Kaul

Jacobi alleges that "Dugan is the Chief Executive Officer and President" of EchoStar and "Kaul is the President of a wholly-owned subsidiary of EchoStar."[61] Both received more than $800, 000 in compensation from EchoStar in 2011 "and as such depend on their employment with the Company for their livelihood."[62] They are therefore "incapable of making an independent and disinterested decision to institute and vigorously prosecute this action."[63] Jacobi further alleges that neither Dugan nor Kaul is "considered independent under either the requirements of NASDAQ or the SEC."[64]

That Dugan or Kaul depends on his employment at EchoStar for his livelihood has nothing to do with Ergen. As Jacobi explains in paragraph nine of his verified complaint, Ergen "stepped down as CEO" and is "no longer... responsible for managing the Company; his only role now is to provide guidance' to management in his capacity as Chairman."[65] Thus, Jacobi has pled no facts to suggest that Dugan's employment at a company that Ergen no longer manages-or Kaul's employment at the subsidiary of a company Ergen no longer manages-could be threatened by his reconsideration of Ergen's stock-options award.[66] Even if he had connected these dots, the assumption that a director lacks independence based on his employment is not enough. As numerous courts have recognized, "demand futility cannot be pled merely on the basis of allegations that directors acted or would act to preserve their positions. If these allegations were sufficient to show lack of independence, every insider director would be disabled from considering a pre-suit demand."[67] Jacobi has not pled sufficient facts to raise a reasonable doubt that Dugan or Kaul-neither of whom sat on the compensation committee-could impartially consider a demand from Jacobi regarding the stock-option grant to Ergen.

That Dugan and Kaul are not considered "independent" under the NASDAQ or SEC rules is also not dispositive of their independence for demand-futility purposes. The independence standards of these entities and the independence standard for the demand-futility analysis are unrelated.[68] Under the NASDAQ standard, any inside director would be considered not independent. This is not the applicable standard for analyzing demand futility. Because independence has a different meaning in the demand-futility analysis than under these additional standards, I find these designations of Dugan and Kaul immaterial to my analysis.

d. Summary

Because Jacobi has not satisfied his burden to show his pre-suit demand was futile with respect to Federico, Ortolf, Schroeder, Dugan, or Kaul-five of the seven board members at the time Jacobi filed this action-his claims must be dismissed.[69] And because I am dismissing all claims under FRCP 23.1, I decline to reach the other dismissal arguments raised in defendants' motion as they are now moot.

B. Leave to Amend

At the end of his response to the defendants' motion to dismiss, Jacobi requests leave to amend his complaint should the court find his allegations insufficient.[70] Rule 15 of the Federal Rules of Civil Procedure requires district courts to "freely give leave [to amend] when justice so requires."[71] The Ninth Circuit has long recognized that this policy is "to be applied with extreme liberality."[72] In the seminal leave-to-amend case of Forman v. Davis , the United States Supreme Court explained, "[i]f the underlying facts or circumstances relied upon by a plaintiff may be a proper subject of relief, [the Plaintiff] ought to be afforded an opportunity to test his claim on the merits."[73] Still, amendment is not automatic. If reasons justify denying opportunity to amend, the court has discretion to foreclose amendment.[74] In the Ninth Circuit, courts consider five factors when determining whether to grant leave: (1) bad faith, (2) undue delay, (3) prejudice to the opposing party, (4) futility of amendment, and (5) whether the plaintiff has previously amended the complaint.[75] Any of the first four factors can serve as a basis for denying leave to amend.[76]

I am not yet convinced that Jacobi cannot state sufficient facts to demonstrate demand futility, and I find that he should be permitted one more opportunity to state his demand-futility allegations if he has additional facts to support them. Because the parties agree that his corporatewaste claim is moot, any amended complaint should not replead that claim. Accordingly, should Jacobi believe that he has sufficient additional facts to demonstrate demand futility, he has until April 20, 2015, to file an amended complaint.

Conclusion

Accordingly, it is HEREBY ORDERED that Defendants' Motion to Dismiss [Doc. 17] is GRANTED in part. The complaint is dismissed without prejudice for failure to file a pre-suit demand or sufficiently plead demand futility. Jacobi has until April 20, 2015, to file an amended complaint if he can state additional facts to establish demand futility. If Jacobi fails to file a sufficiently pled amendment complaint by April 20, 2015, his claims will be dismissed with prejudice and this case will be closed.


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