The Delaware Court of Chancery has shown a renewed interest in holding corporate founders also serving as directors subject to shareholder derivative actions when the founders engaged in self-dealing to leverage control over the board. On October 28, 2013, the Delaware Court of Chancery handed down in the case TVI Corporation et al. v. Gallagher, et al.,  a memorandum opinion that serves as a nonprecedential warning to founder directors who, as the controlling group of stockholders, abused their power through self-dealing. In TVI, a group of shareholders of the closely-held corporation, iCueTV, brought a derivative action against three of the founder-directors and a group of non-founder directors alleging that the founder-directors took actions that wrongfully benefitted them while injuring the corporation and its shareholders. To get into court, the shareholders pled demand futility to board actions and inactions by alleging that every member of the board was either self-interested or lacked independence at the time of the challenged transaction, and could not objectively respond to the shareholders’ demands. The Chancery court declined to grant the directors’ motion to dismiss the shareholders’ claim after finding that the shareholders adequately plead demand futility. This case is unique in that the shareholders successfully made demand futility claims regarding both action and inaction of the board.
Normally, shareholders must make a demand to the board of directors to review possible misconduct by directors and officers before pursing an action in court. However, Delaware courts recognize an exception to this rule when a shareholder demand would be futile, Rule 23.1.Delaware courts analyze demand futility claims differently depending upon whether a claim is challenging board action or board inaction. The shareholders’ first three allegations against the defendant directors were analyzed by the court under the two-pronged test for demand futility for board action articulated in Aronson v. Lewis. Shareholders have two options to establish demand futility under Aronson. They may either argue the majority of the directors on the board were interested or lacked independence from the interested directors on the board; or the director did not exercise of valid business judgment on the challenged transaction. A director is interested if (1) he or she stands to receive a personal financial benefit from a transaction that is not equally shared by the stockholders; or (2) the director undertook the challenged action to maintain control of the board. Then the court will look at the facts alleged and determine whether the objectivity of the remaining uninterested directors on the board was compromised by the wills of the interested.
TVI Corp. v. Gallagher involved a corporation that went insolvent following a series of allegedly questionable officer appointments. After declaring insolvency, the major shareholders of the company, who had previously served on the board, brought claims of breach of fiduciary duty. However, they never made the appropriate demand to the board per Delaware Law. To avoid this requirement, the shareholders alleged that any demands regarding board action approving the employment agreements, retroactive approval of funding, and the wrongful removal of he plaintiff shareholders would have been futile under Aronson.
The court determined that the shareholders’ demands as to the employment agreements and the retroactive approval of the founders advanced funding were both excused. The court reasoned that the board’s ability to control the composition and makeup of the board enabled the founders to “leverage control over the company to benefit one another in an ‘I’ll scratch your back, you scratch mine’ type of relationship.” The founder-directors pushed the newly appointed board members to retroactively approve capital advances provided by the founders. This meant that in the case of insolvency, the founders would be repaid before the equity contributing investors. The court concluded that the shareholders’ demand was excused as to the employment agreements and the retroactive approval of the founder’s advances because the founders were interested in the transaction and the non-founders were under the control of the founders.
The second claim of board action against iCueTV founders related to the wrongful removal of major shareholders from the board of directors. The court determined that the founders’ actions were clearly done to maintain control and dominion over the board, thereby excusing the shareholders’ demand of wrongful removal. The court found that the circumstances surrounding the removals of the shareholder directors supported an inference that the founders wrongfully maintained control over the board to insulate their financial interactions with the company from heightened scrutiny. Therefore, the court allowed the shareholders’ claims regarding board action to survive the motion to dismiss due to demand futility.
Next the court considered the shareholders’ demand futility claims of board inaction, specifically the claims of misappropriation and failure to properly oversee the corporation. Under Rales v. Blasband a plaintiff’s demand of board inaction will be excused when particularized factual allegations create a reasonable doubt that the board of directors could have exercised independent and disinterested business judgment in responding to the plaintiff’s demand.  A board of directors exercises objective judgment when considering a demand if they respond free of personal financial interest and free of any improper extraneous influences.
The court excused the shareholders’ demand futility claims as to the board’s inactions of misappropriation of iCueTV assets, and the directors’ failure to properly oversee the corporation. Under Delaware law a director’s duty of loyalty requires them to “scrupulously place the interests of the corporation and shareholders that the directors serves before his or her own interests. One of the founders, Singley, had funded his private law firm with iCueTV’s assets, and the court determined that he had a financial conflict of interest during his tenure as a founder director. Singley was unable to exercise independent business review of the shareholders’ demand to review possible misappropriation.
Lastly, the court excused the shareholders’ demand that the directors had failed to properly oversee iCueTV. The court found that the founders were interested in the failure of the board to exercise proper oversight because this allowed the founders to avoid scrutiny and investigation of their financial dealings with the corporation. Therefore, the court determined that the shareholders plausibly pleaded that the board did not exercise independent and disinterested judgment in responding to the demand.
Lastly, the court dismissed the shareholders’ claims of breach of the duty of care, the derivative claims of failure to exercise proper oversight, disclosure of corporate information to shareholders, and waste of corporate assets. Delaware law entitles corporate directors the protections of the business judgment rule and the court presumes that the directors acted in good faith and in the best interests of the corporation. The shareholders did not sufficiently or specifically plea enough facts to establish a breach of the duty of care or any of its derivative duties. However, the court did find that the shareholders could proceed on breach of duty of loyalty regarding the one founder-director, Singley, due to the fact that he funded his outside law practice with corporate assets.
The impact of TVI Corp. v. Gallagher on the actions of founder-directors is significant as the opinion strongly suggests that a founder-director must avoid self-dealing of corporate assets. Corporate clients should be advised to provide full disclosure to board members about financial decisions and founder-directors might have to recuse themselves from voting on a board matter that provides personal financial benefit. Simply put, clients should conduct major financial decisions in accordance with the corporate bylaws or the articles of incorporation to avoid future litigation.
In a corporation where founders may have been accustomed to wielding broad managerial power, and then shareholder-directors invest in the corporation, the founder-directors must anticipate potential appearances of conflict of interest and avoid such situations. A founder-director’s failure to exercise restraint not only creates a financially costly battle between the founder-directors and the shareholder-directors, but it has tarnished the professional reputation of TVI Corporation and iCueTV. Future potential equity investors will have no reason to trust the board, and as a result, may not invest in the corporation. Had the directors provided full disclosure to all of the board members or recused themselves from voting on such matters, this case may have been avoidable.
 TVI Corporation, et al. v. Gallagher, et al., C.A. No. 7798-VCP, 2013 WL 5809271 at (Oct. 28 Del. Ch. 2013) (Mem. Op.).
 Edward McNally, Court of Chancery Upholds Complaint of Insider Abuse, Delaware Business Litigation Report (Oct. 28, 2013), .
 Id. at *1.
 Del. Ct. Ch. R. 23.1 (stating that the complaint must allege with particularity the efforts made by the plaintiff to obtain the desired action from the directors and the reasons why the plaintiff could not obtain the action).
 Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
 Levine v. Smith, 591 A.2d 194, 205-06 (Del. 1991).
 Aronson, supra note 6, at 812.
 Id. at 816.
 TVI Corporation, et al. v. Gallagher, et al., C.A. No. 7798-VCP, 2013 WL 5809271 at * 18 (Oct. 28 Del. Ch. 2013) (Mem. Op.).
 Id. at *20.
 Id. at *22 (the founders removed four of the plaintiff shareholders during “shotgun” board meetings after requesting that an audit and investigation of the corporation be completed).
 Id. at *23.
 Rales v. Blasband, 634 A.3d 927, 934 (Del. 1993).
 See TVI at *24 (noting examples of extraneous influence include domination by an interested party and a substantial risk of personal of liability).
 Guth v. Loft, Inc., 5 A.2d 503, 510 (1939).
 TVI Corporation, et al. v. Gallagher, et al., C.A. No. 7798-VCP, 2013 WL 5809271 at * 24 (Oct. 28 Del. Ch. 2013) (Mem. Op.).
 Id. at *26.
 Id. at *31.
 Id. at *30.
 Id. at *35.
 Brad Reid, Founders as Directors Must Avoid Self-Dealing, Huffington Post (Oct. 3, 2013, 3:10 PM), https://www.huffingtonpost.com/brad-reid/founders-as-directors-must-avoid_b_4177982.html.