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From Securities Regulation Daily, February 5, 2015

Shareholder challenge to Smith & Wesson board misses the mark

By John M. Jascob, J.D.

A shareholder of Smith & Wesson Holding Corporation (Smith & Wesson) has failed to establish claims that certain officers and directors breached their fiduciary duties by falsely touting high sales figures for the company’s long guns in the face of collapsing consumer demand. The First Circuit Court of Appeals affirmed dismissal of the derivative suit, holding that the corporation properly rejected the plaintiff’s demand to pursue the litigation after an investigation conducted by the board’s special litigation committee found insufficient evidence of wrongdoing (Sarnacki v. Golden, February 4, 2015, Lynch, S.).

Background and allegations. The suit was just one of several actions alleging that Smith & Wesson falsely represented the prospects for the company’s new rifle and shotgun business between June 2007 and October 2007, despite being aware that inventory far exceeded demand. In the midst of that litigation, the plaintiff, Aaron Sarnacki, filed a derivative complaint on behalf of the corporation, asserting Nevada state-law claims against certain officers and directors for breach of fiduciary duties, waste of corporate assets, and unjust enrichment.

After a three-member special litigation committee appointed by the Smith & Wesson board found insufficient evidence of any breach of fiduciary duty, the defendants moved for summary dismissal based on the committee’s final report. The district court initially denied the motion without prejudice and ordered limited discovery on Sarnacki’s challenge to the adequacy of the committee’s investigation. After discovery, however, the court dismissed Sarnacki’s claims, holding that he failed to establish that the special litigation committee lacked independence or failed to conduct a reasonable, good faith inquiry (see Securities Regulation Daily Wrap Up for March 17, 2014).

Independence. On appeal, the First Circuit affirmed, holding that the undisputed facts demonstrated that the board had met its burden under Delaware law, as adopted by the Nevada courts, as to the committee’s independence and good faith inquiry. Although rejecting as incorrect the district court’s theory that Sarnacki had tacitly conceded the issue of independence by making a demand on the board, the appellate panel observed that Sarnacki had offered no evidence of actual bias or extraneous considerations that affected either the committee’s investigative process or its ultimate recommendation. Moreover, the committee did not use in-house counsel, a disapproved practice, but chose independent counsel.

Sarnacki had argued that two of the three committee members could not be independent because: (1) they were defendants in the case; and (2) as members of the audit committee, they reviewed and approved many of the allegedly misleading statements. The First Circuit declined to apply such a per se rule, noting that if a committee member's status as a defendant in the litigation categorically subverted the independence of the committee, a shareholder would be able to manipulate the process by simply naming the members as defendants after the committee's formation, thereby undercutting the legitimacy of its conclusions. Further, the realities of corporate governance, in which some corporations have small boards, suggest that a special litigation committee will frequently include at least one director who also approved the relevant transaction, the court stated.

Good faith and reasonableness. The appellate court also rejected Sarnacki’s argument that the committee did not conduct a reasonable, good faith inquiry because it abdicated its responsibilities by placing the entire investigation in the hands of counsel.  The court observed that reliance on experienced outside counsel is often taken as evidence that a special litigation committee has conducted its investigation reasonably and in good faith, not the opposite. Moreover, there was no adverse inference to be drawn about the members delegating the discovery methodology or filtering decisions to counsel. In this case, the members had personally reviewed the relevant documents and made the final decisions about the contents of the report, and the plaintiff cited no authority for the proposition that relying on counsel for discovery decisions, without more, is unreasonable or a sign of bad faith.

The court also dismissed Sarnacki’s contention that the special litigation committee’s counsel had engaged in "heavy reliance" on discovery by the defendants' counsel in a related federal securities class action, and that this should have been a "red-flag warning" to the committee that they needed to supervise their counsel more closely. This argument was fatally flawed, the court concluded, because there was no evidence that the special litigation committee’s counsel was biased or conflicted.  Rather, the committee’s choice to save costs and avoid duplication in discovery by using what had already been produced in the securities action was eminently sensible.

The case is No. 14-1414.

Attorneys: Terence K. Ankner (Partridge, Ankner & Horstmann, LLP), Gerald Barrett (Ward Kennan & Barrett PC) and Ashley R. Palmer (Robbins Arroyo LLP) for Aaron Sarnacki. Francis Daniel Dibble, Jr. (Bulkley, Richardson and Gelinas, LLP), Jennifer Martin Foster (Greenberg Traurig, LLP) and Jason C. Moreau (McDermott Will & Emery) for Michael F. Golden, John A. Kelly, Barry M. Monheit, Kenneth W. Chandler, John B. Furman, I. Marie Wadecki and Smith & Wesson Holding Corp.

Companies: Smith & Wesson Holding Corp.

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