In H&N Management Group, Inc. & Aff Cos Frozen Money Purchase Plan v. Robert M. Couch et al., No. 12847-VCMR (Del. Ch. Ct. August 1, 2017), the Court of Chancery denied defendants’ motion to dismiss and held that plaintiffs sufficiently alleged a reason to doubt that the board of AGNC Investment Corp (the “Company”) was adequately informed when approving (i) subsequent renewals of a management agreement between the Company and American Capital Mortgage Management, LLC (the “Manager”) as well as (ii) the acquisition of the Manager for a price of $562 million.

The Company is a Delaware corporation that is a real estate investment trust (“REIT”) investing primarily in mortgage-backed securities and was externally managed by the Manager pursuant to a management agreement that was automatically renewed in 2014, 2015, and 2016; the Manager was paid over $100 million annually under the management agreement and this constituted the Company’s largest annual expense. The Manger also managed and provided the same services to another, smaller REIT, American Capital Mortgage Investment Corporation (“MTGE”) for less than $20 million annually. Both the Company and MTGE had the same board from February 2013 until May 2016 and shared a number of executive officers. In 2016, the Company purchased the Manager for $562 million dollars cash.

H&N Management Group, Inc and AFF Cos Frozen Money Purchase Plan (together, “H&N”) are two investment groups that held shares in the Company and alleged that, among other things, the individual defendants breached their fiduciary duties by subsequently renewing the management agreement and by not acting in the best interests of the Company when purchasing the Manager for $562 million. The defendants moved to dismiss for failure to make demand under Court of Chancery Rule 23.1 and failure to state a claim for breaches of fiduciary duty under Court of Chancery Rule 12(b)(6). The Chancery Court noted that Rule 23.1 is a “more onerous” pleading standard than Rule 12(b)(6) and, so long as the complaint “contains sufficient facts to state a cognizable claim, it necessarily will survive the Rule 12(b)(6) notice pleading standard.” The Chancery Court found that H&N’s complaint alleged particularized facts to state a cognizable claim.

In order to bring a derivative action under Rule 23.1, H&N must either (i) allege the efforts it made to obtain an action from the directors and the reasons for H&N’s failure to obtain such action or (ii) allege that demand on the board is futile. In this case, H&N alleged that demand on the board was futile. Given the board acted by renewing the management agreement and approving the acquisition of the Manger, the Court of Chancery applied the Aronson test. Under Aronson, demand is futile if “a reasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgement.” Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984). Specifically, H&N challenged whether the board satisfied the second prong of the Aronson test for both the renewals and the acquisition.

With respect to the renewals of the management agreement, the Chancery Court found that H&N raised a reasonable doubt that the board of the Company was adequately informed. The management agreement is the board’s largest yearly business decision in terms of expenditures and the complaint sufficiently alleged that (1) the board and the compensation committee, who the board tasked with evaluating the management agreement, did not commit enough time to considering this expense (typically around 15 minutes per year were spent on this issue), (2) the compensation committee only received information from the self-interested Manager, (3) the compensation committee members were conflicted because they also owed fiduciary duties to MTGE, (4) the non-renewal of the management agreement would directly affect MTGE, and (5) the compensation committee never retained independent advisors. The Chancery Court noted that there was nothing in the record or minutes of the Company to defeat these allegations.

With respect to the acquisition of the Manager, the Chancery Court similarly found that H&N raised a reason to doubt that the board of the Company was adequately informed. In determining whether to purchase the Manager and the purchase price for the transaction, the board and the committee tasked with evaluating the transaction relied heavily on Gary Kain, a conflicted individual who was a fiduciary of the Company, MTGE, and the Manager. The committee was aware of Kain’s conflict but still “allowed him to dominate their process, dictate the transaction structure, and direct the ultimate deal terms” without sufficient oversight.

H&N Management Group, Inc. & Aff Cos Frozen Money Purchase Plan v. Robert M. Couch et al., No. 12847-VCMR (Del. Ch. Ct. August 1, 2017)