### In the 

# United States Court of Appeals For the Seventh Circuit

____________________ No. 19-2755

T RAVIS D ORVIT and M ICHAEL M ARTIN , derivatively on behalf of P OWER S OLUTIONS I NTERNATIONAL , I NC ., Plaintiffs-Appellees ,

v.

G ARY S. W INEMASTER , et al. , Defendants-Appellees , and

P OWER S OLUTIONS I NTERNATIONAL , I NC ., Nominal Defendant-Appellee ,

A PPEAL OF : G ARY M C F ADDEN , derivatively on behalf of P OWER S OLUTIONS I NTERNATIONAL , I NC ., Intervenor-ObjectorAppellant.

____________________ Appeal from the United States District Court for the Northern District of Il linois, Eastern Division. No. 17-cv-01097 — Thomas M. Durkin , Judge

.

____________________2 No. 19-2755

A RGUED F EBRUARY 13, 2020

— D ECIDED F EBRUARY 28, 2020

____________________

Before F LAUM , M ANION , and B ARRETT , Circuit Judges

. F LAUM , Circuit Judge . The named plainti ff in a failed state derivative action seeks to reverse the district court’s approval of a se tt lement in a related federa l suit. The court below adequately considered the propriety of the se tt lement’s terms and

we now a ffi rm. I. Background

A. Facts Gary Winemaster founded Power Solutions International, Inc. (PSI) as a private compan y in 1985. The company designs,makes, and distributes engines and power systems to equipment manufacturers around the world. Winemaster served as PSI’s Chairman, President, an d CEO until resigning in 2017.In 2011, PSI merged with an existing corporation and became a publicly traded company. From the time of the merger until his resignation, Winemast er and his brother were PSI’smajority shareholders. As a public company, PSI began implementing (apparently suboptim al) internal controls and reporting standards. The company’s early annual 10-K fi lings with the Securities and Exchange Commission noted that PSI’s “internal controls over fi nancial reporting” su ff ered from “material weakness.” Nonetheless, over the course of 2013, PSI’s per share price rocketed from $16.18 to $75.10. PSI’s shares sustained a high valuation until August 2015.At that time, the company began making a series of disclosures, beginning with a revision to its earnings guidance. PSINo. 19-2755 3

eventually admi tt ed that it needed to restate two full fi scal years’ fi nancial statements. PSI’s auditor resigned, its share price plummeted, and the government began investigatingthe company. It became clear that PSI had improperly recognized millions of dollars in revenue. In early 2017, Winemaster resigned from all three of his leadership roles. In March 2017, PSI announced that Weichai America Corp. (Weichai), a Chinese diesel en gine manufacturer, planned to buy a 20% equity stake in the co mpany with the option to purchase additional common stock up to a majority position. Aspart of the deal, Weichai could select two new directors, enlarging PSI’s board from fi ve to seven seats. In the aftermath of the investment, four existing PSI directors resigned. By the time the board’s realignment was complete, six of PSI’s seven directors were una ffi liated with the company during the period of alleged misconduct. In June 2017, PSI’s former chief operating o ffi cer fi led awhistleblower complaint alleging he had been terminated because he reported PSI’s violation of Generally Accepted Accounting Principles and securities laws. In July 2019, the federal government charged Winemaster with multiple criminal fraud counts.

B. Procedural History There were multiple parallel suits in federal and state court related to this case. We begin with a summary of the federal suits. In 2016, PSI was sued for breach of federal securities laws in a purported class action in th e Northern District of Illinois. (The direct lawsuit is not at issu e in this appeal.) In February 2017, plainti ff Travis Dorvit fi led a derivative complaint on4 No. 19-2755

behalf of PSI in the same District, alleging fi duciary breach and unjust enrichment against certain of PSI’s o ffi cers and directors. In March 2017, the district court stayed the derivative case pending PSI’s motion to dismiss the class action. In April 2018, plainti ff Michael Martin fi led a second derivative suit in federal court, which was transferred to Judge Durkin below. Dorvit and Martin then fi led a joint veri fi ed second amended derivative complaint. It realleged most of the same claims as before, with additional claims against PSI’s fi ve new directors who had been seated in the interim. In July 2018, the parties in the class action se tt led and the district court subsequently lifte d the stay in the derivative suit. On October 1, 2018, both the individual defendants andthe company moved to dismiss the derivative suit; PSI contended that the plainti ff s had failed to make a pre-suit demand on the board of directors. The parties then began mediation and se tt lement negotiations, executing an agreement in May 2019. The se tt lementcalled for a monetary award of $1.875 million from PSI’s director and o ffi cer liability insurers, of which plainti ff ’s counsel would get half. The rest of the money would be earmarked for expenses related to the government’s investigations. The

se tt lement also required the formal enactment of seventeen corporate governance reforms, primarily focusing on strengthening the work and inte grity of the company’s audit functions. In exchange, the plainti ff s agreed to a release against the individual defend ants, including Winemaster. The plainti ff s moved the district court to preliminarily approve the se tt lement, but the court asked for further reassurance regarding the corporate re forms. The parties prepared aNo. 19-2755 5

plain-language explanation of each of the reforms, and in late May 2019 the court granted preliminary approval. Before discussing the se tt lement’s fi nal approval, we turn to the parallel state cases. In May 2017, two plainti ff s fi led state derivative actions on beha lf of PSI in the Cook County Court of Chancery. The state court eventually deemed one complaint operative. It was substantively identical to Dorvit’s initial federal complaint but included additional claimsagainst PSI’s accountants. Intervenor Gary McFadden eventually substituted as lead plainti ffon this state derivative action.In November 2018, the state court dismissed the McFadden complaint, ruling that the federal derivative suit sought identical relief and the state case was thus duplicative. McFadden appealed the dismissal and then intervened in the federal case, fi ling his objections to the se tt lement between its preliminary and fi nal approvals. He argued that the monetary component was insu ffi cient, particularly as half would be going to lawyers, and that the proposed governance reforms lacked substance. McFadden further objected to the release of liability against Winemaster. During the approval hearing, the district court considered the objections to the se tt lement plan. The judge took note of the fact that, because a majority of PSI’s board was una ffi liated with the company during the time in question, any derivative plainti ffwould have a serious issue meeting Delaware’s demand futility standard . Determining that the corporate governance reforms were me aningful, the district court overruled the objections and granted fi nal approval to the settlement.6 No. 19-2755

McFadden timely appealed. Whil e this case awaited argument here, the Illinois Appellate Court a ffi rmed the dismissal of McFadden’s state court derivative action.

II. Discussion

McFadden asks us to fi nd that the district court abused its discretion in approving the se tt lement of the plainti ff s’ derivative claims. We expect district courts, in assessing proposed

se tt lements, to “weigh the probabilities and possibilities of victory or defeat as indicated by the legal or factual situation presented and determine whether the compromise, taken as a whole, is in the best interest of the corporation and all its shareholders.” United Founders Life Ins. Co. v. Consumers Nat. Life Ins. Co. , 447 F.2d 647, 655 (7th Cir. 1971) (internal quotation marks and citation omi tt ed). “[I]n reviewing the appropriateness of the se tt lement approval or disapproval, the reviewing court should interven e only upon a clear showing that the trial court was guilty of an abuse of discretion.” Id.Here, the district court adequately weighed “the probabilities and possibilities of victory or defeat” and it did not abuse its discretion. As explored below, it was appropriate for the district court to place signi fi cant weight on the demand futility issue, which is a critical, substantive aspect of derivative suits.
A. Derivative Actions and Demand Futility As a preliminary ma tt er, we fi nd it helpful to brie fl y discuss the nature of a derivative suit. “A derivative suit is brought by an investor in the corporation’s (not the investor’s) right to recover for injury to the corporation.” Felzen v. Andreas , 134 F.3d 873, 875 (7th Cir. 1998). Because corporate decisions (such as suing on its be half) are typically in the handsNo. 19-2755 7

of the board of directors, deri vative suits represent an anomaly of corporate governance. “Only when the corporation’s board defaults in its duty to pr otect the interests of the investors” may a plainti ff pursue a derivative suit. Id. For this reason, the Federal Rules of Civil Procedure placea special pleading requirement on would-be derivative plainti ff s. Rule 23.1(b)(3) requires that derivative plainti ff s plead with particularity their reasons for not a tt empting to compel the company’s board to take a desired course of action. We refer to this obligation as a de rivative action’s “demand futility” requirement. The upshot is that derivative plainti ff s must show that acourt should usurp the business judgment rule, which normally protects directors’ decisions. See In Re Abbo tt Labs. Deriv. S’holders Litig. , 325 F.3d 795, 807 (7th Cir. 2003) (“[D]emand can only be excused where facts are alleged with particularity which create a reasonable doubt that the directors’ action was entitled to the protections of the business judgment rule.” (quoting Aronson v. Lewis , 473 A.2d 805, 808 (Del. 1984))).

In Aronson , as we have explained, the Delaware Supreme Court laid out the familiar two-prong test for demand futility, holding it is established wher e “the alleged particularized facts raise a reasonable doubt that either (1) the directors are disinterested or independent or (2) the challenged transaction was the product of a valid exercise of the directors’ business judgment.” Abbo tt , 325 F.3d at 807 (citing Aronson , 473 A.2d at 814).
The district court noted that there was a signi fi cant chance that, had it ruled on PSI’s motion to dismiss the derivative8 No. 19-2755

suit, it would have found the demand futility requirement unmet. Because the board in place at the time of the operative complaint had a majority of new directors who could not be tied to the company’s revenue recognition issues, the plainti ff s were unlikely to establish that a majority of the directors

were con fl icted or lacked independence. McFadden does not meaningfully address this point, arguing instead that demand futility is “merely one aspect of a shareholder derivative lawsuit” and a “procedural, pleading requirement” that is “separate fr om the substantive merits” ofthe claim. This is incorrect and squarely contradicted by precedent: “The function of the demand futility doctrine ... is a

ma tt er of substance, not procedure.” Westmoreland Cty. Employee Ret. Sys. v. Parkinson , 727 F.3d 719, 722 (7th Cir. 2013) (citing Kamen v. Kemper Fin. Servs. , 500 U.S. 90, 96 (1991)). Because derivative actions by their very nature require a showing that the board cannot act as it should, the allegations demonstrating this inability are substantive. Contrary to McFadden’s argument, the demand futility requirement is not a mere technical, procedural hurdle. Demand futility is a substantive sine qua non of derivative suits.

McFadden contends that the di strict court put too much weight on the demand futility issue, and essentially should have performed a more “holistic” analysis that gave greater consideration to the strength of the underlying breach and unjust enrichment claims, partic ularly in light of the whistleblower and criminal suits against PSI. As discussed above, McFadden misunderstands the natu re of a derivative suit: the ability to demonstrate demand futility is a substantive element of the strength of such an action.No. 19-2755 9

McFadden claims that “[a]ll to ld, whether or not the Federal Plainti ff s could satisfy Rule 23.1’s pleading requirements is not –– and cannot be –– dispositive for the purposes of weighing the strengths of the de rivative claims here.” That is incorrect. If a plainti ff cannot show demand futility in a case, that disposes of his derivative claim. In sum, the district court’s close a tt ention to the demand futility weakness in the plainti ff s’ claims was appropriate. We now turn to McFadden’s claims th at the district court abused its discretion in approving th e monetary award and the corporate governance reforms.

B. Money Damages
McFadden claims that the se tt lement’s $1.875 million in money damages was insu ffi cient when compared to the potential recovery should the derivative suit have proceeded. Though we have elucidated several factors to guide a district court’s analysis of whether a proposed se tt lement is fair, reasonable, and adequate, we have repeatedly stated that the most important factor relevant to the fairness of a class action se tt lement is ... the strength of plainti ff ’s case on the merits balanced against the
amount o ff ered in the se tt lement. Kaufman v. Am. Express Travel Related Servs. Co., Inc. , 877 F.3d 276, 284 (7th Cir. 2017) (internal quotation marks and citations omi tt ed). McFadden argues that the total monetary award should have been higher, particularly where the plainti ff s’lawyers were going to be awarded over $900,000. But McFadden’s argument is hampered by th e fact that, as discussed, the ability to show demand futility is a substantive component of10 No. 19-2755

the strength of the derivative case. That plainti ff s’ ability to show demand futility is doubtful weighs in favor of a smaller monetary award. Kaufman concerned the approval of a class action se tt lement, another area (besides deri vative suits) where courts typically review terms agreed to by private parties. Id. at 279. There, intervenors objected to a proposed $1.8 million se tt lement, the fi gure that the district court found appropriate considering the defendants’ possible arbitration defense. We declined to hold that the district court abused its discretion in approving the se tt lement:The Intervenors argue that the district court improperly analyzed this factor by giving toomuch weight to Amex’s potential arbitration defense. The district court concluded there was a signi fi cant risk that this court would reverse the district court’s decision and send the action to arbitration, where the Plainti ff s would likely receive nothing. Because of that risk, the district court concluded that the approximately $1.8 million the class would receive from the se tt lement was a reasonable recovery.
Id. at 285. Here, the district court sim ilarly discounted the strength of the plainti ff s’ case because of the risk of dismissal for lack of demand futility. The court’s detailed analysis of this factortracked our precedent’s requirements. In the approval hearing, the court explained:No. 19-2755 11

I have to determine whether or not the se tt lement is fair, reasonable, adequate, and should be approved.

The amount of the defendants’ se tt lement o ff ercompared to the strength of the case, it is something versus nothing. This case could have ... been dismissed. Not saying it would, but itcould have been dismissed. And I think the parties recognized—especially the plainti ff s recognized—the shaky grounds by which this case could have proceeded. To extract any money in a derivative case I agree is unusual. And in this case, it is—it is real money. It is $937,000 or more, depending on the amount of fees I approve, if I lower the request for fees.

... Had the se tt lement not occurred, there’d be inevitable—even more expenses going against the insurance policy, which ultimately would harmthe company when that policy had been completely eroded, all for a result which probably wouldn’t be any be tt er than what we have,which is a number of substantive corporate governance reforms. So for all those reasons, I believe the se tt lementis fair, reasonable, adequate, and should be approved. McFadden has not proposed an alternate monetary fi gure, let alone provided a reasonable justi fi cation for one. In these12 No. 19-2755

circumstances, the district court did not abuse its discretion by approving the $1.875 million in money damages.

C. Corporate GovernanceMcFadden next asserts that the proposed corporate governance reforms—which would be formalized under the settlement—lack substance. Speci fi cally, McFadden insists thatPSI already undertook a number of these reforms prior to settlement, so their formalization is mere window dressing. This claim fails because, as the district court recognized,many of the proposed seventeen reforms had been undertaken prior to the se tt lement but after the company’s investigation into its revenue recogn ition problems began. McFadden fails to distinguish betw een these timeframes. The defendants and plainti ff s convincingly argue that these reform

e ff orts began after the malfeasance, and the district court wascorrect to acknowledge that there is value in having such requirements wri tt en and formalized. Moreover, McFadden failed to properly object to fi fteen ofthe reforms, limiting his criticisms below to two of the seventeen. The following colloquy at the approval hearing is illuminating. THE COURT: Well, are there—I saw nothing from you with a proposal—other proposals for corporate governance, which is typically one ofthe remedies in a case like this. But I saw nothing from you proposing new corporate governance proposals that go beyond what are here, just an objection to two of the 17, saying they’re already doing it. Have I correctly summarized your objection?No. 19-2755 13

MR. CHANG: Yes, that’s correct. Turning to the substance of the reforms themselves, theygo beyond mere window dressing. Below is the plain-language description of each refo rm and the practice that preceded it:

1. The Audit Commi tt ee must meet at least six times per year.

 (Formerly) The Audit Commi tt ee must meet quarterly.

2. The Director of Internal Audit must be a senior vice president (or higher).

 (Formerly) No prior requirements for the Director of Internal Audit existed.

3. The Audit Commi tt ee Charter will require the Director of Internal Audit to communicate at least quarterly with the Chief Financial O ffi cer, Chief Executive O ffi cer, and Audit Commi tt ee,

a tt end all Audit Commi tt ee meetings, and meet at least quarterly with the Audit Commi tt ee.

 (Formerly) None of these requirements existed.

4. The Audit Commi tt ee must meet quarterlywith the Company’s Auditors, without management present, to discuss candidly any audit problems or di ffi culties and management’s responses to the Auditor’s e ff orts to resolve such problems.14 No. 19-2755

 (Formerly) Although the Charter currently requires the Audit Commi tt ee to conduct suchmeetings, it did not specify the number or frequency of these meetings.

5. The Audit Commi tt ee must discuss and review with management quarterly the Company’s major fi nancial risk exposure and the steps management takes to implement plans to monitor and mitigate such risks.

 (Formerly) The Charter previously did not specify the frequency of these reviews.

6. The Audit Commi tt ee must annually reviewthe Company’s procedures for monitoring compliance with laws and regulations, the Company’s code of conduct and other policies relating to compliance with laws and regulations.

 (Formerly) The Charter previously did not specify the frequency of these reviews.

7. The Audit Commi tt ee must publish its Charter on the Company’s website and keep it up to date.

 (Formerly) None of these requirements existed.

8. The Director of Internal Audit must: (a) report directly to the Audit Commi tt ee, (b) communicate at least quarterly with the Chief Financial O ffi cer, Chief Executive O ffi cer and Audit Commi tt ee, (c) a tt end all Audit Commi tt eeNo. 19-2755 15

meetings, and (d) meet at least quarterly with the Audit Commi tt ee.

 (Formerly) None of these requirements existed.

9. The Director of Internal Audit must have full and free access to the Audit Commi tt ee and vice

versa.

 (Formerly) No formal policy regarding the Director of Internal Audit’s access to the Audit Commi tt ee existed.

10. The Director of Internal Audit must report the audit fi ndings to the Audit Commi tt ee, including which fi ndings may relate to the e ff ectiveness and adequacy of the Company’s internal controls, risk management and governance processes.

 (Formerly) No formal policy about the Director of Internal Audit’s reports to the Audit Commi tt ee existed.

11. The Director of Internal Audit must keep the Audit Commi tt ee informed of emerging trends in relevant internal control issues and internal audit ma tt ers and provide the Audit Commi tt ee with a report of outsta nding audit issues and the current status of management’s e ff orts to resolve and improve the control environment.

 (Formerly) No formal policy for the Directorof Internal Audit’s reports to the Audit Committee existed.16 No. 19-2755

12. The Internal Audit Department must keep alog tracking analysis, proposals, and recommendations provided to other departments or management regarding internal controls and accounting and auditing procedures, includingthe time and place (if applicable) that such information was provided, and any deadlines related thereto.

 (Formerly) None of these requirements existed.

13. The Company must hold an annual meeting of stockholders within forty- fi ve (45) days after the fi ling of its proxy statement.

 (Formerly) The Company had not previously commi tt ed to a timetable for holding its next annual meeting.

14. Revise the Company’s Bylaws and Corporate Governance Guidelines to require that the Board maintain standing Audit, Compensation, and Nominating and Governance Commi tt ees.

 (Formerly) The Bylaws did not require the Board to maintain any speci fi c standing commi tt ees, and the Corporate Governance Guidelines only required that the Board maintain an Audit Commi tt ee.

15. The Company must publish on its website all Board commi tt ee charters, biographies of the Company’s Directors and O ffi cers, and a chartNo. 19-2755 17

or list identifying the members of each Board commi tt ee publicly available.

 (Formerly) The Company published only two of the three Board Commi tt ee charters (with the Nominating and Governance Charter not currently published) on its website. It does not publish biographies of the directors or o ffi cers or a listing of the members of each Board Commi tt ee on its website.

16. The Company must adopt a formal clawback policy covering speci fi ed incentive compensation of O ffi cers.

 (Formerly) No claw-back policy existed.

17. The Company must ensu re that the contact information for its whistleblower hotline and website is conspicuously displayed and widely posted on its website, at the Company’s o ffi ces and elsewhere, so as to be available to not only employees but also to customers, vendors, and other third parties.

 (Formerly) There was no formal requirement that the whistleblower hotline be posted on the Company’s website or that information be widely posted and displayed.

These reforms strike us as substantive and meaningful: they mandate an increased frequency of activity, meetings, and reporting among the company’s audit commi tt ee, its audit team, outside auditors, and senior leadership. Further, they increase transparency regarding PSI’s board of directors,18 No. 19-2755

create a claw-back policy, and enhance the visibility of its whistleblowing mechanisms. It was not an abuse of discretion to approve these measures.

D. Federal Plainti ff Adequacy Finally, McFadden brie fl y posits that the existing federal plainti ff s are inadequate. Federal Rule of Civil Procedure 23.1(a) states that a “derivative action may not be maintained if it appears that the plainti ff does not fairly and adequately represent the interests of sh areholders or members who are similarly situated in enforcing the right of the corporation or association.” Because half of the monetary damages went to plainti ff s’ counsel, and because the federal plainti ff s stayed the case while a direct class action was in brie fi ng, McFadden claims the plainti ff s failed to adequately represent PSI’s shareholders. As to the fees, the distri ct court analyzed the basis and propriety of the amount in ex tensive detail during the approval hearing. The judge determined that the requested attorneys’ fees represented “excellent” work done for two mediation sessions, multiple compla int drafts, motion to dismiss brie fi ng, and pre- and post-complaint research and investigation. The judge also cited the se tt lement’s endorsement by the well-regarded mediator. We fi nd no basis to overturn the judge’s thorough review and conclusion, and McFadden does not point to any analytical error. As to the stay of the federal derivative case, McFadden neglects to identify any authorityshowing that such a delay was unusual, let alone inappropriate. McFadden raises another point: that the federal plainti ff s do not meet contemporaneous ownership requirements. TheNo. 19-2755 19

district court found that, because plainti ff s alleged a continuing o ff ense, “they are plainti ff s who can claim damages forowning stock during a period when the company was allegedly engaging in accounting malfeasance.” Again, McFadden does not identify any error in th e district court’s analysis and thus forfeited any relevant argument.

III. Conclusion For the foregoing reasons, we A FFIRM the judgment of the district court.