In the

United States Court of Appeals For the Seventh Circuit ____________________ No. 19-2755 TRAVIS DORVIT and MICHAEL MARTIN, derivatively on behalf of POWER SOLUTIONS INTERNATIONAL, INC., Plaintiffs-Appellees,

v.

GARY S. WINEMASTER, et al., Defendants-Appellees,

and

POWER SOLUTIONS INTERNATIONAL, INC., Nominal Defendant-Appellee,

APPEAL OF: GARY MCFADDEN, derivatively on behalf of POWER SOLUTIONS INTERNATIONAL, INC., Intervenor-Objector- Appellant. ____________________

Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 17-cv-01097 — Thomas M. Durkin, Judge. ____________________ 2 No. 19-2755

ARGUED FEBRUARY 13, 2020 — DECIDED FEBRUARY 28, 2020 ____________________

Before FLAUM, MANION, and BARRETT, Circuit Judges. FLAUM, Circuit Judge. The named plaintiff in a failed state derivative action seeks to reverse the district court’s approval of a settlement in a related federal suit. The court below ade- quately considered the propriety of the settlement’s terms and we now affirm. I. Background A. Facts Gary Winemaster founded Power Solutions International, Inc. (PSI) as a private company in 1985. The company designs, makes, and distributes engines and power systems to equip- ment manufacturers around the world. Winemaster served as PSI’s Chairman, President, and CEO until resigning in 2017. In 2011, PSI merged with an existing corporation and be- came a publicly traded company. From the time of the merger until his resignation, Winemaster and his brother were PSI’s majority shareholders. As a public company, PSI began im- plementing (apparently suboptimal) internal controls and re- porting standards. The company’s early annual 10-K filings with the Securities and Exchange Commission noted that PSI’s “internal controls over financial reporting” suffered 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 disclo- sures, beginning with a revision to its earnings guidance. PSI No. 19-2755 3

eventually admitted that it needed to restate two full fiscal years’ financial statements. PSI’s auditor resigned, its share price plummeted, and the government began investigating the company. It became clear that PSI had improperly recog- nized millions of dollars in revenue. In early 2017, Winemas- ter resigned from all three of his leadership roles. In March 2017, PSI announced that Weichai America Corp. (Weichai), a Chinese diesel engine manufacturer, planned to buy a 20% equity stake in the company with the option to pur- chase additional common stock up to a majority position. As part of the deal, Weichai could select two new directors, en- larging PSI’s board from five 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 unaffiliated with the company during the pe- riod of alleged misconduct. In June 2017, PSI’s former chief operating officer filed a whistleblower complaint alleging he had been terminated be- cause he reported PSI’s violation of Generally Accepted Ac- counting Principles and securities laws. In July 2019, the fed- eral 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 the Northern District of Illinois. (The direct lawsuit is not at issue in this appeal.) In February 2017, plaintiff Travis Dorvit filed a derivative complaint on 4 No. 19-2755

behalf of PSI in the same District, alleging fiduciary breach and unjust enrichment against certain of PSI’s officers and di- rectors. In March 2017, the district court stayed the derivative case pending PSI’s motion to dismiss the class action. In April 2018, plaintiff Michael Martin filed a second de- rivative suit in federal court, which was transferred to Judge Durkin below. Dorvit and Martin then filed a joint verified second amended derivative complaint. It realleged most of the same claims as before, with additional claims against PSI’s five new directors who had been seated in the interim. In July 2018, the parties in the class action settled and the district court subsequently lifted the stay in the derivative suit. On October 1, 2018, both the individual defendants and the company moved to dismiss the derivative suit; PSI con- tended that the plaintiffs had failed to make a pre-suit de- mand on the board of directors. The parties then began mediation and settlement negotia- tions, executing an agreement in May 2019. The settlement called for a monetary award of $1.875 million from PSI’s di- rector and officer liability insurers, of which plaintiff’s coun- sel would get half. The rest of the money would be earmarked for expenses related to the government’s investigations. The settlement also required the formal enactment of seventeen corporate governance reforms, primarily focusing on strengthening the work and integrity of the company’s audit functions. In exchange, the plaintiffs agreed to a release against the individual defendants, including Winemaster. The plaintiffs moved the district court to preliminarily ap- prove the settlement, but the court asked for further reassur- ance regarding the corporate reforms. The parties prepared a No. 19-2755 5

plain-language explanation of each of the reforms, and in late May 2019 the court granted preliminary approval. Before discussing the settlement’s final approval, we turn to the parallel state cases. In May 2017, two plaintiffs filed state derivative actions on behalf 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 claims against PSI’s accountants. Intervenor Gary McFadden even- tually substituted as lead plaintiff on this state derivative ac- tion. In November 2018, the state court dismissed the McFad- den 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, filing his objections to the settlement between its preliminary and final approvals. He argued that the monetary component was insufficient, particularly as half would be go- ing 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 settlement plan. The judge took note of the fact that, because a majority of PSI’s board was unaffili- ated with the company during the time in question, any de- rivative plaintiff would have a serious issue meeting Dela- ware’s demand futility standard. Determining that the corpo- rate governance reforms were meaningful, the district court overruled the objections and granted final approval to the set- tlement. 6 No. 19-2755

McFadden timely appealed. While this case awaited argu- ment here, the Illinois Appellate Court affirmed the dismissal of McFadden’s state court derivative action. II. Discussion McFadden asks us to find that the district court abused its discretion in approving the settlement of the plaintiffs’ deriv- ative claims. We expect district courts, in assessing proposed settlements, 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 quota- tion marks and citation omitted). “[I]n reviewing the appro- priateness of the settlement approval or disapproval, the re- viewing court should intervene only upon a clear showing that the trial court was guilty of an abuse of discretion.” Id. Here, the district court adequately weighed “the probabil- ities 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 significant weight on the demand futil- ity issue, which is a critical, substantive aspect of derivative suits. A. Derivative Actions and Demand Futility As a preliminary matter, we find it helpful to briefly dis- cuss 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. An- dreas, 134 F.3d 873, 875 (7th Cir. 1998). Because corporate de- cisions (such as suing on its behalf) are typically in the hands No. 19-2755 7

of the board of directors, derivative suits represent an anom- aly of corporate governance. “Only when the corporation’s board defaults in its duty to protect the interests of the inves- tors” may a plaintiff pursue a derivative suit. Id. For this reason, the Federal Rules of Civil Procedure place a special pleading requirement on would-be derivative plain- tiffs. Rule 23.1(b)(3) requires that derivative plaintiffs plead with particularity their reasons for not attempting to compel the company’s board to take a desired course of action. We refer to this obligation as a derivative action’s “demand futil- ity” requirement. The upshot is that derivative plaintiffs must show that a court should usurp the business judgment rule, which nor- mally protects directors’ decisions. See In Re Abbott 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 where “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.” Abbott, 325 F.3d at 807 (citing Aronson, 473 A.2d at 814). The district court noted that there was a significant chance that, had it ruled on PSI’s motion to dismiss the derivative 8 No. 19-2755

suit, it would have found the demand futility requirement un- met. 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 plain- tiffs were unlikely to establish that a majority of the directors were conflicted or lacked independence. McFadden does not meaningfully address this point, ar- guing instead that demand futility is “merely one aspect of a shareholder derivative lawsuit” and a “procedural, pleading requirement” that is “separate from the substantive merits” of the claim. This is incorrect and squarely contradicted by prec- edent: “The function of the demand futility doctrine … is a matter of substance, not procedure.” Westmoreland Cty. Em- ployee Ret. Sys. v. Parkinson, 727 F.3d 719, 722 (7th Cir. 2013) (citing Kamen v. Kemper Fin. Servs., 500 U.S. 90, 96 (1991)). Be- cause derivative actions by their very nature require a show- ing 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 district 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, particularly in light of the whistle- blower and criminal suits against PSI. As discussed above, McFadden misunderstands the nature of a derivative suit: the ability to demonstrate demand futility is a substantive ele- ment of the strength of such an action. No. 19-2755 9

McFadden claims that “[a]ll told, whether or not the Fed- eral Plaintiffs could satisfy Rule 23.1’s pleading requirements is not –– and cannot be –– dispositive for the purposes of weighing the strengths of the derivative claims here.” That is incorrect. If a plaintiff cannot show demand futility in a case, that disposes of his derivative claim. In sum, the district court’s close attention to the demand futility weakness in the plaintiffs’ claims was appropriate. We now turn to McFadden’s claims that the district court abused its discretion in approving the monetary award and the cor- porate governance reforms. B. Money Damages McFadden claims that the settlement’s $1.875 million in money damages was insufficient when compared to the po- tential recovery should the derivative suit have proceeded. Though we have elucidated several factors to guide a district court’s analysis of whether a proposed settlement is fair, reasonable, and ad- equate, we have repeatedly stated that the most important factor relevant to the fairness of a class action settlement is ... the strength of plain- tiff’s case on the merits balanced against the amount offered in the settlement. Kaufman v. Am. Express Travel Related Servs. Co., Inc., 877 F.3d 276, 284 (7th Cir. 2017) (internal quotation marks and citations omitted). McFadden argues that the total monetary award should have been higher, particularly where the plaintiffs’ lawyers were going to be awarded over $900,000. But McFad- den’s argument is hampered by the fact that, as discussed, the ability to show demand futility is a substantive component of 10 No. 19-2755

the strength of the derivative case. That plaintiffs’ ability to show demand futility is doubtful weighs in favor of a smaller monetary award. Kaufman concerned the approval of a class action settle- ment, another area (besides derivative suits) where courts typically review terms agreed to by private parties. Id. at 279. There, intervenors objected to a proposed $1.8 million settle- ment, the figure that the district court found appropriate con- sidering the defendants’ possible arbitration defense. We de- clined to hold that the district court abused its discretion in approving the settlement: The Intervenors argue that the district court im- properly analyzed this factor by giving too much weight to Amex’s potential arbitration de- fense. The district court concluded there was a significant risk that this court would reverse the district court’s decision and send the action to arbitration, where the Plaintiffs would likely re- ceive nothing. Because of that risk, the district court concluded that the approximately $1.8 million the class would receive from the settle- ment was a reasonable recovery. Id. at 285. Here, the district court similarly discounted the strength of the plaintiffs’ case because of the risk of dismissal for lack of demand futility. The court’s detailed analysis of this factor tracked our precedent’s requirements. In the approval hear- ing, the court explained: No. 19-2755 11

I have to determine whether or not the settle- ment is fair, reasonable, adequate, and should be approved. The amount of the defendants’ settlement offer compared to the strength of the case, it is some- thing versus nothing. This case could have … been dismissed. Not saying it would, but it could have been dismissed. And I think the par- ties recognized—especially the plaintiffs recog- nized—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 settlement not occurred, there’d be in- evitable—even more expenses going against the insurance policy, which ultimately would harm the company when that policy had been com- pletely eroded, all for a result which probably wouldn’t be any better than what we have, which is a number of substantive corporate gov- ernance reforms. So for all those reasons, I believe the settlement is fair, reasonable, adequate, and should be ap- proved. McFadden has not proposed an alternate monetary figure, let alone provided a reasonable justification for one. In these 12 No. 19-2755

circumstances, the district court did not abuse its discretion by approving the $1.875 million in money damages. C. Corporate Governance McFadden next asserts that the proposed corporate gov- ernance reforms—which would be formalized under the set- tlement—lack substance. Specifically, McFadden insists that PSI already undertook a number of these reforms prior to set- tlement, so their formalization is mere window dressing. This claim fails because, as the district court recognized, many of the proposed seventeen reforms had been under- taken prior to the settlement but after the company’s investi- gation into its revenue recognition problems began. McFad- den fails to distinguish between these timeframes. The de- fendants and plaintiffs convincingly argue that these reform efforts began after the malfeasance, and the district court was correct to acknowledge that there is value in having such re- quirements written and formalized. Moreover, McFadden failed to properly object to fifteen of the reforms, limiting his criticisms below to two of the seven- teen. The following colloquy at the approval hearing is illu- minating. THE COURT: Well, are there—I saw nothing from you with a proposal—other proposals for corporate governance, which is typically one of the remedies in a case like this. But I saw noth- ing from you proposing new corporate govern- ance 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, they go beyond mere window dressing. Below is the plain-lan- guage description of each reform and the practice that pre- ceded it:

1. The Audit Committee must meet at least six times per year.  (Formerly) The Audit Committee must meet quarterly.

2. The Director of Internal Audit must be a sen- ior vice president (or higher).  (Formerly) No prior requirements for the Di- rector of Internal Audit existed.

3. The Audit Committee Charter will require the Director of Internal Audit to communicate at least quarterly with the Chief Financial Officer, Chief Executive Officer, and Audit Committee, attend all Audit Committee meetings, and meet at least quarterly with the Audit Committee.  (Formerly) None of these requirements ex- isted.

4. The Audit Committee must meet quarterly with the Company’s Auditors, without manage- ment present, to discuss candidly any audit problems or difficulties and management’s re- sponses to the Auditor’s efforts to resolve such problems. 14 No. 19-2755

 (Formerly) Although the Charter currently requires the Audit Committee to conduct such meetings, it did not specify the number or fre- quency of these meetings.

5. The Audit Committee must discuss and re- view with management quarterly the Com- pany’s major financial 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 Committee must annually review the Company’s procedures for monitoring com- pliance with laws and regulations, the Com- pany’s code of conduct and other policies relat- ing to compliance with laws and regulations.  (Formerly) The Charter previously did not specify the frequency of these reviews.

7. The Audit Committee must publish its Char- ter on the Company’s website and keep it up to date.  (Formerly) None of these requirements ex- isted.

8. The Director of Internal Audit must: (a) re- port directly to the Audit Committee, (b) com- municate at least quarterly with the Chief Fi- nancial Officer, Chief Executive Officer and Au- dit Committee, (c) attend all Audit Committee No. 19-2755 15

meetings, and (d) meet at least quarterly with the Audit Committee.  (Formerly) None of these requirements ex- isted.

9. The Director of Internal Audit must have full and free access to the Audit Committee and vice versa.  (Formerly) No formal policy regarding the Director of Internal Audit’s access to the Audit Committee existed.

10. The Director of Internal Audit must report the audit findings to the Audit Committee, in- cluding which findings may relate to the effec- tiveness and adequacy of the Company’s inter- nal controls, risk management and governance processes.  (Formerly) No formal policy about the Di- rector of Internal Audit’s reports to the Audit Committee existed.

11. The Director of Internal Audit must keep the Audit Committee informed of emerging trends in relevant internal control issues and internal audit matters and provide the Audit Committee with a report of outstanding audit issues and the current status of management’s efforts to re- solve and improve the control environment.  (Formerly) No formal policy for the Director of Internal Audit’s reports to the Audit Commit- tee existed. 16 No. 19-2755

12. The Internal Audit Department must keep a log tracking analysis, proposals, and recom- mendations provided to other departments or management regarding internal controls and accounting and auditing procedures, including the time and place (if applicable) that such in- formation was provided, and any deadlines re- lated thereto.  (Formerly) None of these requirements ex- isted.

13. The Company must hold an annual meeting of stockholders within forty-five (45) days after the filing of its proxy statement.  (Formerly) The Company had not previ- ously committed to a timetable for holding its next annual meeting.

14. Revise the Company’s Bylaws and Corpo- rate Governance Guidelines to require that the Board maintain standing Audit, Compensation, and Nominating and Governance Committees.  (Formerly) The Bylaws did not require the Board to maintain any specific standing com- mittees, and the Corporate Governance Guide- lines only required that the Board maintain an Audit Committee.

15. The Company must publish on its website all Board committee charters, biographies of the Company’s Directors and Officers, and a chart No. 19-2755 17

or list identifying the members of each Board committee publicly available.  (Formerly) The Company published only two of the three Board Committee charters (with the Nominating and Governance Charter not currently published) on its website. It does not publish biographies of the directors or offic- ers or a listing of the members of each Board Committee on its website.

16. The Company must adopt a formal claw- back policy covering specified incentive com- pensation of Officers.  (Formerly) No claw-back policy existed.

17. The Company must ensure that the contact information for its whistleblower hotline and website is conspicuously displayed and widely posted on its website, at the Company’s offices 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 require- ment 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 committee, its au- dit 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 Plaintiff Adequacy Finally, McFadden briefly posits that the existing federal plaintiffs are inadequate. Federal Rule of Civil Procedure 23.1(a) states that a “derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.” Because half of the monetary damages went to plaintiffs’ counsel, and because the federal plaintiffs stayed the case while a direct class action was in briefing, McFadden claims the plaintiffs failed to adequately represent PSI’s sharehold- ers. As to the fees, the district court analyzed the basis and propriety of the amount in extensive detail during the ap- proval hearing. The judge determined that the requested at- torneys’ fees represented “excellent” work done for two me- diation sessions, multiple complaint drafts, motion to dismiss briefing, and pre- and post-complaint research and investiga- tion. The judge also cited the settlement’s endorsement by the well-regarded mediator. We find 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 authority showing that such a delay was unusual, let alone inappropri- ate. McFadden raises another point: that the federal plaintiffs do not meet contemporaneous ownership requirements. The No. 19-2755 19

district court found that, because plaintiffs alleged a continu- ing offense, “they are plaintiffs who can claim damages for owning stock during a period when the company was alleg- edly engaging in accounting malfeasance.” Again, McFadden does not identify any error in the district court’s analysis and thus forfeited any relevant argument. III. Conclusion For the foregoing reasons, we AFFIRM the judgment of the district court.