Stockholder Litigation | Brian JM Quinn | November 15, 2013


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Stockholder Litigation

Original Creator: Brian JM Quinn Current Version: Brian JM Quinn Show/Hide

Before we turn to too much more case law, it is important to understand the particular procedural aspects of the stockholder litigation that we will be reading. Because the litigation involves stockholders, directors, and the corporation, it is procedurally different than litigation you may have seen until now in law school.

The source of these differences is often a question about who gets to speak for and vindicate the rights of the corporation – the board or the stockholder. Resolution of this question is especially important when it is the board itself that is accused of wrong-doing against the corporation.


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  1. 1 Show/Hide More Direct and Derivative Suits
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    Officers and directors of Delaware corporations are subject to the jurisdiction of Delaware courts under Delaware's long-arm statute for lawsuits related to the corporation and their duties as directors and officers of the corporation. By virtue of incorporating in Delaware and maintaining an agent in Delaware for service of process, directors of a Delaware corporation, no matter where they are, can be served by making service on the corporation's agent as listed in the corporation's certificate of incorporation.

    Stockholders may bring different kinds of litigation against the corporation. Direct suits are brought on behalf of the stockholder in the stockholder's capacity as a stockholder and seek to vindicate the rights of the stockholder. Derivative suits are brought by stockholders on behalf of the corporation and seek to vindicate the rights of the corporation. Stockholders seeking to bring a derivative action on behalf of the corporation must comply with  the requirements of Chancery Rule 23.1.

    Many times the most important question in stockholder litigation turns on the type of litigation that is at issue. Stockholders may attempt to characterize the litigation as direct in order to maintain control, while boards may attempt to characterize the question before the court as derivative in order to assert control over the litigation and end it. Understanding the distinction between direct and derivative suits can be confusing. However, there is a coherent test (Tooley) for determining which is which.

    1. 1.2 Show/Hide More Delaware long arm statute
      Original Creator: Brian JM Quinn
      You might wonder how it is the case that a corporate director sitting in New York or Massachusetts could be subject to the jurisdiction of the courts of Delaware. The short answer is that all persons who agree to become corporate directors also consent to jurisdiction of the Delaware courts under Delaware's “long arm statute.”
    2. 1.3 Show/Hide More DGCL § 321 - Service of process
      Original Creator: Brian JM Quinn
      You may have wondered why the corporate law statute requires that the corporation name a registered agent, along with an address in the state of Delaware, in its certificate of incorporation.  The registered agent plays an important role in ensuring corporate officers and directors are subject to the jurisdiction of the Delaware courts for the purpose of stockholder litigation and other litigation related to the corporation.
    3. 1.4 Show/Hide More DGCL Sec. 327 - Derivative actions
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      In order to have standing in derivative litigation, a stockholder must have already been a stockholder at the time of the bad act that gave rise to the litigation. This requirement prevents people from observing some bad act and then buying into a lawsuit. 
    4. 1.5 Show/Hide More Delaware Rules, Rule 23.1
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      The Delaware Rules of Civil Procedure lay out rules for bringing and maintaining a stockholder derivative action. Compliance with these rules is necessary in order for a claim to stay in court. Often times, defendants will move to dismiss a plaintiff's claim for failure to comply with the requirements of Rule 23.1.  

      The Rule 23.1 Motion to Dismiss often revolves around the characterization of the claim (direct v. derivative) and the independence of the directors (demand required/demand futility).

    5. 1.6 Show/Hide More Tooley v. Donaldson Lufkin, & Jenrette, Inc.
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      In Tooley, the court was asked to determine whether shareholder litigation is direct or derivative. Rather than rely on a more traditional, and cumbersome, “special injury” test, the court in Tooley announced a new, simpler test for determining whether a stockholder action is direct or derivative.

      Since Tooley other jurisdictions, like New York, have abandoned their own versions of the special injury in favor of specifically adopting Delaware's Tooley standard.

    6. 1.7 Show/Hide More Gentile v. Rossette
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      Because there are important procedural hurdles to bringing a derivative suit, it oftentimes becomes an important point of contention between the parties whether the particular litigation is direct or derivative. This case is an example of that problem in action. Note how the court applies the Tooley test to assist it in answering the question whether the claims are direct (and thus properly brought by the stockholder) or are derivative in nature (requiring the stockholder to make a demand on the board and thus lose control over the litigation).

      This opinion is a decision on a Rule 23.1 Motion to Dismiss (“MTD”). Much shareholder litigation lives or dies at this stage. The 23.1 MTD battle is typically fought on two grounds: 1) character of the litigation; and 2) demand futility.

      With respect to the character of the litigation, the defendant board will typically attempt characterize the litigation as derivative and then will argue since the plaintiff failed to make a demand on the board as required under Rule 23.1 for derivative litigation, and for that reason the court should dismiss the litigation in favor of the defendant board.  For its part, plaintiff will attempt to characterize the litigation as direct, thus ensuring that the case cannot be dismissed on procedural grounds. 

      We will take up demand futility later in this chapter.

  2. 2 Show/Hide More Demand and Demand Futility
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    As we know, the corporate law places the board of directors in a central place with respect to the management of the corporation. Section 141(a) and its mandate that the board manage the business and affairs of the corporation extends naturally to control over any legal claims that the corporation may have. Claims of the corporation against third parties are relatively simple to deal with. Stockholders have little reason to worry that a board might not pursue claims against third parties. Legal claims against the corporation's own board of directors or the corporation's own agents, on the other hand, are more troublesome.

    It may not be realistic to expect the board to pursue potential legal claims owned by the corporation against themselves. The derivative action permits stockholders in certain circumstances to stand in the shoes of the corporation to vindicate rights of the corporation that its own directors will not pursue.

    The ability of stockholders to take up litigation on behalf of the corporation is not unlimited.

    In order to preserve the central importance of the board in the management of the corporation, courts will require shareholders who wish to sue on behalf the corporation to jump through certain procedural hoops.

    Consequently, procedure plays an extremely important role in derivative litigation. This section provides an overview to procedural requirements in derivative cases. In particular, Rule 23.1 requires that in any complaint, a statement that the stockholder made a “demand” to the corporation or if they did not why such a demand would have been “futile”. Many cases will be resolved on a Rule 23.1 Motion to Dismiss for failure of the stockholder to make a demand when a demand was required.

    1. 2.1 Show/Hide More Aronson v. Lewis
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      Because derivative litigation is properly litigation that “belongs” to the corporation, stockholders bringing derivative litigation should be the exception rather than the rule.  The requirement that a stockholder make a demand on the board prior to bringing derivative litigation is a recognition of this fact.

      The court in Aronson lays out one test for determining whether a plaintiff in a derivative suit will be relieved of the “demand” requirement. If making a demand on the board would be “futile”, a stockholder plaintiff will be free to bring a derivative claim on behalf of the corporation without first asking the board to take action. In order to establish that demand is futile under Rule 23.1 and the Aronson test, plaintiffs must allege sufficient facts in the complaint as to call into question the business judgment presumption.

    2. 2.2 Show/Hide More Rales v. Blasband
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      In Rales, the court announces a second, alternative, test for demand futility. The focus on the inquiry under the Aronson test is the challenged transaction and questions the interestedness and independence of directors with respect to the challenged transaction. In Rales the court's focus of analysis is different because Rales is applied in circumstances where there is no particular transaction to challenge. Rather, the focus of the analysis is on whether board would be able to fairly consider the stockholder's demand had it been made.

      The claim here involves a “double derivative suit.” In a double derivative suit, stockholders of a parent corporation bring suit against the parent of a wholly-owned subsidiary on behalf of the subsidiary corporation. 

      Notice that this case is presented as a certified question. The Delaware Supreme Court is one of the very few state supreme courts in the country that accepts certified questions. It often does so to resolve novel questions of the Delaware corporate law that arise before other courts. In Rales, the question presented to the Delaware Supreme Court was raised by a US federal district court.

    3. 2.3 Show/Hide More Guttman v. Huang
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      In Guttman, the court applies the Rales standard in the context of a Rule 23.1 Motion to Dismiss. One question the court deals with here is whether it is sufficient under Rales to merely name a director as a defendant in a complaint in order to establish that the director is interested to the extent that the director cannot fairly decide on a demand.
    4. 2.4 Show/Hide More Beam v. Stewart
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      Beam is a ruling on a defendant's 23.1 motion to dismiss. In the 23.1 motion, the defendants are arguing that demand was not futile under the relevant test (Rales in this case), and plaintiffs should have properly made demand. Plaintiffs argue that they didn't make demand because doing so would have been futile because of the board's lack of independence from Martha Stewart and the fact that Stewart was interested in the transaction.

      The Chancery Court articulated the standard at issue here in the following way:

      “Because this claim does not challenge an action of the board of directors of MSO, the appropriate test for demand futility is that articulated in Rales v. Blasband. Particularly, the Court's task is to evaluate whether the particularized allegations “create a reasonable doubt that, as of the time the complaint [was] filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Rales requires that a majority of the board be able to consider and appropriately to respond to a demand “free of personal financial interest and improper extraneous influences.” Demand is excused as futile if the Court finds there is “a reasonable doubt that a majority of the Board would be disinterested or independent in making a decision on demand.”"

      It is important to your understanding of Beam to remember that when the court approaches the question of interestedness and independence of the board in a 23.1 motion to dismiss, the board enjoys the benefit of the business judgment presumption. That means the plaintiff in its pleadings must allege facts to overcome that presumption. Mere statements that board members are either interested or not independent will not be sufficient to establish demand futility.

    5. 2.5 Show/Hide More Shoen v. SAC Holding Corp.
      Original Creator: Brian JM Quinn
      Shoen is a Nevada case. In Shoen, the Nevada Supreme Court adopts the Delaware standards (Aronson and Rales) for determination of demand futility. The Nevada high court's discussion of both standards provides a clear overview and restatement of both tests and their application to pleadings. Shoen is also an example of how state courts around the country look to the Delaware courts for guidance as they form their corporate law.  Through cases like Shoen you can begin to appreciate Delaware's outsized influence in the corporate law arena.
    6. 2.6 Show/Hide More Spiegel v. Buntrock - Wrongful refusal of demand
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      If a board receives and then refuses demand, the stockholder may not bring a derivative claim on behalf of the corporation. Of course, if a board could just refuse demand without regard to the merits of the demand, the demand requirement would devolve into a toothless exercise. Consequently, when a board refuses demand, the good faith and reasonableness of the board's refusal may still be examined by the courts. 

      However, a board's decision to refuse demand is a business decision, like any other. As a result, such decisions receive the protection of the business judgment presumption.  In challenging a demand refusal, a stockholder will have to plead particularized facts with respect to the board's decision to refuse demand as to overcome the business judgment presumption. 

    7. 2.7 Show/Hide More Brehm v. Eisner
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      Aronson test include two prongs. The first prong deals with the interestedness and lack of independence of directors who approve a challenged transaction. The second prong deals with transactions that are not the product of a valid business judgment. In the following case, the interestedness of the board of Disney is not seriously at issue. Consequently, plaintiffs are left to argue that the board's approval of the challenged employment agreement was not the product of a valid business judgment so therefore demand upon the board would be futile.
    8. 2.8 Show/Hide More In Re The Goldman Sachs Group, Inc. Shareholder Litigation
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

      In the case that follows, the Chancery Court considers the defendant's Rule 23.1 motion to dismiss.  In a 23.1 motion, the defendant argues that the complaint should be dismissed for lack of standing.  The defendant argues that the plaintiff lacks standing because it did not comply with the requirements of 23.1, typically failure to make demand when demand is not futile.

      As is required in such cases, in the Goldman case the court reviews the interestedness and independence of each director in order to determine whether demand was futile. However in this particular case, the court applies both Aronson and Rales.

  3. 3 Show/Hide More Special Litigation Committees
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    In situations where demand is futile, stockholders can file derivative litigation without making demand. Does that mean that boards have forever lost control over the derivative litigation? In some circumstances the answer is no.

    The following cases lay out the doctrine with respect to how a board can retake control over derivative litigation in later stages.

    Unlike in the case of demand and demand futility, at this stage of the litigation, boards bear the burden of proving that notwithstanding the fact that demand was previously futile, the board is now in a position to fairly consider the facts of the complaint.  As you will see, this is a heavy burden for a board to bear.

    1. 3.1 Show/Hide More Zapata Corp. v. Maldonado
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      Zapata is the leading case on standard a court will apply to a special litigation committee's attempt to take control over derivative litigation at a later stage – following the 23.1 motion to dismiss and prior to going to trial.
    2. 3.2 Show/Hide More In re Oracle Corp. Derivative Litigation
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      At the later stages of shareholder litigation, a board may use a special litigation committee to attempt to take control of litigation back from shareholders. However, at that time the burden of proof with respect to the independence of the board and its special committee have shifted. The special committee bears the burden of proving its independence. At this stage, facts that might not have been troublesome at the 23.1 stage take on a different light.
  4. 4 Show/Hide More 220 Actions and Tools at Hand
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    Stockholders have a statutory right to access the books and records of the corporation. This power is an extremely important tool for stockholders to monitor the actions the board of directors and to root wrong-doing or malfeasance. However, the right to monitor a corporation's books and records is also subject to limitations. In the following cases we learn about using the “tools at hand” and the limits to their use.

    Courts – as in Beam v. Stewart – regularly exhort plaintiffs to use Section 220 to seek out books and records prior to filing derivative complaints.  However, the 220 process can be lengthy.  Consequently, the economics of plaintiff litigation make it difficult for plaintiffs to both pursue 220 litigation and also maintain control positions in early filed derivative litigation. This challenge makes 220 actions a less than perfect vehicle for curbing the excesses of the litigation industrial complex. 

    1. 4.1 Show/Hide More DGCL Sec. 220 - Inspection of books and records
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      Stockholders who comply with the requirements of §220 can access the books and records of the corporation. 
    2. 4.2 Show/Hide More Seinfeld v. Verizon Communications Inc.
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      Sec 220 – stockholder inspection rights
    3. 4.3 Show/Hide More LAMPERS v Lennar Corp
      Original Creator: Brian JM Quinn Current Version: Brian JM Quinn
      What are the standards for a 220 books and records action? PL must have a proper purpose and a credible basis for believing further investigation will uncover mismanagement
  5. 5 Show/Hide More Settlements and D&O Insurance
    Original Creator: Brian JM Quinn Current Version: Brian JM Quinn

    Few shareholder lawsuits end up going to trial. More often, they settle. The unique combination of incentives for directors, plaintiffs, and Directors & Officers insurance lead to this outcome.

    The PAETEC opinion is the result of a settlement hearing where both the plaintiffs and the defendants come to court with a memorandum of understanding with respect to a settlement. Ordinarily, such proceedings are not all that exciting. In our adversarial system, when the plaintiff and defendant are in agreement there is little for a court to rule on except the amount of the fee for counsel if any.

    Sometimes, a plaintiff who is not represented by the plaintiff's counsel may object to the proposed settlement for their own reasons. The presence of an “objector” can give the court an opportunity to weigh in on the substance of the voluntary settlement between the parties.


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June 10, 2016

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