Demand and Demand Futility | Brian JM Quinn | November 15, 2013

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Demand and Demand Futility

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

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.

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  1. 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 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. 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. 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. 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. 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. 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. 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.

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May 26, 2014

shareholder litigation demand futility derivative

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