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The Demand Requirement in Derivative Litigation: Part I

Over the next few days, I will be posting a series of blog entires that collectively make up a short monograph on the role the demand requirement plays in derivative litigation. This is an experiment in doing “real” scholarship in the blog format where I think I have something worth saying, but not worth devoting the time and effort that would go into a traditional law review article.

The Demand Requirement

Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit.

Accordingly, Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action. To be sure, the demand must be sufficiently specific as to apprise the board of the nature of the alleged cause of action and to evaluate its merits.[2] “At a minimum, a demand must identify the alleged wrongdoers, describe the factual basis of the wrongful acts and the harm caused to the corporation, and request remedial relief.”[3]

Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[4] The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement.

We will take up the substantive implications of the demand requirement in a fture post. In this post, we focus on the procedural issue of when a shareholder is required to make demand. In particular, we contrast the two leading approaches to the problem—those of New York and Delaware.

New York’s demand futility standard

Demand is required in all cases, except those in which it is excused. Well, you ask, when is it excused? Demand is excused when it is futile. New York restated its demand futility standard in Marx v. Akers.[5] Plaintiff filed a derivative suit against IBM and its directors alleging that the directors had authorized excessive compensation both for themselves and IBM executives. The defendants moved to dismiss on the ground that plaintiff had failed to make demand. As to plaintiff’s claim that the board had approved excessive executive salaries, the court agreed that demand was required. As to the claim that the directors had approved excessive compensation for themselves, however, demand was excused.

In a commendably scholarly opinion, the court identified three bases on which demand is excused under New York law: First, the complaint alleges with particularity that a majority of the board of directors is interested in the challenged transaction. Director interest obviously is present where the directors have a personal self-interest in the challenged transaction. Directors who cause the corporation to enter into a transaction from which they financially benefit, for example, are clearly interested for this purpose.[6] Alternatively, however, director interest may be present where the director has no personal interest in a transaction but is dominated or controlled by a self-interested director.[7]

Second, demand is excused if the complaint alleges with particularity that the board of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances. (Notice the implicit parallel to Delaware’s decision in Smith v. Van Gorkom[8] that the business judgment rule does not protect directors who have made an uninformed judgment.) Consistent with corporate law’s strong formal emphasis on the board’s primacy, Marx makes clear that directors who “passively rubber-stamp” management decisions have not made an informed judgment.[9]

Finally, demand is excused where the complaint alleges with particularity that the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment of the directors. Note the parallel to cases like Litwin v. Allen,[10] which supposedly withdraw the business judgment rule’s protections from directors who have acted irrationally. Because a prerequisite of rationality easily can erode into a prerequisite of reasonableness, courts would do well to reserve this prong of Marx for the legal equivalent of a hundred year flood.

In Marx, the court acknowledged that its earlier decision in Barr v. Wackman[11] had been widely interpreted as creating a lenient standard for demand futility. Whether or not Barr had been read correctly, which the court denied, the court clearly raised the bar in Marx. It is not enough that one director is interested in the transaction or even if several directors are interested (or failed to inform themselves). Instead, demand is excused only when one of the three Marx prongs is satisfied with respect to a majority of the board.[12] The mere fact that a majority of the board is named as defendants does not make them interested for purposes of demand futility. Although being named as defendants may give them a stake in the lawsuit, the requisite interest must be one in the underlying transaction or event. Finally, and perhaps most significantly in light of prior more lenient precedents to the contrary, the mere fact that a majority of the board acquiesced in or approved the transaction is insufficient.

As applied to the case at bar, demand was required with respect to the claim of excessive executive compensation. Only three of the 18 directors were executives and only they had a direct personal interest in such compensation. There was no showing that the 15 outsiders were dominated by interested parties and plaintiff’s “conclusory allegations” that the board had used faulty procedures to calculate executive salaries did not suffice with respect to either of the latter two Marx prongs. With respect to the allegedly excessive director compensation, however, demand was excused. The court adopted a virtual per se rule that directors are interested in their own compensation. Defendants, however, had also moved to dismiss for failure to state a claim. Taking back with one hand what it had given with the other, the court agreed that plaintiff’s “conclusory allegations” did not state a claim.

Delaware’s demand futility standard

As with New York, Delaware requires demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware supreme court set forth the following test for demand futility:

[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[13]

Several aspects of this standard jump out at one. First, did the court really mean to phrase it in the conjunctive? Must plaintiff create a reasonable doubt as to both prongs? In its subsequent Levine v. Smith opinion, the court made clear that the test is in the disjunctive, such that satisfying either prong suffices.[14]

Second, and more significant, what is this business about “reasonable doubt”? This odd phrasing has been widely (and justly) criticized. As Judge (and former corporate law professor) Easterbrook complained:

The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[15]

In defense of the reasonable doubt standard, the Delaware supreme court rather weakly countered that “the term is apt and achieves the proper balance.”[16] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.” As we shall see, however, the standard still needs further tweaking.

Let’s start our analysis of the Aronson standard where the plaintiff begins—at the pleading stage. Because the relevant facts must be plead with particularity, prolix pastiches of conclusory allegations will not cut it.[17] If plaintiffs file without first making pre-suit demand, and defendant(s) move to dismiss for failure to do so, however, the issue of demand futility is decided on the pleadings—plaintiffs are not entitled to discovery.[18] What then is the plaintiff to do? For the most part, plaintiffs must rely on what the Delaware supreme court calls “the tools at hand”;[19] i.e., external sources of information, such as media reports and corporate regulatory filings. In appropriate cases, shareholder-plaintiffs also may invoke their inspection rights to demand pre-suit access to corporate books and records.

We turn then to the substantive standard for demand futility. The confusing and somewhat problematic Aronson standard was helpfully restated in Grimes v. Donald:

One ground for alleging with particularity that demand would be futile is that a “reasonable doubt” exists that the board is capable of making an independent decision to assert the claim if demand were made. The basis for claiming excusal would normally be that: (1) a majority of the board has a material financial or familial interest; (2) a majority of the board is incapable of acting independently for some other reason such as domination or control; or (3) the underlying transaction is not the product of a valid exercise of business judgment. If the stockholder cannot plead such assertions consistent with Chancery Rule 11, after using the “tools at hand” to obtain the necessary information before filing a derivative action, then the stockholder must make a pre-suit demand on the board.[20]

As to the first prong, directors are interested if they have a personal financial stake in the challenged transaction or otherwise would be materially affected by the board’s actions.[21] Consequently, for example, the chancery court excused demand on director interest grounds where five of nine directors approved a stock appreciation rights plan likely to benefit them.[22]

Under the second Grimes prong, the key doctrinal question is whether the directors can base their judgment on the merits rather than on extraneous considerations. Again, demand is not excused simply because the plaintiff has named a majority of the board as defendants.[23] Indeed, it is not enough even to allege that a majority of the board approved of, acquiesced in, or participated in the challenged transaction.[24] In other words, merely being named as defendants or participants does not render the board incapable, as a matter of law, of objectively evaluating a pre-suit demand and, accordingly, does not excuse such a demand. Instead, demand typically will be excused under this prong only if a majority of the board was dominated or controlled by someone with a personal financial stake in the transaction.[25] Directors whose independence is compromised by undue influences exerted by interested parties are presumed, as a matter of law, of being incapable of exercising valid business judgment.

The inquiry under the first two Grimes prongs, which collectively comprise the first Aronson prong, is a highly factual and contextual one. In Cooper Companies, for example, Vice Chancellor Jacobs held that three of ten directors were interested in the challenged transactions because they derived personal benefits from those transactions. A fourth director lacked the requisite independence due to a familial relationship with one of the principal wrongdoers. Two other directors were corporate officers and subordinates of a principal wrongdoer who exercised “considerable influence” over them. Consequently, demand was excused.[26] The third set of directors raised the most difficult questions. Although members of the board are nominally equals, there can be de facto hierarchies within the board. Where board members were nominated and/or elected by a controlling shareholder, for example, concerns over their independence seem legitimate. Likewise, insider board members may be dependent upon other board members for their continued employment. Neither fact standing alone suffices, however, as the Delaware supreme court made clear in Aronson. In that case, the chief alleged wrongdoer owned 47% of the corporation’s stock and allegedly had personally selected each board member. The supreme court held that all of this did not render the board per se incapable of exercising independent judgment. Instead, plaintiff must “demonstrate that through personal or other relationships the directors are beholden to the controlling person.”[27] Consequently, courts should not presume inside directors are subject to improper influence merely by virtue of their employment relationship with the firm.

Turning to the third Grimes prong, should one rephrase it to ask whether the business judgment rule applies to the underlying challenged transaction? Some cases have done so. In Zupnick v. Goizueta,[28] plaintiff conceded that the board was disinterested and independent. Under those circumstances, Vice Chancellor Jacobs properly phrased the test as whether the “particularized factual allegations of the complaint create a reason to doubt” that the board’s decision “was entitled to the protection of the business judgment rule.” In Brehm v. Eisner, the Delaware supreme court adopted a similar approach, emphasizing that the inquiry under this prong focuses on “the directors’ decisionmaking process, measured by concepts of gross negligence.”[29]

In both Zupnick and Brehm, however, plaintiff’s complaint challenged a specific board action; namely, allegedly excessive executive compensation. What about the important class of cases in which plaintiff alleges that the board failed to exercise proper oversight? Recall that the business judgment rule is inapplicable where the board did not exercise business judgment.[30] Is demand therefore automatically excused in oversight cases?

The Delaware supreme court first addressed this question in Rales v. Blasband. Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:

Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[31]

The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.

The Rales standard makes sense as applied to derivative suits brought to enforce corporate rights as against wrongdoers outside the corporation. If the shareholder-plaintiff sued a third party for breach of contract vis-à-vis the corporation, for example, the board obviously ought to have a chance to evaluate the suit before it goes forward. It is less obvious that Rales should apply where the shareholder-plaintiff alleges, for example, that the board failed to adequately supervise corporate employees. Yet, post-Rales decisions have applied its standard to such board oversight cases.[32]

Finally, we turn to appellate review of a chancery court decision on demand futility. Until quite recently, it was assumed that the chancery court’s decision on demand futility was subject to review by the Delaware supreme court solely for abuse of discretion. Indeed, numerous supreme court opinions so stated, going back as far as Aronson itself.[33] In Brehm v. Eisner,[34] however, the Delaware supreme court disavowed all such statements as mere dicta. Because demand futility is decided on the pleadings, the Brehm court held, the chancery court’s decision is subject to de novo review on appeal.

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[1] Federal Rule 23.1 contemplates that demand may be made on shareholders in appropriate cases. A few jurisdictions require demand on shareholders, at least in some cases. See, e.g., Heilbrunn v. Hanover Equities Corp., 259 F. Supp. 936 (S.D.N.Y. 1966) (demand on shareholders excused where wrongdoers hold a majority of corporation’s stock); Mayer v. Adams, 141 A.2d 458 (Del. Ch. 1958) (demand on shareholders excused where alleged wrong could not be ratified by shareholders).

[2] See, e.g., Shlensky v. Dorsey, 574 F.2d 131, 141 (3d Cir. 1978) (demand must be made in writing, be addressed to the board, and provide sufficient specificity to “give the directors a fair opportunity to initiate the action”).

[3] Allison v. Gen. Motors Corp., 604 F. Supp. 1106, 1117 (D. Del.), aff’d mem., 782 F.2d 1026 (3d Cir 1985).

[4] See Levine v. Smith, 591 A.2d 194, 207 (Del. 1991) (“The demand requirement is not a ‘mere formalit[y] of litigation,’ but rather an important ‘stricture[ ] of substantive law.’”); see also Barr v. Wackman, 368 N.Y.S.2d 497, 505 (1975) (“demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits”).

[5] 644 N.Y.S.2d 121 (1996).

[6] Barr v. Wackman, 368 N.Y.S.2d 497 (1975).

[7] Marx v. Akers, 644 N.Y.S.2d. 121, 128 (1996).

[8] 488 A.2d 858 (Del. 1985).

[9] Marx v. Akers, 644 N.Y.S.2d. 121, 128 (1996).

[10] 25 N.Y.S.2d 667 (Sup. Ct. 1940).

[11] 368 N.Y.S.2d 497 (1975).

[12] Marx v. Akers, 644 N.Y.S.2d. 121, 127-28 (1996).

[13] Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).

[14] Levine v. Smith, 591 A.2d 194 (Del. 1991), stating without apologies or blushes that: “The premise of a shareholder claim of futility of demand is that a majority of the board of directors either has a financial interest in the challenged transaction or lacks independence or otherwise failed to exercise due care. On either showing, it may be inferred that the Board is incapable of exercising its power and authority to pursue the derivative claims directly.” Id. at 205 (citations and emphasis in the original omitted; emphasis supplied).

[15] Starrels v. First Nat’l Bank of Chi., 870 F.2d 1168, 1175 (7th Cir. 1989) (Easterbrook, J., concurring) (citations omitted). See also Marx v. Akers, 644 N.Y.S.2d 121, 125 (1996); 2 ALI Principles at 57.

[16] Grimes v. Donald, 673 A.2d 1207, 1217 (Del. 1996).

[17] Brehm v. Eisner, 746 A.2d 244, 249 (Del. 2000).

[18] Rales v. Blasband, 634 A.2d 927, 934 n.10 (Del. 1993); Levine v. Smith, 591 A.2d 194, 208-10 (1991),

[19] Brehm v. Eisner, 746 A.2d 244, 249 (Del. 2000).

[20] Grimes v. Donald, 673 A.2d 1207, 1216 (Del. 1996). The term “majority” should be taken literally. In Kohls v. Duthie, 2000 WL 1041219 (Del. Ch. 2000), for example, demand was excused even though half of the board was deemed capable of impartially assessing the litigation. Id. at *7.

[21] See, e.g., Pogostin v. Rice, 480 A.2d 619, 624 (Del. 1984) (“Directorial interest exists whenever divided loyalties are present, or a director either has received, or is entitled to receive, a personal financial benefit from the challenged transaction which is not equally shared by the stockholders.”); Seminaris v. Landa, 662 A.2d 1350, 1354 (Del. Ch. 1995) (“A director is interested if he will be materially affected, either to his benefit or detriment, by a decision of the board, in a manner not shared by the corporation and the stockholders.”).

[22] Bergstein v. Texas Int’l Co., 453 A.2d 467, 471 (Del. Ch. 1982).

[23] Grimes v. Donald, 673 A.2d 1207, 1216 n.8 (Del. 1996). See also Lewis v. Anderson, 615 F.2d 778, 783 (9th Cir. 1979), cert. denied, 449 U.S. 869 (1980) (“To allow one shareholder to incapacitate an entire board of directors merely by leveling charges against them gives too much leverage to dissident shareholders.”). Recall that the same is true in New York. See Marx v. Akers, 644 N.Y.S.2d 121, 128 (1996). Likewise, directors are not interested for purposes of the first Grimes prong just because they are named as a defendant in the derivative litigation. The “mere threat” of personal liability in connection with the litigation also is not enough, although a “substantial likelihood” of personal liability in connection therewith will excuse demand. Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993); Aronson v. Lewis, 473 A.2d 805, 815 (Del. 1984); Seminaris v. Landa, 662 A.2d 1350, 1354-55 (Del. Ch. 1995). There are cases to the contrary outside Delaware. See, e.g., Abbey v. Control Data Corp., 603 F.2d 724, 727 (8th Cir. 1979) (directors “subject to personal liability in the action cannot be expected to determine impartially whether it is warranted”). Note that the analysis of this issue also tends to merge with the third Grimes prong, in which courts seek to determine whether the transaction involved misconduct sufficiently egregious that the business judgment rule is unlikely to shield the directors from liability. See, e.g., Kohls v. Duthie, 2000 WL 1041219 (Del. Ch. 2000); Seminaris v. Landa, 662 A.2d 1350, 1354-55 (Del. Ch. 1995).

[24] Grimes v. Donald, 673 A.2d 1207, 1216 n.8 (Del. 1996). See also Aronson v. Lewis, 473 A.2d 805, 817 (Del. 1984) (“In Delaware mere directorial approval of a transaction, absent particularized facts supporting a breach of fiduciary duty claim, or otherwise establishing the lack of independence or disinterestedness of a majority of the directors, is insufficient to excuse demand.”). Again, recall that the same is true in New York. See Marx v. Akers, 644 N.Y.S.2d 121, 128 (1996). There are contrary precedents in other jurisdictions, however. See, e.g., Galef v. Alexander, 615 F.2d 51 (2d Cir. 1980) (opining that Ohio law might excuse demand where the directors simply authorized the underlying transaction); cf. Nussbacher v. Chase Manhattan Bank, 444 F. Supp. 973, 977 (S.D.N.Y. 1977) (opining that it is “inconceivable that directors who participated in and allegedly approved of the transaction under attack can be said to have exercised unbiased business judgment in declining suit based on that very transaction”).

[25] See Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984) (“where officers and directors are under an influence which sterilizes their discretion, they cannot be considered proper persons to conduct litigation on behalf of the corporation”); cf. Marx v. Akers, 644 N.Y.S.2d 121, 125 (1996) (describing Delaware law).

[26] In re Cooper Cos., Inc. Shareholders Derivative Litigation, 2000 WL 1664167 at *7 (Del. Ch. 2000).

[27] Aronson v. Lewis, 473 A.2d 805, 815 (Del. 1984). See also Polar Intern. Brokerage Corp. v. Reeve, 108 F. Supp.2d 225, 247 n.38 (S.D.N.Y. 2000).

[28] 698 A.2d 384 (Del. Ch. 1997).

[29] Brehm v. Eisner, 746 A.2d 244, 259 (Del. 2000) (emphasis in original).

[30] See § ___.

[31] Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993).

[32] See, e.g., Kohls v. Duthie, 2000 WL 1041219 at *4-5 (Del. Ch. 2000); Seminaris v. Landa, 662 A.2d 1350, 1354 (Del. Ch. 1995).

[33] See, e.g., Scattered Corp. v. Chi. Stock Exch., 701 A.2d 70, 72-73 (Del. 1997); Grimes v. Donald, 673 A.2d 1207, 1217 n. 15 (Del. 1996); Heineman v. Datapoint Corp., 611 A.2d 950, 952 (Del. 1992); Levine v. Smith, 591 A.2d 194, 207 (Del. 1991); Grobow v. Perot, 539 A.2d 180, 186 (Del. 1988); Pogostin v. Rice, 480 A.2d 619, 624-25 (Del. 1984); Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).

[34] 746 A.2d 244, 254-54 (Del. 2000).

© Stephen M. Bainbridge, William D. Warren Professor of Law, UCLA School of Law, 2007