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The Demand Requirement in Derivative Litigation: Part V

This is the last in a series of posts that collectively constitute a short monograph on the role of the demand requirement in derivative litigation. We’ve acknowledged the oddity that demand has become the linchpin in determing whether the board will be able to terminate derivative litigation. In this final post, we consider alternatives that would deemphasize the demand requirement.

The demand requirement is, at least in part, a corollary of the basic proposition that a derivative action is representative in nature. The demand requirement thus allows the corporation to take over the cause of action or to resist it, according to the judgment of the directors. Under both Delaware and New York law, however, the demand requirement has been charged with an additional task; namely, functioning as the principal sieve by which meritorious shareholder litigation is separated from the chaff. If the board of directors is so clearly disabled by conflicted interests that its judgment cannot be trusted, the shareholder should be permitted to go forward, absent intervention by a special litigation committee. If not, the board should be allowed to decide whether the litigation should proceed.

Although an inquiry into the board’s ability to exercise disinterested judgment seems warranted, it is not at all clear that the demand requirement is a necessary—or even appropriate—vehicle for undertaking said inquiry. Both the ALI Principles and the Model Business Corporation Act have done away with the demand futility inquiry. In its place, both have imposed a universal demand requirement, while preserving, albeit in different forms, a sieve to identify cases in which the board’s conflicted interests preclude deference to board decisions.

MBCA § 7.44

MBCA § 7.42 requires a written demand upon the board in all cases and, further, precludes a shareholder from bringing suit for 90 days after the demand is made unless irreparable injury would result or the board rejects demand. MBCA § 7.44 then takes over, providing two alternatives for internal corporate review of the demand: If the independent and disinterested directors constitute a quorum, the demand may be reviewed by the board. Whether or not the independent directors constitute a quorum, the independent directors may appoint by majority vote a committee of two or more independent directors.[1]

As under both New York and Delaware law, directors can be deemed independent even if they were nominated by the defendants, area named as a defendants, or they approved the challenged transaction. If either the board or committee “determined in good faith after conducting a reasonable inquiry upon which its conclusions are based that the maintenance of the derivative proceeding is not in the best interests of the corporation” the court “shall” dismiss the complaint.[2] If a majority of the board was independent at the time that determination was made, the burden of proof with respect to the board’s independent disinterest and the adequacy of its investigation is on plaintiff; if a majority of the board was not independent, the burden of proof is on the defendant. The comments to § 7.44 make clear that the MBCA’s drafters rejected Zapata: “Section 7.44 does not authorize the court to review the reasonableness of the determination” made by the board or committee. So long as the determination has “some support” in the findings of the inquiry, the standard is satisfied.

ALI Principles Part VII

As for the ALI Principles, years of controversy and repeated drafting efforts, including last-minute amendments from the floor, produced an astonishingly long and complex set of rules and commentary that basically tracks Delaware law, albeit adding (among other wrinkles) a universal demand requirement.[3] Principles § 7.03(b) requires demand in all cases, excepting only those in which plaintiff demonstrates that irreparable injury to the corporation would result. In the following sections, covering well over 100 pages (counting commentary and reporters’ notes), the Principles distinguish and provide for judicial review of two basic categories of cases.

The first set of cases is comprised of proceedings against persons other than directors, senior executives, or controlling persons of the corporation. A board recommendation to dismiss a derivative suit against such non-insiders is reviewed under the business judgment rule.[4] The second set comprises suits against directors, senior executives, or controlling persons of the corporation. Judicial review of a derivative proceeding against such insiders is further bifurcated, with the scope of review effectively depending on whether the cause of action is premised on a breach of the duty of care or the duty of loyalty. In the former case, the court should apply the business judgment rule to a recommendation to dismiss made by the disinterested directors (acting either as the board or a committee thereof).[5] In the latter case, subject to a convoluted exception for certain cases in which defendants would retain an improper personal benefit, the court should dismiss the proceeding upon such a recommendation “if the court finds . . . that the board or committee was adequately informed under the circumstances and reasonably determined that dismissal was in the best interests of the corporation, based on grounds that the court deems to warrant reliance.”[6]

Evaluating universal demand

Does any of this matter? The demand futility inquiry mandated by both New York and Delaware law has been subjected to considerable criticism. Judge Frank Easterbrook contends, for example, that the demand futility inquiry produces “gobs of litigation” collateral to the merits. In a derivative proceeding under the federal Investment Company Act against fund directors, Easterbrook therefore fashioned a federal common law of derivative proceedings that included a universal demand requirement.[7] As Professor Michael Dooley notes, “the usually highly perceptive Judge Easterbrook [was led into this] reversible error” by a misunderstanding of the demand futility inquiry’s function.[8]

Determining the scope of judicial review of any board of director decision requires one to make trade-offs between preserving the board’s decisionmaking authority and ensuring that the board has not misused its authority for the personal benefit of board members. In the derivative litigation context, New York and Delaware have used the demand futility inquiry as the vehicle by which those trade-offs are made. Replacing the demand futility inquiry with a universal demand requirement does not eliminate the need to separate out those cases in which conflicted interests have so tainted the board’s decisionmaking processes as to preclude giving the resulting decisions the deference usually accorded them by corporate law. Instead, as the drafters of both the ALI Principles and the MBCA appear to have recognized, it simply shifts the task of effecting such a separation to a different stage of the process.

The only justification for a universal demand therefore seems to be the claim that it conserves judicial resources. In its perceptive unanimous opinion reversing Judge Easterbrook, the Supreme Court explained that a universal demand requirement was unlikely to produce much in the way of judicial economy. In support of Easterbrook’s universal demand rule, the defendants contended such a rule “would force would-be derivative suit plaintiffs to exhaust their intracorporate remedies before filing suit and would spare both the courts and the parties the expense associated with the often protracted threshold litigation that attends the collateral issue of demand futility.” In rejecting defendants’ argument, the Court first noted the federalism implications of creating universal demand requirement as a matter of federal common law. “Under KFS’ proposal, federal courts would be obliged to develop a body of principles that would replicate the substantive effect of the State’s demand futility doctrine but that would be applied after demand has been made and refused.” Doing so would impinge on the states’ power to regulate corporations, as well as subjecting corporations to conflicting standards in state and federal litigation. The court then turned to the purported judicial economies of a federal universal demand rule:

Requiring demand in all cases, it is true, might marginally enhance the prospect that corporate disputes would be resolved without resort to litigation; however, nothing disables the directors from seeking an accommodation with a representative shareholder even after the shareholder files his complaint in an action in which demand is excused as futile. At the same time, the rule proposed by KFS is unlikely to avoid the high collateral litigation costs associated with the demand futility doctrine. So long as a federal court endeavors to reproduce through independent review standards the allocation of managerial power embodied in the demand futility doctrine, KFS’ universal-demand rule will merely shift the focus of threshold litigation from the question whether demand is excused to the question whether the directors’ decision to terminate the suit is entitled to deference under federal standards. Under these circumstances, we do not view the advantages associated with KFS’ proposal to be sufficiently apparent to justify replacing “the entire corpus of state corporation law” relating to demand futility.[9]

Well said, indeed.

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[1] Interestingly, the MBCA partially followed the Iowa Supreme Court’s Miller decision by providing a third alternative. Under MBCA § 7.44(f), upon motion by the corporation, the court may appoint a panel of one or more independent persons to determine whether the suit should go forward. If that panel recommends dismissal, the court shall dismiss the action unless plaintiff can prove the independent panel failed to act in good faith or failed to conduct a reasonable inquiry upon which its conclusions were based. Unlike Miller, however, this option is not exclusive of the SLC process.

[2] MBCA § 7.44(a).

[3] See generally Carol B. Swanson, Juggling Shareholder Rights and Strike Suits in Derivative Litigation: The ALI Drops the Ball, 77 Minn. L. Rev. 1339 (1993). Pennsylvania has adopted the ALI approach in toto. Cuker v. Mikalauskas, 692 A.2d 1042 (Pa. 1997).

[4] ALI Principles § 7.07(a)(1).

[5] ALI Principles §§ 7.07(a)(2) and 7.10(a)(1).

[6] Id. at § 7.10(a)(2).

[7] Kamen v. Kemper Fin. Servs., Inc., 908 F.2d 1338 (7th Cir. 1990), rev’d, 500 U.S. 90 (1991).

[8] Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 502 (1992).

[9] Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 106 (1991).

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