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The Demand Requirement in Derivative Litigation: Part III

In a series of posts, we have reviewed the law governing the demand requirement in derivative litigation. In the immediately preceding post, we turned to the role the demand requirement plays in determing the extent to which the board of directors can control shareholder derivative litigation.

It is curious that the seemingly technical requirement of demand on the board has become the critical issue in derivative litigation. If demand is required, the shareholder-plaintiff has very little prospect of success. If demand is excused, the shareholder-plaintiff’s prospects improve—but not by much. Derivative litigation thus bifurcates at the demand stage. If demand is required, two questions arise: What happens if the board accepts the demand? Conversely, what happens if the demand is rejected? If demand is excused, the key issue is whether the board can wrest control of the litigation back from the shareholder-plaintiff .

In this post, we focus on cases in which demand is excused.

Anecdotal evidence suggests that boards generally settle demand excused cases. The incentives for both sides to settle before a decision on the merits are just too strong. Yet, a recalcitrant board intent upon resisting a derivative suit has a weapon by which it can regain control of the litigation even when demand is excused; namely, the so-called special litigation committee (SLC).

The SLC emerged in response to a sharp rise in derivative litigation during the 1970s. In demand excused cases, the board would appoint a committee to investigate the challenged transaction or event and make a recommendation to the court as to whether or not the litigation was in the firm’s best interests. The committee members were specially chosen for their independence and disinterest (or so corporations said). Indeed, the committee typically was comprised of newly appointed board members chosen specifically to serve on the committee. The committee was vested with all of the board’s powers for the limited purpose of deciding what position the corporation should take in connection with the litigation. The theory explained to the courts was that the committee could take over and prosecute meritorious suits, while seeking dismissal of frivolous actions. The principal legal issue thus was whether the court should defer to a committee recommendation that the suit be dismissed.

New York law. New York’s answer to that question was handed down in Auerbach v. Bennett.[1] Agents of GTE had paid out some $11 million in illegal bribes and kickbacks. Four of GTE’s directors were personally involved in the misconduct. A GTE shareholder brought a derivative action against GTE, all of its directors, and its outside auditor for breach of fiduciary duty to the corporation. The board responded to the litigation by appointing a SLC, which concluded that none of the defendants had violated their statutory duty of care, none had profited personally from the incidents and that the claims were without merit. The committee therefore recommended that the court dismiss the suit. Noting that the business judgment doctrine generally bars judicial inquiry into actions of corporate directors taken in good faith and in the exercise of honest judgment in the lawful furtherance of corporate purposes, the court opined that analysis of the case at bar turned on whether the business judgment rule applied to such a recommendation by a SLC.

Judicial review of a SLC recommendation to terminate derivative litigation implicates a two-tiered set of questions. The first tier is the challenged transaction; here the illegal payments. The second tier is the committee’s recommendation that the action be dismissed. The Auerbach defendants argued that the second tier action insulated the first tier from judicial review because the business judgment rule mandates judicial deference to the committee’s recommendation. We might call this the Tootsie Pop defense—you cannot see the chewy center (the first tier wrongdoing) because the hard candy shell (the second tier committee recommendation) blocks your view.

The Court of Appeals agreed that the committee’s ultimate substantive decision to dismiss the litigation is protected from review. Judicial inquiry is permissible with respect to two aspects of the committee’s work, however: (1) the committee’s disinterested independence; and (2) the adequacy and appropriateness of the procedures by which the decision was made. It seems that plaintiff has the ultimate burden of proof with respect to the committee’s independence and the adequacy of their procedures, although there is language in the opinion suggesting that the committee may have the initial burden of showing that its procedures were reasonable.

If the court is not satisfied as to either the SLC’s disinterested independence or the adequacy of its procedures, the suit will not be dismissed and review of the first tier decision will not be foreclosed. If the court is satisfied on both scores, however, the case must be dismissed without reaching the merits. In Auerbach, accordingly, in which there apparently was no question that the payments were illegal, the challenged misconduct thus was not to be reviewed so long as the committee was independent and used proper procedures in reaching its decision. (Of course, if one thinks that directors and officers can violate the law without necessarily violating their fiduciary duties, this outcome will not seem problematic.)

On the facts before it, the court determined that the committee was independent. None of the committee members were members of the board when the illegal payments took place and none had any prior affiliation with the firm. The latter point—lack of prior affiliation—seems to be the key. As long as the committee members have no demonstrable contact with the corporation or the board, they likely will be deemed independent.

In examining the committee’s procedures, Auerbach teaches that a reviewing court may explore whether the areas and subjects the committee investigated were reasonably complete. The court may also determine whether the inquiry was conducted in good faith. The court will be looking for proof that the investigation was restricted in scope, shallow in execution, pro forma or half-hearted. Relevant factors thus include such matters as the number of hours spent on the matter, whether the committee had independent legal counsel and other advisers, who was interviewed, and the like. On the other hand, the court may not consider the evidence the committee uncovered, the factors the committee considered, the relative weight accorded to those factors in the committee’s decisionmaking process, or even whether the evidence supports the conclusion. The following analogy may be useful—the court may ensure all the proper papers are in the file, but is forbidden from reading the papers to see what they say.

Delaware law. The Delaware supreme court took a less deferential approach to this issue in Zapata Corp. v. Maldonado.[2] In Zapata, the Delaware Supreme Court specifically rejected Auerbach’s conclusion that the business judgment rule applies to a SLC’s recommendations. Instead, the court laid out a new set of procedures to be followed in such cases. After an “objective and thorough investigation,” the committee may cause the corporation to file a motion to dismiss the derivative action. The motion should include a written record of the committee’s investigation and its findings and recommendations. Each side is given a limited opportunity for discovery with respect to the court’s mandated areas of inquiry.

In deciding whether to dismiss the action, the court is to apply a two-step test: (1) The court should inquire into the independence and good faith of the committee. The court also should inquire into the bases supporting the committee’s recommendations. The corporation will have the burden of proving independence, good faith, and a reasonable investigation. (2) If the first step is satisfied, the court may but need not go on to apply its own business judgment to the issue of whether or not the case is to be dismissed.

The first step differs from Auerbach in that the Delaware court looks not only at the procedures used, but also at the reasonableness of the basis for the committee’s decision—something Auerbach expressly forbids.[3] In other words, Delaware judges not only make sure all the papers are in the file, they also read the papers to see if the investigative results support the committee’s conclusions.

The second step is intended to catch cases complying with the letter, but not the spirit, of the first step.[4] In other words, the court is saying that judges should not dismiss meritorious derivative suits merely because the board and its committee jumped through the correct procedural hoops. Unfortunately, Zapata gave no real standards by which judges should apply their own business judgment in the second-step. The supreme court simply opined that the trial court should consider such things as the corporation’s interest in having the suit dismissed and “matters of law and public policy,”[5] which could mean everything under the sun. In its subsequent Kaplan v. Wyatt decision, moreover, the court made clear that the chancellors are not obliged to conduct the second step inquiry and that a refusal to do so was subject to review under the abuse of discretion standard.[6]

In Joy v. North,[7] a diversity case arising under Connecticut law, federal Circuit Judge Ralph Winter held that Connecticut courts would follow Zapata, rather than Auerbach, but thought it necessary to lay out more determinate guidelines for judicial review of SLC recommendations. The central question under Joy is whether the litigation is in the best interests of the corporation. The burden is on the corporation to demonstrate that the litigation is more likely than not to be against its interests. The court will examine the underlying data developed by the committee, the adequacy of the committee’s procedures, and whether there is a reasonable basis for the committee’s recommendation. Again, note the difference from Auerbach. As in Zapata, Judge Winter looks behind the procedures to see what the committee actually found.

The break with Zapata came when Judge Winter articulated a methodology not unlike the Hand Formula familiar from tort law. If the cost of litigation to the corporation exceeds the product of the likely recoverable damages times the probability of liability, suit must be dismissed. The costs that may be considered include attorney’s fees, out of pocket expenses, time spent by corporate personnel preparing for and participating in trial, and potential mandatory indemnification (discounted by the probability of liability). On the cost side, the court may not consider discretionary indemnification or insurance.[8] Where the likely recovery to the corporation is small in comparison to total shareholders’ equity, the court may also consider two other factors: (1) the degree to which key personnel may be distracted from corporate business by the litigation and (2) the potential for lost business.

Judicial concern with structural bias

The significantly less deferential approach taken by Zapata and Joy, relative to Auerbach, resulted from the former courts’ heightened sensitivity to the potential for bias on the part of SLC members. Because the members of the committee typically are appointed by the defendants to the derivative litigation, there is a natural concern that the persons selected will be biased in favor of the defendants. The requirements of independence and disinterest purportedly eliminate the risk of actual bias. Because the persons selected frequently are directors or senior officers of other corporations, however, there is a concern that the SLC’s members will have excessive sympathy for colleagues facing personal liability. As the Delaware supreme court put it: “The question naturally arises whether a ‘there but for the grace of God go I’ empathy might not play a role.”[9] The legitimacy of this concern is supported by the fact that in only one of the first 20 reported SLC decisions did the committee determine that the suit should proceed.[10]

Despite the potential for actual or structural bias, neither Auerbach, Zapata, nor Joy accepted their respective plaintiffs’ arguments that the defendant board of directors was per se disabled from appointing a SLC and delegating to that committee power to act on the corporation’s behalf. In Miller v. Register and Tribune Syndicate, Inc.,[11] by way of contrast, the Iowa supreme court concluded that the structural bias purportedly inherent in the SLC process incapacitated directors charged with misconduct from appointing a SLC. Instead, the board may petition the court to appoint a special panel, to whose recommendations the court will defer.

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[1] 419 N.Y.S.2d 920 (1979). Everyone involved seems to have assumed that Auerbach was properly viewed as a demand excused case. Query whether that would still be true today, following the subsequent decision in Marx v. Akers, 644 N.Y.S.2d 121 (1996). The first Marx prong asks whether a majority of the board of directors was interested in the challenged transaction. Director interest may either be self-interest in the transaction at issue, or because a director with no direct interest in a transaction is controlled by a self- interested director. In Auerbach, although all directors sued, only 4 were alleged to have participated in the challenged transaction. Merely being named as a defendant is not enough to render one interested for purposes of this prong of Marx. Under Marx’s second prong, demand will be excused where the complaint alleges that the board of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances. Under the third prong, demand is excused where the complaint alleges 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. How should we apply the latter two factors to a case in which a majority of the board was unaware of the alleged misconduct and, consequently, did not exercise business judgment? Under Rales v. Blasband, 634 A.2d 927 (Del. 1993), Delaware would not regard the failure to exercise business judgment as grounds for excusing demand. If New York followed that precedent, demand would not be excused on Auerbach­-like facts. For a still useful critique of Auerbach, see George W. Dent, Jr., The Power of Directors to Terminate Shareholder Litigation: The Death of the Derivative Suit?, 75 Nw. U. L. Rev. 96 (1980).

[2] 430 A.2d 779 (Del. 1981). In Alford v. Shaw, 358 S.E.2d 323 (N.C. 1987), North Carolina adopted a Zapata-based standard for all derivative suits, without regard to whether demand is excused or required.

[3] Several other states also require their courts to determine whether the committee’s recommendation has a reasonable basis. See, e.g., Houle v. Low, 556 N.E.2d 51 (Mass. 1990); Lewis v. Boyd, 838 S.W.2d 215 (Tenn. App. 1992).

[4] Cf. Johnson v. Hui, 811 F. Supp. 479, 490 (N.D. Cal. 1991) (describing second step of Zapata as a “smell test”).

[5] Zapata Corp. v. Maldonado, 430 A.2d 779, 789 (Del. 1981).

[6] Kaplan v. Wyatt, 499 A.2d 1184, 1192 (Del. 1985).

[7] 692 F.2d 880 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983). As a diversity case applying the law of another state, of course, Joy is not binding on the Delaware courts.

[8] Suppose plaintiff’s claim is for $1 million. Defendant director has personal assets of $100,000, but is covered by a D&O liability policy that will pay up to $20 million per incident. Can the existence of that policy be considered by the court and, if so, for what purposes? Insurance is relevant to the likely recovery side of the equation, but not to the costs side of the formula. Thus, the court cannot consider either past premiums or future premium increases in its calculation of costs.

[9] Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (Del. 1981). Or, as Judge Winter put it in Joy: “It is not cynical to expect that such committees will tend to view derivative actions against the other directors with skepticism. Indeed, if the involved directors expected any result other than a recommendation of termination at least as to them, they would probably never establish the committee.” 692 F.2d 880, 888 (2d Cir. 1982), cert. denied, 460 U.S. 1051 (1983).

[10] See James D. Cox, Searching for the Corporation’s Voice in Derivative Suit Litigation: A Critique of Zapata and the ALI Project, 1982 Duke L.J. 959.

[11] 336 N.W.2d 709 (Iowa 1983).

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