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Teaching the Derivative Suit Demand Requirement Using Marx v. Akers

We covered Marx v. Akers in my Corporations class this past week, and I felt like I could have done a better job explaining the case so I thought I’d post an analysis for my weekly contribution here, which I will be able to share with my students.  If you have any comments, I’d appreciate it if you emailed them to me directly at spadfie@uakron.edu, in addition to posting them here.

We start with the basic proposition that when a corporation has a valid legal claim, the decision whether to pursue that claim is first and foremost a business decision.  As such, it rests in the first instance with the board of directors.  However, because there are times when we may be suspicious of a board’s ability to exercise its discretion in good faith (e.g., when the claim is against members of the board itself), we also allow shareholders to bring such claims derivatively on behalf of the corporation. This right to file a derivative suit then raises its own concerns, particularly that a frivolous suit may be brought purely for settlement value.  Accordingly, various procedural hurdles are placed in the way of shareholders filing a derivative suit, including the requirement that they first make demand on the board to bring the claim directly.  In Marx v. Akers, 88 N.Y. 2d 189, we see the New York Court of Appeals deal with a variety of issues related to this demand requirement.

The court first notes that some jurisdictions impose a universal demand requirement, consistent with the approach followed by the Model Business Corporation Act.  This approach is to be distinguished from one that allows shareholders to forgo making demand where to do so would be futile.  One of the justification for a universal demand requirement is that litigation resolving the issue whether demand is excused is avoided.  As the Marx court noted:

A universal demand requirement would dispense with the necessity of making case-specific determinations and impose an easily applied bright line rule. The Business Law Section of the American Bar Association has proposed requiring a demand in all cases, without exception, and [prohibits] the commencement of a derivative proceeding within 90 days of the demand unless the demand is rejected earlier (Model Business Corporation Act § 7.42 [1] [1995 Supp]). However, plaintiffs may file suit before the expiration of 90 days, even if their demand has not been rejected, if the corporation would suffer irreparable injury as a result [of waiting the 90 days] (Model Business Corporation Act § 7.42 [2]).

Critics have argued that little is gained via a universal demand requirement because many, if not all, the same questions will likely need to be addressed later in the proceedings anyway.  When I reached out to Joan Heminway for comments on this post, she noted the following:

When I note this criticism, I sometimes ask my students to question its validity.  Consider, e.g., the circumstances where the court allows the suit to proceed because demand is excused as futile.  There then can be a separate battle over a special committee decision to move to dismiss and a substantive trial if that motion fails.  So, given the court's differing, yet similarly rooted, standards for excuse and dismissal, do we really need both of those steps?  Why isn't universal demand the answer?  What lobby/ies is/are fighting to maintain the non-mandatory demand in Delaware and elsewhere?  Does it serve any useful purpose other than giving plaintiffs more of an element of surprise and fattening the wallets of litigators?

Given that most of the decisive battles in this area in Delaware currently appear to be fought over whether demand was excused (a well-advised plaintiff would rarely, if ever, make demand in Delaware because state law there provides that by doing so the plaintiff waives the right to challenge the disinterestedness of the board later), and most of those battles apparently end up with plaintiffs losing, one can certainly question who most benefits from such a structure and how a universal demand requirement might shift the balance of power.  Regardless, the Marx court noted that it was for the legislature to decide whether New York was going to impose a universal demand requirement, and so it proceeded to delve into demand futility.  (It is worth noting here, as indicated above, that there are basically 3 related suits in this area (only some of which will be argued in any particular case): (1) challenging a board’s decision to reject demand where demand has been made and rejected; (2) challenging the futility of demand where the plaintiff claims the right to proceed without making demand; and (3) challenging the ability of a special litigation committee to dismiss a claim even where demand has been excused.  All of these are in addition to the actual underlying claim itself.  We are focusing here on the demand futility analysis.)

The court started by noting the Delaware approach to analyzing whether demand is excused, as set forth in Aronson v. Lewis:

Plaintiffs must allege particularized facts which create a reasonable doubt that, (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Hence, the Court of Chancery must make two inquiries, one into the independence and disinterestedness of the directors and the other into the substantive nature of the challenged transaction and the board’s approval thereof.

While consistent with the general rule, this formulation raises a number of additional issues.  First, is a “reasonable doubt” standard appropriate?  The Marx court chose instead to merely require plaintiff to plead the relevant elements with particularity, noting:

The reasonable doubt threshold of Delaware’s two-fold approach to demand futility has been criticized. The use of a standard of proof which is the heart of a jury’s determination in a criminal case has raised questions concerning its applicability in the corporate context. The reasonable doubt standard has also been criticized as overly subjective, thereby permitting a wide variance in the application of Delaware law to similar facts ….

Second, what is the role of “substantive care”?  As the Marx court put it: “Whether a board has validly exercised its business judgment must be evaluated by determining whether the directors exercised procedural (informed decision) and substantive (terms of the transaction) due care.”  However, a later Delaware decision expressly rejected a role for substantive care: “As for the plaintiffs' contention that the directors failed to exercise ‘substantive due care,’ we should note that such a concept is foreign to the business judgment rule…. Due care in the decisionmaking context is process due care only.”  (Brehm v. Eisner, 746 A.2d 244.)

Some additional caveats are worth noting here: (A) The Brehm court’s formulation embodies what is meant by the statement that the business judgment rule is about process only.  (B) The distinction between process-only review and a standard of review including a substantive care analysis may be less dramatic than the Brehm court implies.  As the Brehm court itself went on to note: “Irrationality is the outer limit of the business judgment rule. Irrationality may be the functional equivalent of the waste test or it may tend to show that the decision is not made in good faith, which is a key ingredient of the business judgment rule.”  In other words, while a plaintiff in Delaware may not be able to argue substantive due care, they will be able to argue waste—which may frequently be the same thing in application.  (C) Delaware actually recognizes what may be deemed a heightened substantive due care analysis when a special litigation committee is seeking to dismiss a shareholder derivative suit brought where demand has been excused (Zapata v. Maldonado).

Finally, what happens if the board that would respond to demand is not the same board that authorized the underlying transaction being challenged.  At least one answer to that question was provided by the Supreme Court of Delaware in Rales v. Blasband, 634 A.2d 927:

Consistent with the context and rationale of the Aronson decision, a court should not apply the Aronson test for demand futility where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit. This situation would arise in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where, as here, the decision being challenged was made by the board of a different corporation. 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.

In other words, only the first prong of the Aronson test is applicable in these circumstances.  A conclusion to which RTB's own Jay Brown added the following:

The first prong of Aronson and the test in Rales looks to the independence of the board.  Here is where, in my opinion, the reasonable doubt standard has been abused.  Time and time again shareholders raise issues with respect to board independence (friendship in Beam, directors who serve on boards of non-profits that receive significant contributions from the company in Goldman, outside lawyers whose firm receives significant fees in Disney).  All of these failed at the demand futility stage.  In other words, the courts with respect to demand futility apply a much higher standard than reasonable doubt.  Moreover, in Beam, the friendship between Martha Stewart and Darla Moore (in which Moore described herself in a magazine article as a best friend of Stewart) could only be explored through discovery since relevant information is not typically in the public domain.

The failing for me of the Aronson/Rales approach is that in fact directors who are not independent (or, more accurately, directors where there is a reasonable doubt about independence) are left with the decision about whether to bring a case. 

So, there you have it.  Crystal clear, right?

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