Derivative Suits, Delaware and the Race to the Bottom: Schoon v. Smith (Part 5)

We are discussing Schoon v. Smith, a Delaware case holding that a single director could not initiate a derivative suit. We take the opportunity to provide a final thought.

The right of individual directors to bring lawsuits against their brethren on the board is not an easy one and, while we would have argued for a different outcome, we understand that reasonable minds can disagree. But the matter needs to be put in context. First, this is a decision that characterizes derivative suits as strike suits. In other words, the Court approached the issue from the perspective that these suits should be limited. The holding reflects this attitude.

Second, the right of directors to maintain a suit must be considered in the context of the other limits imposed by the Delaware courts on derivative suits. Under the approach set out in Aronson, shareholders have the affirmative obligation to show in the complaint that the board lacks a majority of independent directors. Because this issue is resolved without discovery, shareholders often have some evidence of a disqualifying relationship (frequently taken right from the company's proxy statement, a gift of the federal regulatory regime) but are limited to what they can find in the public domain with the result that courts often dismiss the challenges at the pleading stage. In other words, the directors may well lack independence but the courts do not allow any fact collection process to determine this.

Putting aside that director independence is usually an issue unrelated to the merits of the derivative suit, the Delaware approach results in the dismissal of cases that will then be left to an interested and not independent board, with the consequences obvious.

Had the Court allowed the single director to go forward with a suit, it would have provided a safety valve of sorts to this process. A single director will sometimes know reasons why directors are not independent, sidestepping the limits on discovery. Moreover, the director will sometimes not be free to release the information to potential plaintiffs. Moreover, the suits would be rare. Directors qua directors would rarely bring suit against others on the board.

The case, therefore, sends a strong message. Delaware courts do not like derivative suits and will do what is necessary to continue to limit them, irrespective of the merits. This is an issue of process. It is another area that could ultimately be targeted for federal preemption.

We have posted the opinion and redacted briefs on the DU Corporate Governance web site.