Inroads into the Chimera of Demand Refusal in Delaware: Louisiana Municipal Police v. Morgan Stanley (Part 1)
Espinoza v. Hewlett-Packard, a case discussed on this Blog, shows just how difficult a time shareholders have in using inspection rights to obtain documents that they need to exercise their rights as owners.
Louisiana Municipal Police v. Morgan Stanley, a decision by VC Laster, however, is an example of how the inspection rights provision ought to be interpreted. Although ultimately granting the request to inspect, the Vice Chancellor did not write a particularly shareholder friendly decision. The case was careful to permit disclosure only of materials directly relevant to the purpose put forward by shareholders. The decision, however, recognized that there are certain kinds of information that are inherently important to owners of the company and granted access to them without requiring them to meet excessive pleading requirements or overcome other hurdles.
The case, however, also subtly challenged a long recognized dynamic of derivative litigation in Delaware. Shareholders filing these suits invariably allege demand futility, something that mostly turns on the independence of the board of directors. They do so because the alternative is to make demand and wait for the board’s determination.
Shareholders almost never opt for the latter approach. This is because the board will invariably decide not to bring the action (demand refusal). See Carol B. Swanson, Juggling Shareholder Rights and Strike Suits in Derivative Litigation: The ALI Drops the Ball, 77 Minn. L. Rev. 1339, 1364 (1993) ("statistics show that litigation committees almost inevitably reject shareholder demands while ritualistically using conclusory and generalized justifications for dismissing the derivative suits.").
To the extent shareholders want to challenge a decision not to bring a derivative suit (demand refusal), they must overcome the almost impenetrable presumption of the business judgment rule. The availability of the presumption turns not on the seriousness of the underlying claims but on the process used by the board in making its decision. Thus, even if shareholders allege egregious mismanagement, companies can opt for demand refusal and, assuming proper process, know that any challenge to the decision will be rejected by the courts.
In short, once demand is made, the response is well known and carefully choreographed. A committee of the board (consisting of only independent directors) will conduct an investigation, which really means it will hire consultants (often a law firm) to conduct the investigation. There will be a flurry of activity, with loads of process, and, ultimately, a report will emerge that recommends that no law suit for mismanagement be filed. The committee will, after considerable deliberation, agree with the recommendation and so will the board. Case closed. See John C. Coffee, Jr., New Myths and Old Realities: The American Law Institute Faces the Derivative Action, 48 Bus. Law. 1407 (August 1993) (making demand on the board "thereby acknowledge[s] the applicability of the business judgment rule to the directors' decision whether or not to reject demand (and, for most practical purposes), concede the outcome of the case).").
In many, if not most, cases, the board may well be correct in refusing to bring the action. The costs simply don't outweight the benefits. But in some instances, the balance has to go the other way. In Louisiana Municipal Police Employees Retirement System v. Morgan Stanley & Co., CA No. 5682-VCL, Del. Ch., March 4, 2011, it is clear that VC Laster is seeking to give shareholders the tools needed to make sure that, in the right circumstances, a board will have an incentive not to opt for demand refusal.