05/13/2013 05:43 pm ET Updated Jul 13, 2013

Directors Must Investigate Shareholders' Concerns

Directors have a fiduciary duty to shareholders to act with due care and in good faith. A fiduciary has a high standard of care that requires that informed decisions be made honesty and fairly. Shareholders with concerns about corporate oversight must first demand that the directors act unless a court concludes that it would be futile to do so. Having demanded action, if the directors are deemed to have acted improperly, the shareholder may sue the directors on behalf of the corporation, an action called a "derivative suit."

While directors have a reasonable time to investigate a shareholder's demand, how long is this? The Court of Chancery of Delaware addressed this question in an unpublished April 25, 2013, decision, Rich v. Chong. The shareholder in a letter dated July 19, 2010, demanded that the directors address several issues including the corporation's weak internal controls. The board of directors appointed a "Special Internal Investigation Committee" but by March 2012 the committee had lost both of its members due to personnel changes. In this time the committee had held no meetings; however, the corporation had released information concerning accounting errors and restated financial statements.

When the shareholder instituted the derivative suit, the directors responded that the Audit Committee of the board of directors had investigated accounting problems and that the derivative suit could not proceed until the directors had completed their investigation. The Delaware court's decision addressed these facts.

In responding to the shareholder's demand, the directors are presumed to be acting in good faith under "the business judgment rule" that protects directors from honestly made mistakes. However, the directors must become fully informed of the facts and must not disregard their duties. In this situation two and a half years had passed since the demand was made.

The Delaware court allowed the shareholder's suit to continue since there was reason to doubt that the directors were responding with due care and in good faith to the shareholder's demand. The investigation had been left in limbo, in fact abandoned, due to a variety of facts. While some individual directors may have acted properly, these particular facts had not yet been presented.

The lesson for directors is that a timely investigation of a shareholder's demand must be undertaken. While the directors may have good reason to reject the demand, they cannot by failing to act prevent a derivative suit. Individual directors should carefully document their actions to demonstrate that they are entitled to the protection of the business judgment rule. If the board as a whole refuses to meaningfully investigate, the individual director's best action may be to resign.