12/15/2011 05:25 pm ET Updated Feb 14, 2012

Shareholders Must Go to the Corporation Before Going to the Courthouse

While shareholders are the owners of a corporation, in everyday actions the board of directors and officers manage the business. If a shareholder disagrees with the action or inaction of the board, it is possible to sue the directors in a "derivative action to enforce a right that the corporation or association may properly assert but has failed to enforce" (Federal Rule of Civil Procedure 23). Two very recent federal court of appeals decisions decided on the same day, November 21, discuss the procedural requirement that the complaint must state any effort by the plaintiff to obtain the desired action from the directors or comparable authority...and the reasons for not obtaining the action or not making the effort. These decisions reinforce the limited application of what is termed "demand futility." In essence the complaining shareholder must first go to the corporation before going to the courthouse.

The precise demand for director action requirement imposed by Rule 23 is governed by the state law where the corporation is incorporated. The two November 21 decisions reached the same conclusion. The Federal Court of Appeals for the Ninth Circuit in Baca v. Crown and Insight Enterprises, Inc., a Delaware Corporation, determined that Delaware state law, while excusing a shareholder's demand in some situations, required such a demand in this case. The suit was dismissed. The Federal Court of Appeals for the Second Circuit in Kautz v. Sugarman applied Maryland's demand requirement in dismissing the derivative suit for similar reasons.

According to Delaware Supreme Court decisions, demand is excused (demand futility) when the directors lack independence in evaluating the demand or there is reasonable doubt that the challenged action came from a valid exercise of business judgment. Independence is lacking if the directors receive a personal financial benefit from a transaction that is not equally shared by the shareholders or face a substantial likelihood of liability for approving a questioned transaction.

The demand requirement, along with shareholder ownership, is a prerequisite to reaching the merits of the derivative suit complaint. Additionally there should be a factual basis for the suit. These asserted facts may be verified by a shareholder's request to inspect the records of the corporation. In a 2011 decision, King v. Verifone Holdings, Inc., the Delaware Supreme Court determined that the shareholder's failure to request corporate records before filing the derivative suit did not prevent the request from being made after the suit was filed. Directors are typically protected from suit under the protection granted by the "business judgment rule" that allows honest mistakes when the directors acted with due care and in good faith on behalf of the corporation.

Shareholder derivative suits are controversial. Depending upon one's point of view, they are either another tool attorneys use to enrich themselves or the only way to force directors to act responsibly on behalf of smaller shareholders. The damages recovered from the directors in a derivative suit are paid to the corporation and not the plaintiff. Typically under state law there is no percentage ownership required for a derivative suit although the plaintiff must fairly and adequately represent the interests of the shareholders. One reason plaintiffs attempt to bring a derivative suit without making a "demand" is that states such as Delaware allow the board to create a special litigation committee to review the derivative demand claim. If this committee is independent, acts in good faith, and has a reasonable basis for its conclusions, then a court will frequently follow the committee's recommendation that the derivative suit be dismissed.

Courts are reluctant to overturn decisions made by directors and officers and view shareholder derivative suits as a remedy of last resort. The "demand" must be specific in nature and the shareholder must be willing to assist the corporation in bringing suit according to a 1985 Fifth Circuit decision. This decision in turn relied upon the U.S. Supreme Court's 1882 decision in Hawes v. Oakland.

Hawes v. Oakland stated: "...before the shareholder is permitted in his own name to institute and conduct a litigation which usually belongs to the corporation, he should show to the satisfaction of the court that he has exhausted all the means within his reach to obtain, within the corporation itself, the redress of his grievances, or action in conformity to his wishes. He must make an earnest, not simulated effort, with the managing body of the corporation, to induce remedial action on their part and this must be made apparent to the court." Modern requirements essentially mirror this statement.

A 2010 Delaware Court of Chancery opinion began with language critical of lawyers that race to the courthouse: "A plaintiff owing a small number of shares in a corporation rushed off to a federal court to file a derivative suit shortly after the corporation announced that it had to restate its financial statements. ... Haste was the order of the day because the plaintiff's lawyers wanted to win the filing Olympics. And they did. The court handling the derivative suit rewarded the plaintiff and his counsel with lead plaintiff status. But in the lawyers' haste, they did not conduct an adequate pre-suit investigation. And when their complaint was confronted with a motion to dismiss for failure to plead demand excusal, it could not survive that motion." (King v. Verifone Holdings, Inc.).

These two November 21 Ninth Circuit and Second Circuit decisions illustrate the difficulty of bringing a derivative suit without first working within the corporation for an appropriate result. The balance between the directors' authority and the directors' accountability to shareholders is one that continues to be debated. "There is no single blueprint that a board must follow to fulfill its duties" affirmed the Delaware Supreme Court in Lyondell Chemical Company v. Ryan (2009). This broad board discretion continues to be a major roadblock to shareholder litigation that attempts to challenge the decisions of the board of directors. A shareholder's derivative suit that proceeds without first attempting to resolve the issue internally has an uphill battle in surviving a motion to dismiss.