The Company
5.5 Shareholders’ limited corporate governance rights
5.5.2 Shareholders’ derivative litigation: a hurdle race
To establish a shareholder’s derivative action, the plaintiff must (i) estab- lish a standing; (ii) either make a pre-suit demand on the corporation board of directors or allege demand futility; and (iii) adequacy of the demand. Each step requires a Herculean effort that the Delaware court itself recognized: the burden of proof and the unlikelihood of success.
(i) Standing
In general, or under the Federal Rules of Civil Procedure (FRCP), the plaintiff must meet the requirements of FRCP 23.1, which provides, in pertinent part that:
In a derivative action ... the complaint ... shall allege ... that the plaintiff was a shareholder or member at the time of the transaction of which the plaintiff complains or that the plaintiff’s share or membership thereafter devolved on the plaintiff by operation of law.
The Delaware procedural law is even more restrictive as it requires that the plaintiff remain stockholder throughout the litigation. Otherwise, the plaintiff loses the standing to pursue a derivative action. However, despite the statutory contemporaneous stock ownership under 8 Del. C.
Par. 327, Rule 23.1 of the FRCP allows stockholders who purchase shares after the alleged wrongful conduct began to pursue their claims if the alleged wrong is a continuing one and has not been consummated. To determine whether a wrong complained of is a continuing wrong, courts examine ‘when the specific acts of alleged wrongdoing occur, and not when their effect is felt’. 42
(ii) Demand or futility of demand
Rule 23.1 requires that the shareholder (plaintiff) make a pre-suit demand to the corporation’s board of directors or allege that such a demand is futile. In general, a shareholder, through a derivative action would either challenge the action taken by the board or the inaction of the board. The Delaware courts have developed two different sets of standard depending on whether the plaintiff is challenging the board’s action or inaction.
In any event, the Delaware Court of Chancery has identified the factors that the plaintiff must satisfy for its claim to qualify as a demand. In Yaw v. Talley , the Chancery Court has held:
To constitute a demand, a communication must specifically state: (i) the identity of the alleged wrongdoers, (ii) the wrongdoing they alleg- edly perpetrated and the resultant injury to the corporation, and (iii) the legal action the shareholder wants the board to take on the corpo- ration’s behalf. 43
The requirement is stringent as the Delaware courts have held that the ambiguity of the plaintiff’s communication to the corporation should be constructed against the finding that demand was made. Further, the Delaware Supreme Court has held that a stockholder who makes a demand on the board of directors waives his right to claim that demand would be futile. 44 Likewise, when a plaintiff demand has been rejected by the board of directors, the plaintiff is barred from alleging demand futility. 45
Once a plaintiff has made a proper and adequate demand, the board of directors should have sufficient time to respond to the demand whether by taking the plaintiff’s requested action or by rejecting the demand. If the board of directors decides to reject the demand, the plaintiff’s chances to process are slim because the business judgment rule 46 would shield and
protect the board decision, unless, the plaintiff alleges particularized facts to establish the wrongness of the board’s rejection. Due to the hurdles to success for an adequate demand plaintiffs, in derivative actions, have a tendency to commence an action without making any demand at all. To that end, plaintiffs must show that directors’ conduct was so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of directors’ liability therefore exists. The Delaware Supreme Court has developed the test for evaluating the futility of demand whether when the plaintiff challenges the board’s action or the board’s failure to act.
• The plaintiff challenge of the board action(s)
When plaintiff challenges the board’s action, the Delaware courts apply a two-prong test developed in Aronson v. Lewis 47 to assess demand futility.
In that case, the Delaware Supreme Court held:
In determining demand futility the Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that (i) the directors are disinterested and independent, or (ii) the challenged transaction was otherwise the product of a valid exercise of busi- ness judgment.
More, plaintiff must establish that demand is excused or futile as to each separate claim. 48
Aronson first prong
Under each prong of Aronson , the plaintiff must plead particularized facts creating a reasonable doubt that (i) the directors are disinterested and independent, or (ii) that the transaction was a valid exercise of the board business judgment. Directors’ interest would exist if directors appear on both sides of a transaction or expect to derive any personal financial benefit from it in the sense of self-dealing. 49 Plaintiff alleging directors’ lack of independence must establish particularized facts that support that through personal or other relationships, the directors are beholden to the controlling person. 50
Aronson second prong
Under the second prong of Aronson , plaintiff must plead particularized facts sufficient to raise (i) a reason to doubt that the board’s action was taken honestly and in good faith, or (ii) a reason to doubt that the board was adequately informed in making the decision. Meeting the second
prong requirement is often an insurmountable hurdle as the Delaware Supreme Court has almost always maintained that:
Approval of a transaction by a majority of independent, disinterested directors almost always bolsters a presumption that the business judg- ment rule attaches to transactions approved by a board of directors that are later attacked on ground of lack of due care. 51
● The plaintiff challenge of the board inaction
When the board has not taken any action concerning the attacked trans- action, the Delaware courts assess the futility of demand under the Rales standard. 52 That is, plaintiff must plead particularized facts that show that directors completely and utterly failed to even attempt to meet their duties. The burden is heavy and often insurmountable.
(iii) Adequacy of the demand
To pursue a derivative action, a plaintiff who has met the standing and the demand requirement, must also fairly and adequately represent the interests of all stockholders. Rule 23.1 provides that:
The derivative action may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation.
However, the Delaware courts have also recognized that deriva- tive actions could be maintained even if the representative stock- holder did not have the support of a majority of the corporation’s stockholders. In Emerald Partners , 53 the Chancery Court has held that:
Among the elements which the courts have evaluated in considering whether the derivative plaintiff meets Rule 23.1’ s representation require- ments are: economic antagonisms between representative and class; the remedy sought by the plaintiff in the derivative action; indications that the named plaintiff was not the driving force behind the litigation; plain- tiff’s unfamiliarity with the litigation; other litigation pending between the plaintiff and defendants; the relative magnitude of plaintiff’s personal interest as compared to his interest in the derivative action itself; plaintiff’s vindictiveness towards the defendants and, finally, the degree of support plaintiff was receiving from the shareholders he purported to represent.
(iv) Disclosure of materials
It is extremely difficult for a shareholder-plaintiff to succeed at trial. 54 Disclosure: contrary to Martin Gelter’s allegations, the pre-trial dis- covery is almost not granted. 55 Shareholder-plaintiffs are not entitled to discovery (even limited) to assist their compliance with the particular- ized pleading requirement of Rule 23.1 in a case of demand refusal, or in demand excused cases. 56 Rather, the Delaware courts have reiterated that shareholder-plaintiffs should avail themselves of the tools at hand when filing derivative actions. 57 Indeed, section 220 of the DGCL allows shareholder-plaintiffs to inspect the minutes, records and other corporate books. More, the Delaware courts have always asserted that:
There is variety of public sources from which the details of a corporate act may be discovered, including the media and governmental agen- cies such as the Securities and Exchange Commission.
Paradoxically, in the Citigroup case, 58 where the shareholder-plaintiff’s claim was that the Citigroup board ignored a number of ‘red flags’ that signaled likely problems in the sub-prime mortgage market in pursuit of short-term profits. The ‘red flags’ referred to by the plaintiffs were events from May 27, 2005 to October 18, 2007, including a New York Times article warning of a speculative bubble in the housing market, the decline and failure of certain sub-prime lenders, Freddie Mac’s announcement that it would refinance borrowers unable to afford their resetting adjustable- rate mortgages, credit rating agency downgrades of sub-prime bonds, and warnings of spreading mortgage defaults.
The court here, found that red flags raised in the public information did not constitute particularized facts susceptible to establish the board’s failure to monitor.
The ’red flags‘ in the Complaint amount to little more than portions of public documents that reflected the worsening conditions in the subprime mortgage market and in the economy generally.
However, a narrow discovery exception may exist in cases where a spe- cial litigation committee was set up to look over the shareholder-plaintiff claim. Under what is referred to as the Zapata requirement, 59 the corpo- ration should bear the burden of proving independence, good faith and reasonable investigation of its committee, rather than presuming inde- pendence, good faith and reasonableness. The court still may exercise its own (discretionary) business judgment before granting such a narrowed
discovery exception. In most the cases, the courts have rejected the share- holder-plaintiff requests.
(v) Attorney’s fee
In the US litigation is very expensive, and shareholders seeking to com- mence a derivative action are often intimidated by the attorney’s fee, the uncertainty of the case or court bias, even when they have a strong case at hand. Such a hurdle has dissuaded many shareholders from challenging their greedy boards. Under the Delaware courts, a plaintiff would be awarded litigation fees if (i) the litigation was meritorious when filed; (ii) the action rendering the litigation moot produced the same or similar benefit sought by the litigation, and (iii) there was a causal relationship between the litigation and the action taken produc- ing the benefit.