Glenn Reynolds sent along what I assume is an email from one of his readers re the CBS forgery story:
First, any shareholder suit would have to be brought as a derivative one on behalf of the corporate entity rather than a direct shareholder class action. “Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. The basic tests are: (1) Who suffered the most immediate and direct injury? The shareholder or the corporation? Note that it is not enough for a shareholder to allege that the challenged conduct resulted in a drop in the corporation’s stock market price. (2) To whom did the defendant’s duty run? The shareholder or the corporation? As employees of CBS, Dan Rather and his fellow journalists owe a duty to the entity but owe no relevant duties directly to the shareholders thereof. In addition, to the extent the shareholders of CBS are injured, it will be a result of the prior injury Rather did to the corporate entity's reputation.
Second, because the suit must be brought derivatively, a shareholder-plaintiff will run into procedural barriers that likely will be insurmountable on these facts. Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit. Accordingly, Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.
Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation. The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement.
New York and Delaware both require demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware supreme court set forth the following test for demand futility:
As to the first prong, directors are interested if they have a personal financial stake in the challenged transaction or otherwise would be materially affected by the board’s actions. The prospect of being sued is not enough; rather, there must be a financial interest in the underlying transaction. Obviously, this basis for excusing demand is irrelevant in this case. There's no way any of the directors have a direct, pre-existing financial stake in this story.
Under the second prong, the key doctrinal question is whether the directors can base their judgment on the merits rather than on extraneous considerations. Again, demand is not excused simply because the plaintiff has named a majority of the board as defendants. Indeed, it is not enough even to allege that a majority of the board approved of, acquiesced in, or participated in the challenged transaction. In other words, merely being named as defendants or participants does not render the board incapable, as a matter of law, of objectively evaluating a pre-suit demand and, accordingly, does not excuse such a demand. Instead, demand typically will be excused under this prong only if a majority of the board was dominated or controlled by someone with a personal financial stake in the transaction. Directors whose independence is compromised by undue influences exerted by interested parties are presumed, as a matter of law, of being incapable of exercising valid business judgment. Again, I can't see demand being excused under this prong. The board simply wasn't involved, as far as we now know.
Let us assume for sake of argument that Rather and his fellow journalists were grossly negligent in running the story. Because there is no evidence that CBS' board of directors were involved in any way in the decision to run the story, the shareholder will be unable to satisfy the Aronson standard for demand futility. Accordingly, the shareholder will have to make demand on the board that they sue Rather before the shareholder would be allowed to sue. (If the shareholder files the lawsuit without first making demand, the court would stay the litigation and require the shareholder to make demand.)
Where the shareholder makes demand, either pre-suit or after a judicial determination that demand was required, the board is expected to undertake a two-step process. The board must first inform itself of the relevant facts relating to the challenged transaction or other alleged wrongdoing, as well as the legal and business considerations attendant to resolving the matter. Any factual investigation must be reasonable and conducted in good faith, but within those parameters the board has great discretion. Having done so, the board must elect amongst the three principal alternatives available to it: (1) accepting the demand and prosecuting the action; (2) resolving the matter internally without resort to litigation; or (3) refusing the demand.
If the board accepts the demand and then attempts to resolve the matter through a settlement of the derivative claim with the shareholder-plaintiff, the parties must comply with the judicial approval requirement of Federal Rule 23.1 or its relevant state counterpart. Suppose, however, that the corporation resolves the matter through a settlement with the alleged wrongdoers. In that case, the judicial approval requirement under Federal Rule 23.1 and its state counterparts does not apply. If the corporation gives the defendants a sweetheart deal, of course, the shareholder-plaintiff could initiate a new derivative suit for “fraud or waste in releasing corporate claims for inadequate payment.” Presumably the same would be true if the corporation accepted demand but then lost the case due to a failure to vigorously prosecute it.
Anecdotal evidence strongly suggests that the board’s typical response, however, is to refuse the demand. If the board does so, the shareholder may seek judicial review of that refusal, but the plaintiff bears the burden of proving that the refusal was wrongful. Worse yet, at least from plaintiff’s perspective, the relevant standard of review is the business judgment rule. Worst of all, again from plaintiff’s perspective, plaintiff is not entitled to discovery.
Some suggest that the wrongful refusal inquiry should be directed at the business judgment rule’s applicability to the underlying challenged transaction where that transaction “was approved by the same directors who are reviewing the plaintiff’s demand.” In Grimes v. Donald, however, the Delaware supreme court made clear that the inquiry is directed to whether “the board in fact acted independently, disinterestedly, or with due care in response to the demand.” Note the potential for even a clear case of self-dealing, such as an interested director transaction, to be immune from challenge through a derivative suit so long as a majority of the board was not involved. A disinterested and independent majority of the board is deemed capable of deciding whether to refuse demand, at least where the decision does not involve fraud, illegality or self-dealing on the part of a majority of the board. A demand refusal by such a board will be protected by the business judgment rule.
So now we see the bottom line. If a shareholder sues CBS over Rather's conduct, the suit will be derivative. Demand will be required. The board of directors will refuse demand. The business judgment rule will insulate the board's decision. So the lawsuit will be dismissed. I guarantee it.
Some readers doubtless will be outraged by this result. But there are good and sufficient reasons for courts to defer to the board's judgment in these cases. If you want to know why, however, you'll have to buy the book.
The officers and directors of CBS have fiduciary duties to the shareholders of CBS. Likewise the officers and directors of CBS's corporate owners have fiduciary duties to the shareholders of their companies. I.e., at some point their personal assets will be on the line for this. Additionally a stockholders' derivative action might now be feasible.I'm as annoyed/amused as anybody by the forgery story (see, e.g., this post). So I hate to throw cold water on Glenn's reader's idea, but there is zero - nada, zilch - chance a shareholder derivative suit over the forgery story would succeed. (The following is adapted from the chapter on shareholder litigation in my treatise Corporation Law and Economics.)
First, any shareholder suit would have to be brought as a derivative one on behalf of the corporate entity rather than a direct shareholder class action. “Direct” shareholder suits arise out of causes of action belonging to the shareholders in their individual capacity. It is typically premised on an injury directly affecting the shareholders and must be brought by the shareholders in their own name. In contrast, a “derivative” suit is one brought by the shareholder on behalf of the corporation. The cause of action belongs to the corporation as an entity and arises out of an injury done to the corporation as an entity. The shareholder is merely acting as the firm’s representative. The basic tests are: (1) Who suffered the most immediate and direct injury? The shareholder or the corporation? Note that it is not enough for a shareholder to allege that the challenged conduct resulted in a drop in the corporation’s stock market price. (2) To whom did the defendant’s duty run? The shareholder or the corporation? As employees of CBS, Dan Rather and his fellow journalists owe a duty to the entity but owe no relevant duties directly to the shareholders thereof. In addition, to the extent the shareholders of CBS are injured, it will be a result of the prior injury Rather did to the corporate entity's reputation.
Second, because the suit must be brought derivatively, a shareholder-plaintiff will run into procedural barriers that likely will be insurmountable on these facts. Because the derivative suit is premised on a cause of action belonging to the corporation, one might assume that the corporation would simply bring the lawsuit itself. Derivative suits in fact are relatively rare; most corporate lawsuits are brought by the entity, rather than its shareholders. The derivative suit, of course, was devised so as to permit shareholders to seek relief on behalf of the firm in those cases where the corporation’s management for some reason elected not to pursue the claim. Logically, however, it would seem that the corporation should be given an opportunity to decide whether to bring suit before a shareholder is allowed to file a derivative suit. Accordingly, Federal Rule 23.1 provides that shareholders may not bring suit unless they first make demand on the board of directors or demand is excused.
Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation. The foundational question in derivative litigation is the extent to which the corporation, acting through the board of directors or a committee thereof, is permitted to prevent or terminate a derivative action. Put another way, who gets to control the litigation—the shareholder or the corporation’s board of directors? Curiously, the answer to that question depends mainly on the procedural posture of the particular case with respect to the demand requirement.
New York and Delaware both require demand in all cases except those in which it is excused on grounds of futility. In the seminal Aronson v. Lewis decision, the Delaware supreme court set forth the following test for demand futility:
[T]he Court of Chancery in the proper exercise of its discretion must decide whether, under the particularized facts alleged, a reasonable doubt is created that: the directors are (1) disinterested and (2) independent and (3) the challenged transaction was otherwise the product of a valid exercise of business judgment.The third prong will fall out in this case. The Delaware supreme court in Rales v. Blasband held that where the litigation, inter alia, arises out of some transaction or event not involving a business decision by the board (as this one would) only the first two Aronson prongs are in play: "a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand."
As to the first prong, directors are interested if they have a personal financial stake in the challenged transaction or otherwise would be materially affected by the board’s actions. The prospect of being sued is not enough; rather, there must be a financial interest in the underlying transaction. Obviously, this basis for excusing demand is irrelevant in this case. There's no way any of the directors have a direct, pre-existing financial stake in this story.
Under the second prong, the key doctrinal question is whether the directors can base their judgment on the merits rather than on extraneous considerations. Again, demand is not excused simply because the plaintiff has named a majority of the board as defendants. Indeed, it is not enough even to allege that a majority of the board approved of, acquiesced in, or participated in the challenged transaction. In other words, merely being named as defendants or participants does not render the board incapable, as a matter of law, of objectively evaluating a pre-suit demand and, accordingly, does not excuse such a demand. Instead, demand typically will be excused under this prong only if a majority of the board was dominated or controlled by someone with a personal financial stake in the transaction. Directors whose independence is compromised by undue influences exerted by interested parties are presumed, as a matter of law, of being incapable of exercising valid business judgment. Again, I can't see demand being excused under this prong. The board simply wasn't involved, as far as we now know.
Let us assume for sake of argument that Rather and his fellow journalists were grossly negligent in running the story. Because there is no evidence that CBS' board of directors were involved in any way in the decision to run the story, the shareholder will be unable to satisfy the Aronson standard for demand futility. Accordingly, the shareholder will have to make demand on the board that they sue Rather before the shareholder would be allowed to sue. (If the shareholder files the lawsuit without first making demand, the court would stay the litigation and require the shareholder to make demand.)
Where the shareholder makes demand, either pre-suit or after a judicial determination that demand was required, the board is expected to undertake a two-step process. The board must first inform itself of the relevant facts relating to the challenged transaction or other alleged wrongdoing, as well as the legal and business considerations attendant to resolving the matter. Any factual investigation must be reasonable and conducted in good faith, but within those parameters the board has great discretion. Having done so, the board must elect amongst the three principal alternatives available to it: (1) accepting the demand and prosecuting the action; (2) resolving the matter internally without resort to litigation; or (3) refusing the demand.
If the board accepts the demand and then attempts to resolve the matter through a settlement of the derivative claim with the shareholder-plaintiff, the parties must comply with the judicial approval requirement of Federal Rule 23.1 or its relevant state counterpart. Suppose, however, that the corporation resolves the matter through a settlement with the alleged wrongdoers. In that case, the judicial approval requirement under Federal Rule 23.1 and its state counterparts does not apply. If the corporation gives the defendants a sweetheart deal, of course, the shareholder-plaintiff could initiate a new derivative suit for “fraud or waste in releasing corporate claims for inadequate payment.” Presumably the same would be true if the corporation accepted demand but then lost the case due to a failure to vigorously prosecute it.
Anecdotal evidence strongly suggests that the board’s typical response, however, is to refuse the demand. If the board does so, the shareholder may seek judicial review of that refusal, but the plaintiff bears the burden of proving that the refusal was wrongful. Worse yet, at least from plaintiff’s perspective, the relevant standard of review is the business judgment rule. Worst of all, again from plaintiff’s perspective, plaintiff is not entitled to discovery.
Some suggest that the wrongful refusal inquiry should be directed at the business judgment rule’s applicability to the underlying challenged transaction where that transaction “was approved by the same directors who are reviewing the plaintiff’s demand.” In Grimes v. Donald, however, the Delaware supreme court made clear that the inquiry is directed to whether “the board in fact acted independently, disinterestedly, or with due care in response to the demand.” Note the potential for even a clear case of self-dealing, such as an interested director transaction, to be immune from challenge through a derivative suit so long as a majority of the board was not involved. A disinterested and independent majority of the board is deemed capable of deciding whether to refuse demand, at least where the decision does not involve fraud, illegality or self-dealing on the part of a majority of the board. A demand refusal by such a board will be protected by the business judgment rule.
So now we see the bottom line. If a shareholder sues CBS over Rather's conduct, the suit will be derivative. Demand will be required. The board of directors will refuse demand. The business judgment rule will insulate the board's decision. So the lawsuit will be dismissed. I guarantee it.
Some readers doubtless will be outraged by this result. But there are good and sufficient reasons for courts to defer to the board's judgment in these cases. If you want to know why, however, you'll have to buy the book.
Comments