“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.
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 suits in the corporation’s name 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.[1] The requisite demand can take any form, although most jurisdictions require that it be in writing. The demand need not be in the form of a pleading nor a detailed as a complaint, but rather simply must request that the board bring suit on the alleged cause of action. To be sure, the demand must be sufficiently specific as to apprise the board of the nature of the alleged cause of action and to evaluate its merits. “At a minimum, a demand must identify the alleged wrongdoers, describe the factual basis of the wrongful acts and the harm caused to the corporation, and request remedial relief.”[2] The demand must be directed to the board of directors as a whole, and not merely to the chairman of the board, senior officers, or a majority shareholder.[3] Hence, for example, a fax sent to the office of the corporation’s chairman of the board did not satisfy the demand requirement.[4]
Although the demand requirement looks like a mere procedural formality, it has evolved into the central substantive rule of derivative litigation.[5] 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.
Delaware requires 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: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.[6]
Several important questions immediately arise. First, did the court really mean to phrase the standard in the conjunctive? Must plaintiff create a reasonable doubt as to both prongs? In its subsequent Levine v. Smithopinion, the court made clear that the test is in the disjunctive, such that satisfying either prong suffices.[7]
Second, and more significant, how does “reasonable doubt” come into it? This odd phrasing has been sharply criticized:
The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. If “reasonable doubt” in the Aronson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?[8]
In its leading defense of the reasonable doubt standard, the Delaware Supreme Court rather weakly countered that “the term is apt and achieves the proper balance.”[9] Somewhat more helpfully, the court rephrased the test by reversing it: “the concept of reasonable doubt is akin to the concept that the stockholder has a ‘reasonable belief’ that the board lacks independence or that the transaction was not protected by the business judgment rule.”
The Aronson standard proved awkward in some cases, such as when there had been a turnover in board composition, where the complaint alleged inaction rather than action, and so on. In Rales v. Blasband. Plaintiff brought a double derivative suit on behalf of a parent corporation with respect to the sale of subordinated debentures by its wholly owned subsidiary. Because the derivative suit did not challenge a decision by the parent corporation’s board, the court held that the Aronson standard did not apply:
Instead, it is appropriate in these situations to examine whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations. Thus, 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. If the derivative plaintiff satisfies this burden, then demand will be excused as futile.[10]
The court noted three scenarios in which this test is to be used in lieu of the Aronson standard: (1) where a majority of the board that made the challenged transaction has been replaced by disinterested and independent members; (2) where the litigation arises out of some transaction or event not involving a business decision by the board; and (3) where the challenged decision was made by the board of a different corporation.
In my Business Associations class, I have often argued that the Delaware Supreme Court should overrule Aronson and adopt Rales as the general standard. In a recent case involving Facebook, which Professor Ann Lipton noted on Twitter, Delaware Vice Chancellor Travis Laster advocated just such a move:
Both tests remain authoritative, but the Aronson test has proved to be comparatively narrow and inflexible in its application, and its formulation has not fared well in the face of subsequent judicial developments. The Rales test, by contrast, has proved to be broad and flexible, and it encompasses the Aronson test as a special case.[11]
VC Laster went on to explain that:
In using the standard of review for the challenged transaction as a proxy for the risk of director liability and hence the test for demand futility, Aronson was a creature of its time. Subsequent jurisprudential developments severed the linkage between these concepts. Under current law, the application of a standard of review that is more onerous than the business judgment rule does not render demand futile. Similarly, the availability of exculpation means that a standard of review that is more onerous than the business judgment rule may not result in a substantial likelihood of liability.[12]
Laster went on to review these changes in detail, explaining how they had called into question the continuing utility of Aronson.
In addition to its declining doctrinal relevance, the Aronson test has always been an awkward way of getting at the core problem in the derivative suit context. Recall that we are dealing here not with a lawsuit brought to redress an injury done to the shareholder but rather one done to the corporate entity. The board of directors is charged with running the corporation and therefore ought to control corporate litigation. On the other hand, when it is the directors or their associates who are on trial, we may not trust them to make unbiased decisions. Consequently, the law governing derivative litigation must balance the competing policies of deference to the board’s decision-making authority and the need to hold erring directors accountable.
The core question thus is: Do we trust the board of directors to make a good faith decision about the merits of the lawsuit in question. If so, the board should be allowed to control the case. If not, the shareholder should be allowed to go forward.
Aronson gets at that question only indirectly. In contrast, as Laster explained, Rales does so directly:
The significant advance made by Rales was to refocus the inquiry on the decision regarding the litigation demand, rather than the decision being challenged. . . . The Rales decision thus asked directly “whether the board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations.”
Under Rales, a director is disqualified from exercising judgment regarding a litigation demand if the director was interested in the alleged wrongdoing, such as when the director received a personal benefit from the wrongdoing that was not equally shared from the stockholders. A director also is disqualified from exercising judgment regarding a litigation demand if another person was interested in the alleged wrongdoing, and the director lacks independence from that person. Id. Although these aspects of the Rales inquiry look to the relationship between the alleged wrongdoing and the directors considering the litigation demand, they do so for purposes of analyzing the directors’ ability to evaluate the litigation demand, not to determine the standard of review that would apply to the alleged wrongdoing.[13]
Ultimately, of course, the Delaware Supreme Court will have the final word. But the court will have a very hard time trying to justify preserving Aronson.
[1] Federal Rule 23.1 contemplates that demand may be made on shareholders in appropriate cases. A few jurisdictions require demand on shareholders, at least in some cases. See, e.g., Heilbrunn v. Hanover Equities Corp., 259 F.Supp. 936 (S.D.N.Y.1966) (demand on shareholders excused where wrongdoers hold a majority of corporation’s stock); Mayer v. Adams, 141 A.2d 458 (Del.Supr.1958)(demand on shareholders excused where alleged wrong could not be ratified by shareholders).
[2] Allison v. General Motors Corp., 604 F.Supp. 1106, 1117 (D.Del.), aff’d mem., 782 F.2d 1026 (3d Cir.1985). Accord Lewis v. Sporck, 646 F.Supp. 574, 577–78 (N.D.Cal.1986).
[3] See, e.g., Kaster v. Modification Systems, Inc., 731 F.2d 1014, 1017–19 (2d Cir.1984) (holding that demand on an individual who was president, chairman of the board, and 71% stockholder did not satisfy demand requirement under FRCP 23.1); Shlensky v. Dorsey, 574 F.2d 131, 141 (3d Cir.1978) (four letters sent to the company’s president did not satisfy FRCP 23.1).
[4] Equitec-Cole Roesler LLC v. McClanahan, 251 F.Supp.2d 1347 (S.D.Tex.2003).
[5] See Levine v. Smith, 591 A.2d 194, 207 (Del.1991) (“The demand requirement is not a ‘mere formalit[y] of litigation,’ but rather an important ‘stricture[ ] of substantive law.’ ”); see also Barr v. Wackman, 368 N.Y.S.2d 497, 505 (1975) (“demand is generally designed to weed out unnecessary or illegitimate shareholder derivative suits”).
[6] Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984).
[7] 591 A.2d 194, 205 (Del.1991).
[8] Starrels v. First Nat’l Bank of Chicago, 870 F.2d 1168, 1175 (7th Cir.1989) (Easterbrook, J., concurring) (citations omitted).
[9] Grimes v. Donald, 673 A.2d 1207, 1217 (Del.1996).
[10] Rales v. Blasband, 634 A.2d 927, 934 (Del.1993).
[11] United Food & Comm. Workers Union v. Zuckerberg, C.A. No. 2018-0671-JTL at 18-19 (Del. Ch. Oct 26, 2020).
[12] Id. at 22-23.
[13] Id. at 36-37.
