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Advanced Corporate Law
University of Wyoming School of Law
Gelb, Harvey

University of Wyoming, Prof. Gelb, Adv. Business Orgs., Spring 2010
 
SHAREHOLDER DERIVATIVE ACTIONS
 
Introduction
 
Shareholder Derivative Suit∷ An action brought by a shareholder on behalf of the corporation for a wrong done to the corporation by a third party, often an insider, e.g. an executive officer or director.
 
Characteristics of a Shareholder Derivative Suit
–           Unique in the corporate law, which traditionally states that the corporate power to sue lies exclusively with management: shareholders circumvent classical director power
–           Corporation is technically a defendant
–           Action lies in equity, because there is no legal theory available via direct wrong to the shareholder; there is no contract in place
–           Implied in equity as to other business entities, e.g., LLCs.
–           May look similar to a shareholder direct action where one shareholder is a representative in a class action against the corporation, but is not the same at all.
 
Policies for Captioning the Corporation as a Defendant
1.         To give the corporation notice
2.         To require action by the corporation, especially even if its directors did not want to pursue the suit:
a.         There may be a conflict of interest caused by the parties controlling the corporation as to their unwillingness to direct the corporation to sue themselves
b.         The directors are not necessarily acting wrongly, but do not wish to pursue the suit as a matter of policy
 
Strike Suit∷ A shareholder derivative suit of questionable merit brought for the purposes of enriching the shareholder, the attorney, or both, usually with the strategy of coercing a settlement by the corporation.
 
Legal Requirements for (Obstacles to) Shareholder Derivative Suits
1.         Security for Expenses
2.         Demand on Directors
3.         Special Litigation Committees
 
Security for Expenses
 
Security for Expenses:: Statutory requirement that the plaintiff-shareholder in a derivative suit, if unsuccessful, liable for attorneys’ fees of the defense and requires the plaintiff in the meantime to either to already own a sufficient share in the corporation or provide a bond as security for those legal expenses.
 
Current Status of Security for Expenses Laws
–           Largely repealed
–           Ineffective / discriminatory as to small shareholders
 
Cohen v. Beneficial Indus. Loan Corp.
Facts: Delaware corporation.  Del. has no statute re: security for expenses to protect against strike suits.  The company does business in NJ, which does have a statute mandating bonded security for expenses unless the shareholder owns 5% or $50,000 worth of stock
Issue: Even though Delaware law would apply to internal corporate affairs, should New Jersey law regarding strike suits be applied?
Analysis: Strike suit law is substantive in nature, not procedural.  By Erie, state law is applied
Holding: New Jersey substantive law regarding strike suits is applicable.
Criticism: If state law is applied, and Delaware state law was applicable, why wasn’t Delaware law applied, since it should be the governing state law!?
 
Cohen Rules for Shareholder Derivative Suits
Rule of Fiduciary Character: A stockholder who brings a suit on a cause of action derived from the corporation assumes a position that is one of fiduciary character.
Policy: The interests of all in redress are in the plaintiff’s hands; there was no election of the plaintiff by the other shareholders, because he is a “volunteer champion.”
Rule of State Plenary Power: A state has plenary power to regulate strike suits.
Policies: 1) Constitution does not obligate placing the litigation and adjudication processes at the disposal of such a representative; 2) Lawyers can and do use strike suits to extort corporations out of settlement fees, so the state has a legitimate interest in protecting corporations from this activity.
 
Must Determine Whether a Suit is Derivative or Direct: One must determine ahead of time whether a suit is derivative or direct in nature to further determine whether the plaintiff is liable for defendants’ attorneys’ fees if unsuccessful, and whether plaintiff is liable to provide a security bond during the pendency of the case.
 
Del. Direct vs. Derivative Two-Prong Standard (Tooley v. Donaldson)
1)         Who suffered the alleged harm, the corporation or the suing stockholders, individually?
2)         Who would receive the benefit of any recovery or other remedy?
 
N.Y. Direct vs. Derivative Test (Gordon v. Elliman, see also Eisenberg v. Flying Tiger)
1)         Whether the object of the lawsuit is to recover upon a chose in action belonging to the stockholders directly –OR–
2)         Whether to object of the lawsuit is to compel performance of corporate acts which good faith requires the directors to take in order to perform a duty they owe to the corporation.
Gelb Criticism: This is a fuzzy, unworkable rule, because, for instance, a dividend would be a corporate act within the discretion of the directors, but also a de facto direct remedy.
 
Wyoming’s Exception to Derivative Recovery (Lynch v. Patterson): For closely held corporations in a derivative suit, recovery may be allowed directly to the shareholder, because else, the money taken from the controlling shareholders would go back to the corporation, which they could simply withdraw again using their own corporate powers.
 
Demand on Directors
 
Delaware Framework for Demand Requirement (Grimes v. Donald)
0.         Determine whether the suit is derivative or direct
            a.         Employ the Tooley v. Donaldson Test (see supra)
i.          Who suffered the alleged harm, the corporation or the suing stockholders, individually?
ii.         Who would receive the benefit of any recovery or other remedy?
            b.         Also see the test previously used in Grimes for additional comprehension:
i.          If the power of the decision to make a claim lies in the directors, the shareholder suit is derivative;
ii.         if the power of decision to make a claim does not lie in the directors, the shareholder suit is direct.
            c.         If the suit is direct, no demand on the directors is required.
            d.         If the suit is derivative, demand on the directors may be required.
1.         Can Demand Be Excused for Futility?
            a.         A majority of the board has a material financial or familiar interest;
b.         A majority of the board is incapable of acting independently for some other reason such as domination or control; –OR–
c.         The underlying transaction is not the product of a valid exercise of business judgment.
2.         If demand cannot be excused for futility or the plaintiff cannot gather sufficient particularized proof using “tools at hand,” then the pre-suit demand must be made.
a.         A pre-suit demand in Delaware has the effect of estopping the plaintiff from denying the independence of the board of directors.
–           A shareholder who makes a demand cannot argue demand is excused or contest the independence of the board.
b.         Post demand, if the demand is rejected, the Business Judgment Rule applies unless the plaintiff can show, with particularity, reasonable doubt that the board of directors is not entitled to the presumption of the business judgment rule.
i.          If there is reason to doubt the board acted independently or with due care in responding to the demand, the stockholder may have the basis ex post to claim wrongful refusal.
ii.         If the demand was wrongful

l motion to dismiss.
            Motion’s Components:
–           Include a thorough written record of investigation and its findings & recommendations;
–           Akin to a motion on summary judgment: moving party must demonstrate there is no genuine issue of material fact
–           Each side must have an opportunity to make a record on the motion;
 
Delaware Court’s Two-Step Inquiry into SLC Motion to Dismiss
1.         Procedure: Court must inquire into the independence & good faith of the committee and the bases supporting its conclusions.
            a.         Limited discovery
b.         No presumption: Corporation has the burden of proving independence, good faith, and a reasonable investigation.
c.         If the court is not satisfied with the corporation’s proof, it denies the motion.
d.         If the court is satisfied, then it proceeds to step 2.
2.         Substance: The Court applies its own independent business judgment to determine whether the motion should be granted.
            –           Works to thwart corporations who meet the letter of the test but not the spirit
–           The Court of Chancery should give special consideration to matters of law and public policy in addition to the corporation’s best interests, when appropriate.
–           The Court may grant the motion, subject to any equitable terms or conditions the Court finds necessary or desirable.
 
In re Oracle Corp. Derivative Litigation Rule: Independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind (impartiality & objectivity); Tests for SLC Dependence or Partiality: Domination & Control vis-à-vis professional connections; alumni donations; friendship . . .
 
Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart Rule: A variety of motivations, including friendship, may influence the demand futility inquiry.  But to render a director unable to consider demand, a relationship must be of a bias-producing nature.  Allegations of mere personal friendship or a mere outside business relationship, standing alone, are insufficient to raise a reasonable doubt about a director’s independence.
 
Roadmap to Derivative Suits in Delaware
 
Direct or Derivative: Tooley
See § 102(b)(7)
Security for Expenses (deprecated)
Demand on the Directors
–           Excused –OR–
–           Made and refused (BJR now applies)
Special Litigation Committees: Zapata
–           See also In re Oracle
–           See also Beam ex rel Martha Stewart Living Omnimedia, Inc.
–           Limited discovery is allowed
–           Proof of independence, good faith & reasonable investigation lies with the SLC
Gelb Criticism of Delaware’s Method: Delaware’s position seems unfair, because it requires particularity in the complaint, but restricts/limits discovery to publicly available “tools at hand.”
 
Model Business Corporation Act (1984) Approach to Derivative Suits
 
§ 7.40. Subchapter Definitions
In this subchapter: