Proposed Amendments
The Committee proposes changes to section 1.43, section 2.08, and chapter 7D of the Model Act and the associated sections of the Official Comment as set forth below. Changes to the existing provisions are marked with deletions shown by strikeout and additions by underscoring.
§ 1.43. Qualified Director
- (a) A “qualified director” is a director who, at the time action is to be taken under:
- (1) section 2.02(b)(6), is not a director (i) to whom the limitation or elimination of the duty of an officer to offer potential business opportunities to the corporation would apply, or (ii) who has a material relationship with any other person to whom the limitation or elimination would apply;
- (2) section 7.44, does not have (i) a material interest in the outcome of
thea derivative proceeding, or (ii) a material relationship with a person who has such an interest;
- (3) section 8.53 or 8.55, (i) is not a party to the proceeding, (ii) is not a director as to whom a transaction is a director’s conflicting interest transaction or who sought a disclaimer of the corporation’s interest in a business opportunity under section 8.70, which transaction or disclaimer is challenged in the proceeding, and (iii) does not have a material relationship with a director described in either clause (i) or clause (ii) of this subsection (a)(3);
- (4) section 8.62, is not a director (i) as to whom the transaction is a director’s conflicting interest transaction, or (ii) who has a material relationship with another director as to whom the transaction is a director’s conflicting interest transaction; or
- (5) section 8.70, is not a director who (i) pursues or takes advantage of the business opportunity, directly, or indirectly through or on behalf of another person, or (ii) has a material relationship with a director or officer who pursues or takes advantage of the business opportunity, directly, or indirectly through or on behalf of another person.
- (b) For purposes of this section:
- (1) “material relationship” means a familial, financial, professional, employment or other relationship that would reasonably be expected to impair the objectivity of the director’s judgment when participating in the action to be taken; and
- (2) “material interest” means an actual or potential benefit or detriment (other than one which would devolve on the corporation or the shareholders generally) that would reasonably be expected to impair the objectivity of the director’s judgment when participating in the action to be taken.
- (c) The presence of one or more of the following circumstances shall not
automatically, by itself, prevent a director from being a qualified director:
- (1) nomination or election
of the director to the current board of directors by any directorperson who is not a qualified director with respect to the matter (or by any person that has a material relationship with that director), acting alone or participating with others;, including any defendant in a derivative proceeding or other person against whom action is demanded under section 7.42;
- (2) service as a director of another corporation of which a director who is not a qualified director with respect to the matter (or any individual who has a material relationship with that director)
, is or was also a director; or
- (3) with respect to action to be taken under section 7.44, status as a named defendant, as a director against whom action is demanded under section 7.42, or as a director who approved the conduct being challenged.
Cross-References
Advance for expenses, see § 8.53.
Business opportunities, see § 8.70.
Demand, see § 7.42.
“Derivative proceeding” defined, see § 7.40.
Determination and authorization of indemnification, see § 8.55.
Directors’Director action in director’s conflicting interest transaction, see § 8.62.
Director’s conflicting interest transaction, see § 8.60.
Dismissal of derivative proceeding, see § 7.44.
Official Comment
The definition of the term “qualified director” identifies those directorsa director: (i) who may take action on the dismissal of a derivative proceeding (section 7.44); (ii) who areis eligible to make, in the first instance, the authorization and determination required in connection with the decision on a request for advance for expenses (section 8.53(c)) or for indemnification (sections 8.55(b) and (c)); (iii) who may authorize a director’s conflicting interest transaction (section 8.62); (iv) who may disclaim the corporation’s interest in a business opportunity (section 8.70(a)); and (v) who may make applicable the limitation or elimination of a duty of an officer to offer the corporation business opportunities before the officer or a related person of the officer pursues or takes the opportunity (section 2.02(b)(6)).
Although the term “qualified director” embraces the concept of independence, it does so only in relation to the director’s interest or involvement in the specific situations to which the definition applies. The judicial decisions that have examined the qualifications of directors for such purposes have generally required that directors be both disinterested, in the sense of not having exposure to an actual or potential benefit or detriment arising out of the action being taken (as opposed to an actual or potential benefit or detriment to the corporation or all shareholders generally), and independent, in the sense of having no personal or other relationship with an interested director (e.g., a director who is a party to a transaction with the corporation) that presents a reasonable likelihood that the director’s objectivity will be impaired. The “qualified director” concept embraces both of those requirements, and its application is situation-specific; that is, “qualified director” determinations will depend upon the directly relevant facts and circumstances, and the disqualification of a director to act arises from factors that would reasonably be expected to impair the objectivity of the director’s judgment. On the other hand, the concept does not suggest that a “qualified director” has or should have special expertise to act on the matter in question.
1. Disqualification Due to Conflicting Interest
The “qualified director” concept prescribes significant disqualifications, depending upon the purpose for which a director might be considered eligible to participate in the action to be taken. These disqualifications include the following:
- In the case of action under a provision adopted under the authority of section 2.02(b)(6) to limit or eliminate any duty of an officer to offer the corporation business opportunities, the definition excludes any director who is also an officer and to whom the provision would apply.
- In the case of action on dismissal of a derivative proceeding under section 7.44, the definition excludes any director who has a material interest in the outcome of the proceeding, such as where the proceeding involves a challenge to the validity of a transaction in which the director has a material financial interest.
- In the case of action to approve indemnification or advance of funds for expenses, the definition excludes any director who is a party to the proceeding (see section 8.50 for the definition of “party” and for the definition of “proceeding”).
- In the case of action to approve a director’s conflicting interest transaction, the definition excludes any director whose interest, knowledge or status results in the transaction being treated as a “director’s conflicting interest transaction.” See section 8.60 for the definition of “director’s conflicting interest transaction.”
- In the case of action under section 8.70(a) to disclaim corporate interest in a business opportunity, the definition excludes any director who directly or indirectly pursues or takes advantage of the business opportunity, or who has a material relationship with another director or officer who does so.
Whether a director has a material interest in the outcome of a derivative proceeding in which the director does not have a conflicting personal interest is heavily fact-dependentdepends on the circumstances. At one end of the spectrum, if a claim against a director is clearly frivolous or is not supported by particularized and well-pleaded facts challenging the director’s objectivity, the director should not be deemed to have a “material interest in the outcome of thea derivative proceeding” within the meaning of section 1.43(a)(2), even though the director is named as a defendant. At the other end of the spectrum, a director normally should be deemed to have a “material interest in the outcome of thea derivative proceeding” within the meaning of section 1.43(a)(2) if a claim against the director is supported by particularized and well-pleaded facts which, if true, would be likely to give rise to a significant adverse outcome against the director.
2. Disqualification Due to Relationships with Interested Persons
In each context in which the “qualified director” definition applies, it also excludes any director who has a “material relationship” with another director (or, with respect to a provision applying to an officer under section 2.02(b)(6) or section 8.70, a “material relationship” with that officer) who is not disinterested for one or more of the reasons outlined in the preceding paragraph. Any relationship with such a person, whether the relationship is familial, financial, professional, employment or otherwise, is a “material relationship,” as that term is defined in section 1.43(b)(1), if it would reasonably be expected to impair the objectivity of the director’s judgment when voting or otherwise participating in action to be taken on a matter referred to in section 1.43(a). The determination of whether there is a “material relationship” should be based on the practicalities of the situation rather than on formalistic considerations. For example, a director employed by a corporation controlled by another director shouldwould usually be regarded as having an employment relationship with that director. On the other hand, a casual social acquaintance with another director shouldwould not ordinarily be regarded as a disqualifying relationship.
The term “qualified director” is distinct from the generic term “independent director,” which is not used in the Act. As a result, a director who might typically be viewed as an “independent director” may in some circumstances not be a “qualified director,” and vice versa. See also the Official Comment to section 8.01.
3. Elimination of Automatic Disqualification in Certain Circumstances
Section 1.43(c) addresses three categories of circumstances that, if present alone or together, do not automaticallyby themselves prevent a director from being a qualified director:
- Subsection (c)(1) makes it clear that the participation of
nonqualified directors (or interested shareholders or other interested persons), including nonqualified directors, interested shareholders, or defendants in a derivative proceeding, in the nomination or election of a director does not automatically, by itself, prevent thethat director so nominated or elected from being qualified. Special litigation committees acting with regard to a derivative litigationproceeding often consist of directors nominated or elected (whether before or after the alleged wrongful acts) by directors named as defendants in the actionproceeding. In other settings, directors who are seeking indemnification, or who are interested in a director’s conflicting interest transaction, may have participated in the nomination or election of an individual director who is otherwise a “qualified director.”
- Subsection (c)(2) provides, in a similar fashion, that the mere fact that an individual director is or was a director of another corporation—on the board of which a director who is not a “qualified director” also serves or has served—does not
automatically, by itself, prevent qualification to act.
- Subsection (c)(3) confirms
a number of decisions, involving dismissal of derivative proceedings, in which the court rejected a disqualification claim predicated on the mere fact that a director had been named as a defendant, was an individual against whom action has been demanded, or had approved the action being challenged. These cases have held that, where a director’s approval of the challenged action is at issue, approval does not automatically, by itself, make the director ineligible to act. On the other hand, for example, director approval of a challenged transaction, in combination with other particularized facts showing that the director’s ability to act objectively on a proposal to dismiss a derivative proceeding is impaired by a material conflicting personal interest in the transaction, disqualifies a director from acting on the proposal to dismiss the proceeding.
The effect of section 1.43(c), while significant, is limited. It merely precludes an automatic inference of director disqualification frombased solely on the circumstances specified in that subsection.
§ 2.08. Forum Selection Provisions
- (a) The articles of incorporation or the bylaws may require that any or all internal corporate claims shall be brought exclusively in any specified court or courts of this state and, if so specified, in any additional courts in this state or in any other jurisdictions with which the corporation has a reasonable relationship.
- (b) A provision of the articles of incorporation or bylaws adopted under subsection (a) shall not have the effect of conferring jurisdiction on any court or over any person or claim, and shall not apply if none of the courts specified by such provision has the requisite personal and subject matter jurisdiction. If the court or courts of this state specified in a provision adopted under subsection (a) do not have the requisite personal and subject matter jurisdiction and another court of this state does have such jurisdiction, then the internal corporate claim may be brought in such other court of this state, notwithstanding that such other court of this state is not specified in such provision, and in any other court specified in such provision that has the requisite jurisdiction.
- (c) No provision of the articles of incorporation or the bylaws may prohibit bringing an internal corporate claim in the courts of this state or require such claims to be determined by arbitration.
- (d) “Internal corporate claim” means, for the purposes of this section, (i) any claim that is based upon a violation of a duty under the laws of this state by a current or former director, officer, or shareholder in such capacity, (ii) any derivative
action or proceeding brought on behalf of the corporation, (iii) any action asserting a claim arising pursuant to any provision of this Act or the articles of incorporation or bylaws, or (iv) any action asserting a claim governed by the internal affairs doctrine that is not included in (i) through (iii) above.
Cross-References
Derivative proceedings, see ch. 7D.
Official Comment
Section 2.08(a) authorizes a provision in either the articles of incorporation or the bylaws creating an exclusive forum or forums for the adjudication of internal corporate claims. Under section 2.08(a), the provision must specify at least one court of this state (i.e., a state court rather than a federal court). The provision may also include additional specified courts or all courts of this state or courts in this state (such as federal courts) or in one or more additional jurisdictions with a reasonable relationship to the corporation. In addition, the provision may prioritize among the specified courts. For example, the provision may specify that the claim shall be brought exclusively in a particular court of this state unless such court does not have the requisite personal and subject matter jurisdiction, in which case the claim shall be brought in other specified courts.
Under the last sentence of section 2.08(b), an internal corporate claim will always be permitted to be brought in at least one court of this state unless there is no court of this state that has the requisite personal and subject matter jurisdiction. For example, if the articles of incorporation or the bylaws provide that an internal corporate claim may only be brought in a specified court of this state and in the courts of another state with a reasonable relationship to the corporation, and the specified court of this state does not have the requisite personal and subject matter jurisdiction, then the claim can be brought in any other court of this state that does have the requisite jurisdiction or in the courts of the specified other state (so long as those courts have the requisite jurisdiction). Similarly, if the articles of incorporation or the bylaws provide that an internal corporate claim may only be brought in a specified court of this state and in the federal courts in this state, and the specified court of this state does not have the requisite personal and subject matter jurisdiction, then the claim can be brought in any other court of this state that does have the requisite jurisdiction or in the federal courts in this state (so long as the federal court has the requisite jurisdiction). In each of the foregoing examples, (i) if the specified court of this state does have the requisite personal and subject matter jurisdiction, then such court would be the only court of this state in which the internal corporate claim could be brought, and (ii) if no court of this state has the requisite personal and subject matter jurisdiction, then the courts of the other state (in the first example) or the federal courts in this state (in the second example) would become the exclusive forum for such internal corporate claim, in each case so long as such court has the requisite jurisdiction.
If no court of this state has the requisite personal and subject matter jurisdiction, and none of the other courts, if any, specified in the provision of the articles of incorporation or the bylaws has the requisite jurisdiction, then the provision will have no effect and the internal corporate claim may be brought in any court that does have the requisite jurisdiction.
Subchapter D.
Derivative Proceedings
§ 7.40. Subchapter Definitions
In this subchapter:
“Derivative proceeding” means a civil suit in the right of a domestic corporation or, to the extent provided in section 7.47, in the right of a foreign corporation, to recover for an injury to the corporation
“Shareholder” means a record shareholder, a beneficial shareholder, and an unrestricted voting trust beneficial owner.
Cross-References
“Beneficial shareholder,” “record shareholder” and “unrestricted voting trust beneficial owner” defined, see § 1.40.
Shares held by nominees, see § 7.23.
Voting trusts, see § 7.30.
Official Comment
In a derivative proceeding, the corporation receives the benefit of the recovery or other remedy to compensate it for its injury. In contrast, a claim in which the remedy would be paid directly to a shareholder to compensate such shareholder for the injury would be a direct claim. For example, a claim that the board of directors caused a corporation to overpay in acquiring an asset would be brought in a derivative proceeding. In that case, the corporation was injured by overpaying for the asset and would be entitled to a remedy, such as monetary damages equal to the difference between the actual purchase price and a fair price. This is so even though shareholders may have been harmed indirectly because the value of their shares declined due to the overpayment. However, if the board of directors violated a duty of disclosure to shareholders, a claim would be brought by shareholders as a direct claim because the shareholders were injured by being deprived of information necessary to cast an informed vote.
The definition of “shareholder,” for purposes of chapter 7Dsubchapter D, extends the right to bring a derivative proceeding to a beneficial shareholder and an unrestricted voting trust beneficial owner. The inclusion of beneficial shareholder and unrestricted voting trust beneficial owner recognizes that these persons have or hold, allowing them to act on their own rather than only through the record shareholder or voting trustee. The references to “shareholder” in subchapter D, however, do not prevent a court from recognizing the standing of a creditor of an insolvent corporation, as successor to the residual interests in the corporation, to assert a derivative claim on behalf of others an economic interest in the sharescorporation.
§ 7.41. Standing
A shareholder may not commence or maintain a derivative proceeding unless the shareholder (i) was a shareholder of the corporation at the time of the act or omission complained of or became a shareholder through transfer by operation of law from one who was a shareholder at that time and (ii) fairly and adequately represents the interests of the corporation in enforcing the right of the corporation.
Cross-References
“Derivative proceeding” defined, see § 7.40.
“Shareholder” defined, see § 7.40.
Official Comment
Section 7.41 requires (i) the plaintiff to be a shareholder and therefore does not permit, for example, creditors or holders of options, warrants, or conversion rights to commence a derivative proceeding, and (ii) that the plaintiff fairly and adequately represent the interests of the corporation, rather than shareholders similarly situated as provided in some rules of procedure, because the reference to the corporation more clearly reflects the nature of the derivative suitproceeding.
The introductory language ofBecause section 7.41 refers both to the commencement and maintenance of thecontemplates that a derivative proceeding to make it clear that thewill be commenced and maintained by a shareholder, the derivative proceeding shouldwould be dismissed if, after commencement, the plaintiff ceases to be a shareholder or a fair and adequate representative. The latter. This would occur, for example, if the plaintiff were using the proceeding for personal advantage. If a plaintiff no longer has standing, courts have in a number of instances provided an opportunity for one or more other shareholders to intervene.sold its shares or its shares were cancelled in a merger, although a court might consider an exception where the merger is carried out for the fraudulent purpose of depriving the shareholder of standing or where the merger is a reorganization that does not affect the shareholder’s ownership of the business enterprise.
§ 7.42. Demand
No shareholder may commence a derivative proceeding until (i) a written demand has been made upondelivered to the corporation to take suitable action and (ii) 90 days have expired from the date delivery of the demand was made unless the shareholder has earlier been notified that the demand has been rejected by the corporation or unless irreparable injury to the corporation would result by waiting for the expiration of the 90-day period. The written demand must describe in reasonable detail the reasons for the demand and the action being requested and state that the shareholder may commence a derivative proceeding if the action is not taken. If the shareholder is a beneficial shareholder or an unrestricted voting trust beneficial owner, the written demand shall be accompanied by evidence of such beneficial ownership.
Cross-References
“Deliver” defined, see § 1.40.
“Derivative proceeding” defined, see § 7.40.
Notices and other communications, see § 1.41.
“Shareholder” defined, see § 7.40.
Official Comment
Section 7.42 requires a written demand for two reasons. First, even though no director may be “qualified” (see section 1.43), the demand will give the corporation the opportunity to re-examine the act complained of in the light of a potential lawsuit and take corrective action. Second, the provision eliminates the time and expense of litigating whether demand is required. Requiring a demand in all cases does not impose an onerous burden given the relatively short waiting period and that this period may be shortened if irreparable injury to the corporation would result by waiting for the expiration of the 90-day period.
1. Form of Demand
Section 7.42 specifies only that the demand shall be in writing. Detailed pleading is not required givenensures that the corporation can contactis on notice that the shareholder for clarification if there are any questions, and cases have noted that a demand which sets forth the facts concerning share ownership and is sufficiently specific should apprise the corporation of the action sought to be taken and the grounds for that action so that the demand can be evaluated.may commence a derivative proceeding if corrective action is not taken and that the corporation has sufficient information to review the demand. The requirement for a shareholder who is a beneficial owner to provide evidence of beneficial ownership might be satisfied by providing a copy of a brokerage statement or similar documentation.
2. Upon Whom Demand Should Be Made
To ensure that the demand reaches the appropriate person for review, it should be addressed to the board of directors, chief executive officer, or secretary at the corporation’s principal office. In most cases the board of directors will be the appropriate body to review the demand but there may be instances, such as a decision to sue a third party for an injury to the corporation, in which the taking of, or refusal to take, action would fall within the authority of an officer of the corporation.
32. The 90-Day Period
The 90-day period in section 7.42 was chosen as a reasonable time within which the board of directors can meet, conduct the necessary inquiry into the charges, receive the results of the inquiry and make its decision. A fixed time period also eliminates litigation over what is or is not a reasonable time. If additional time is needed, the corporation may request counsel for the shareholder to delay filing suitcommencing the derivative proceeding until the inquiry has been completed or, if suitthe derivative proceeding is commenced, the corporation can apply to the court for a stay under section 7.43.
Two exceptions are provided to the 90-day waiting period. The first exception is the situation where the shareholder has been notified of the rejection of the demand before the end of the 90 days. The standard under the second exception for irreparable injury to the corporation is intended to be the same as that governing the entry of a preliminary injunction. Other factors may also be considered, such as the possible expiration of the statute of limitations, although this would depend on the period of time during which the shareholder was aware of the grounds for the derivative proceeding.
The shareholder bringing suitthe derivative proceeding does not necessarily have to be the person making the demand. Only one demand need be made in order for the corporation to consider whether to take corrective action.
43. Response by the Corporation
There is no obligation on the part of the corporation to respond to the demand. However, if the corporation, after receiving the demand, decides to institute litigation or, after a derivative proceeding has commenced, decides to assume control of the litigation, the shareholder’s right to commence or control the proceeding normally ends unless it can be shown that the corporation will not adequately pursue the matter.
§ 7.43. Stay of Proceedings
If the corporation commences an inquiry into the allegations made in the demand or complaint, the court may stay any derivative proceeding for such period as the court deems appropriate.
Cross-References
Demand, see § 7.42.
“Derivative proceeding” defined, see § 7.40.
Official Comment
A stay may be appropriate where, for example, the complaint is filed 90 days after demand but the inquiry into matters raised by the demand has not been completed or where a demand has not been investigated but the corporation commences the inquiry after the complaint has been filed. In any case, theby the date of filing. The court will likely monitor the course of the inquiry to ensure that the corporation is proceeding expeditiously and in good faith.
§ 7.44. Dismissal
- (a) A derivative proceeding shall be dismissed by the court on motion by the corporation if a determination is made, whether before or after the commencement of the derivative proceeding, by one of the groups specified in subsection (b)
or subsection (e) has determined in good faith, after conducting a reasonable inquiry upon which its conclusions are based, that the maintenance of the derivative proceeding is not in the best interests of the corporation.
- (b)
Unless a panel is appointed pursuant to subsection (e), theThe determination in subsection (a) shall be made by:
- (1) a majority vote of qualified directors present at a meeting of the board of directors if the qualified directors constitute a quorum;
or
- (2) a majority vote of a committee consisting of two or more qualified directors appointed by majority vote of qualified directors present at a meeting of the board of directors, regardless of whether such qualified directors constitute a quorum
.; or
- (3) upon motion by the corporation, a panel of one or more individuals appointed by the court.
- (c) If a
derivative proceeding is commenced after a determination has been made rejecting a demand by a shareholder, the complaintby one of the groups specified in subsection (b) that maintaining the derivative proceeding is not in the best interests of the corporation, in order to contest the determination, the plaintiff shall allege with particularity facts establishing either (1) that a majority of the board of directors did not consist of qualified directors at the time the determination was made or (2) that the requirements of subsection (a) have not been met.
- (d) The burden of proving whether the requirements of subsection (a) have been met shall be determined as follows:
- (
d1) If a majority of the board of directors consisted of qualified directors at the timeif the determination was made, by one of the groups specified in subsection (b)(1) or (2), then the plaintiff shall have the burden of proving that the requirements of subsection (a) have not been met; if not, unless the plaintiff has alleged with particularity facts establishing that a majority of the board of directors at the time the determination was made did not consist of qualified directors, in which case the corporation shall have the burden of proving that the requirements of subsection (a) have been met.; or
- (
e2) Upon motion by the corporation, the court may appoint a panel of one or more individuals to make a determination whether the maintenance of the derivative proceeding is in the best interests of the corporation. In such case,if the determination was made by a panel appointed pursuant to subsection (b)(3), then the plaintiff shall have the burden of proving that the requirements of subsection (a) have not been met.
- (e) The court on its own motion or on the motion of any party may order that any motion to dismiss under subsection (a) be made within a specified reasonable time.
Cross-References
Board of directors:
committees, see § 8.25.
meetings, see § 8.20.
quorum and voting, see § 8.24.
Demand, see § 7.42.
“Derivative proceeding” defined, see § 7.40.
“Qualified director” defined, see § 1.43.
“Shareholder” defined, see § 7.40.
Standards of conduct for directors, see § 8.30.
Standing, see § 7.41.
Official Comment
Section 7.44 addresses the corporation’s decision to dismiss a derivative proceeding, but the corporation might respond to a shareholder’s demand in several ways. For example, the corporation might (i) not respond to the demand, in which case a shareholder could commence the derivative proceeding after complying with section 7.42; (ii) conduct an inquiry and determine that some or all of the claims in the demand should be pursued by the corporation, in which case the ability of a shareholder to commence or maintain a derivative proceeding typically ends; (iii) not object to a shareholder’s commencement of the derivative proceeding to pursue some or all of the claims even though the corporation itself will not pursue such claims, in which case a shareholder might commence the derivative proceeding after complying with section 7.42; or (iv) after conducting the requisite inquiry, determine that maintaining the derivative proceeding is not in the corporation’s best interests, in which case the corporation typically would move to dismiss the derivative proceeding pursuant to section 7.44.
Section 7.44 only addresses the corporation’s decision not to maintain the derivative proceeding because subchapter D’s primary focus is on who has the authority to pursue claims on behalf of the corporation. Therefore, section 7.44 also does not address a situation where the corporation responds to a demand by pursuing the claim but the shareholder objects to how the claim was handled or resolved.
The procedures set forth in section 7.44 are not intended to be exclusive. Discretion is left with the courts to determine when a derivative actionproceeding should be dismissed under circumstances other than those set forth in section 7.44. For example, as noted in the comment to section 7.42, there may be instances where a decision to commence an action falls within the authority of an officer of the corporation, depending upon the amount of the claim and the identity of the potential defendants. The derivative proceeding may also be dismissed under other sections in subchapter D, for example, where the shareholder failed to make a demand on the corporation as required by section 7.42 or no longer satisfies the standing requirements in section 7.41.
1. The Persons Making the Determination and Timing
The determination under section 7.44(ba) that the maintenance of the derivative proceeding is not in the best interests of the corporation can be made before commencement of the derivative actionproceeding in response to a demand or after commencement of the actionproceeding upon examination of the allegations of the complaint. SectionSections 7.44(b) allows(1) and (2) allow the determination to be made by “qualified directors” as defined in section 1.43. These provisions parallel the mechanics for authorizing an officer’s pursuit of a business opportunity pursuant to a provision in the articles of incorporation (section 2.02(b)(6)), for determining entitlement to indemnification (section 8.55), for authorizing directors’ conflicting interest transactions (section 8.62), and for renunciation of the corporation’s interests in a business opportunity (section 8.70). Section 7.44(eb)(3) provides for the appointment of a panel by the court only upon motion by the corporation. This would not, however, prevent the court on its own initiative from appointing a special master if permitted under applicable state rules of procedure.
ThisAlthough the panel procedure is not common, it may be desirable in a number ofsome circumstances, particularly if there are no qualified directors available. In addition, even if there are qualified directors, they may not be in a position to conduct the inquiry.
If no determination is made by qualified directors or a court-appointed panel or the determination does not meet the requirements of section 7.44(a), then the shareholder who otherwise meets the requirements of this subchapter may continue to maintain the derivative proceeding.
2. Standards to Be Applied
Section 7.44(a) contemplates that the court will examine the “good faith” of the persons making the determination. Both the determination and the inquiry in section 7.44(a) mustshall be made in “good faith.” Section 7.44(a) does not authorize the court to review the reasonableness of the determination to reject a demand or seek a dismissal. The “good faith” standard, which is also found in section 8.30 (general standards of conduct for directors) and section 8.51 (authority to indemnify), is a subjective one, meaning “honestly or in an honest manner.”
The word “inquiry”—rather than “investigation”—has been used to make it clear that the scope of the inquiry will depend upon the issues raised and the knowledge of the group making the determination with respect to those issues. The time and expense of an inquiry will be influenced by the seriousness and credibility of the allegations in the demand. In some cases, the demand may be without merit or the issues may be within the knowledge of the group so that an extensive additional investigationinquiry is not necessary or would be disproportionate to the alleged harm to the corporation. In other cases, the group may need to engage counsel and possibly other professionals to conduct an investigation and assist the group in its evaluation of the issues.
TheSection 7.44(a) does not authorize the court to review the reasonableness of the determination to reject a demand or seek a dismissal. The phrase “upon which its conclusions are based,” however, requires that the conclusions of the persons making the determination follow logically from the inquiry. The burden
of convincing the court about this issue lies with whichever party has the burden under section 7.44(d). This phraseIf the plaintiff opposes a corporation’s motion to dismiss a derivative proceeding, subsection (c) requires the plaintiff ’s complaint (or, if the determination has been made after the commencement of the derivative proceeding, an amended complaint or other filing with the court) to plead with particularity that the directors making the determination were not qualified or that they did not otherwise meet the requirements of subsection (a). Section 7.44 does not require the persons making the determination to prepare a written report that sets forth their determination and its bases, as circumstances will vary as to the need for such a report.
Section 7.44 is not intended to modify the general standards of conduct for directors set forth in section 8.30 but rather to make those standards more explicit in the derivative proceeding context. In this regard, the qualified directors making the determination would be entitled to rely on information and reports from other persons in accordance with section 8.30.
§ 7.45. Discontinuance or Settlement
A derivative proceeding may not be discontinued or settled without the court’s approval. If the court determines that a proposed discontinuance or settlement will substantially affect the interests of the corporation’s shareholders or a class or series of shareholders, the court shall direct that notice be given to the shareholders affected.
Cross-References
“Derivative proceeding” defined, see § 7.40.
“Shareholder” defined, see § 7.40.
Official Comment
Section 7.45’s requirement that alla proposed settlements and discontinuancessettlement or discontinuance of a derivative proceeding receive judicial approval supports the proposition that a derivative suitproceeding is brought for the benefit of allthe corporation, such that some or all of its shareholders and thusmay have an interest in the outcome, and the proceeding should not be settled privately.
By requiring that notice be given to all affected shareholders if the court determines that the proposed settlement may substantially affect their interests, section 7.45 permits the court to decide whether notice to shareholders (or holders of a class or series of shares) need be given. For example, the court may decide not to require notice of dismissal if, in the court’s judgment, the derivative proceeding is frivolous or has become moot. Section 7.45 also makes a distinction between classes or series of shareholders, an approach that could be used, for example, to eliminate the costs of notice to preferred shareholders where the settlement does not have an effect on their rights, such as their rights to dividends or a liquidation preference.
Section 7.45 does not address the issue of which party should bear the cost of giving this notice or the manner in which the notice should be given, which is left to the discretion of the court reviewing the proposed settlement.
§ 7.46. Payment of Expenses
On termination of the derivative proceeding the court may:
- (1) order the corporation to pay the plaintiff ’s expenses incurred in the derivative proceeding if it finds that the derivative proceeding has resulted in a substantial benefit to the corporation;
- (2) order the plaintiff to pay the corporation’s or any defendant’s expenses incurred in responding to the demand or defending the derivative proceeding if it finds that the demand was made or the derivative proceeding was commenced or maintained without reasonable cause or for an improper purpose; or
- (3) order a party to pay an opposing party’s expenses incurred because of the filing of a pleading, motion or other paper, if it finds that the pleading, motion or other paper (i) was not well grounded in fact, after reasonable inquiry, or warranted by existing law or a good faith argument for the extension, modification or reversal of existing law or (ii) was interposed for an improper purpose, such as to harass or cause unnecessary delay or needless increase in the cost of litigation.
Cross-References
“Derivative proceeding” defined, see § 7.40.
“Expenses” defined, see § 1.40.
Official Comment
The requirement in section 7.46(a1) that the court may order the corporation to pay the plaintiff ’s expenses if it finds that the derivative proceeding has resulted in a “substantial” benefit to the corporation, should discourage a plaintiff from proposing inconsequential matters to justify the payment of counsel fees. The provision does not specify the method for calculating attorneys’ fees given that there is a substantial body of case law that delineates this issue, which usually includes taking into account the amount or character of the benefit to the corporation.
The standard under section 7.46(b2) for the court to require the plaintiff to pay the corporation’s and defendants’ expenses if the actiondemand was made or the derivative proceeding was commenced without reasonable cause or for an improper purpose is intended to discourage proceedings brought for the sole purpose of obtaining early settlement payments by defendants to avoid significant defense costs, while also protecting plaintiffs whose suits have a reasonable foundation. This test is similar to but not identical to the test utilized in section 13.31, relating to dissenters’ rights, where the standard for award of expenses is that dissenters “acted arbitrarily, vexatiously or not in good faith” in demanding a judicial appraisal of their shares. The derivative actionproceeding situation is sufficiently different from the dissenters’ rights situation to justify a different and less onerous test for imposing costs on the plaintiff. The corporation’s expenses may include the attorneys’ fees and other expenses incurred by the qualified directors who conduct an inquiry under section 7.44(a) (including through a special litigation committee) or a panel appointed by the court under section 7.44(b)(3).
Section 7.46(c3) addresses other abuses in the conduct of derivative litigation which may occur on the part of the defendants and their counsel as well as by the plaintiffs and their counsel. This provision may be unnecessary if these abuses are already addressed under applicable rules of civil procedure.
§ 7.47. Applicability to Foreign Corporations
In any derivative proceeding in the right of a foreign corporation, the matters covered by this subchapter shall be governed by the laws of the jurisdiction of incorporation of the foreign corporation except for sections 7.43, 7.45, and 7.46.
Cross-References
“Derivative proceeding” defined, see § 7.40.
“Foreign corporation” defined, see § 1.40.
Foreign corporations, see ch. 15.
Official Comment
Section 7.47 clarifies the application of the provisions of chapter 7Dsubchapter D to foreign corporations by setting forth a choice of law provision for derivative proceedings involving foreign corporations. It provides, subject to three exceptions, that the matters covered by the chapter 7Dsubchapter D shall be governed by the laws of the jurisdiction of incorporation of the foreign corporation.
The three exceptions to the general rule are areas which are traditionally part of the forum’s oversight of the litigation process: section 7.43, dealing with the ability of the court to stay derivative proceedings; section 7.45, setting forth the procedure for settling a derivative proceeding; and section 7.46, providing for the assessment of reasonable expenses (including counsel fees) in certain situations.
