Shareholder Derivative Litigation Remains an Extraordinary Remedy
Corporate directors and officers have a “general authority . . . to manage the business affairs of the corporation.” Boland v. Boland, 31 A.3d 529, 548 (Md. Oct. 25, 2011) (quoting Werbowsky v. Collomb, 766 A.2d 123, 133, 135 (Md. 2001)). The shareholder derivative suit evolved as “an ‘extraordinary equitable device to enable shareholders to enforce a corporate right’” where the board and management allegedly cannot or will not do so. Id. “The derivative suit thus balances the interests of the shareholders with those of the corporation and its directors” and “courts maintain this balance” using the “business judgment rule.” Id. at 548 (internal quotation marks and citations omitted). This rule “is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts.” Id.(quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)).
[B]ecause a shareholder’s derivative action necessarily intrudes upon the managerial prerogatives ordinarily vested in the directors . . . the law soon attached to this new mechanism the condition that, before being allowed to proceed with a derivative action, a shareholder first make a good faith effort to have the corporation act directly.
Werbowsky v. Collomb, 766 A.2d 123, 133 (Md. 2001).
This “demand requirement is important” to ensure that directors will not “be put unnecessarily at risk by minority shareholders bent simply on mischief, who file derivative actions not to correct abuse as much to coerce nuisance settlements.” Id. at 144 (emphasis original); see also Brehm v. Eisner, 746 A.2d 244, 255 (Del. 2000). The demand requirement enables the corporation’s board of directors (or a subcommittee) to investigate the demand and determine whether pursuing the claims therein is in the company’s best interest. See, e.g., Mona v. Mona Elec. Group, Inc., 934 A.2d 450, 466 (Md. 2007). If the board rejects the demand, the shareholder can then bring suit claiming that the demand was wrongfully refused. Id.
The “Demand Futility” Exception to the Demand Requirement Is Narrow
A derivative plaintiff who fails to make a demand must “state with particularity the reasons for not obtaining the action or not making the effort.” Fed. R. Civ. P. 23.1; see also Del. Ch. R. 23.1 (providing similar state rule to federal counterpart); Werbowsky v. Collomb, 766 A.2d 123, 144 (Md. 2001). Circumstances excusing demand include a risk of imminent, irreparable harm to the corporation, or “demand futility”—that is, that “a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to a demand in good faith and within the ambit of the business judgment rule.” Werbowsky v. Collomb, 766 A.2d at 144 (construing the Maryland standard for demand futility). The futility allegations must be made in a particularized fashion; loose allegations of “demand futility” or “demand excused” will not suffice. Brehm, 746 A.2d at 254 (Demand “pleadings must comply with stringent requirements of factual particularity. . . . Rule 23.1 is not satisfied by conclusory statements or mere notice pleading.”).
Two decisions in 2011 underscored the importance of the demand requirement. In Boland v. Boland, the Maryland Court of Appeals recognized a trend toward a universal demand requirement, although ultimately it stopped short of imposing such a requirement. “Over time, courts and legislatures have moved towards a ‘universal demand’ requirement. This court has yet to close the door on the ‘futility exception’ . . .” Although it did not abolish the exception, the Boland court reiterated that demand futility is a narrow exception, applicable only in limited circumstances. “‘We adhere, for the time being, to the futility exception, but, consistent with what appears to be the prevailing philosophy throughout the country, regard it as a very limited exception. . . .’” Boland, 31 A.2d at 550 n.25 (quoting Werbowsky, 766 A.2d at 144, and citing Werbowsky, 766 A.2d at 123, 135).
The Boland court also theorized about the procedural implications of imposing a universal demand requirement, noting “the procedural distinctions between a ‘demand excused’ and a ‘demand refused’ action may no longer be viable” and “it is clear that the derivative plaintiff may continue to contest the independence of the board members after filing such a demand.” Boland, 31 A.2d at 550 n.25. In other words, although traditionally shareholders who made a demand upon the corporation presumptively conceded the ability of the board to evaluate the demand, if a universal demand requirement was imposed, the shareholder should not be prejudiced for complying with the demand requirement.
In Kautz v. Sugarman, No. 11-1767-cv, 2011 WL 5829664 (2d Cir. Nov. 21, 2011), the Second Circuit further underscored the narrowness of the “demand futility” exception by holding that refusal of an earlier demand does not provide grounds for excusing demand by a different derivative plaintiff. Plaintiff Kautz did not make a pre-suit demand upon iStar Financial Inc. before filing a derivative suit against corporate directors and officers for alleged “breaches of fiduciary duties, waste of corporate assets, unjust enrichment, and related claims.” Kautz, 2011 WL 5829664 at *1. Kautz alleged that demand was futile because, among other things, the iStar board previously rejected a demand by another alleged shareholder asserting substantially similar claims. Id. The district court dismissed the complaint, holding that “the Board’s negative response to the [previous demand] did not excuse the requirement that Kautz make his own pre-suit demand” and that “Kautz had failed to allege the existence of mutual releases between the directors and the departed executives.” Id. at *2. The Second Circuit agreed, noting that
Kautz does not point to a single case in which demand is excused as against one plaintiff because an unrelated plaintiff earlier made an unsuccessful demand. We decline to create such a rule out of whole cloth, and find that Kautz's first assignment of error is meritless.
Id. at *3.
Both the district court and the Second Circuit also rejected claims of demand futility based on the plaintiff’s speculation that, in permitting three of iStar’s executives, who allegedly participated in the wrongdoing, to resign or retire, the board had released any claims against them. The courts held that the pleadings alleged no facts to support the existence of mutual releases, “but merely a string of speculations,” which was insufficient. Id. at *4. Moreover, even if Kautz had pled the existence of such releases, it would be insufficient to plead demand futility because “the mere fact that a director may have a financial interest that would be harmed if an investigation goes forward does not render that director so personally and directly conflicted as to excuse demand.” Id. at *4 (internal quotation marks and citations omitted).
Boland and Kautz serve as reminders that it is the prerogative of the corporation, acting through its elected directors, to evaluate potential claims against its directors and officers and determine whether it is in the corporation’s best interest to pursue them. Self-appointed shareholders cannot assume authority to act on behalf of the corporation absent a particularized showing that the board is disabled from performing its normal function. See, e.g., Werbowsky, 766 A.2d at 139; Aronson, 473 A.2d at 814–17.
Discretion to Pursue Opportunities—and Risk—on Behalf of the Corporation
In In re Goldman Sachs Group, Inc. Shareholder Litigation, Civil Action No. 5215-VCG, 2011 WL 4826104, *1 (Del. Ch. Oct. 12, 2011), the Delaware Chancery Court recently reaffirmed that corporate actors possess a “broad freedom to pursue opportunity on behalf of the corporation, in the myriad ways that may be revealed to creative human minds, [which freedom] has made the corporate structure a supremely effective engine for the production of wealth.” Indeed, “[e]xercising that freedom is precisely what directors and officers are elected by their shareholders to do.” Id.
In Goldman, the shareholder plaintiffs brought derivative litigation on behalf of the corporation, without first making a demand, alleging that Goldman’s compensation structure encouraged its employees to engage “in highly risky trading practices and . . . over-leverag[e] the company’s assets,” resulting in a “windfall” to themselves for any successes but leaving the shareholders to shoulder any losses for failures. Id. The derivative plaintiffs alleged that the directors breached their fiduciary duties by approving such a compensation structure, that such compensation amounted to corporate waste, and that the directors failed to satisfy their oversight responsibilities because this yielded overly risky, unethical, and illegal practices. Id. at *2.
In dismissing the lawsuit, the chancery court reaffirmed the ability of directors and officers to make business decisions —even unpopular business decisions—on behalf of the company. The mere “fact that Plaintiffs may desire a different compensation scheme does not indicate that equitable relief is warranted.” Id.
The court also called into serious doubt the ability of any plaintiff to bring a viable claim for alleged failure to monitor business risk. “[T]his Court has not definitively stated whether a board’s Caremark duties include a duty to monitor business risk.” Goldman, 2011 WL 4826104 at *21–22 (citing Caremark, 698 A.2d at 970 and Citigroup, 964 A.2d at 131). The chancery court further held that if any such claim could exist, it could extend only to whether there was a bad-faith, conscious failure to establish a risk-monitoring process, id. at *22 & n. 217, not to an evaluation of the ultimate results of that process or the actual judgments made by the directors and officers:
[T]he essence of [plaintiffs’] complaint is that I should hold the Director Defendants personally liable for making (or allowing to be made) business decisions that in hindsight turned out poorly for the company. If an actionable duty to monitor business risk exists, it cannot encompass any substantive evaluation by a court of a board’s determination of the appropriate amount of risk.
Id. at *22 (emphasis added).
Thus, “‘[o]versight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.’” Id.at *23 (quoting In re Citigroup, Inc. Shareholder Derivative Litig., 964 A.2d 106, 131 (Del. Ch. 2009) (emphasis original)).
Special Litigation Committee Decisions Entitled to Deference
“[M]any business dealings are approved by directors who are not entirely disinterested; those dealings thus may not be entitled to deference on their decisions regarding a derivative lawsuit.” Boland, 31 A.3d at 550–51. To “retain a voice in the derivative lawsuit” but inoculate themselves against charges of self-interest and yet not “strip such transactions of the business judgment rule’s protection,” directors may delegate the decision-making function to special litigation committees (SLCs) that are “composed of independent, disinterested directors, either inside the corporation of specially appointed outside the corporation.” Boland, 31 A.3d at 551. SLCs are used to evaluate the demand and the propriety of pursuing the demanded litigation, but boards of directors can, and often do, appoint SLCs to evaluate transactions involving the potential conflict of interest. See, e.g.,Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997). Although the use of SLCs is widespread, there is some disagreement on the standard to be applied by a court in reviewing the validity of an SLC’s decision to terminate the derivative suit. In Boland, the Maryland Court of Appeals considered two different approaches in deciding “how rigorously a court should review” this recommendation of an SLC. Boland, 31 A.3d at 551.
The first approach was that adopted by the New York courts in Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979). Under Auerbach, a court “treats the SLC’s decision like other corporate decisions, and engages in limited review under the business judgment rule.” Boland, 31 A.3d at 551 (citing and discussing Auerbach). In other words, the court can examine the process by which an SLC made its decision and the composition of the SLC, but not examine the substance of the decision itself. Id. The rationale for the Auerbach approach is that “courts are ill equipped and infrequently called on to evaluate what are and must essentially be business judgments,” whereas they are “well equipped” to inquire into the “methodologies and procedures best suited to the conduct of an investigation of facts and the determination of legal liability.” Auerbach, 393 N.E.2d at 1000 and 1002.
The alternative approach considered by the Maryland court in Boland was the Zapata approach, originated by the Delaware case Zapata Corp. v. Maldonado. Boland, 31 A.3d at 551 (citing and discussing Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1980)). In Zapata, the Delaware Supreme Court held that “[w]hether the Court of Chancery will be persuaded by the exercise of a committee power resulting in a summary motion for dismissal of a derivative action . . . should rest, in our judgment, in the independent discretion of the Court of Chancery.” Zapata, 430 A.2d at 788–89. Accordingly, when reviewing the decision of an SLC, a “court should determine, applying its own independent business judgment, whether the motion should be granted.” Id.
In evaluating these competing positions, the Maryland Court of Appeals essentially adopted the more deferential Auerbach process-oriented standard but squarely placed the burden of proof on the corporation: The court of appeals concluded that “there should be no presumption on these issues” but that “the court should not grant summary judgment on the basis of an SLC’s decision unless the directors have stated how they chose the SLC members and come forward with some evidence that the SLC followed reasonable procedures and that no substantial business or personal relationships impugned the SLC’s independence and good faith.” Boland, 31 A.3d at 556 (emphasis added). In doing so, the court of appeals emphasized that “[t]he court’s review, though not on the merits, can be rigorous on the questions of good faith, independence, and procedure.” Id. at 557. Thus, although Maryland subjects the SLC selection and decision-making process to significant scrutiny to ensure that a business judgment was made after a reasonable good-faith investigation by disinterested directors, it reflects deference to business judgments reached after such a process.
Derivative Actions Remain an Effective Remedy
The Delaware Chancery Court’s award of a $1.347 billionjudgment In re Southern Peru Copper Corp. Shareholder Derivative Litigation, 30 A.3d 60, 120 (Del. Ch. Dec. 20, 2011),provides an important reminder that the derivative actions can provide meaningful remedies in appropriate circumstances. The case arose from the acquisition of Minera Mexico, S.A. de C.V., a Mexican mining company, by Southern Peru Copper Corp., a Peruvian mining company. Grupo Mexico S.A.B. de C.V. owned 54.17 percent of Southern Peru’s stock and could exercise 63.08 percent of Southern Peru’s voting power. Grupo Mexico also owned a 99.15 percent stake in Minera. In 2004, Grupo Mexico proposed that Southern Peru buy Grupo Mexico’s stake in Minera for 72.3 million shares of Southern Peru’s own stock, which had a market value of roughly $3 billion. Id. at *65.
Southern Peru employed the typical procedures for evaluating such transactions— including appointing a special committee to evaluate it and hiring legal and financial advisors to assist in that process. But the chancery court nevertheless held that the transaction failed to meet the standard of “entire fairness” to Southern Peru and its minority stockholders. Id. at 75–76 & n. 69. The more stringent “entire fairness” standard, which evaluated the substance of the transaction, applied rather than the business-judgment rule, because the transaction involved a controlling shareholder on both sides of the transaction. Id.
As an initial matter, the court found, the special committee suffered from a “controlled mindset” and “blinkered perspective” because it considered only the controlling shareholder’s proposal and not other options. Id.at 98.Then, after initially finding that the proposed price of approximately $3.1 billion in shares of Southern Peru would purchase value in Minera of $1.3 billion less, the special committee and its advisors “justified paying a higher price through a series of economic contortions” that deflated the share value of Southern Peru below the market price and inflated Minera’s value. Id.at *46. As Chancellor Strine acidly summarized the transaction:
A focused, aggressive control[ling shareholder] extracted a deal that was far better than market, and got real, market-tested value of over $3 billion for something that no member of the special committee, none of its advisors, and no trial expert was willing to say was worth that amount of actual cash. Although directors are free in some situations to act on the belief that the market is wrong, they are not free to believe that they can in fact get $3.1 billion in cash for their own stock but then use that stock to acquire something that they know is worth far less. . . . That non-adroit act of commercial charity toward the control[ling shareholder] resulted in a manifestly unfair transaction.
After a bench trial, the chancellor held that Grupo Mexico, the controlling shareholder, should be required to return to Southern Peru a number of shares equal to the excess value of $1.347 billion, plus interest.
Notably, this substantial judgment was against Grupo Mexico only, not the special-committee-member defendants. This was because the court had previously granted summary judgment dismissing the claims against the individual special-committee-member defendants. Southern Peru had adopted an exculpatory provision under 8 Del. C. § 102(b)(7), providing that directors could not be held personally liable to the corporation for monetary damages absent bad faith or a breach of the fiduciary duty of loyalty. Id. at 70. While the court was critical of the committee members’ judgment, Chancellor Strine found that the plaintiff had failed to present evidence supporting a non-exculpated breach of their fiduciary duty of loyalty. Id.
Southern Peru thus serves as a timely, dramatic reminder both of the substantial remedies that may be obtained on behalf of a corporation through derivative litigation and of the value to directors of the protections of exculpatory provisions adopted pursuant to state corporate law.
Keywords: litigation, professional liability, demand futility exception, Southern Peru
Scott B. Schreiber and Andrew T. Karron are partners, and Kavita Kumar Puri is an associate, with Arnold & Porter LLP in Washington, D.C.