The Third Circuit has recently held that a district court’s decision to dismiss a derivative action for failure to plead demand futility under Federal Rule of Civil Procedure 23.1 is reviewed de novo. See In re Cognizant Tech. Solutions Corp. Derivative Litig., Case No. 22-3027 (3rd Cir. 2024). This decision overturned previous decisions where the court held that the standard of review was abuse of discretion. See, e.g., Blasband v. Rales, 971 F.2d 1034 (3rd Cir. 1992).
In In re Cognizant, Cognizant Technology Solutions Corporation was an information technology services and consulting company incorporated in Delaware and headquartered in New Jersey. It was alleged that from 2010 to 2015, Cognizant employees, working in its international operations in India, authorized about $2 million in bribes to Indian government officials for the purpose of securing construction-related permits and operating licenses that would allow the company to receive tax holidays and related economic benefits.
During that same period, Cognizant’s board of directors received updates indicating that the company’s anti-corruption controls could use improving. However, in 2015 and 2016, the board signed off on two published sustainability reports that stated that no incidents of corruption had been reported in either 2014 or 2015. Cognizant managers eventually discovered the bribery scheme in India and notified the Department of Justice and the Securities and Exchange Commission (SEC). The SEC then opened an investigation into Cognizant’s compliance with the Foreign Corrupt Practices Act that would result in Cognizant incurring over $60 million in investigative costs and a $25 million fine from the SEC.
The shareholders of Cognizant decided to bring a derivative suit against the board and five of Cognizant’s current and former officers for breach of fiduciary duties. The defendants moved to dismiss the complaint on the basis that plaintiffs failed to make a pre-suit litigation demand on the board pursuant to Rule 23.1. After the district court granted the defendants’ motion to dismiss, the Third Circuit affirmed the decision, exercising de novo review and finding no error in the district court’s holding that the plaintiffs’ complaint failed to state with particularity the reasons why making such a demand would have been futile.
The Third Circuit adopted a de novo standard of review because it determined that: 1) because demand futility is a pleading issue, district courts are in no better position than appellate courts to decide whether demand should be excused as futile; 2) de novo review is appropriate because the doctrines of demand futility are reasonably uniform and amenable to general rules that cover a wide range of circumstances; 3) there is nothing in Rule 23.1 or applicable state law that indicates a preference for the trial court’s decision on this issue that would warrant abuse of discretion; and 4) demand futility has substantial consequences for shareholder cases, given both the potential consequence of ending the litigation and the frequency with which this issue arises in derivative suits.
With this new standard of review, practitioners in the Third Circuit should consider whether an appeal of a dismissal of their derivative suit is now more likely to succeed.
