Derivative Actions: Demand Futility Test and SLCs

Two important filters apply only to derivative actions, not direct actions: The “demand futility” test, and dismissal by a special litigation committee (SLC) of the board. In theory, both can lead to dismissal at any stage of a derivative action. In practice, the demand futility test is invoked virtually exclusively at the motion to dismiss stage, and SLCs tend to be formed after the motion to dismiss was denied, often prompting a stay of discovery until the SLC has given its recommendation.

The term “demand futility” derives from the somewhat quaint idea that, in principle, a dissatisfied shareholder should first ask the board to bring the lawsuit, i.e., make a “demand” on the board. The shareholder should be allowed to sue in the corporation’s name only (a) after the board wrongfully rejects the shareholder’s demand or (b) if a demand seems “futile” because the board is hopelessly conflicted. In practice, it is very rare for plaintiffs to make a formal demand, and even rarer for boards to accede to it. If the board were inclined to sue, it would not need the shareholder’s reminder, and in the practically relevant case where the board or some of its members are the potential defendant, the board will be very much not inclined to sue. The shareholder thus has little to gain from making a demand, but a lot to lose because Delaware courts consider a demand a concession that demand was not futile, i.e., that the board is impartial with respect to the suit. The only option for a shareholder whose demand was rejected would be to challenge the board’s procedure in rejecting the demand—a near impossible task under the business judgment rule. Thus, shareholders just sue, alleging demand futility.

Substantively, the demand futility test lets a shareholder derivative suit proceed only if a majority of the board appears partial as to the outcome of the suit. But the test of partiality is not mechanical. Most importantly, merely naming a director as defendant is not enough to disqualify that director. Nor is it enough to make abstract allegations. Rather, the shareholder-plaintiff must allege particularized facts that allow a reasonable inference that a director breached his or her duty, has a self-interest in the underlying transaction, or is connected to someone ticking either of these boxes. Crucially, this means the derivative plaintiff must be in possession of at least some pertinent incriminating facts before even being allowed to enter discovery. In the case of a derivative action against the entire board for violation of their duties, the demand futility test is thus a heightened pleading standard: the derivative complaint must allege particularized facts that suggest they may actually be liable. To meet this standard, would-be derivative plaintiffs make copious “books and records” requests under section 220 of the DGCL, often leading to separate “220 litigation” before a derivative lawsuit is even filed.

Demand futility is litigated in virtually every derivative action because defendants virtually always move to dismiss the complaint for failure to plead demand futility.

By contrast, special litigation committees are a rarer beast. This is in part because an SLC is unnecessary if the derivative action is dismissed for failure to plead demand futility, as most are. If the derivative action is not dismissed, boards often form an SLC composed of disinterested and independent directors and vested with the power to terminate the lawsuit should the continuation of the latter not serve the company's best interests. This forces courts into a balancing act:

If, on the one hand, corporations can consistently wrest bona fide derivative actions away from well-meaning derivative plaintiffs through the use of the committee mechanism, the derivative suit will lose much, if not all, of its generally-recognized effectiveness as an intra-corporate means of policing boards of directors. If, on the other hand, corporations are unable to rid themselves of meritless or harmful litigation and strike suits, the derivative action, created to benefit the corporation, will produce the opposite, unintended result. […]

The context here is a suit against directors where demand on the board is excused. We think some tribute must be paid to the fact that the lawsuit was properly initiated. [… W]e have to be concerned about the creation of an ‘Independent Investigation Committee’ […] years later, after the election of [some] new outside directors [who compose the committee]. Situations could develop where such motions could be filed after years of vigorous litigation for reasons unconnected with the merits of the lawsuit.

Moreover, notwithstanding our conviction that Delaware law entrusts the corporate power to a properly authorized committee, we must be mindful that directors are passing judgment on fellow directors in the same corporation and fellow directors, in this instance, who designated them to serve both as directors and committee members. The question naturally arises whether a ‘there but for the grace of God go I’ empathy might not play a role.

[…] We thus steer a middle course […]

After an objective and thorough investigation of a derivative suit, an independent committee may cause its corporation to file a pretrial motion to dismiss in the Court of Chancery. The basis of the motion is the best interests of the corporation, as determined by the committee. The motion should include a thorough written record of the investigation and its findings and recommendations. […] The Court should apply a two-step test to the motion.

First, the Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions. Limited discovery may be ordered to facilitate such inquiries. The corporation should have the burden of proving independence, good faith and a reasonable investigation, rather than presuming independence, good faith and reasonableness. […]

The second step provides, we believe, the essential key in striking the balance between legitimate corporate claims as expressed in a derivative stockholder suit and a corporation's best interests as expressed by an independent investigating committee. The Court should determine, applying its own independent business judgment, whether the motion should be granted. […] The Court of Chancery of course must carefully consider and weigh how compelling the corporate interest in dismissal is when faced with a non-frivolous lawsuit. The Court of Chancery should, when appropriate, give special consideration to matters of law and public policy in addition to the corporation's best interests.

—Zapata Co. v. Maldonado, 430 A.2d. 779, 786-789 (Del. 1981) (footnotes and internal references omitted).

• Questions
  1. What is worse for derivative plaintiffs: dismissal because demand was not futile or later dismissal upon recommendation of an SLC?
  2. What do you think the Zapata court means by the Chancery Court’s “own independent business judgment”?