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An Introduction to the Law of Corporations: Cases and Materials, Fall 2017

Historical Development of Derivative Litigation

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It is black-letter law that the board of directors of a Delaware corporation exercises all corporate powers and manages, or directs others in the management of, the business and affairs of the corporation. One corporate power exercised by the board of directors is the conduct of litigation that seeks to redress harm inflicted upon the corporation, including harm inflicted upon the corporation by its officers or directors from a breach of fiduciary duty owed to the corporation and its shareholders. Recognizing, however, that directors and officers of a corporation may not hold themselves accountable to the corporation for their own wrongdoing, courts of equity have created an ingenious device to police the activities of corporate fiduciaries: the shareholder's derivative suit. Chancellor Wolcott described this device:

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Generally a cause of action belonging to a corporation can be asserted only by the corporation. However, whenever a corporation possesses a cause of action which it either refuses to assert or, by reason of circumstances, is unable to assert, equity will permit a stockholder to sue in his own name for the benefit of the corporation solely for the purpose of preventing injustice when it is apparent that the corporation's rights would not be protected otherwise.

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As the above description reveals, a derivative action may not be pursued if the corporation is willing and able to assert the suit on its own behalf, i.e., the complaining shareholder must give the board of directors the opportunity to manage the litigation to its satisfaction or the board of directors must for some reason be incapable of pursuing the litigation.

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The requirement that shareholders exhaust their remedies within the corporation before pursuing derivative litigation is found in Court of Chancery Rule 23.1. Rule 23.1 requires that the complaint in a derivative action "allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff's failure to obtain the action or for not making the effort." Even if attempting to obtain the action that the plaintiff desires from the board of directors would be futile because a majority of the directors suffer some disabling interest, the board may appoint a special litigation committee of disinterested directors that may recommend dismissal of the derivative action after a reasonable investigation. Rule 23.1 also requires, as does Section 327 of the Delaware General Corporation Law, that the complaint allege that "the plaintiff was a stockholder of the corporation at the time of the transaction." Rule 23.1 further provides that a derivative action generally may not be dismissed or settled without approval of this Court and notice to other shareholders. The requirements of Rule 23.1, while burdensome to the equitable device created by the courts to remedy harm inflicted upon a corporation, are necessary to prevent the potentially disruptive effects of derivative litigation on the ability of a board of directors to direct the business and affairs of a corporation. The prerequisites to a derivative action, developed over time, have attempted to balance the Delaware prerogative that directors manage the affairs of a corporation with the realization that shareholder policing, via derivative actions, is a necessary check on the behavior of directors that serve in a fiduciary capacity to shareholders.

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The exacting procedural prerequisites to the prosecution of a derivative action create incentives for plaintiffs to characterize their claims as "direct" or "individual" in the sense that they seek recovery not for harm done to the corporation, but for harm done to them. A decision finding that a complaint alleges direct claims allows plaintiffs to bypass the ability of the corporation's board to decide, in the best interests of the corporation, how to proceed with the litigation. In clear-cut cases, where the corporation has not been harmed by the conduct at issue in the litigation but the plaintiff has suffered injury, bypassing the board's involvement in the litigation is of little concern. In fact, it seems wholly inappropriate to allow a board of directors to control litigation where the corporation's concerns are only tangential and the corporation would not share any eventual recovery.

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    • Agostino v. Hicks, 845 A. 2d 1110 - Del: Court of Chancery 2004