In a new article, I argue that, under current Delaware law, there is a collision between the definition of pre-suit demand and shareholder voice. To demonstrate, imagine that a sophisticated institutional shareholder of a Delaware public corporation has determined that the board of directors approved a transaction that violated export control laws, risking harm to the corporation. The shareholder has several traditional options: It could file a lawsuit, which seems drastic at this stage; it could vote against the board nominees in the next election, which seems ineffectual; or it could sell its shares, which seems premature. Instead, the shareholder elects a more modern approach, at least as an initial strategic step: to exercise its voice.

The shareholder sends a letter to the board identifying the issue and requesting corrective action. The shareholder is careful not to request that the board institute litigation on behalf of the corporation; rather, the shareholder requests that the board bring the transaction into legal compliance for the benefit of the corporation. After several months, the board sends a perfunctory refusal. The shareholder elects to file a derivative suit, alleging that the board violated the fiduciary duties it owes to the corporation and its shareholders by approving the violative transaction. The defendants move to dismiss the suit, arguing that the shareholder’s communication constituted a “pre-suit demand” and that the derivative complaint must be dismissed under the “wrongful refusal” standard that applies in “demand made” cases. The Court of Chancery dismisses the suit on that basis. The shareholder has learned a valuable lesson: If it wishes to retain the option to pursue a viable derivative action on behalf of a corporation, it must stifle its voice.

It is common wisdom that, in Delaware, shareholders who seek to pursue derivative claims are discouraged from making pre-suit litigation demands on the board. The board’s decision to reject a shareholder’s demand is subject to the business judgment rule, and, under Spiegel v. Buntrock,[1] the fact that the shareholder made a demand is deemed to be a tacit concession of the board’s independence to consider the demand. Thus, if the board rejects the demand, the only way for the shareholder to avoid dismissal of the derivative suit is to satisfy the onerous wrongful refusal pleading standard.

That standard requires the shareholder to plead with particularity that there is reasonable doubt about whether (1) the board’s investigation was grossly negligent and thus not reasonable, (2) the board’s investigation was not performed in good faith, or (3) the board did not act independently when considering the demand, despite the shareholder’s tacit concession that a majority of the board receiving the demand was independent. Indeed, consistent with the common wisdom, I find in my study of the 23 cases in which the Delaware courts have ruled on wrongful refusal of demand since Speigel was decided, 87 percent of demand made cases were dismissed for failure to plead wrongful refusal. Thus, shareholders who seek to pursue derivative claims almost invariably bypass demand and instead seek to plead demand futility.

I argue, however, that shareholders are also discouraged from making pre-suit demands on the board for corrective action other than litigation. The Delaware courts’ current definition of pre-suit demand – which requires merely that the communication state “the legal action the shareholder wants the board to take on the corporation’s behalf”[2] – reaches broadly enough to include not only communications demanding litigation on behalf of the corporation, but also communications demanding other corrective action that would benefit the corporation. Thus, if a shareholder wants the option to pursue future derivative litigation about an issue, it must not call the issue to the attention of the board.

This expansive definition of pre-suit demand stifles shareholder voice, undercutting shareholder monitoring and information-sharing within the firm. It is also at odds with the rationales underlying Spiegel’s tacit concession theory. Indeed, a reasonable shareholder could determine that a board, even if incapable of making an independent decision about whether to file a lawsuit, is capable of deciding whether to take other corrective action to benefit the corporation.

I argue for a revised definition of pre-suit demand that is limited to demands for litigation on behalf of the corporation. Under this revised definition, the hypothetical shareholder communication described above would not constitute a pre-suit demand. This definition would revive shareholder voice, align with the rationales underlying Spiegel, and further the policy rationales for the demand requirement itself. Because pre-suit communications requesting corrective action other than litigation would no longer be discouraged, directors could correct the problem before courts got involved.

ENDNOTES

[1] 571 A.2d 767 (Del. 1990).

[2] Yaw v. Talley, No. CIV.A. 12882, 1994 WL 89019, at *7 (Del. Ch. Mar. 2, 1994).

This post comes to us from Professor Wendy Gerwick Couture at the University of Idaho. It is based on her recent article, “Reviving Shareholder Voice by Redefining Pre-Suit Demand,” forthcoming in the Fordham Journal of Corporate & Financial Law and available here.