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Futility? Exception to Demand Requirement in Derivative Actions

September 5, 2012 //  by Harrison & Moberly

Derivative actions are actions maintained by a shareholder for the benefit of a corporation against a third-party because of the corporation’s failure to take action against the third-party. Derivative actions redress an injury sustained by, or to enforce a duty owed to, the corporation. These actions are governed largely by Ind. Trial R. 23.1 and Ind. Code §23-1-32 et. seq.

 

 

Derivative action complaints should be verified, commenced in the name of the corporation, and allege the plaintiff was a shareholder at the time the challenged transaction occurred (or his interest devolved by operation of law), and the plaintiff made a demand to the corporation’s board of directors to take the requested action. A derivative action may not be maintained if the plaintiff does not fairly and adequately represent the interests of the other similarly situated shareholders. These requirements, expressly established by Trial Rule 23.1 and Ind. Code §23-1-32-1 and 2, are commonly known as the Standing, Demand, and Fair and Adequate Representation requirements. Two excellent Indiana Supreme Court cases discussing these requirements are In re ITT Derivative Litigation, 932 N.E.2d 664 (Ind. 2010) and G & N Aircraft, Inc. v. Boehm, 743 N.E.2d 227 (Ind. 2001).

 

The demand requirement is found in Ind. Trial R. 23.1 and Ind. Code §23-1-32-2. Trial R. 23.1 states:

[T]he complaint shall [] allege with particularity the efforts, if any, made by the plaintiff, to obtain the action he desires from the directors or comparable authority and the reasons for his failure to obtain the action or for not making the effort.

The trial rule follows its statutory counterpart. Ind. Code §23-1-32-2 requires the complaint to allege with particularity the demand made, if any, and either allege the demand was refused or ignored or allege why the shareholder did not make the demand. The substantive law on demand is the law of the state of incorporation.

 

 

In some instances a claimant’s failure to make a demand will excused if it would be futile to make the demand. The futility exception was discussed recently in Carter ex rel CNO Financial Group, Inc. v. Hilliard, 970 N.E.2d 735 (Ind. Ct. App. 2012). Although filed in Indiana, the action was governed by the substantive law of Delaware. That said, the case provides an interesting discussion of the futility exception. Delaware distinguishes between futility based on affirmative actions taken by a board of directors, and futility based on a board’s complete failure to act.

 

 

Where the board of directors take an affirmative action, the plaintiff must plead particularized facts showing there is a reasonable doubt (1) the directors are disinterested and independent, or (2) the challenged transaction was the product of a valid exercise of business judgment. See Aronson v. Lewis, 473 A.2d 805 (Del. 1984).

 

On the other hand, where the board takes no action, the plaintiff must plead particularized facts showing there is a reasonable doubt the board of directors could have properly exercised an independent and disinterested business judgment in responding to the plaintiff’s demand. Rales v. Blasband, 634 A.2d 927 (Del. 1993). [Note: Indiana courts have referenced Delaware case law in deciding issues impacting derivative actions, and have approved application of the Rales case, see In re ITT Derivative Litigation, 932 N.E.2d 664, 668-669 (Ind. 2010)].

 

 

On the issue of “director interest,” the Indiana court in Carter stated:

A director is considered interested where he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders. Directorial interest also exists where a corporate decision will have a materially deterimental impact on a director, but not on the corporation and the stockholders. Additionally, the mere threat of personal liability is insufficient to show that a director is interested. But a director’s interest may be demonstrated by showing that that director faces a substantial likelihood of liability.

 

 

Carter, 970 N.E.2d at 749 quoting Rales, 634 A.2d at 936. (quotations from text of opinion deleted); accord Ind. Code §23-1-32-4(d); In re ITT Derivative Litigation, 932 N.E.2d at 668 (“A director is ‘interested’ for demand futility purposes if a derivative claim poses a significant risk of personal liability for the director. Being deemed ‘interested’ requires more than a ‘mere threat’ of personal liability—there must be ‘a substantial likelihood’ of liability for the director.”).

 

The Carter court, applying the Rales Test, concluded the plaintiff’s amended complaint failed to include particularized factual allegations creating a reasonable doubt as to whether a majority of the Director Defendants could have properly exercised their disinterested business judgment in responding to a demand. Accordingly, futility, in these circumstances, would not excuse the plaintiff’s failure to make a demand prior to commencing the derivative action in Indiana.

 

Futility, as an exception to the demand requirement, has limits in Indiana beyond the pleading-type issues discussed in the Carter case.  For example, the Indiana Business Corporation law authorizes a corporation to establish a disinterested committee of board members to determine whether the corporation should pursue claims that are the subject of a derivative action. Ind. Code §23-1-32-4. Once established, which can be done before or after the derivative action is filed, the decision of the committee is presumed to be conclusive unless a claimant can establish the committee was not disinterested or its determination was not made as a result of a good faith investigation. Ind. Code §23-1-32-4(c).The standard for determining whether a director serving on the committee is interested in the subject of the shareholder demand is the same standard for determining demand futility. See In re ITT Derivative Litigation, 932 N.E.2d 664 (Ind. 2010). The trial court may stay a derivative action pending the completion of a corporation’s investigation. Ind. Code §23-1-32-2.

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