Pumping the Brakes on Shareholder Demands and Threats of Derivative Lawsuits against Your Company

Every state recognizes the right of a company’s shareholder (or member in the case of a limited liability company) to make a demand of the Board of Directors to initiate litigation that the shareholder believes will benefit the company. If the Board fails or refuses to act, the shareholder has the right to sue derivatively on behalf of the company. While derivative lawsuits can serve as a useful check on the unbridled authority of Directors, they are too often used by overzealous shareholders to create and improperly exert leverage over the company. Indeed, demands are often accompanied by draft complaints that already assume that Directors will decline to act, and threats to commence the lawsuit within days.

Courts generally frown upon demands that are perfunctory in nature, that do not even afford impartial Directors with a meaningful opportunity to investigate and respond. Under Delaware law, the mere act of making a pre-suit demand is tantamount to a shareholder’s concession that there is, at least, a majority of the Board that is capable of acting independently and impartially with respect to the demand.  As such, a shareholder must afford those Directors a reasonable opportunity to provide an informed response to the demand.  How much time is reasonable will vary based on the facts and circumstances, but a court applying Delaware law dismissed a derivative complaint filed four and a half months after the initial demand was made, because the committee formed to evaluate the plaintiff’s demand had not concluded its investigation.

Moreover, it is important to note that the Board’s exercise of its business judgment in deciding whether or not to move forward with the suit is generally afforded great deference. For Delaware corporations, a shareholder that makes a pre-suit demand may only sue derivatively if he or she can demonstrate that the Board “wrongfully refused” that demand, and can cite to particular facts that raise reasonable doubt as to whether the decision was properly the product of business judgment. An action that fails to meet this high standard can be dismissed as premature.

The key for the Directors is taking reasonable steps to assure that their judgment is afforded the highest level of deference. To assure impartiality, the nature of the allegations may require the formation of a special committee to examine the claims. The Board or Committee should also strongly consider engaging special counsel (counsel that did not advise the company with respect to the acts or transactions that give rise to the claim) to assist in conducting an appropriately thorough investigation and evaluation. Make sure your General Counsel gets immediate notice of any shareholder demand to prepare that the Company’s initial response and chart a course forward.