Court of Chancery Clarifies Standards for Demand Futility

In Park Employees’ and Retirement Bd. Employees Annuity and Benefit Fund of Chicago v. Richard M. Smith, et al., C.A. No. 11000-VCG (Del. Ch. May 31, 2016) defendants are current and former directors of BioScrip, a pharmaceutical company, in which plaintiffs owned stock.  Plaintiffs filed a Rule 23.1 derivative lawsuit, thus making a demand, claiming that the individual directors were not capable in acting in the corporate interest.  The plaintiffs asserted six derivative claims, centering on breach of fiduciary duties of loyalty and care by the directors, as well as insider trading by three directors.  The plaintiffs filed this action on May 7, 2015, right before a director election was proposed.  On May 11, 2015, following the election, five of the remaining seven directors were independent, and not named in this action.  The defendants moved to dismiss this claim under Court of Chancery Rule 23.1, failure to make a demand, and Rule 12(b)(6), failure to state a claim.

Vice Chancellor Glasscock started out his opinion by stating that this case “presents a twist to the usual requirement under Rule 23.1”, since there was large board turnover between the May 7 filing and the May 11 election.  In analyzing demand futility, Vice Chancellor Glasscock explained that demand is typically analyzed by assessing the directors seated at date the complaint was filed and changes to a board’s composition is usually disregarded.  However, he stated that in this case the May 11, not May 7, board was in a better position to assess the plaintiff’s complaint.  He dismissed the plaintiffs’ contention that there would be gamesmanship by directors in future actions if there was no hard line rule on date of filing, and that he “has every confidence that this Court can sniff out and preempt improper manipulation of the board.”  Courts of equity have to look at substance, and here it did not make sense for the May 7 directors to only have four days to assess the claim. Therefore, the May 11 board was the right board for to assess this action.  He concluded that demand futility could not be applied here, and that the plaintiffs have thirty days to amend their complaint or else he will grant the defendants’ motion to dismiss.

Key Points of Law:

  • “It is just as obvious that the pleading requirement [in derivative litigation] must be rigorous; otherwise, an unsubstantial allegation of potential liability would be sufficient to wrest control of the litigation asset away from the board in favor of the stockholder, with potentially pernicious results for the corporation.”
  • “Demand is excused if the directors who control the asset at the time when demand would otherwise be made- that is, at the time derivative litigation is filed-are incapable of exercising appropriate judgment on the corporate behalf.”
  • “The Court generally does not require that a stockholder make a demand or replead demand futility in response to changes to the board’s composition, after the filing of the complaint.”
  • “The derivative suit is a device that exists to aid a stockholder in vindicating the corporation’s rights, only where the board of the corporation, typically entrusted with that responsibility, is not capable of doing so.”
  • “I have every confidence that this Court can sniff out and preempt improper manipulation of board composition in this context.”

Special thanks to Matthew Arnold for preparing this summary.