Opinion ID: 515708
Heading Depth: 2
Heading Rank: 1

Heading: The Substance of the Demand Requirement

Text: 14 The requirement of the exhaustion of intracorporate remedies as a precondition to the commencement of a shareholder derivative suit originated in the English courts of equity. See, e.g., Foss v. Harbottle, 2 Hare 461, 67 Eng.Rep. 189 (V.Ch.1843). In the United States, the Supreme Court first articulated the demand requirement for derivative actions in Hawes v. Oakland, 104 U.S. 450, 26 L.Ed. 827 (1882). There the Court required the shareholder-plaintiff to 15 show to the satisfaction of the court that he has exhausted all the means within his reach to obtain, within the corporation itself, the redress of his grievances, or action in conformity to his wishes. He must make an earnest, not a simulated effort, with the managing body of the corporation, to induce remedial action on their part, and this must be made apparent to the court.... And he must show a case, if this is not done, where it could not be done, or it was not reasonable to require it. 16 Id. at 460-61. 3 The Court soon thereafter implemented its holding in Hawes through Equity Rule 94 (1882), and later through Equity Rule 27 (1912). The Federal Rules of Civil Procedure incorporated Equity Rule 27 in Rule 23(b), which in 1966 was substantially restated in current Rule 23.1. See Comment, The Demand and Standing Requirements in Stockholder Derivative Actions, 44 U.Chi.L.Rev. 168, 171 n. 23 (1976). Many jurisdictions have expressly imposed the demand requirements by statute or court rule, but it usually applies even in the absence of statute or court rule to such effect. H. Henn & J. Alexander, Laws of Corporations Sec. 364 (3d ed. 1983) (footnote omitted). 17 In applying the demand requirement over the years, courts have frequently not specified the source of the substance of the requirement. See, e.g., Kaster v. Modification Systems, Inc., 731 F.2d 1014, 1017 (2d Cir.1984). Many federal courts have apparently assumed that the federal procedural rule establishes both the pleading guidelines as well as the substantive contours of the underlying demand requirement. See, e.g., In re Kauffman Mutual Fund Actions, 479 F.2d at 263; Greenspun v. Del E. Webb Corp., 634 F.2d 1204, 1208-10 (9th Cir.1980); see generally C. Wright, A. Miller, & M. Kane, Federal Practice and Procedure: Civil 2d Sec. 1831 (2d ed. 1986). 18 More recently, however, some courts have begun to question whether in fact Rule 23.1 can be the source of the substantive requirement, or whether today state corporate law must provide the source of the requirement. 4 See, e.g., Lewis v. Curtis, 671 F.2d 779, 785 (3d Cir.), cert. denied, 459 U.S. 880, 103 S.Ct. 176, 74 L.Ed.2d 144 (1982); Cottle v. Hilton Hotels Corp., 635 F.Supp. 1094, 1097 (N.D.Ill.1986). These courts have found support in the Supreme Court's reasoning in Burks v. Lasker, 441 U.S. 471, 99 S.Ct. 1831, 60 L.Ed.2d 404 (1979). There, the Court addressed the authority for directors to terminate derivative lawsuits, concluding that state law should control in the first instance. The Court stated that the fact that parties presented a federal question did not make state law irrelevant: while acknowledging that in certain areas it had held that federal statutes authorized the development of a complete body of federal law, the Court noted: 19 Corporation law ... is not such an area.... [I]n this field congressional legislation is generally enacted against the background of existing state law; Congress has never indicated that the entire corpus of state corporation law is to be replaced simply because a plaintiff's cause of action is based upon a federal statute. 20 Id. at 477-78, 99 S.Ct. at 1836-37 (citations omitted). Courts relying on state law for the substance of the demand requirement point to its underlying purpose as protecting the integrity of corporate self-governance, a touchstone of traditional corporate law. 21 Gaubert has attempted to draw this court into the dispute over the source of the demand requirement by arguing that the district court improperly imposed a more stringent standard than would have been applied under Texas law, which he argues should govern here. 5 Although current law sends conflicting signals as to the proper source of the substance of the demand requirement, we are not presently required to decide that issue: we discern no meaningful differences between the prevailing federal standard and the requirements that Texas courts have applied, and thus a decision as to which law prevails in this context is immaterial to the central issue on appeal--whether the dismissal of Gaubert's complaint should be affirmed. 22 Whether grounded in the correct source or not, a dominant national view of the basic demand requirement has emerged. Most jurisdictions in one way or another impose the general requirement that shareholders bringing a derivative action must first contact the board of directors and give the board the opportunity to pursue the litigation on behalf of the corporation. See generally Fletcher Cyc. Corp. Sec. 5963 (perm. ed.). Several purposes have been cited to support the imposition of this requirement. As a general matter, the integrity of corporate self-governance is preserved if the board of directors is given an opportunity from the start to address the issues raised by a discontented shareholder. Thus, at its most fundamental, the demand requirement furthers a principle basic to corporate organization, that the management of the corporation be entrusted to its board of directors. Comment, The Demand and Standing Requirements in Stockholder Derivative Actions, 44 U.Chi.L.Rev. 168, 171 (1976); see also Elfenbein v. Gulf & Western Industries, Inc., 590 F.2d 445, 450 (2d Cir.1978); Aronson v. Lewis, 473 A.2d 805, 812 (Del.Sup.Ct.1984). In a more practical vein, the demand for relief may alert the board to problems of which it was unaware, and may cause it to champion the complainant's cause more directly, more efficiently, and/or more effectively than the shareholder could have done alone--perhaps without the need for litigation. The demand requirement also serves the goal of judicial economy, by giving the corporation a full opportunity to put its house in order before it is prematurely hauled into a court to account for its actions. See generally Principles of Corporate Governance Sec. 7.03 (ALI Tent. Draft No. 6, 1986). 23 No jurisdiction's demand requirement is absolute, however. Rather, courts have recognized that there are times when insisting on demand will erect a needless barrier to valid shareholder litigation. In cases when demand would be futile, the requirement has been excused. See Untermeyer v. Fidelity Daily Income Trust, 580 F.2d 22, 23-24 (1st Cir.1978). There is, however, disagreement about the precise scope of the futility exception to the demand requirement. The predominant federal view is that the board of directors must have been actively involved in the alleged wrongdoing for demand to be excused: only when directors' actions demonstrate self-interest or some other form of bias will most courts find that it is presumptively unlikely that they would respond fairly to a shareholder demand for corporate action. See, e.g., In re Kauffman Mutual Fund Actions, 479 F.2d at 265; Greenspun, 634 F.2d at 1210. In this view, mere acquiescence in the challenged act by the board of directors is not enough to show that the board will not consider the shareholder's petition fairly. See Heit v. Baird, 567 F.2d 1157, 1160 (1st Cir.1977); accord In re Consumers Power Co. Derivative Litigation, 111 F.R.D. 419, 424 (E.D.Mich.1986) ([I]n a case where the directors have merely acquiesced or approved a transaction, even if they were grossly negligent in doing so, there is no irrebutable presumption that the directors would not consider a claim for relief.). 24 Indeed, as some commentators have noted, any less restricted exception to the demand requirement would likely eviscerate the doctrine: rare is the significant corporate act that has not in one way or another been approved of or acquiesced in by the board of directors. The acquiescence formulation casts the futility net too widely: if board intractability is to be presumed whenever there is board acquiescence, and shareholders are excused from approaching the board in these circumstances, there is virtually nothing left of the requirement that shareholders exhaust intracorporate remedies before a court will entertain a derivative action. See In re Kauffman Mutual Fund Actions, 479 F.2d at 265 (If by plaintiff's merely alleging error, the directors are to be presumed incapable of exercising sound business judgment, Rule 23.1 would become virtually meaningless....); Lewis v. Graves, 701 F.2d 245, 248 (2d Cir.1983). Nevertheless, some courts have used language that reflects acceptance of this less rigorous standard for demand futility. See, e.g., Clark v. Lomas & Nettleton Financial Corp., 625 F.2d 49, 53 (5th Cir.1980), cert. denied, 450 U.S. 1029, 101 S.Ct. 1738, 68 L.Ed.2d 224 (1981). 6 25 Gaubert argues that Texas law conforms to this more liberal acquiescence standard for demand futility. We disagree. In the seminal Texas case of Cates v. Sparkman, 73 Tex. 619, 621, 11 S.W. 846, 849 (1889), the Texas Supreme Court laid out, in an admittedly prolix sentence, the requirements to be imposed in these circumstances: 26 The rule referred to, that it must be shown that the corporation refuses to sue, does not obtain where the allegations of the bill show that such request would have been useless, or if they show such facts as are tantamount to a virtual refusal to sue: as, where the fact of the complicity in the alleged fraud by the controlling officers of the company appears from the averments, so that the application would be unavailing, it need not be formally alleged to have been made[;] or that the present board connived at and approved of the act complained of, which the stockholder sought to impeach, it was held to be a sufficient excuse for not applying to the company. (Emphasis added, citation omitted.) 27 Far from suggesting that mere acquiescence by the board will excuse demand, the court advanced a much higher level of active involvement to show futility: the board must be shown to have connived at the alleged wrongdoing. 7 This language accords with the cases cited earlier that have required more than a showing of carelessness by the board, demanding instead that a shareholder show that the directors could not be trusted to exercise independent judgment regarding the corporation's best interests. 28 More recent Texas cases construing the demand futility exception further support this reading. In Zauber v. Murray Savings Ass'n, 591 S.W.2d 932, 936 (Tex.Civ.App.--Dallas 1979), writ ref'd n.r.e., 601 S.W.2d 940 (Tex.1980), the court of civil appeals held that [o]nly when it can be shown that something beyond unsound business judgment has been exercised by the board of directors, resulting in a wrongful refusal to act, will a shareholder be allowed to institute the suit on behalf of the corporation (emphasis added). 8 The Texas court went on to conclude that [t]he fundamental inquiry is whether the directors have such a personal interest in the controversy or are so controlled by the alleged wrongdoers that they could not reasonably be expected to diligently pursue the action. Zauber, 591 S.W.2d at 937; accord Langston v. Eagle Publishing Co., 719 S.W.2d 612, 616-17 (Tex.App.--Waco 1986). In light of this precedent, we cannot credit Gaubert's position that under Texas law the fact of directors' prior, affirmative approval of the act in question suffices to excuse demand. Reply Brief for Appellant at 13. Rather, we agree with the district court that something more than board acquiescence in the actions complained of must be present before demand will be excused. 29