Opinion ID: 2156030
Heading Depth: 1
Heading Rank: 6

Heading: Evolution of the Futility Exception

Text: As noted, the concept of a shareholder's derivative action, to which was attached the demand requirement and the futility exception, was a common law development established and fashioned by the courts as a justifiable, but limited, intrusion upon the general authority of the directors to manage the business affairs of the corporation, and, for most of the century-and-a-half of its existence, it remained largely within the domain of the common law. In Maryland, it retains its common law status. [4] In much of the country, however, it is now governed by statutes, many of which have either repealed or significantly curtailed the futility exception. We have not visited the doctrine since Parish in 1968, and we therefore need to take account of what has transpired in the meanwhileboth by statute and through the course of common law development in other States. We first entertained the device of the derivative action in Booth v. Robinson, 55 Md. 419 (1881), where shareholders of a corporation sued the directors to recover for the loss in value of their stock by reason of what they asserted was willful and fraudulent mismanagement of the affairs of the corporation. We recognized that directors were not to be held accountable for the consequences of unwise or indiscreet management, if their conduct is entirely due to mere default or mistakes of judgment, but that they would be liable upon clear proof of fraud, combination, or gross negligence. Id. at 438. We observed that, in such cases, the proper party to complain was the corporation itself, because the duty owing by the directors is to the corporation and not directly to the shareholders, and thus held that to enable a shareholder ... to maintain a bill against directors for such fraud or breaches of trust, he must allege and show, not only the violations of duty or breaches of trust on the part of the directors, but that he as stockholder has been damnified thereby, and that the corporation has failed or refused to take the proper legal steps for the redress of the wrong. Id. at 439 (emphasis added). Booth came to this Court from a judgment entered on the merits after trial. The complaint was directed primarily against two of the six directors, who were charged with deliberately ruining the company in order to achieve personal objectives, emanating from their connection with competing interests, that conflicted with their duties to the corporation. In the course of our discussion of the requirement that the plaintiff show that the corporation had failed to take corrective action, we stated that if the allegations of the bill are sustained by proof that a majority of the shares are owned by [the competing company] and that a majority of the directors are adverse to the interest of the plaintiffs, and are combined against them, and would by means of the control that they exercise, frustrate and defeat any attempt to induce the corporation to take action for the redress of the wrongs alleged; such facts would be a sufficient excuse for not making or alleging a formal demand upon the corporation to take action. Id. at 439 (emphasis added). The Court elucidated further on the futility exception in Davis v. Gemmell, 70 Md. 356, 17 A. 259 (1889), where a shareholder sued to have a judgment that had been entered in the name of an assignee of the president of the corporation declared to be the property of the corporation. The company owned a coal mine and could have entered into a contract to supply coal to a railroad at $1.15/ton. Instead, the directors authorized the president of the company, individually, to enter into the contract and to pay the company 10 cents/ ton for the coal taken. When the railroad breached the contract, the president recovered a judgment, which he assigned to a third party. The action by the directors, we held, constituted a plain breach of trust on their part and was in fraud of the rights of the stockholders. Noting that redress of such injury was normally for the corporation to pursue and that, to give stockholders a standing in court, it must appear that the directors have refused to institute proceedings in behalf of the company, or that for certain reasons they are not proper persons to be entrusted with prosecuting the suit, we concluded: If, however, the directors, or officers of a corporation having the authority to direct its litigation, are themselves guilty of the wrong complained of, a Court of equity will interfere at the instance of the stockholders, and this, too, without proof of a demand and refusal on the part of the corporate authorities. And for the reason that a demand upon them would, under such circumstances be useless, and further that it would be against the plainest principles of justice to permit the perpetrators of the wrong to conduct a litigation against themselves. Id. at 376, 17 A. at 265. We commented on the demand requirement in Eisler v. Eastern States Corp., 182 Md. 329, 333, 35 A.2d 118, 119 (1943) and Waller v. Waller, 187 Md. 185, 49 A.2d 449 (1946), although neither case turned on that requirement. In Eisler, the shareholder sued the corporation, seeking the appointment of a receiver to institute action against the directors and officers. The corporation was solvent, most of the transactions complained of occurred before the plaintiff became a shareholder, and there was no indication that any other shareholders were dissatisfied with the current management. We affirmed the denial of relief but observed that, with respect to transactions that occurred after the plaintiff became a shareholder, he was entitled to seek redress in a derivative action after having requested that company's officers to take action, and having been refused. Eisler, 182 Md. at 336, 35 A.2d at 121 (quoting Williams v. Messick, 177 Md. 605, 609, 11 A.2d 472, 474). Waller was a direct action by a shareholder against corporate officers and directors. We affirmed the dismissal of the action, holding that the action should have been brought as a derivative one. In that regard, we observed that if the courts would open their doors to all complaining stockholders without requiring them to show that it was impossible to obtain redress through regular corporate action, litigation of this kind would be endless. Waller, at 192, 49 A.2d at 453. Thus, we continued, before a stockholder will be permitted to maintain a suit for injury to the corporation, he must allege and prove he requested the directors to institute suit in the name of the corporation, and they refused. Id. (emphasis added). In McQuillen v. National Cash Register Co., 22 F.Supp. 867 (D.Md.1938), aff'd, 112 F.2d 877 (4th Cir.1940), cert. denied, 311 U.S. 695, 61 S.Ct. 140, 85 L.Ed. 450 (1940), the U.S. District Court considered the futility issue, which was one of several grounds raised in a motion to dismiss a shareholder's derivative action. The plaintiffs offered as an excuse for failing to make demand on the directors or shareholders for remedial action that the company was dominated and controlled by the individual defendants and that, if they were permitted to conduct the suit, it would be prosecuted by them for the company against themselves. The District Court agreed that, on that allegation, an appeal to the directors would be futile, since it is apparent on the face of the pleadings that their interests are antagonistic to those of the plaintiffs. McQuillen, 22 F.Supp. at 874. Although McQuillen was decided under principles of Federal, rather than Maryland, law, [5] Judge Coleman's pronouncement in that case was treated by us as authoritative in Parish. Parish involved a derivative action by several members of an incorporated cooperative association against the association and a number of individual officers and directors, complaining of fraud, mismanagement, and self-dealing on the part of the officers and directors. The case reached us from the sustaining of demurrers upon a finding that the complaint failed to state a cause of action. The principal question that dominated the 82 page opinion in that case was whether the substantive allegations were sufficient, but one sub-issue was whether the complaint alleged sufficient grounds to excuse the plaintiffs' failure to seek remedial action from the directors before filing suit. Noting that the complaint alleged acts of fraud, concealment, illegality, gross negligence, waste of corporate assets, and conspiracy to conceal losses on the part of the directors and averred as well that a majority of the current board participated in some of those acts, we concluded that it would be futile for the plaintiffs to make demand upon those directors to cause the Association to sue them to recover for their own wrongful injuries to the Association. Parish, 250 Md. at 83, 242 A.2d at 545. Our determination of futility seems to have been based on two somewhat different precepts: (1) it was not likely that the culpable directors would, in fact, agree to permit the company to sue them; and (2) even if they would so agree, because of their conflicted status, a court should not permit them to do so. The first of these is a pragmatic futility; the second is more policy-oriented. We noted that, in considering the entire question, it should be kept in mind that the trend in the more modern authorities is to be more tolerant of the derivative suits of minority members or stockholders in that [t]he size and complexity of corporate transactions makes necessary and important this form of `legal therapeutics.' Id. at 86, 242 A.2d at 546. [6] Whatever may have been the perceived trend in 1968, when Parish was decided, the trend since then has been to enforce more strictly the requirement of pre-suit demand and at least to circumscribe, if not effectively eliminate, the futility exception. As noted, most, if not all, of the States had adopted at least a generalized prerequisite of a pre-suit demand and most had recognized as well a futility exception to that requirement. Until Kamen, supra, 500 U.S. 90, 111 S.Ct. 1711, 114 L.Ed.2d 152, some of the Federal courts had fashioned a Federal common law that embodied both the requirement and the exception. The problem was that, though generally accepting the principle that some level of directorial involvement in a challenged transaction excuses demand, the courts had frequently disagreed over how to apply this principle and jurisdictions differ significantly in the circumstances deemed sufficient to excuse demand. 2 AMERICAN LAW INSTITUTE, PRINCIPLES OF CORPORATE GOVERNANCE: ANALYSIS AND RECOMMENDATIONS § 7.03 cmt. d (1994); see also DEMOTT, supra, § 5.07. Professor Swanson has noted that the futility determination sometimes turns on whether all directors are named as defendants, whether the alleged wrongdoers constitute a majority of the board, or whether a demand would likely prod the directors into corrective action, and that [e]ven among these general approaches, each state jurisdiction tends to have a slightly different formula. Carol B. Swanson, Juggling Shareholder Rights and Strike Suits in Derivative Litigation: The ALI Drops the Ball, 77 Minn. L.Rev. 1339, 1351-52 (1993). The disarray in implementation may well have been the product of differing responses to competing basic viewpoints about derivative lawsuits, played out in a wide variety of contextscomplaints against directors, against corporate officers or employees, against majority shareholders, against third parties, complaints based on nonfeasance, as opposed to misfeasance or malfeasance, complaints alleging mismanagement or waste, complaints alleging fraud or self-dealing, situations where the directors simply approved a challenged decision or transaction and situations where they participated more actively in the allegedly wrongful conduct, situations where the directors had a direct personal interest in the transaction or decision and situations where their personal interest was more remote. As noted by Swanson, supra, 77 Minn.L.Rev. at 1340-41, one perspective embraces derivative suits as an invaluable procedural vehicle permitting shareholders to champion their corporation's rights when corporate management refuses to do so, while another cautions that corporations, not the courts, should resolve internal conflicts, and that derivative litigation necessarily raises the specter of shareholder strike suits and undue judicial interference with the business judgments of management. Beginning in the 1980's, some courts and other interested groups began to search for and develop a more objective and articulable balance between the competing viewpoints. In Aronson v. Lewis, 473 A.2d 805 (Del.1984), the Delaware Supreme Court fashioned the two-prong test that was applied by the Circuit Court in this case. The Delaware court began by recognizing that the demand requirement was a recognition of the fundamental precept that directors manage the business and affairs of corporations. Id. at 812. The court viewed the question of demand futility as inextricably bound to issues of business judgment and the standards of that doctrine's applicability. Id. The business judgment rule, in turn, was both an acknowledgment of the managerial prerogatives of directors and a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Id. [7] Absent an abuse of discretion, that judgment will be respected by the courts. The function of the business judgment rule, the court continued, was of paramount significance in the context of a derivative action, coming into play in addressing a demand, in the determination of demand futility, in efforts by independent disinterested directors to dismiss the action as inimical to the corporation's best interests, and generally, as a defense to the merits of the suit. Id. Its protection, however, can be claimed only by disinterested directors whose conduct otherwise meets the tests of business judgment. Id. From the standpoint of interest, this means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally. Id. Accordingly, if that kind of director interest is present and the transaction is not approved by a majority consisting of disinterested directors, the business judgment rule has no application. Apart from an absence of that kind of conflict, the court noted that, to avail themselves of the business judgment rule, directors have a duty to inform themselves of all material information reasonably available to them and to act with requisite care in the discharge of their duties. The test for director liability in Delaware is predicated on concepts of gross negligence. Turning then to the demand futility issue, the court observed that the rule emanating from earlier cases was that where officers and directors are under an influence which sterilizes their discretion, they cannot be considered proper persons to conduct litigation on behalf of the corporation, but concluded that those cases cannot be taken to mean that any board approval of a challenged transaction automatically connotes `hostile interest' and `guilty participation' by directors, or some other form of sterilizing influence upon them. Id. at 814. Were that so, the court stated, the demand requirements of our law would be meaningless. Id. The balance struck by the court, in determining whether a pre-suit demand would have been futile, was for the trial court to decide, under the particularized facts alleged, whether a reasonable doubt is created that: (1) the directors are disinterested and independent and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Id. Only if the particularized facts support a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment is a demand excused. Id. at 815. As applied by the Delaware courts, that formulation is an exacting requirement. In Aronson, the court made clear that the shorthand shibboleth of `dominated and controlled directors' is insufficient, and that it is not enough to charge that a director was nominated by or elected at the behest of those controlling the outcome of a corporate decision, for [t]hat is the usual way a person becomes a corporate director. Id. at 816. Nor is mere directorial approval of a transaction, absent particularized facts supporting a breach of fiduciary duty claim, or otherwise establishing the lack of independence or disinterestedness of a majority of the directors sufficient to excuse demand. Id. at 817. Later cases have made clear that interest or dependence may not be found merely from the fact that directors are paid for their services or on speculative, non-specific allegations that they acted in order to secure their retention as directors. Grobow v. Perot, supra, 539 A.2d 180. With respect to allegations of corporate waste, the test, both as to ultimate liability and with respect to demand futility, is whether what the corporation has received is so inadequate in value that no person of ordinary, sound business judgment would deem it worth that which the corporation has paid. Id. at 189 (quoting Saxe v. Brady, 184 A.2d 602, 610 (Del.Ch.1962)). See also Levine v. Smith, supra, 591 A.2d 194. Both before and after the formulation of the Delaware test, the Section of Business Law of the American Bar Association (ABA) and the American Law Institute (ALI) were working on statutory models to deal with the demand futility problem. In 1950, the ABA section drafted the first Model Business Corporation Act, which had no provision dealing with derivative actions. In 1960, a new version of the Model Act contained an optional provision on derivative suits, but it said nothing about a demand requirement. The first insertion of a demand requirement came in 1981, upon the recommendation of the section's Committee on Corporate Laws, and was essentially a pleading requirement comparable to Fed.R.Civ.P. 23.1, requiring that a derivative action complaint allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors and the reasons for his failure to obtain the action or for not making the effort. See Report: Proposed Revisions of the Model Business Corporation Act Affecting Actions by Shareholders, 37 Bus. Lawyer 261, 262 (1981). There was no discussion in the recommendation as to the standards to be applied in excusing the failure of a demand, only that plaintiff should be excused from the demand when he pleads facts which show that the effort would be useless. Id. at 264. In 1989, the ABA Section of Business Law came to a dramatically different conclusion and, upon the recommendation of its Committee on Corporate Laws, proposed a flat universal demand requirement. See Changes in the Model Business Corporation ActAmendments Pertaining to Derivative Proceedings, 44 Bus. Lawyer 543 (1989). New § 7.42 of the Model Business Corporation Act now provides: No shareholder may commence a derivative proceeding until: (1) a written demand has been made upon the corporation to take suitable action; and (2) 90 days have expired from the date the demand was made unless the shareholder has earlier been notified that the demand has been rejected by the corporation or unless irreparable injury to the corporation would result by waiting for the expiration of the 90-day period. The Official Comment to § 7.42, taken verbatim from the recommendation of the Committee on Corporate Laws, explains: This approach has been adopted for two reasons. First, even though no director may be independent, the demand will give the board of directors the opportunity to re-examine the act complained of in the light of a potential lawsuit and take corrective action. Secondly, the provision eliminates the time and expense of the litigants and the court involved in litigating the question whether demand is required. It is believed that requiring a demand in all cases does not impose an onerous burden since a relatively short waiting period of 90 days is provided and this period may be shortened if irreparable injury to the corporation would result by waiting for the expiration of the 90-day period. Moreover, the cases in which demand is excused are relatively rare. Many plaintiffs' counsel as a matter of practice make a demand in all cases rather than litigate the issue whether demand is excused. In 1978, the ALI, building on earlier initiatives, began work on its Project on the Structure and Governance of Corporations. In 1992, it approved and published its comprehensive Principles of Corporate Governance: Analysis and Recommendations, Part VII, Chapter 1 of which dealt with derivative actions. With respect to the demand requirement, the ALI adopted a position very close to that of the ABA Section on Business Law. Section 7.03 of the Principles, captioned Exhaustion of Intracorporate Remedies: The Demand Rule, provides: (a) Before commencing a derivative action, a holder or a director should be required to make a written demand upon the board of directors of the corporation, requesting it to prosecute the action or take suitable corrective measures, unless demand is excused under § 7.03(b). The demand should give notice to the board, with reasonable specificity, of the essential facts relied upon to support each of the claims made therein. (b) Demand on the board should be excused only if the plaintiff makes a specific showing that irreparable injury to the corporation would otherwise result, and in such instances demand should be made promptly after commencement of the action. (c) Demand on shareholders should not be required. (d) Except as provided in § 7.03(b), the court should dismiss a derivative action that is commenced prior to the response of the board or a committee thereof to the demand required by § 7.03(a), unless the board or committee fails to respond within a reasonable time. The ALI gave a number of reasons for its recommendation. It first stated the several recognized objectives of the demand requirement, each of which it regarded as legitimate. It noted as well that courts had traditionally accepted the principle that some level of directorial involvement in a challenged transaction excuses demand but that they differ significantly in the circumstances deemed sufficient to excuse demand. The Institute found, however, that all of the formulations were somewhat inexact and reflect a largely outmoded view of the function of the demand rule. See cmt. d to § 7.03. The ALI took note of the Delaware two-prong test but concluded that, by applying a reasonable doubt standard, it seems to inject a substantial measure of subjective judicial discretion into the decision whether to excuse demand and noted that a number of Federal cases applying Delaware law had found a reasonable doubt about the board's performance that might not have sufficed in Delaware. Id.; see also Starrels v. First Natl. Bank of Chicago, 870 F.2d 1168, 1175 (7th Cir.1989) (Easterbrook, J., concurring) (questioning applicability of criminal standard of proof in corporate context); and John Coffee, New Myths and Old Realities: The American Law Institute Faces the Derivative Action, 48 Bus. Lawyer 1407, 1412-13 (1993) (second prong of standard is susceptible to highly variant interpretation and application). The universal demand proposal, it said, eliminates much of the threshold litigation, collateral to the merits of the action, that today slows the pace and increases the cost of derivative actions, in that, under § 7.03(b), courts would not need to resolve the often complex, but ultimately peripheral, issue whether demand was necessary before reaching the central issue of the board's or committee's justifications for dismissal of the action.... Principles of Corporate Governance, supra, at § 7.03 cmt. e. It observed, as well, that, because making demand on the board is a relatively costless step, imposing this requirement places little burden on the plaintiff and that, conversely, demand may sometimes induce the board to take corrective action that moots or permits an early resolution of the action. Id. Finally, the ALI suggested that a universal demand rule better enabled the corporation to respond in those circumstances in which a demand might be excused because the directors were interested and therefore disqualified. In that regard, it noted: Although requiring demand when a majority of the board is clearly interested in the challenged transaction has struck some courts as an exercise in futility, this view misconceives the range of options still open to the board. Even in such a case, the board as a whole can appoint the minority of the board that is disinterested, or some of them ... to a special committee, which can consider the demand, or, once litigation has commenced, can move ... to dismiss the action or ... can seek to settle it. Id. These recommendations from the ABA and the ALI have had a considerable impact. At least 17 States have, by statute, adopted § 7.42 of the Model Business Corporation Act [8] and one more, Florida, established a universal demand requirement in different language. [9] The Pennsylvania Supreme Court adopted a number of sections of the Principles, including § 7.03, by judicial decision, concluding that they provided necessary guidance and were consistent with Pennsylvania precedent. See Cuker v. Mikalauskas, 547 Pa. 600, 692 A.2d 1042 (1997); Drain v. Covenant Life Ins. Co., 551 Pa. 570, 712 A.2d 273 (1998). In Boland v. Engle, 113 F.3d 706 (7th Cir.1997), the Court of Appeals for the Seventh Circuit, applying Indiana law, predicted that the Indiana Supreme Court would modify its dated common law and follow § 7.03 of the Principles, although, in light of its finding that the plaintiff's failure to make demand could not be excused under existing Indiana law, the court did not need to rest its decision on that prediction. Noting the adoption of the ABA/ALI recommendation eliminating the futility exception by 11 States at the time, the Federal court rejected the suggestion that Indiana would follow the Delaware approach and concluded, [r]ather, we surmise that the highest court in Indiana would today be persuaded by the general trend in the law towards narrowing, if not eliminating, the exceptions from the demand requirement. Id. at 712. [10] In 1996, the New York Court of Appeals looked with some apparent favor on § 7.42 of the Model Business Corporation Act and § 7.03 of the Principles, but, in light of the facts that (1) those provisions were inconsistent with an existing New York statute, and (2) bills to codify a universal demand had been thrice rejected by the New York legislature, the court declined to do what the Pennsylvania court did. See Marx v. Akers, supra, 88 N.Y.2d 189, 644 N.Y.S.2d 121, 666 N.E.2d 1034.