Opinion ID: 4511550
Heading Depth: 2
Heading Rank: 1

Heading: Derivative Actions and Demand Futility

Text: As a preliminary matter, we find it helpful to briefly discuss the nature of a derivative suit. “A derivative suit is brought by an investor in the corporation’s (not the investor’s) right to recover for injury to the corporation.” Felzen v. Andreas, 134 F.3d 873, 875 (7th Cir. 1998). Because corporate decisions (such as suing on its behalf) are typically in the hands No. 19-2755 7 of the board of directors, derivative suits represent an anomaly of corporate governance. “Only when the corporation’s board defaults in its duty to protect the interests of the investors” may a plaintiﬀ pursue a derivative suit. Id. For this reason, the Federal Rules of Civil Procedure place a special pleading requirement on would-be derivative plaintiﬀs. Rule 23.1(b)(3) requires that derivative plaintiﬀs plead with particularity their reasons for not attempting to compel the company’s board to take a desired course of action. We refer to this obligation as a derivative action’s “demand futility” requirement. The upshot is that derivative plaintiﬀs must show that a court should usurp the business judgment rule, which normally protects directors’ decisions. See In Re Abbott Labs. Deriv. S’holders Litig., 325 F.3d 795, 807 (7th Cir. 2003) (“[D]emand can only be excused where facts are alleged with particularity which create a reasonable doubt that the directors’ action was entitled to the protections of the business judgment rule.” (quoting Aronson v. Lewis, 473 A.2d 805, 808 (Del. 1984))). In Aronson, as we have explained, the Delaware Supreme Court laid out the familiar two-prong test for demand futility, holding it is established where “the alleged particularized facts raise a reasonable doubt that either (1) the directors are disinterested or independent or (2) the challenged transaction was the product of a valid exercise of the directors’ business judgment.” Abbott, 325 F.3d at 807 (citing Aronson, 473 A.2d at 814). The district court noted that there was a significant chance that, had it ruled on PSI’s motion to dismiss the derivative 8 No. 19-2755 suit, it would have found the demand futility requirement unmet. Because the board in place at the time of the operative complaint had a majority of new directors who could not be tied to the company’s revenue recognition issues, the plaintiﬀs were unlikely to establish that a majority of the directors were conflicted or lacked independence. McFadden does not meaningfully address this point, arguing instead that demand futility is “merely one aspect of a shareholder derivative lawsuit” and a “procedural, pleading requirement” that is “separate from the substantive merits” of the claim. This is incorrect and squarely contradicted by precedent: “The function of the demand futility doctrine … is a matter of substance, not procedure.” Westmoreland Cty. Employee Ret. Sys. v. Parkinson, 727 F.3d 719, 722 (7th Cir. 2013) (citing Kamen v. Kemper Fin. Servs., 500 U.S. 90, 96 (1991)). Because derivative actions by their very nature require a showing that the board cannot act as it should, the allegations demonstrating this inability are substantive. Contrary to McFadden’s argument, the demand futility requirement is not a mere technical, procedural hurdle. Demand futility is a substantive sine qua non of derivative suits. McFadden contends that the district court put too much weight on the demand futility issue, and essentially should have performed a more “holistic” analysis that gave greater consideration to the strength of the underlying breach and unjust enrichment claims, particularly in light of the whistleblower and criminal suits against PSI. As discussed above, McFadden misunderstands the nature of a derivative suit: the ability to demonstrate demand futility is a substantive element of the strength of such an action. No. 19-2755 9 McFadden claims that “[a]ll told, whether or not the Federal Plaintiﬀs could satisfy Rule 23.1’s pleading requirements is not –– and cannot be –– dispositive for the purposes of weighing the strengths of the derivative claims here.” That is incorrect. If a plaintiﬀ cannot show demand futility in a case, that disposes of his derivative claim. In sum, the district court’s close attention to the demand futility weakness in the plaintiﬀs’ claims was appropriate. We now turn to McFadden’s claims that the district court abused its discretion in approving the monetary award and the corporate governance reforms.