Court Opinion

ID: 8967868
Source: CourtListenerOpinion
Date Created: 2022-11-27 10:19:30.447129+00
Date Added: 2024-06-11T17:10:22.805780
License: Public Domain

EASTERBROOK, Circuit Judge,
concurring.
Delaware excuses demand on directors in a derivative suit when
under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.
Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984). See also Pogostin v. Rice, 480 A.2d 619, 624-25 (Del.1984); Grobow v. Perot, 539 A.2d 180, 183, 186 (Del.1988). The court uses this standard, and I join its opinion. Having applied Delaware’s law as best we can, we might move on to other business. This case illustrates, however, the difficulty courts have had with the rule of Aronson — which in Grobow led the Supreme Court of Delaware to dress down the Chancellor for misunderstanding the rule. Perhaps a federal judge may be forgiven the temerity of suggesting to members of the state bench that the problem lies not in the Chancellor's appreciation of Aronson but in the approach taken by that case. This is a subject of mutual interest, *1173not only because Aronson governs proceedings directly in diversity cases but also because federal courts apply their own demand rules when claims are based wholly on federal law, and in the latter they must decide whether to absorb into the body of federal law the rule stated by Aronson.
Why must shareholders demand that corporations act before filing suit? The rule could reflect a hope that the dispute will go away without litigation, that the board of directors will “do something” (or persuade the putative plaintiff that suit is pointless). Demand then initiates a form of alternative dispute resolution, much like mediation. Steps to control the volume of litigation are welcome, and courts give this as a justification for the demand rule. It is not, however, a powerful one, because on balance the rule creates more litigation than it prevents. It is difficult to identify cases in which the board’s response to a demand satisfied the shareholder and thus prevented litigation; even if the board acts the shareholder may believe the board did too little. It is easy to point to hundreds of cases, including this one, in which the demand requirement was itself the centerpiece of the litigation.
An approach uncertain in scope and discretionary in operation — that is, any rule except one invariably requiring or excusing demand — promotes litigation. When the stakes are high (as they frequently are in cases of this character), even a small disagreement between the parties about the application of a legal rule makes it difficult to resolve disagreements peaceably. It will be especially hard to resolve disputes out of court when, as in Delaware, making a demand affects the merits. A demand may be understood to concede that the board of directors possesses the discretion not to pursue the claim — and to block the investor’s pursuit of it too. See Zapata Corp. v. Maldonado, 430 A.2d 779 (Del.1981). The case reports overflow with decisions concerning the demand requirement, and under Aronson’s approach litigation to determine whether a demand should have been made entails questions closely associated with “the merits”. As a way to curtail litigation, the demand rule is a flop.1
The persuasive rationale for the demand requirement is that it allows directors to make a business decision about a business question: whether to invest the time and resources of the corporation in litigation. See Daily Income Fund, 464 U.S. at 532-33, 104 S.Ct. at 836-37; Aronson, 473 A.2d at 811-13; Deborah A. DeMott, Demand in Derivative Actions: Problems of Interpretation and Function, 19 U.C. Davis L.Rev. 461, 484-94 (1986); Daniel R. Fischel, The Demand and Standing Requirements in Stockholder Derivative Actions, 44 U. Chi.L.Rev. 168, 171-72 (1976). Firms must make operational decisions; if these misfire, they must decide what to do next. Each decision must be made with the interests of the corporation at heart. Whether to fire a negligent employee, or to extend another chance, is no less a “business decision” than the choice to hire him initially or approve his strategy. So too the decision to file a lawsuit or choose something simpler — discharge, demotion, dressing-down, ratification — in the wake of questionable conduct. Even doing nothing is justified when the resources of top managers required to act exceed the injury to the firm; when “something must be done”, acts short of litigation could have net benefits exceeding those of litigation. If the directors run the show, then they must control litigation (versus other remedies) to the same extent as they make the initial business decision. They may conclude that in*1174ternal remedies such as discharge or a reduction in compensation are more cost-effective for the firm. A lawsuit that seems to have good prospects and a positive value (net of attorneys’ fees) still may be an unwise business decision because of the value of managerial time that would have to be invested, time unavailable to pursue the principal business of the corporation. Similarly, a lawsuit that appears to have a negative net value may be useful to the firm if it deters future misconduct.
Choosing between litigation and some other response may be difficult, depending on information unavailable to courts and a sense of the situation in which business executives are trained. Managers who make such judgment calls poorly ultimately give way to superior executives; no such mechanism “selects out” judges who try to make business decisions. In the long run firms are better off when business decisions are made by business specialists, even granting the inevitable errors. If principles such as the “business judgment rule” preserve room for managers to err in making an operational decision, so too they preserve room to err in deciding what remedies to pursue.
This rationale need not, however, imply universal demand. If courts would not respect the directors' decision not to file suit, then demand would be an empty formality. Perhaps the directors are interested in the transaction, so that they have a financial stake in the transaction and bear the burden of establishing its propriety. In such duty-of-loyalty cases courts frequently say that demand would be “futile”. Or perhaps all of the directors are so ensnarled in the transaction that even when only the duty of care is at stake, their judgment could not be respected. Again demand would be an empty gesture. Delaware attempts to identify these cases and excuse demand in them.2
Aronson surveys these justifications and limits. The court observes that a decision not to sue is a business judgment. “[A] conscious decision to refrain from acting may nonetheless be a valid exercise of business judgment and enjoy the protections of the [business judgment] rule .... Unless the business judgment rule does not protect the refusal to sue, the shareholder lacks the legal managerial power to continue the derivative action”. 473 A.2d at 813. Yet the rule of law devised in Aronson does not track the court’s own remarks. The rule bears repeating; the court must ask whether
under the particularized facts alleged, 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.
Part (1) of this inquiry asks whether the directors’ business decision not to sue would be respected. Part (2) asks whether the original decision is sheltered from liability by the business judgment rule. Ar-onson, Pogostin, and Grobow tell us that if the shareholder satisfies either part of the inquiry, demand is unnecessary. Yet this cuts even a disinterested board out of the process whenever there is a serious question about the status of the challenged conduct, denying the firm the initial opportunity to make a business decision whether to pursue litigation although there may be no reason to doubt the integrity of the board’s decision.
If the original decision — that is, the decision to engage in “the challenged transaction” — was the product of a “valid exercise *1175of business judgment”, then the directors cannot in good faith authorize litigation. Only if there is a “reasonable doubt” about the application of the business judgment rule to the decision to undertake the “challenged transaction” may the firm litigate in its own name. The upshot of Aronson is that whenever the board may pursue litigation, demand is unnecessary; but when litigation would be an abuse of process, demand is required so that the board can make up its mind. Why should demand be excused when it might be useful and required only when the outcome is foredoomed? Judge Seitz, who served on the chancery court of Delaware for 20 years (and was Chancellor for 15) wrote in Lewis v. Curtis, 671 F.2d 779, 786 (3d Cir.1982), that a plaintiff need not allege that the challenged transaction was unprotected by the business judgment rule and that courts should inquire instead whether the board could make a valid business judgment in response to a demand. That inquiry is more in line with the rationales of the demand requirement limned in Aronson than is the rule stated in Aronson.
Most of the “challenged transaetionfs]” in today’s case were authorized by managers who do not sit on the board. Some were down a considerable distance in the corporate hierarchy. Why would the exposure of these employees of the firm to liability (on the ground that their deeds are not sheltered by the business judgment rule) eliminate the need to make demand on the board? The board of a corporation wants as much as any shareholder to prevent and punish delicts by subordinate managers — probably they want to do so even more urgently, because members of the board are likely to hold larger stakes in the firm than are shareholder-plaintiffs. See Harold Demsetz & Kenneth Lehn, The Structure of Corporate Ownership: Causes and Consequences, 93 J.Pol.Econ. 1155 (1985). This board, in particular, was concerned about these gaffes, in particular. Counsel informed us at oral argument that heads have rolled as a result of the transactions against which the complaint rails, and that some suits have been filed. Ironically, the fact that the board “did something” should be the magic arrow in plaintiffs quiver, for it suggests that the transactions were not sheltered by the business judgment rule. Such a topsy-turvy approach generates little other than mirth, however, which may be why the plaintiff did not pursue the point, and why this court can write that a sequence of events that had led to legal action did not create even a “reasonable doubt” about the protection of the business judgment rule.
Self-contradiction is not the only problem with the formulation of Aronson. The reference to “reasonable doubt” summons up the standard applied in criminal law. It is a demanding standard, meaning at least a 90% likelihood that the defendant is guilty. See C.M.A. McCauliff, Burdens of Proof: Degrees of Belief, Quanta of Evidence, or Constitutional Guarantees?, 35 Vand.L. Rev. 1293, 1325-32 (1982) (reporting a survey of federal judges). See also Branion v. Gramly, 855 F.2d 1256, 1263 n. 5 (7th Cir.1988); United States v. Hall, 854 F.2d 1036, 1043-44 (7th Cir.1988) (concurring opinion). If “reasonable doubt” in the Ar-onson formula means the same thing as “reasonable doubt” in criminal law, then demand is excused whenever there is a 10% chance that the original transaction is not protected by the business judgment rule. Why should demand be excused on such a slight showing? Surely not because courts want shareholders to file suit whenever there is an 11% likelihood that the business judgment rule will not protect a transaction. Aronson did not say, and later cases have not supplied the deficit. If “reasonable doubt” in corporate law means something different from “reasonable doubt” in criminal law, however, what is the difference?, and why use the same term for two different things?
A final oddment in the Aronson approach. Rule 23.1 and its parallel in Delaware practice require the court to determine at the pleading stage whether demand was necessary. This requires courts to adjudicate the merits on the pleadings, for a decision that the business judgment rule shelters the challenged conduct is “the merits” in derivative litigation, and under *1176Aronson also shows that demand was necessary. It is a bobtailed adjudication, without evidence. If facts suggesting (at the one-in-ten level) that the business judgment rule will not prevent recovery have come to light, the investor may plead them and litigate further, setting the stage for still another decision about the scope of the business judgment rule. See Grobow, 539 A.2d at 186-87 (noting the link between the demand requirement and the need for discovery). If facts of this character would come to light only with discovery, then demand is necessary and plaintiff may not litigate at all — for in Delaware a demand-required case is one the board may elect to prevent or dismiss under Zapata. The amount of information in the public domain is unrelated to the ability of the board to make a business judgment concerning litigation, is unrelated indeed to any function of the demand requirement. Why should the board acquire the power to dismiss under Zapata just because the plaintiff needs discovery and so cannot make the required showing “with particularity” in the complaint? Aronson and its successors do not discuss the point.
A rule of universal demand, as the American Law Institute has proposed, would avoid these difficulties. If Delaware thinks it wise to distinguish demand-required and demand-excused cases, then a rule requiring demand unless the board is so wrapped up in the transaction that it cannot be relied on to make a business decision about the wisdom of litigation would do nicely. It would reflect the functions of having a demand rule in the first place. A rule excusing demand when there is a serious question about the status of the “challenged transaction” does not respond to the reasons for thinking demand useful, and one wonders whether it might be better to have no demand requirement at all than to excuse demand when the board might want to sue and compel demand when the board could not responsibly litigate.

. Even without the link between demand and the board’s ability to squelch the suit, there is a steady flow of litigation about the demand requirement. Why this should occur is something of a mystery. Why should shareholders prefer costly litigation about the need for a demand to the cheap expedient of making one? Is it to get priority in the queue for attorneys’ fees if multiple suits are filed? (Courts could establish what amount to property rights with priority from the making of the demand, reducing this source of litigation.) Is it the need to beat the statute of limitations? Unlikely, for there is usually ample time to act. Is it the time pressure in transactions affecting corporate control? This might account for many suits but can’t account for Starrels’s. Anyway, it would be simple to require demand as soon as practicable even if the rush of events justifies expeditious litigation.

. Whether the game is worth the candle is a different question. Difficulties in sorting cases into demand-required and demand-excused bins might justify a universal requirement, with the understanding that requiring demand does not always give the corporation authority to block litigation. There is much to recommend the American Law Institute's proposal to require universal demand and decouple that requirement from doctrines concerning the board’s ability to prevent or dismiss derivative litigation. Principles of Corporate Governance: Analysis and Recommendations §§ 7.03, 7.08, and commentary at 64-71 (Tent. Draft No. 8, 1988). (Section 7.03(b) of Tentative Draft No. 8 would excuse demand when "irreparable injury to the corporation would otherwise result", but the Institute voted to require the shareholder to serve demand even after commencing a suit in advance of demand in reliance on feared "irreparable injury".)