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"Litigation Supply Should Not Exceed Shareholder Demand: How Proper Use of the Demand Requirement in Derivative Suits Can Decrease Corporate Litigation" by Joseph C. Barsalona II


Litigation Supply Should Not Exceed Shareholder ADR Demand:
How Proper Use of the Demand Requirement in Derivative Suits Can Decrease Corporate Litigation

by Joseph C. Barsalona II

Introduction

Imagine that you are a shareholder of a Fortune 500 company. One morning you wake up, open the day's edition of The New York Times, and the front page features an article about your company. You read the headline, and your jaw drops: the CEO has a $5 million dollar salary despite the fact that he spends more time in Cabo, Mexico, than he does in the boardroom.

Assuming that you love this company and are not willing to sell your shares immediately, what recourse is available? Unfortunately for you, your fellow shareholders, and even the company itself, the state in which the company incorporates holds all the answers. See Kamin v. Kemper Fin. Servs., 500 U.S. 90 (1991) (holding that the Demand Requirement is substantive state law).

A shareholder should have the choice to either bring a class action lawsuit or a derivative lawsuit against his/her company. See FED. R. CIV. P. 23.1; see also Grimes v. Donald, 673 A.2d 1207 (Del. 1995); Marx v. Akers, 666 N.E.2d 1034 (N.Y. 1996). However, in the last 20 years, the amount of class action lawsuits has increased substantially, seemingly leaving its derivative counterpart in the past. See Jesse Tiko Smallwood, Nationwide, State Law Class Actions and the Beauty of Federalism, 53 DUKE L.J. 1137, 1151 (stating that "state court class action filings increased 1,315 percent" in the 1990s). The reason behind this trend is simple: class action lawsuits allow parties to sue a corporation directly while parties filing a derivative suit must go through the process of requesting the company to basically sue itself, i.e. making demand upon the company. Compare FED. R. CIV. P. 23 (allows any party to sue directly), with FED. R. CIV. P. 23.1 ("The complaint shall also allege with particularity the efforts, if any, made by the plaintiffs to obtain the action the plaintiff desires from the directors or comparable authority . . . and the reasons for the plaintiff's failure to obtain the action or for not making the effort.").

Because of this languid process, savvy plaintiff attorneys have long evaded corporate codes to skip over the demand procedure for many years while state case law aided their cause. See Grimes, 673 A.2d 1207, and Marx, 666 N.E.2d 1034. As an indirect result, companies fight hundreds of class action lawsuits in the courtroom without the possibility of internal resolution with their shareholders.

There is a way to fix this problem. It starts with amending the demand requirement in state corporate codes. If shareholders avoid the requirement because it consistently leaves them in the dark, it is the state legislature's responsibility to modify state corporate codes, i.e. the codified version of each state's demand requirement, by revitalizing the original dispute resolution policies. Adopting the Model Business Corporation Act's demand procedure, MOD. BUS. CORP. ACT (1984) [hereinafter MBCA], as other states have done, could be the most viable way to initiate this change. See ARIZ. REV. STAT. ANN. § 10-742 (2011); CONN. GEN. STAT. ANN. § 33-722 (2011); FLA. STAT. ANN. § 607.07401 (2011). The MBCA's version strengthens the alternative dispute resolution (ADR) policies behind the requirement and is the best solution for reducing the number of class actions and overall number of corporate suits between companies and their shareholders in general.

This article explores the contours of the demand requirement, the forgotten ADR mechanism available to all litigating shareholders, and how its efficient use will be beneficial for all parties involved and the greater corporate community. Part II describes the derivative suit and the demand requirement generally, with particular attention focused on the procedure in Delaware and New York. Because these two states have the most domestic incorporations of all states, it is important to see how their processes change the landscape of the requirement. See DALE A. OESTERLE, THE LAW OF MERGERS AND ACQUISITIONS 137 (3d ed. 2005) (stating that "[a]pproximately 60 percent of the largest industrial firms are incorporated in Delaware").

Part III delves deeper into the demand requirement and begins to explain its ADR policies and characteristics. Part IV describes the MBCA model and explains why it gives the best possibility for improvement with corporate ADR. It discusses the positive effects in the adopting states and how the same changes to other corporate codes could be the best way for companies and shareholders to save time and money. Part V concludes this essay by reiterating the importance of the demand requirement, why more states and corporations should be utilizing its benefits, and promoting the MBCA model as a positive outlook for the future.

The Demand Requirement And Its Role In The Derivative Suit

A. Derivative Suits

While class action lawsuits garner the most press, derivative suits provide a more cooperative option for shareholders to fix companies. Through enabling statutes in state corporate codes, derivative plaintiffs can champion their rights against all types of "wrongdoers," including employees within the company and third parties that harmed the corporate entity. Carol B. Swanson, Juggling Shareholders Rights and Strike Suits in Derivative Litigation: The ALI Drops the Ball, 77 MINN L. REV. 1339, 1345 (1993). While there are many hurdles to bringing a derivative suit, the steps a shareholder must follow are meant to facilitate the parties' collaboration to avoid any court appearances. See FED. R. CIV. P. 23.1; Pogostin v. Rice, 480 A.2d 619, 624 (Del. 1984) (describing the demand requirement as a threshold mechanism designed to "prevent abuse and to promote intracorporate dispute resolution").

Collaborative decision-making is already heralded in the corporate landscape when creating relationships with suppliers and professional relationships between attorneys; collaboration between shareholders and the board of directors (board(s)) would reap those same benefits. See John Lande, Principles for Policymaking About Collaborative Law and Other ADR Processes, 22 OHIO ST. J. ON DISP. RESOL. 619, 704 (2007) (discussing the advantages of collaboration). In that sense, the derivative lawsuit is a valuable tool that should remain the top choice of any shareholder trying to amend an in-house problem.

Generally speaking, when a shareholder brings a derivative suit, they step into the shoes of the corporation in order to sue on its behalf. Grimes, 673 A.2d at 1215. Such suits are useful because the attentive shareholder may spot a problem through other sources (e.g., the newspaper) that the company's agents were either too preoccupied to notice or had yet to announce publicly. See In re Cendant Corp. Derivative Action Litig., 96 F. Supp. 2d 394, 401 (D.N.J. 2000) (plaintiffs found grounds for suit based on facts in a New York Times article). Of course, the suits are usually based on problems caused by those agents themselves, and so this option exists for those shareholders who do not trust the officers hired to resolve the company's problems from within. Compare Grimes, 673 A.2d at 1210 (plaintiff sued the board based on an allegedly wasteful employment agreement) with Marx, 666 N.E.2d at 1040 (plaintiff sued board on alleged self-dealing through excessive awards).

Once a shareholder steps into the shoes of the company, the party being sued is the individuals who run the company or a third party. Grimes, 673 A.2d at 1210. Considering that the officers' and directors' primary function is to make money for the shareholders, it is the shareholders' responsibility to sue those agents who breached their fiduciary duties. See Ian B. Lee, Efficiency and Ethics in the Debate About Shareholder Primacy, 31 DEL. J. CORP. L. 533, 535 (2006; see also Paula J. Dalley, To Whom It May Concern: Fiduciary Duties and Business Associations, 26 DEL. J. CORP. L. 515, 519 (2001) for a general discussion on fiduciary duty doctrine. In that sense, the derivative suit is analogous to parents punishing their children for shirking on their chores: the parents lose time and labor by punishing the children, but hope that the quality of the effort will increase.

Because a shareholder sues to redress an injury to the company, and not one the shareholder suffers personally, there are strict standing requirements that all plaintiffs must satisfy. See Kamin, 500 U.S. at 95 ("Devised as a suit in equity, the purpose of the derivative action was to place in the hands of the individual shareholder a means to protect the interests of the corporation . . . ."). While every state may have different procedural hurdles, the majority of states defer to the Federal Rules of Civil Procedure format, and therefore that model requires discussion.

First, the plaintiff must have been a shareholder at the time of the wrong. FED. R. CIV. P. 23.1(1). If an individual learns of the problem, buys a few shares, and then attempts to sue on behalf of the corporation, the standing problem stops that individual from proceeding with the suit.

Second, the plaintiff must be a shareholder for the duration of the action. Id. The law requires that the shareholder have a stake in the company so that as long as the suit continues, the plaintiff will share in the stock's financial gains or losses during the litigation. See Ann M. Scarlett, Confusion and Unpredictability in Shareholder Derivative Litigation: The Delaware Court's Response to Recent Corporate Scandals, 60 FLA. L. REV. 589, 627-28 (2008) (describing how "[i]ncreased shareholder derivative suits could cause investors to lose confidence in director-managed corporations" thereby hurting the price of the stock in the market). This requirement deters plaintiffs that would rather have their stock remain strong instead of investigating a possible problem with the company. See Reinier Kraakman, Hyun Park & Steven Shavell, When are Shareholder Suits in Shareholder Interests?, 82 GEO. L.J. 1733, 1743 (1994) (explaining that derivative suits that decrease corporate value are rare).

Third, the plaintiff must "fairly and adequately" represent the other shareholders. See HER, Inc. v. Parenteau, 770 N.E.2d 105, 109 (Ohio 2002) (providing a comprehensive list of elements used to determine whether a shareholder fairly and adequately represents similarly situated shareholders). In other words, the hardship that the plaintiff-shareholder experienced must not be one that only he/she experienced personally, but that all shareholders suffered collectively; usually this requires the plaintiff to have a significant amount of shares of a particular corporation. See Estate of Soler v. Rodriguez, 63 F.3d 45 (1st Cir. 1995) (plaintiff's ownership of 50.43% of all outstanding voting stock was sufficient for standing in a derivative suit).

Additionally, because derivative suits are state substantive law, many states have their own financial standing requirements that accompany the legal standing requirements. See Kamin, 500 U.S. at 90 For example, some states require a plaintiff to pay a bond to the corporation in order to bring suit, while others require only specific parties to be paid upon the completion of the suit. Compare N.Y. BUS. CORP. LAW § 627 (2011) (allowing the defendant corporation to request a bond from the plaintiff shareholder), with MBCA § 7.46(2) (requiring all expenses charged on plaintiff if found that there was no "reasonable cause" for the claim). These additional requirements not only make derivative suits expensive, but they motivate shareholders pursue a different legal route altogether, hence the growing popularity of class action lawsuits.

B. The Demand Requirement

If a shareholder satisfies the state's requisite standing requirements, the stage is set for bringing the derivative suit. Theoretically, if the shareholder sues on behalf of the corporation, it follows that the plaintiff must request permission from the board. See Grimes, 673 A.2d at 1215 (the ultimate decision to assert the claim comes from the corporation itself). Therefore, the plaintiff is 'demanding' the board to either fix the current deficiency or to allow the shareholder to take legal action. The requirement is thus designed to promote intracorporate dispute resolution and to fix the corporation as a whole. See id. at 1216 ("[T]he demand requirement invokes a species of [ADR] procedure which might avoid litigation altogether."); Pogostin, 480 A.2d at 624 ("[Demand] . . . exists . . . to promote intracorporate dispute resolution.").

The codification of the demand requirement changes state by state, but because the majority of public companies incorporate in Delaware, see OESTERLE, supra, at 137, this essay will critique Delaware case law pertaining to derivative suits.

In Delaware, it is the responsibility of the shareholder to contact the board and to explain the perceived problem. See DEL. CH. CT. R. 23.1; DEL. CODE ANN. tit. 8, § 141 (2011) (stating that "[t]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board"). The communication between the shareholder and the board could be as simple as a letter, but must state the issue the shareholder wishes to alleviate. See, e.g., Grimes, 673 A.2d at 1211-12 (the plaintiff's letter to the board stated explicitly "I hereby demand that the Board . . . take immediate steps to abrogate . . . the Employment Agreement" of the defendant).

Once demand is made, it is the board's responsibility to either amend the problem or choose to do nothing. In Delaware, the choice to seek or terminate litigation is governed by the "business judgment rule," an almost impenetrable barrier for shareholders. John C. Coffee, Jr., New Myths and Old Realities: The American Law Institute Faces the Derivative Action, 48 BUS. LAW. 1407, 1412 (1993); see also Andrew C.W. Lund, Rethinking Aronson: Board Authority and Overdelegation, 11 U. PA. J. BUS. L. 703, 704 (2009) ("[After demand is made] [b]oards are then free, within the boundaries of their fiduciary duties, to determine whether to accept or refuse the demand."). Usually, the board will assemble a special litigation committee if the company chooses to pursue the matter.

Most plaintiffs, however, do not trust the board to handle these issues in-house, and instead attempt to bypass the demand requirement entirely, i.e. asking a court to "excuse" demand, because the process would be futile. Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984). The original futility test was a two-prong, alternative inquiry that could be easily defeated by a diligent shareholder: "[U]nder 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." Id. To do so, in their pre-trial motions, plaintiffs' attorneys plead why there is a reasonable doubt that demand is futile. See Grimes, 673 A.2d at 1216 (stating that a there must be a "reasonable doubt...that the board is capable of making an independent decision to assert the claim if demand were made...."). If the judge is convinced, demand is excused, and the suit may proceed to trial. See id. at 1216.

The suits that pass the motions stage usually has unsatisfying results: the shareholder obtains only a moral victory over his company and the company has suffered a financial and reputational detriment as a result. See DEL. CH. CT. R. 23.1 (b)(ii) (entitling the winning party to "fees, costs or other payments as the Court expressly approves"); see also N.Y. BUS. CORP. LAW § 626(e) (2011) (stating that plaintiffs' attorneys may receive "reasonable attorneys' fees" for either a judgment or settlement while the plaintiff is "limited to a recovery of the loss or damage sustained by them"). Therefore, the existence of futility not only complicates the derivative process but ultimately eliminates all ADR processes available to the parties involved. See Werbowsky v. Collomb, 766 A.2d 123, 144 (Md. 2001) ("The futility exception essentially eliminates any chance at meaningful pre-litigation [ADR]. It also virtually assures extensive and expensive judicial wrangling over a peripheral issue that may result in preliminary determinations regarding director culpability that . . . turn out to be unsupportable.").

If the power to excuse demand mortally wounds the procedure, the effect of making demand and having it refused ultimately kills it. See Grimes, 673 A.2d at 1219 (creating a stronger standard to prove wrongful refusal of demand if a corporation chooses to set aside the complaint). In Delaware, once actual demand is made upon a corporation, the demanding shareholder waives his/her claim of excusal. See Spiegel v. Buntrock, 571 A.2d 767, 774 (Del. 1990) (actual demand waived the right of excusal). Simply put, by asking for the company to investigate, the shareholder may have already lost his/her case merely by asking permission from the board. See Grimes, 673 A.2d at 1219 (business judgment rule applies when reviewing ex post). As a result, many potentially substantive suits will be lost in the process as the shareholder is caught in an inevitable "Catch-22." See Coffee, supra, at 1413 (the shareholder must choose to plead reasonable doubt under the Aronson standard or concede that the board was disinterested). Thus, shareholders looking for help from Delaware courts for fiduciary duty claims are much more likely to turn to class action lawsuits instead of traveling the labyrinthine paths of derivative suits.

Once demand is made by a shareholder, the corporation organizes a special litigation committee. 13 WILLIAM MEADE FLETCHER ET AL., FLETCHER CYCLOPEDIA OF THE LAW OF CORPORATIONS § 6019.50 (perm. ed., rev. vol. 2011). This committee is composed of independent directors and is specifically authorized by statute in some state corporate codes. See, e.g., GA. CODE ANN. § 14-2-744(b) (2011); IND. CODE ANN. § 23-1-32-4 (2011); N.H. REV. STAT. ANN. § 293-A:7.44(b) (2011); WIS. STAT §180.0744(2) (2011). While special litigation committees may be formed to terminate all types of litigation against the company, in the specific instance of derivative suits, the committee's duties are twofold: 1) to investigate the allegations made by the shareholder and 2) to decide whether litigation is necessary or dismissible. See FLETCHER, supra; Bender v. Schwartz, 917 A.2d 142, 152 (Md. 2007) ("Once a demand is made, the corporation's board . . . must conduct an investigation into the allegations in the demand . . . [through the] appoint[ment of] a committee of disinterested directors . . . ."); see also Kesling v. Kesling, 546 F. Supp. 2d 627, 634 (Ind. 2008) ("The board may . . . establish a committee to investigate the allegations and determine whether the corporation should pursue litigation.").

Such committees are useful in dissipating meritless and otherwise frivolous strike suits. See Black v. NuAire, Inc., 426 N.W.2d 203, 208 (Minn. Ct. App. 1988) ("The purpose of [the special litigation committee enabling statute] is to grant corporations the ability to respond effectively to the potential abuses of strike suits, in which a single dissenting shareholder, owning only one share of stock, may file a derivative suit for its nuisance value alone."). Nevertheless, there are certainly a number of legitimate derivative lawsuits that will fall by the wayside. See Douglas C. Buffone, Note, Predatory Attorneys and Professional Plaintiffs: Reforms Are Needed To Limit Vexatious Securities Litigation, 23 HOFSTRA L. REV. 655 (1995), for a discussion on the many ways meritorious claims fall on deaf ears, one of which being the demand procedure of derivative suits.

There are many flaws in a corporation creating, and paying for, a committee dedicated solely to terminating litigation by its own shareholders and too many to discuss in this essay. However, these committees have survived scrutiny from the courts and even constitutional attacks. See Starrels v. First Nat. Bank of Chicago, 870 F.2d 1168, 1173 (7th Cir. 1989) (opining that despite the ADR justification for demand, the requirement leads to more litigation in the aggregate); FLETCHER, supra (citing Black v. NuAire, Inc., 426 N.W.2d 203 (Minn. Ct. App. 1988). As long as they exist, though, shareholders will continually face a roadblock to their claims and grievances will continue without redress. The use of special litigation committees epitomizes the current sad state of derivative suit litigation, but when examining the policies behind the rule, it is questionable whether the statutory framers ever foresaw such a result.

The ADR Polices Behind Demand

Initially, the demand requirement looks like a mechanism of litigation procedure, but when analyzing the requirement's intent, one can see that it is meant to create a form of ADR within the company so that litigation never comes to pass.

First, in its simplest form, the demand requirement is a way to put a board on notice of both the problems they may overlook and the subsequent shareholder disapproval. See Special Feature: Ombuds Standards, 54 ADMIN. L. REV. 535 (2002) (describing the role that ombuds play in workplace disputes and board's specific designation is needed before communication to an ombuds becomes actual notice). If used properly, the demand requirement could be one of the most interactive mechanisms for shareholders in the day-to-day operations of a public company. See Lee, supra, at 540-41, for a discussion about the positive effects of an active shareholder-board relationship that creates a "mediating hierarchy." It is impossible for a board to be aware of every single discrepancy within a large company; if the demand requirement is utilized properly, the shareholders have the opportunity to increase internal awareness and ultimately raise profits for all. Id. at 540-41.

Second, the demand requirement is meant to "exhaust intracorporate remedies" so that all damaging issues remain in-house. See Cramer v. Gen. Tel. & Elecs. Corp., 582 F.2d 259, 275 (3d Cir. 1978); see also Grimes, 673 A.2d at 1216; Aronson, 473 A.2d at 811-12. Every company handles problems differently, but the best remedies are often found in the boardroom. See, e.g., Lynne L. Dallas, The Multiple Roles of Corporate Boards of Directors, 40 SAN DIEGO L. REV. 781, 783-84 (2003) (opining that both insider-dominated and outsider-dominated boards are equated to more successful corporations in terms of return on assets). If demand is to regain this mode of cooperation between shareholders and officers, there needs to be a mechanism that facilitates communication between all parties. See Elisa Westfield, Note, Resolving Conflict in the 21st Century Global Workplace: The Role for Alternative Dispute Resolution, 54 RUTGERS L. REV. 1221, 1225-28 (2002) (illustrating how ADR procedures increase communication and collaboration between the directors and their shareholders). While the introduction of excusal hampered the method of communication created by demand, a reinforcement of demand's results could positively reset the system.

Finally, demand is meant to keep shareholders and boards out of the courtroom, saving litigation costs for both the individual shareholder and the company itself. See CPR And GE: Working Together to Grow ADR, METROPOLITAN CORPORATE COUNSEL, July 2008, at 22. By avoiding the demand requirement and suing corporations directly through class actions, unnecessary time and money is spent to resolve the issue. According to statistics provided by the Administrative Office of the U.S. Courts, the number of filed cases pertaining to "securities, commodities and exchanges" has risen by an average of 140 filings per year since the beginning of the recession in early 2008. United States Courts, www.uscourts.gov (view "Statistics"; then "Judicial Business Of The U.S. Courts"; then "Judicial Business 2009"; then "Table C-2A Cases Commenced, by Nature of Suit, 2005 Through 2009"), at 146. Considering how little the judgments are for plaintiffs, it would not be surprising if many were content with an ADR procedure that both saves money and fixes the underlying problems. See Nancy H. Rogers & Craig A. McEwen, Employing the Law to Increase the Use of Mediation and to Encourage Direct and Early Negotiations, 13 OHIO ST. J. ON DISP. RESOL. 831, 839-47 (1998).

In sum, distrust between suing shareholders and boards must be eradicated, and demand provides the most peaceful and efficient way of doing so. Though it is a method of civil procedure, the demand requirement is unquestionably an ADR mechanism that can bring shareholders and companies together to alleviate any divisive problems within the corporation. With this knowledge, state legislatures must look to amend their corporate codes to make the demand requirement a more popular option. Considering studies show that mediation is becoming more popular in the corporate arena, incorporating mediation into the demand process might be the progressive step following uniform demand adoption. See David B. Lipsky & Ronald L. Seeber, The Appropriate Resolution of Corporate Disputes: A Report on the Growing Use of ADR by U.S. Corporations, CORNELL/PERC INST. ON CONFLICT RESOL. (1998) (showing the continual utilization of mediation to resolve dispute in Fortune 1000 companies).

While some courts acknowledge demand's positive characteristics, see Grimes, 673 A.2d at 1216 (noting how "[t]he demand requirement serves a salutary purpose"); Aronson, 473 A.2d at 811-12 ("[B]y promoting . . . [ADR], rather than immediate recourse to litigation, the demand requirement is a recognition of the fundamental precept that directors manage the business and affairs of corporations."), others question whether the requirement's good intentions lead to actual change. See, e.g., Starrels, 870 F.2d at 1173. Indeed, some courts come close to mocking demand's ADR policies. See, e.g., Seaford Funding Ltd. P'ship v. M & M Assocs. II, L.P., No. 1598-S, 1995 Del. Ch. LEXIS 51, at *12-13 (Del. Ch. April 26, 1995). Is this because they are cynical about its effectiveness in the corporate setting, where share price and profits are the most important goal? Or do the critics generally distrust boards to follow ADR processes properly? In actuality, it may be a combination of both.

One author, in a scathing piece against director indemnification, argues that the root of the problem lies in the presumed corporate landscape of "self-protecting boards, greedy lawyers, [and] passive shareholders." See Mae Kuykendall, A Neglected Policy Option: Indemnification of Directors For Amounts Paid to Settle Derivative Suits--Looking Past "Circularity" to Context and Reform, 32 SAN DIEGO L. REV. 1063, 65 (1995). In essence, the literature on corporate litigation believes that parties to whom profits are the biggest priority are adverse to compromise and therefore the judicial process is the only viable solution. See id. at 1083-87.

The problem with the literature's rationale, however, is that it chills positive "avenues of reform": the consistent mistrust of the dispute resolving abilities of boards and shareholders will always bring the parties back into the courtroom, costing both sides money that they would be better off spending improving the company as a whole. See id. at 1072-75. As a response, Ms. Kuykendall advocates "fine-tuning of the mechanism of derivative litigation rather than making wholesale decisions about its vitality." Id. at 1087.

If derivative suits that proceed to court are the problem, and mere "fine-tuning" of the procedure is all that is needed to alleviate it, then the solution lies in the procedure that is most ripe and ready for change: the demand requirement. Id. Because this procedure is consistently avoided in jurisdictions such as New York and Delaware through futility and excusal case law, state legislatures must amend their corporate codes and court rules so that demand becomes a mandatory procedure obligating the parties to work through their disputes before courts become involved. The MBCA procedure provides the precise model that state legislatures need.

Integrating the MCBA Rules Will Increase In-House Dispute Resolution

A possible method to fix the current inadequacies of derivative suits in state corporate codes is for states to adopt the procedure set out in the Model Business Corporation Act. MBCA § 7.42. At least 18 states have adopted the MBCA method in full. See Werbonsky v. Bertand Collomb, 766 A.2d 123, 141-42 (Md. 2001). This accounts for an increase of five states since Marx, 666 N.E.2d at 1034, and 14 states since the Supreme Court held that demand was a matter of substantive state law in Kamin, 500 U.S. at 102. With more support from the ADR community, that number can continue to grow nationally. The MBCA method utilizes the dispute resolution mechanisms of a corporation by (1) reducing the amount of futility claims, (2) increasing the amount of communication between shareholders and their agents, and (3) giving shareholders the right to bring suit if all else fails.

Pleading that demand is futile essentially removes the possibility that the shareholder and the corporation will resolve the dispute outside of the courtroom. See Kenneth B. Davis, Jr., The Forgotten Derivative Suit, 61 VAND. L. REV. 387, 440 (2008) (describing futility requirements as the most rigorous). The MBCA procedure remedies this by making demand mandatory for all shareholders and putting a time limit on how long a board has to make the decision. MBCA § 7.42. Other courts have mentioned the positive potential of universal demand, but results in those states that actually adopted it truly prove the point. See Marx, 666 N.E.2d at 1038.

While New York and Delaware case law allows shareholders to avoid demand altogether through excusal claims, the MBCA has a universal demand requirement. MBCA § 7.42. This means that demand must be made in every case with no special exceptions. Id. Demand should not be seen as a burden, but rather an effective means for the parties to cooperatively resolve the problem. See Rogers & McEwen, supra (in-house counsel involved in a study reflected that "[l]awyers generally were resistant to the spread of ADR within the company"); see also Werbonsky, 766 A.2d at 144 ("[A] pre-suit demand on the directors is not an onerous requirement."). By making demand mandatory, the shareholders' attorneys will be forced to contact the board rather than running to court with pleadings of futility and excusal, see N.Y. BUS. CORP. LAW § 626 (2011), ultimately benefiting their clients. See Miriam P. Hechler, The Role of The Corporate Attorney Within the Takeover Context: Loyalties to Whom?, 21 DEL. J. CORP. L. 943, 980 (1996) ("The mandatory rule enforces both the attorney's and the board's monitoring function and simultaneously protects shareholders."). Moreover, because of the low costs associated with making demand, the requirement's litigation-deterrent effects are more worthwhile than filing suit. (For a discussion on universal demand, see Shiro Kawashima and Susumu Sakurai, Shareholder Derivative Litigation in Japan: Law, Practice, and Suggested Reforms, 33 STAN. J. INT'L L. 9, 46 (1997)).

Also, mandatory demand removes the collective action problem that exists with most potential suits. See Seung Wha Chang, The Role of Law in Economic Development and Adjustment Process: The Case of Korea, 34 INT'L LAW. 267 (2000) ("To solve a collective action problem . . . it is often necessary for lawyers to take an initiative in bringing a derivative suit."). Often, because bringing a lawsuit is very expensive and time-consuming, even those shareholders aware of the problem are hesitant to bring the suit themselves and would rather wait for a representative to take the reins. See J.W. Verret, Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation, Part II, A Self-Regulation Proposal, 32 DEL. J. CORP. L. 799, 834 (2007) ("[M]any firms face a collective action problem. The profits from acting are exceeded by the individual cost of activism."); see also, Davis, Jr., 61 VAND. L. REV. at 433 (for many derivative suits "the prospect for meaningful monetary recovery is remote and, even when obtained, almost always will be covered indemnification or insurance paid for by the corporation"). Here, a universal demand requirement puts everyone on equal footing: demand must always be the first step and those that bring claims of excusal do not have the first shot at monopolizing the company's attention. By taking the greedy, individual aspirations out of suing a corporation, the shareholders can work with the board to fix whatever problems may arise through a more collaborative method rather than the adversarial method that dominates the American legal psyche. See John C. Coffee, Jr., Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter is Not Working, 42 MD. L. REV. 215 (1983).

Unlike the Delaware and New York model where the shareholder is left in the dark after demand is made, the MBCA model imposes a 90-day time limit for the company to respond. See MBCA § 7.42. This time limit has three positive effects: (1) it guarantees a response for the shareholder in a reasonable amount of time, (2) it gives an appropriate window for the company to make a decision to handle the problem or to deny suit, and (3) it also gives a fair amount of time to the company to prepare a defense if a suit should go forward. See Jiong Deng, Building an Investor-Friendly Shareholder Derivative Lawsuit System in China, 46 HARV. INT'L L.J. 347, 379 (2005) ("In order to avoid wasting two months and to provide a timely remedy for shareholders, the SPC may wish to follow this approach and exempt futile demands.").

The hope is that after notice of a pending suit is received, the company will do all it can to work with the shareholders to alleviate the problem rather than contact their legal team. See Andrea M. Matwyshyn, Imagining the Intangible, 34 DEL. J. CORP. L. 965, 1012 (2009) ("As a practical matter, the board should view this demand as a warning; shareholders are seeking an explanation of the rationale behind a particular corporate decision or omission which is alleged to have harmed the corporation."). The time limit is one that a shareholder must abide before bringing the lawsuit; it gives no control to the company other than to resolve the dispute by answering the demand or to inform the plaintiff that the company feels it unnecessary to proceed with litigation. By removing the sole power from the company, the time limit forces the parties to collaborate promptly. It is within this window that the parties should negotiate or mediate the problem so that a lawsuit should never come to pass.

A single demand letter from a shareholder can be forgotten, but hundreds of such letters will force a board to have a healthy and much needed conversation with their principals. A universal demand requirement provides just that: open communication between shareholders and the board, putting the latter on notice of any particular deficiencies. It could even improve the personal relationships between the board and the shareholders looking to solve the problem. See id. at 1011 ("Satisfactory response [to demand] demonstrates care in management and can, perhaps, prevent shareholders from selling shares out of anger and begin to rebuild trust.").

A shareholder meeting is one of the few opportunities where the board can interact with its shareholders, and yet these events suffer from lack of attendance. See Stephen Choi and Jill Frisch and Marcel Kahan, The Power of Proxy Advisors: Myth or Reality?, 59 EMORY L.J. 869 (2010) (stating that shareholder meetings suffer from poor attendance). An economical way of alleviating this attendance problem is by promoting the demand requirement as a communication tool rather than just a preamble to a lawsuit. This way, every demand letter could be analogous to a question at a board meeting and yet get more attention than it normally would in the group setting. Demand pinpoints the problem and gives the parties the opportunity to collectively amend it. Therefore, just like any negotiation, the demand requirement obligates both sides to replace their independent goals with the company's overall interests. See Jill Schachner Chanen, Collaborative Counselors: Newest ADR Option Wins Converts, While Suffering Some Growing Pains, 92 A.B.A.J. 52 (2006), for a discussion on how all successful negotiators should focus on replacing the goals of the parties involved with interests. The only way to achieve this is through an adequate means of communication; formal demand can jump-start that method of communication for which state legislatures should strive.

Of course, like any other negotiation or mediation, sometimes talks break down, and a lawsuit follows. Although lawsuits should be avoided wherever possible, the MBCA model allows aggrieved shareholders the opportunity to go to trial if all else fails. See MBCA § 7.42. This characteristic makes the MBCA model more attractive than the Delaware and New York model: the right to bring suit is never waived, so shareholders can always keep that option open during negotiations. Also, if the company is in fact breaking the law, after all in-house ADR mechanisms fail the shareholder always can ask a judge or jury to make the determination of whether changes are needed in the structure of the company. As the literature shows, a corporation would want to keep this type of decision away from judges and juries at all costs. See John Gibeaut, Fear and Loathing in Corporate America: Big Business's Public Tribulations Have Led to Skeptical Juries, New Laws and In-House Lawyers Working to Tighten Compliance, 89 A.B.A.J. 50 (January 2003) (describing how the rise in jury awards against corporations at the beginning of the millennium has lead to the movement towards increased ADR). Based on the facts of individual cases, lawsuits are sometimes the only viable means of fixing the problem; only the MBCA model allows shareholders both the collaboration of demand and the possibility of suit.

There is also a positive trickle-down effect from the company knowing it can be sued: if the board has no control over whether the shareholder decides to sue or not, the possibility of suit should be enough to keep the conflicts from arising. Conversely, if the problems with the company cannot be prevented, a board seeking to amend its relationship with its shareholders will immediately handle the problem without hesitation. The threat of suit is a powerful negotiation tool for any shareholder and should always be available to aggrieved shareholders.

Conclusion

The demand requirement is an important ADR mechanism that deserves new life in the corporate law landscape. Because of its unpopular procedure, many plaintiffs have turned to large class-action lawsuits that waste time and money while allowing the majority of problems within the company to go unchanged. In order to revitalize the derivative suit, state legislatures should follow the MBCA model and amend the demand requirement so that its beneficial dispute resolving features are utilized. Furthermore, if state legislatures strive to include an ADR procedure like demand into the early stages of the process, intracorporate remedies would be the only line of defense against corporate suits, and the number of state courts filings would decrease immensely. By adopting the MBCA standard, shareholders and boards will have the opportunity to work collaboratively when resolving company disputes, thus successfully bringing ADR back to where it is most needed: corporate law.

Joseph C. Barsalona II is a third-year student at The Ohio State University Moritz College of Law with an interest in corporate bankruptcy, debtor-creditor rights, and general corporate litigation. He is also a member of the New York State Bar Association. Prior to attending law school, Joseph was a corporate legal assistant in the mergers & acquisitions department of Cravath, Swaine & Moore LLP. He is the Chief Managing Editor for the Ohio State Journal on Dispute Resolution and will compete in Wilimington, DE in March 2012 on the Corporations Moot Court Team. In August 2012 he will begin a two-year term as law clerk to the Hon. Robert N. Opel, II for the U.S. Bankruptcy Court for the Middle District of Pennsylvania. He plans to sit for the New York and New Jersey bar in July 2012.


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This page contains a single entry from the blog posted on November 23, 2011 4:56 PM.

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