What Is a Shareholder Derivative Action?
A shareholder derivative action is an action maintained by a shareholder for the benefit of a corporation against a third-party, most often an insider of the corporation such as an executive officer or director, because of the corporation’s failure to take action against the third-party.
What Are the Requirements for a Plaintiff to Maintain Derivative Action?Corporations are creatures of state law, and the fiduciary duties of a corporation's directors are defined by its state of incorporation. Therefore, in a derivative action, the substantive law of the corporation's state of incorporation will apply. If filed in different state court, such as where corporation is headquartered or filed in federal court, then the procedural rules of that state or federal court will apply, but that court will apply the substantive law of the state of incorporation.
State laws and federal procedures almost universally contain several of the same requirements. First, derivative action complaints should be verified, commenced in the name of the corporation, and allege the plaintiff was a shareholder at the time the challenged transaction occurred (or his interest devolved by operation of law). Second, the plaintiff must allege he made a demand to the corporation's board of directors to take the requested action, and the reasons for not obtaining the action or not making the effort. Third, a derivative action may not be maintained if the plaintiff does not fairly and adequately represent the interests of the other similarly situated shareholders. These requirements, which are expressly established by Fed. R. Civ. Ap. 23.1, are commonly known as the Standing, Demand, and Fair and Adequate Representation requirements.
The Standard for Pleading Demand FutilityA shareholder lacks standing to bring suit on the corporation's behalf unless the stockholder (i) has demanded that the directors pursue the corporate claim and the demand is wrongfully refused; or (ii) alleges with particularity why presuit demand is excused as futile. While the test for pleading demand futility may vary in particular states, most states will look to Delaware law for guidance given its vast body of law on the subject due to the fact a majority of company's incorporate in Delaware.
Under Delaware law, there are two different standards used in determining whether a plaintiff has adequately alleged demand futility. The applicable standard depends on the composition of the board of directors at the time of the complaint and whether a specific board decision is challenged.
First, in a situation where a board decision is challenged and those directors who made the decision alleged to have harmed the corporation are the same as those who would consider plaintiff's pre-suit demand, Delaware courts apply the two-pronged test articulated in by the Delaware Supreme Court in Aronson v. Lewis, 473 A.2d 805 (Del. 1984). Under Aronson, demand is excused where the complaint alleges particularized facts creating reasonable doubt that (1) the directors are disinterested and independent on the subject or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.
Second, is the situation "where the board that would be considering the demand did not make a business decision which is being challenged in the derivative suit." Rales v. Blasband, 634 A.2d 927, 933-34 (Del. 1993). As explained by the court in Rales, such a situation may arise "in three principal scenarios: (1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where*the decision being challenged was made by the board of a different corporation." Under the Rales test, a complaint alleging demand futility must plead sufficient particularized facts to create reasonable doubt about the ability of the board that would be addressing the demand (i.e. the board at the time the complaint was filed) to consider the demand impartially.