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A Fun New Fact Pattern for Demand Futility

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June 22, 2016
Morris James LLP
Delaware Court Business Insider

The concept of demand futility, rooted in the fundamental elements of Delaware corporate law, has been present for decades. The demand futility rules developed, as most doctrines of Delaware corporate law do, through judicial decisions over the years. While one can argue about if there is any fundamental difference between the Aronson and Rales tests and whether the standards should be unified, one thing that almost everyone agreed on was that the court tested demand futility as of the date the complaint was filed. Changes in board composition after the filing of the complaint usually did not affect the demand futility analysis, unless the plaintiff amended the complaint after a change in board composition to assert a claim not already validly in litigation, or the complaint was dismissed and then refiled. This rule itself was subject to equitable modification, so, for instance, if the board changes after the filing of the complaint and the plaintiff wants to amend its complaint, she need not plead demand futility as to the board on the date of the amendment for claims already "validly in litigation," e.g., Braddock v. Zimmerman, 906 A.2d 776 (Del. 2006). On the other hand, if the complaint gets dismissed and then refiled, the board on the date of the refiling is the proper board to determine demand futility. In Park Employees' and Retirement Board Employees Annuity and Benefit Fund of Chicago v. Smith, C.A. No. 11000-VCG (Del. Ch. May 31, 2016), the Delaware Court of Chancery addressed a new twist on the change in board composition argument: What happens if the board changes as a result of a properly noticed stockholder meeting shortly after the filing of the complaint? On the unique facts of this case, the Court of Chancery held that it would determine demand futility based on the board elected shortly after the plaintiff filed the complaint.

The facts of Park Employees tell a familiar tale of investigation of alleged Medicare and Medicaid fraud, alleged failure to disclose deterioration of a line of business and alleged insider trading at BioScrip Inc. These events prompted several securities law-based actions to be filed in the U.S. District Court for the Southern District of New York. Certain stockholders also made a demand under Delaware law to inspect the BioScrip books and records to investigate the same issues. The company produced some records in response to the demand.

While the company and the demanding stockholder were working through certain issues related to the document production, BioScrip mailed to its stockholders its notice of annual meeting of stockholders to be held May 11, 2015, and proxy solicitation materials (the proxy). In the proxy, BioScrip disclosed that three of the 10 directors would not sit for re-election, and that nine nominees were running unopposed for election. The proxy also disclosed that the company anticipated the re-election of the 10th director pursuant to an agreement between the company and certain stockholders. If elected, the company's proposed slate of 10 directors would include three new directors and three existing directors upon whom the plaintiff did not allege demand would be futile.

The plaintiff filed its derivative action on May 7, 2015, four days before the annual meeting of BioScrip. In its complaint, the plaintiff alleged that demand would have been futile as to seven of the 10 directors of BioScrip as of that date. On May 11, 2015, the board held its annual meeting at which the stockholders elected the 10 directors identified in the proxy. Immediately after the annual meeting, however, three directors resigned, including two who were named as defendants in the action. As a result, by the end of the day on May 11, 2015, BioScrip's board consisted of seven directors, five of whom were not named as a defendant in the complaint. The plaintiff served the complaint on BioScrip on May 27, almost three weeks after the May 11 election and resignations.

The defendants moved to dismiss, arguing that the court should use the board as of May 11 to determine demand futility. The court agreed. The court analyzes demand futility in terms of the "board that would actually be tasked with determining whether or not the corporation will pursue the litigation." While in most cases, application of that rule means the board as of the date of the complaint, the facts of this case required a different result. Here, the court reasoned that even if the directors as of May 7 had received a demand on May 7, 2015, they would not have had time to assess the demand or complaint before being replaced four days later. In addition, the plaintiff did not even serve the complaint until May 27, when the "new" board was in place, which led the Court of Chancery to the conclusion that the May 11 board was the appropriate board to determine demand futility.

The court also rejected the plaintiff's arguments that the holding could lead to manipulation of board composition to avoid derivative actions and it was improper to consider events after the filing of the complaint to determine demand futility. The court was confident that it could "sniff out and pre-empt improper manipulation of board composition in this context." The court also noted that in In re Puda Coal Stockholders Litigation, the court looked at events after the filing of the complaint in assessing demand futility. In Puda Coal, the members of an independent committee charged with investigating wrongdoing all resigned, along with one conflicted director, leaving only the alleged principal wrongdoer as the only director of the company. The independent directors moved to dismiss, arguing that because three of the five directors as of the filing of the complaint were independent, demand was not futile. The court, however, denied the motion to dismiss, holding that the reality was that granting the motion to dismiss would leave control of the litigation in the hands of the main wrongdoer. The court acknowledged that the facts here were different than in Puda Coal, but the same kind of principles apply. That is, the board with the operative task of considering whether to bring or maintain the action should be the board against whom demand futility should be measured.

While the facts of this case are unlikely to repeat themselves, the court's willingness to apply equitable principles to the "bright-line" rule could be helpful in other instances in which board composition changes in unexpected ways. As the court indicated, determining which board had actual responsibility for considering a demand is the functional test, leaving room to move off the board on the date the complaint was filed.

Delaware Court Business Insider | June 22, 2016

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