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Court of Chancery Dismisses Derivative Action for Failure to Establish Demand Futility

Highland Legacy Ltd. v. Singer, C.A. No. 1566-N, 2006 WL 741939 (Del. Ch. Mar. 17, 2006). A large shareholder brought a derivative action alleging that the directors committed corporate waste by approving exorbitant fees to unqualified financial advisers. The defendants moved to dismiss the complaint under Court of Chancery Rule 23.1 for failure to allege with particularity facts establishing demand futility. The court's review of the complaint revealed that plaintiff did not allege with particularity facts from which the court could reasonably conclude that the majority of the directors were disabled from impartially considering a demand. The court therefore granted defendants' motion to dismiss under Rule 23.1.

In their motion to dismiss the complaint, defendants argued that the plaintiff did not make a demand on the board before proceeding with the derivative suit and did not show that the demand was excused as futile. In response, plaintiff argued that a majority of the board was either interested or not independent. Plaintiff's primary contention was that three of the seven directors lacked independence because they were under the control of one of the other directors. The court's opinion began by acknowledging that the board of directors has the authority to decide whether or not to initiate litigation on behalf of a corporation. A stockholder may pursue derivative litigation without obtaining the board's approval pursuant to Rule 23.1 by establishing that a pre-suit demand on the board would have been futile. The test for determining demand futility was stated in Aronson v. Lewis, 473 A.2d 804 (Del. 1984), as a two prong test under which the plaintiff must create a reasonable doubt that: (1) the directors are disinterested and independent; and (2) the challenged transaction was a valid exercise of business judgment. In determining that the first prong of the Aronson test was not met, the court stated that an allegation that directors are dominated and controlled, standing alone, does not meet the demand futility; there must be some alleged nexus between the domination and the resulting personal benefit to the controlling party. In addition, the fact that several board members previously served together on boards of unaffiliated companies is not enough to overcome the presumption of a director's independence. The court concluded that the factual allegations in the complaint did not create a reasonable doubt that the majority of the board was disinterested or independent. The court also concluded that the plaintiff failed to meet the second prong of the Aronson test because the complaint made generalized allegations that did not raise a reasonable doubt that the challenged transactions were the product of due care. Authored by: Fotini Antonia Skouvakis 302.888.5202 fskouvakis@morrisjames.com