The Company v. Itself: Derivative Action Pitfalls

Wednesday, March 1, 2006 - 00:00

I. Introduction

Shareholder derivative actions are unlike any other type of lawsuits brought
against corporations. In them, a shareholder seeks to step into the shoes of the
corporation to pursue wrongdoing by others to the corporation. Typically, the
"others" being pursued are themselves - the officers or directors of the
corporation. By their nature then, derivative actions have the potential to be
highly invasive, and mishandling them poses obvious challenges to a business and
its governance. When appropriately and carefully handled, however, the
corporation can in many cases reassert control over the process, avoid needless
expense and litigation, and terminate derivative litigation lacking merit.

The rules that have arisen to govern derivative actions reflect a tension
inherent in the law and policy underlying corporate governance. On the one hand,
public policy wants to enable shareholders to seek redress for wrongdoing by the
corporate management, particularly where the board of directors is somehow
involved or culpable. On the other hand, this need must be weighed against the
desirable latitude given to the board of directors to oversee the affairs of the
business. At the same time, courts are also wary of the prospect that derivative
actions present for opportunistic shareholders or attorneys to interfere with
the affairs of the corporation, not for the benefit of the corporation, but to
advance their own self-interest or alternative agenda. Indeed, in some instances
shareholders who own only a few shares in numerous corporations have served as
serial derivative action plaintiffs.

Importantly, because the harm asserted in a derivative action is to the
company, any recovery is returned to the corporation itself, although attorneys'
fees are available to prevailing shareholder's counsel. This differs from
litigation in which corporate actions are alleged to harm shareholders directly
and give rise to claims and, when appropriate, monetary recovery by shareholders
- for example, a lawsuit brought to remedy a deprivation of shareholders' voting
rights.

This article briefly addresses two areas key to understanding and
appropriately responding to a derivate action - the demand requirement and the
opportunity for shareholders to obtain access to the corporation's
attorney-client privileged communications and work-product materials.

II. The Demand Requirement

Unless excused, the demand requirement in derivative litigation obligates a
shareholder to seek the approval of the board of directors prior to instituting
a lawsuit. Receipt of a demand represents a delicate situation for the
corporation and striking the appropriate balance in formulating a response has
become a thicket for those required to do so. Although the conduct of officers
and directors is commonly implicated by a demand, that fact alone will not
disqualify a board from deciding whether the corporation should initiate the
proposed litigation or take other actions demanded of it.

The law of the state of incorporation will be the law governing the demand
requirement in a derivative action. While generally similar, different
jurisdictions impose varying obligations on a shareholder in making a demand.
Most states provide for some set of circumstances that excuse a demand, in which
case the shareholder plaintiff may proceed with the derivative litigation. Under
the law of Delaware and a majority of states, the basic rule is that the
shareholder need not make a demand if the complaint casts reasonable doubt that
the directors are disinterested and independent or that the underlying
transaction resulted from a valid business judgment. See, e.g ., Brehm
v. Eisner
, 746 A.2d 244, 255 (Del. 2000). However, after much debate, the
American Law Institute's ("ALI") Principles of Corporate Governance Analysis
and Recommendations
proposed a universal demand requirement, absent exigent
circumstances, in an attempt to alleviate the extensive litigation that had come
to surround the question whether demand was excused. The ALI standard was first
adopted by the Pennsylvania Supreme Court in Cuker v. Mikalauskas, 692
A.2d 1042 (Pa. 1997), and has been adopted by others since. All told, at least
twelve states now have a universal demand requirement, including Connecticut,
Florida, Georgia, Michigan, Mississippi, Montana, Nebraska, New Hampshire, North
Carolina, Virginia, and Wisconsin.

Satisfaction of the demand requirement is a key component of any derivative
suit because if the shareholder has failed to comply with the requirement, the
court will dismiss the action. When a demand is made, it obligates the board to
engage in a good faith and reasonable investigation of claims, consider the
implications of the various courses of action available to it, and
respond within a reasonable time. Determining the appropriate response will vary
with each demand in relation to the nature of the allegations, their urgency,
and their complexity. Often, the board of directors will create a special
litigation committee of outside or disinterested directors to examine the issues
raised by the demand and make a recommendation to the Board. This committee may
retain counsel (generally, for prudential reasons, a firm without prior recent
engagements by the company), conduct an investigation, and make a recommendation
to the full board. In certain situations, it may be desirable to create a
special committee with binding authority so as to alleviate a conflict of
interest of the board.

If, at the conclusion of the investigation, the board rejects the shareholder
demand, the shareholder may still pursue a derivative action, but before the
action can proceed, the shareholder must establish that the rejection of the
demand was wrongful by casting reasonable doubt that it was the product of valid
business judgment. Conclusory allegations will not satisfy this standard; a
plaintiff must allege particularlized facts to overcome the business judgment
presumption that the board acted properly in rejecting the demand. If the board
accepts the shareholder demand, the board then controls the litigation.
Regardless of the substantive outcome of the board's investigation, crafting an
appropriate and meaningful response to a shareholder demand places the
corporation in an advantageous position in any litigation that subsequently
arises regarding the subject matter of the demand.

III. Privilege Issues

Because in pursuing a derivative action the shareholder is stepping into the
shoes of the corporation itself, courts have wrestled with whether the
corporation's privileged information or work product protected documents must be
disclosed to the shareholder, and, if so, at what stage of the litigation.
Accordingly, although confidentiality orders may in theory limit dissemination
of privileged information, the corporation in a derivative action runs a risk of
having to disgorge not only internal advice relating to the alleged wrongful
conduct, but also its own subsequent investigations. This is so whether such
investigation was undertaken in connection with the derivative action, other
litigation or governmental investigations, or independently of external
activity.

Jurisprudence on this privilege issue remains murky and concentrated in the
trial courts, and to further complicate matters different law may be applied
when considering attorney-client privileged communications and work product.
With respect to determining the applicability of privilege, courts will
generally apply the law of the state with the most significant contacts with the
communication. For work-product, courts will apply the law of the forum court.
In evaluating the issue, many courts have adopted a balancing test, permitting
the shareholder to pierce the privilege when good cause is shown. To determine
good cause, a court may consider factors including the number of shareholders
pursuing the claim, the amount of stock they hold, the obvious merit (or lack
thereof) of a claim, the true motivations of the plaintiffs, the necessity of
obtaining the information, the nature of the alleged wrongful conduct, whether
the communications relate to past or prospective actions, if the communication
concerns the litigation itself, whether the communications might reveal trade
secrets, and the specificity of the request. See Garner v.
Wolfinbarger
, 430 F.2d 1093 (5th Cir. 1970). At their core, these factors
reduce to a balance of the merits of the claims and the necessity of the
documents against the potential abusive nature of the suit itself and the
discovery request. Not all courts agree with the principles informing the
balancing test enunciated in Garner, and the ALI Principles of
Corporate Governance
rejects applying different standards to privilege and
work product questions in the derivative context. See, e.g.,
Cuker, 692 A. 2d at 1049 (adopting ALI Principle § 7.13, rejecting
a special privilege and work product standards).

In light of the uncertainty deriving from the Garner balancing test,
in conducting any internal investigation (including in response to a demand
itself), the participants should remain cognizant that privileged and
confidential documents and communications may be disclosed to the shareholder
plaintiffs, particularly when the corporation files a motion to dismiss or for
summary judgment based on the grounds that the board or special litigation
committee recommended that no suit be brought. As a result, other potential
plaintiffs and counsel, or the public or government, may obtain access to such
documents (although courts may enter confidentiality orders that bar
dissemination of confidential, privileged materials). Although the integrity of
any investigation cannot and should not be compromised by the potential for
disclosure, where possible, the corporation and committee should take
precautions to minimize the risks associated with disclosure.

IV. Conclusion

Derivative actions are a reality of corporate existence. By understanding the
nature of its obligations in the face of a shareholder demand and the benefits
and risks associated with undertaking to provide a thorough and appropriate
response, a corporation may protect itself against opportunistic suits and
reinforce the positive ideals of corporate
governance.

Stephen J. Kastenberg is a Partner at Ballard Spahr
Andrews & Ingersoll, LLP where he serves as Vice Chair of the Litigation
Department. He focuses his practice on complex business litigation and
antitrust. Lesley Frieder Wolf is an Associate at Ballard Spahr Andrews
& Ingersoll, LLP where she focuses her practice on complex business
disputes.

Please email the authors at kastenberg@ballardspahr.com or wolfl@ballardspahr.com with
questions about this article.