Nexus: Chapman's Journal of Law and Public Policy

Derivative suits enable shareholders to stand in the shoes of the corporation and sue on its behalf. One purpose of the derivative suit is to empower shareholders to sue the board of directors for their wrongful actions (such as breach of fiduciary duty) since it is unlikely that board members will initiate litigation against themselves. For example, if management is falsifying accounting records and board members are involved, it may be doubtful that the remaining board members will confront the wrongdoers because there are incentives to ignore the problem. These include receiving higher salaries due to the appearance of economic profits, the avoidance of confrontation that could create permanent resentment with other board members, or fear of public scrutiny if the scandal is made public.

Considering the corporate greed that was shown by once admired Fortune 500 companies like Enron, WorldCom, and Tyco (to name a few), shareholders need a stronger instrument to hold board members accountable. If shareholders do not police their own corporations the government will likely intervene and enact regulations such as it did with Sarbanes Oxley. But is it really desirable to have the government impose more costly monitoring restrictions on corporations? The existence of the board of directors already satisfies this purpose by allowing shareholders to monitor their corporation through representation. If the board of directors fails to act properly in their role as a fiduciary, a shareholder can initiate a derivative suit on behalf of the corporation. However, over the years it appears that the derivative suit has lost its effectiveness to discourage impropriety by the board of directors and either legislatures or the courts should alter the procedural requirements for shareholders to bring a derivative suit.

Under Delaware law, where many publicly traded companies are incorporated, a plaintiff shareholder must make a demand on the board to pursue and redress the alleged misconduct before filing a derivative suit, unless that demand would be futile.1 In theory, this procedural requirement of demand is supposed to give the board notice and an opportunity to address the issue. But this demand by shareholders on the board rarely occurs anymore because if the board of directors refuses to take legal action, the court will apply the business judgment rule (presumption that the board acted in good faith and in the best interest of the company2) and dismiss the case. So based on fear of dismissal by the business judgment rule, most shareholders avoid making a demand on the board and argue that the requirement should be waived because the demand would have been futile.
This procedural aspect of the rule weakens the effectiveness of the shareholder derivative suit for several reasons. First, without notice it is unlikely that the board of directors will have an opportunity to resolve the matter internally before the complaint is filed. Second, the court uses its valuable resources to determine whether the demand would have been futile rather than resolving the true matters of the case. Finally, many derivative suits are ultimately dismissed since demand futility is difficult to prove. To address these concerns the Model Business Corporations Act (MBCA) suggests that courts eliminate the demand futility exception and require written demand on the board of directors in all derivative suits.3 This approach gives the board an opportunity to reexamine the act complained of in light of a potential lawsuit and take corrective action.4 Additionally, it eliminates the time and expense of the parties and the court involved in litigating the question whether demand is required.5 Further, the MBCA approach reduces some of the risk to plaintiff shareholders of outright dismissal under the business judgment rule by allowing the court to inquire as to whether the board acted in good faith in determining that the maintenance of the lawsuit was not in the best interest of the corporation.6

In light of the egregious acts of recent board of directors that brought down multibillion dollar corporations, maybe jurisdictions that follow Delaware law should reconsider its procedural requirements for the shareholder derivative suit and consider adopting the MBCA approach. This will enable the derivative suit to regain its intended force to compel board of directors to act properly in their role as a fiduciary.