United States: Shareholder Derivative Actions: From Cradle To Grave

1. What Is A Derivative Action?

a. A derivative action is actually two causes of action: it is an action to compel the corporation to sue and it is an action brought by a shareholder on behalf of the corporation to redress harm to the corporation. See Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984) ("The nature of the action is two-fold. First, it is the equivalent of a suit by the shareholders to compel the corporation to sue. Second, it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it."); Brown v. Tenney, 532 N.E.2d 230, 232 (Ill. 1988) (a derivative action is in effect two actions: "one against the directors for failing to sue; the second based upon the right belonging to the corporation.").

b. A derivative action allows shareholders to monitor and redress harm to the corporation caused by management where it is unlikely that management will redress the harm itself. Meyer v. Fleming, 327 U.S. 161, 167 (1946) ("[T]he purpose of the derivative action [is] to place in the hands of the individual shareholder a means to protect the interest of the corporation from the misfeasance and malfeasance of 'faithless directors and mangers'" (quoting Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548 (1949)); Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (same); Jones v. H. F. Ahmanson & Co., 1 Cal. 3d 93 (1969) ("A shareholder's derivative suit seeks to recover for the benefit of the corporation and its whole body of shareholders when injury is caused to the corporation that may not otherwise be redressed because of failure of the corporation to act. Thus, 'the action is derivative, i.e., in the corporate right, if the gravamen of the complaint is injury to the corporation, or to the whole body of its stock or property without any severance or distribution among individual holders, or if it seeks to recover assets for the corporation or to prevent the dissipation of its assets.").

c. An action is derivative when brought by a shareholder on behalf of the corporation for harm suffered by all shareholders in common. See Levine v. Smith, 591 A.2d 194, 200 (Del. 1991) ("A shareholder derivative suit is a uniquely equitable remedy in which a shareholder asserts on behalf of a corporation a claim belonging not to the shareholder, but to the corporation."); Lewis v. Knutson, 699 F. 2d 230, 237-38 (5th Cir. 1983) ("When an officer, director, or controlling shareholder breaches [a] fiduciary duty to the corporation, the shareholder has no 'standing to bring [a] civil action at law against faithless directors and managers,' because the corporation and not the shareholder suffers the injury[; e]quity, however, allow[s] him to step into the corporation's shoes and to seek in its right the restitution he could not demand on his own."); Avacus Partners, L.P. v. Brian, CCH Fed. Sec. L. Rep. ¶ 96,232 (Del. Ch. 1990) (action is derivative because it is brought by one or more shareholders on behalf of the corporation rather than by the corporation itself); see also, Katz v. Halperin, 1996 WL 66006, at *4 (Del. Ch. Feb. 5, 1996) ("A proven claim of mismanagement resulting in corporate waste is a direct wrong to the corporation, and all stockholders experience an indirect wrong. Corporate waste claims are derivative, not individual.").

d. In contrast, an action brought by a shareholder for harm done to an individual shareholder or a group of shareholders is a direct action. See Kahn v. Kaskel, 367 F. Supp. 784 (S.D.N.Y. 1973) (a class action by shareholders is based upon individual rights belonging to each member of the class); Von Brimer v. Whirlpool Corp., 367 F. Supp. 740 (N.D. Cal. 1973) (if the injury is to one of the shareholders and not the corporation, it is direct), aff'd in part, rev'd on other grounds, 536 F.2d 838 (9th Cir. 1976); Behrens v. Aerial Comm., Inc. Del. Ch., No. 17436 (May 18, 2001) ("The distinction between a direct and derivative claim . . . turns on the existence of direct or 'special' injury to the plaintiff stockholder.").

2. How To Distinguish Between Direct And Derivative Actions?

a. It is not always easy to tell whether an action is derivative or direct. See Abelow v. Symonds, 156 A.2d 416, 420 (Del. Ch. 1959) ("[T]he line of distinction between derivative suits and those brought for the enforcement of personal rights asserted on behalf of a class of stockholders is often a narrow one, the latter type of actions being designed to enforce common rights running against plaintiffs' own corporation or those dominating it, while the former are clearly for the purpose of remedying wrongs to the corporation itself"). Often, the same set of facts gives rise to both direct and derivative claims. See, e.g., Grimes v. Donald, 673 A.2d 1207, 1212 (Del. 1996); H. F. Ahmanson & Co., 1 Cal. 3d at 107 ("The individual wrong necessary to support a suit by a shareholder need not be unique to that plaintiff. The same injury may affect a substantial number of shareholders. If the injury is not incidental to an injury to the corporation, an individual cause of action exists."); Behrens, Del. Ch., No. 17436 ("The distinction between a direct and derivative claim, which is difficult to apply in specific circumstances, turns on the existence of direct or 'special' injury to the plaintiff stockholder."); Tuscano v. Tuscano, 403 F. Supp. 2d 214, 222 (E.D.N.Y. 2005) ("Obviously, any benefit derived by a corporation through derivative litigation will inure to an individual who owns half of that corporation. [But, that] standing alone, is not a reason to dismiss [a] plaintiff''s lawsuit. Under New York law, a shareholder derivative action is an appropriate method for one fifty-percent shareholder to obtain relief in the name of the corporation against the other fifty-percent shareholder."); In re J.P. Morgan Chase & Co. S''holders Litig., 2005 WL 1076069, at *6 (Del. Ch. Apr. 29, 2005) ("[When a] board of directors authorizes the issuance of stock for no or grossly inadequate consideration, the corporation is directly injured and shareholders are injured derivatively . . . [and] mere claims of dilution, without more, cannot convert a claim traditionally understood as derivative, into a direct one."); Gentile v. Rossette, 2005 WL 2810683, at *4-5 (Del. Ch. Oct. 20, 2005) (plaintiffs' claim for dilution for conversion of notes and stock was derivative; when board of directors authorizes the issuance of stock for no or grossly inadequate consideration the corporation itself is directly injured and the stockholders are injured derivatively); Rawoof v. Texor Petroleum Co., Inc., 521 F.3d 750, 757-58 (7th Cir. 2008) (plaintiff brought a direct action invoking the agency doctrine, claiming that he entered into an agreement with defendant corporation as an agent of his own company; court held that plaintiff was barred from bringing a direct claim because his status as a sole shareholder, officer and director of his own company did not "automatically make him an agent of the corporation for purposes of the transaction in question").

b. Courts "have wide discretion" to determine whether an action is derivative or direct. See e.g., Hanson v. Kake Tribal Corp., 939 P.2d 1320 (Alaska 1997) (looking to the adequacy of the remedies under derivative and direct actions).

c. Deciding whether an action is direct or derivative has been greatly complicated by courts that use a "special injury" test to determine whether a claim is direct or derivative. These courts require shareholders to show that they have suffered a special or distinct injury from other shareholders in order to bring a direct claim. See, e.g., Geer v. Cox, 242 F. Supp. 2d 1009, 1018 (D. Kan. 2003) ("Because plaintiff has failed to show that there was any duty owed to him that was not owed to all shareholders . . . or that he suffered any harm individually, his direct claim must be dismissed . . .") (interpreting Delaware law); Pate v. Elloway, 2003 WL 22682422, at *2 (Tex. App. Hous. Nov. 13, 2003) ("To have standing to assert a direct or individual claim, a stockholder must allege an injury that is separate and distinct from other stockholders . . .") (applying Delaware law). Other cases, however, have rejected this line of reasoning. See, e.g., Strougo v. Bassini, 282 F.3d 162, 172 (2d Cir. 2002) ("[W]here shareholders suffer a distinct injury, i.e., an injury that does not derive from corporate injury, they may bring direct suit, even if their injury is undifferentiated among them.") (interpreting Maryland law and rejecting "undifferentiated effect on shareholders" standard followed in other jurisdictions); Kennedy v. Venrock Assoc., 348 F.3d 584, 591-92 (7th Cir. 2003) ("The charge that [the corporation's] directors issued a misleading proxy statement in violation of their fiduciary obligation is a legitimate direct claim . . . since the effect of the reincorporation was to reduce the shareholders' power over the corporation's affairs rather than to reduce the value of the corporation. It shows that a direct suit is not necessarily precluded by the common shareholders having suffered an 'undifferentiated harm.' They can suffer such a harm without the corporation's being injured."); Dansie v. City of Herriman, 134 P.3d 1139, 1144 (Utah 2006) ("A shareholder does not sustain an individual injury because a corporate act results in disparate treatment among shareholders. Rather, the shareholder must examine his injury in relation to the corporation and demonstrate that the injury was visited upon him and not the corporation."); PricewaterhouseCoopers, LLP v. Massey, 860 N.E.2d 1252, 1262 (Ind. Ct. App. 2007) (shareholder directors could not bring a direct action against company auditor because they did not suffer an injury separate and distinct from that suffered by all other shareholders; the value of their stock declined, but they had no additional out-of-pocket expenses due to their positions on the Board).

d. In 2004, the Delaware Supreme Court, acknowledging the prior "confusing jurisprudence on the direct/derivative dichotomy," stated that it "disapprove[d] [of] the use of the concept of 'special injury' as a tool" in analyzing whether a claim is direct or derivative. See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1035 (2004). The Court held: "We set forth in this Opinion the law to be applied henceforth in determining whether a stockholder's claim is derivative or direct. That issue must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?" Id. at 1033. The Court disapproved the concept that a claim is necessarily derivative if it affects all stockholders equally. Id. Rather, the focus, under the new test, is whether the stockholder has shown that he or she has suffered an injury that is not dependent on injury to the corporation. Id. at 1036.

e. An increasing number of courts have also abandoned the distinction between direct and derivative actions in the context of closely held corporations. See Marcuccilli v. Ken Corp., 766 N.E. 2d 444, 450 (Ind. Ct. App. 2002) (quoting Barth v. Barth, 659 N.E. 2d 559 (Ind. 1995)) (quoting A.L.I., Principles of Corporate Governance § 7.01(d)) ("In the case of a closely held corporation, the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not (i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons."); see also Sharkey v. Emery, 272 B.R. 574, 582-83 (Bankr. D.N.J. Nov. 2001) (relying on Brown v. Brown, 323 N.J. Super. 30, 36 (App. Div. 1999) (the distinction between derivative and direct actions in a closely held corporation is immaterial where defendants will not be exposed to a multiplicity of actions, creditors, interests could be protected, and proceeds could be distributed fairly among interested persons); Hubbard v. Tomlinson, 747 N.E. 2d 69, 71-72 (Ind. Ct. App. 2001) (quoting the Indiana Supreme Court in G & N Aircraft, Inc. v. Boehm, 743 N.E. 2d 227, 236 (2001)) ("[A] shareholder in a close corporation need not always bring claims of corporate harm as derivative actions[;] rather, in such an arrangement, the shareholders are more realistically viewed as partners, and the formalities of corporate litigation may be bypassed."); DeHoff v. Veterinary Hospital Operations of Central Ohio, Inc., 2003 WL 21470388, at *14 (Ohio App. 10 Dist. June 26, 2003) (allowing minority shareholder of closely held corporation to bring a direct action for breach of fiduciary duty against controlling shareholder because a derivative remedy would primarily benefit the alleged wrongdoers); Fritzmeier v. Krause Gentle Corp., 669 N.W.2d 699, 707-08 (2003) (allowing shareholders of wholly owned corporations to pursue a direct action because there is no distinction between the shareholder and the corporation, and thus, no danger of duplicative recovery); but see Mynatt v. Collis, 57 P.3d 513, 529-30 (Kan. 2002) (although it recognized the "close corporation exception," the Court emphasized that "the decision whether to allow a party to proceed with a direct suit in lieu of a derivative action is entrusted to the court's discretion"; even if all three prongs are met (as discussed in Marcuccilli above) a court, "in its equitable power and discretion," can deny a shareholder from bringing a direct action); Redeker v. Litt, 2005 WL 1224697, at *5 (Iowa Ct. App. May 25, 2005) ("If a closely held corporation operates more like a partnership, some jurisdictions allow the shareholders to bring an individual action, even though the cause of action may technically be that of the corporation."); Woolard v. Davenport, 601 S.E.2d 319, 324-25 (N.C. Ct. App. 2004) (quoting Norman v. Nash Johnson & Sons' Farms, Inc., 537 S.E.2d 248, 258 (N.C. Ct. App. 2000)) ("[I]t seems particularly appropriate to allow minority shareholders to file individual actions when a dispute arises within the context of a family owned corporation, or other corporation in which all shares of stock are held by a relatively small number of shareholders . . . . When the close relationships between the shareholders in a 'family' or closely held corporation tragically break down, the majority of shareholders are obviously in a position to exclude the minority shareholders from management decisions, leaving the minority shareholders with few remedies."); Durham v. Durham, 871 A.2d 41, 46 (N.H. 2005) ("A direct action may be appropriate in this case because all of the corporation's shareholders are before the court as either the plaintiff or defendants; thus, there is no risk that a direct suit would expose the corporation to a multiplicity of actions.").

f. Most states, including Delaware, however, have yet to adopt this so-called "closely held corporation exception." See Ferrara, Abikoff, Gansler, Shareholder Derivative Litigation: Besieging the Board §-1.02[2] (hereinafter "Ferrara, et al."); see also Glod v. Baker, 851 So. 2d 1255, 1264-67, 1276 (La. App. 3rd Cir. Aug. 6, 2003) (shareholders in closely held corporations, partnerships and limited liability companies could not pursue individual claims on their own behalf even though they were "severely personally damaged as a result of the wrongs done to their entities" because the right of action belonged solely to the entities); Mannos v. Moss, 155 P.3d 1166, 1172 (Idaho 2007) (shareholder in closely-held corporation could not bring a direct claim; "[a]ny claim . . . regarding the defendants depletion of corporate assets [could] only be pursued by [plaintiff] through a derivative action").

3. State Law Applies

a. State law controls the determination of whether an action is derivative or direct in diversity actions brought in federal court. Sax v. World Wide Press, Inc., 809 F.2d 610, 613 (9th Cir. 1987) (characterization of an action as derivative or direct question of state law); Seidel v. Allegis Corp., 702 F. Supp. 1409 (N.D. Ill. 1989) (same); Gadd v. Pearson, 351 F. Supp. 895 (M.D. Fla. 1972) (same); Sybold v. Groenink, 2007 WL 737502, at *5-6 (S.D.N.Y. Mar. 12, 2007) (court applied New York's "internal affairs" doctrine to hold that plaintiff lacked standing to bring a derivative action under Dutch law).

1. Plaintiffs Must Be A Shareholder At Time Of Suit

a. Most states and Federal Rule of Civil Procedure 23.1 require a plaintiff to be a shareholder of the corporation at the time a derivative action is filed and at the time of the challenged transaction. See Ferrara, et al., § 4.02[1] and [2] and cases and statutes cited therein; see also Wright, Miller & Kane, Federal Practice and Procedure: Civil 2d § 1826 and § 1828 and cases cited therein. The second requirement is often known as the "contemporaneous ownership" requirement. This requirement is designed to curtail strike suits by prohibiting potential plaintiffs from buying into a lawsuit or commencing a derivative action by simply purchasing shares after the alleged wrong has occurred. See, e.g., Brambles USA, Inc. v. Blocker, 731 F. Supp. 643 (D. Del. 1990); In re Penn Cent. Transp. Co., 341 F. Supp. 845 (E.D. Pa. 1972).

b. In diversity actions brought under Federal Rule 23.1, a threshold question is whether the court looks to state or federal law to determine a plaintiff's standing. The first requirement (i.e., that the plaintiff be a shareholder of the corporation at the time the action was filed) is governed by state law. See Wright & Miller § 1826 and cases cited therein. Courts have also generally held that the contemporaneous ownership requirement is procedural and have applied the contemporaneous ownership requirement found in Federal Rule 23.1 in the face of inconsistent state law. See, e.g., Kona Enter., Inc. v. Estate of Bishop, 179 F.3d 767, 769 (9th Cir. 1999); Perrott v. U.S. Banking Corp., 53 F. Supp. 953 (D. Del. 1944); Piccard v. Sperry Corp., 36 F. Supp. 1006 (S.D.N.Y.), aff'd without opinion, 120 F.2d 328 (2d Cir. 1941).

c. The size of plaintiff's financial stake in the corporation is immaterial. Koster v. (American) Lumbermens Mut. Cas. Co., 330 U.S. 518 (1947); Subin v. Goldsmith, 224 F.2d 753, 761 (2d Cir. 1955). The only time a plaintiff's financial stake may be of consequence is where state law provides security-for-expenses. States that have adopted security-for-expenses statutes include Arizona, California, Colorado, Florida, Nebraska, New Jersey, New York, Pennsylvania, and Wisconsin. For a general discussion on securities-for-expenses statutes see Wright & Miller § 1835 and cases cited therein.

2. The Requirement That A Shareholder Own Stock When A Derivative Action Is Started

a. Maryland and New York have statutes that expressly require stock ownership at the time an action is commenced. See Md. Code Ann. § 4A-802 and N.Y. Bus. Corp. L. § 626. Other jurisdictions have judicially imposed this requirement. See, e.g., Weffel v. Kramarsky, 61 F.R.D. 674, 679 (S.D.N.Y 1974).

b. In some jurisdictions, beneficial owners are not permitted to bring derivative actions. See Ferrara, et al., § 4.02[1]. Other states expressly allow beneficial owners to bring such suits. See id. and statutes cited therein.

c. In some community property states, a spouse has a beneficial interest arising from the other spouse's ownership of stock. See, e.g., American Guar. & Liab. Ins. Co. v. Keiter, 360 F.3d 13, 18 (1st Cir. 2004) ("In Washington, a community property state, one spouse is deemed to have a beneficial interest in stock owned by the other spouse by virtue of the one-half community property interest" and is not contingent upon the other spouse's death because the non-ownership spouse is not merely a legatee, but rather, is an owner of the one-half community interest).

d. Those jurisdictions that do not have statutes addressing the issue, such as Delaware, look to see if the plaintiff has an equitable interest in the stock. Quality Dev., 31 P.3d at 301-02. (citing Anadarko Petroleum Corp. v. Panhandle E. Corp., 545 A.2d 1171, 1176 (Del. 1988); Harrf v. Kerkorian, 324 A.2d 215, 218 (Del. Ch. 1974), aff'd in part, rev'd in part 347 A.2d 133 (Del. 1975); Rosenthall v. Burry Biscuit Corp., 60 A.2d 106, 113 (Del. Ch. 1948)).

e. The British Virgin Islands—an increasingly popular jurisdiction for incorporating—has a "leave to sue" provision requiring a shareholder in a B.V.I. corporation to obtain leave to initiate a derivative suit. On May 26, 2009, a California appellate court held that the "internal affairs doctrine" required the court to apply B.V.I. law and affirm a derivative action's dismissal because the plaintiff had not complied with the "leave to sue" provision. Vaughn v. LJ Int'l, Inc., 174 Cal. App. 4th 217, 223-25 (2009).

3. The Contemporaneous Ownership Requirement

a. In most jurisdictions, a derivative plaintiff must have been a shareholder at the time of the challenged transaction and must remain a shareholder pending the outcome of the litigation. See, e.g., Lewis v. Anderson, 477 A.2d 1040, 1049 (Del. 1984) ("[A] plaintiff who ceases to be a shareholder, whether by reason of a merger or for any other reason, loses standing" to sue derivatively); see also Brambles USA, Inc., 731 F. Supp. at 648 ("[A] derivative plaintiff [must] be a shareholder of the corporation at the time of the transaction of which he complains . . . [and] must also maintain that status throughout the lawsuit"); Schilling v. Belcher, 582 F.2d 995, 996 (5th Cir. 1978) ("[A] shareholder who sells his stock pending appeal of a favorable judgment in a stockholder's derivative suit . . . loses standing to further prosecute or defend the case"); Strategic Asset Mgmt., Inc. v. Nicholson, 2004 WL 2847875, at *3 (Del Ch. Nov. 30, 2004) (rejecting the argument that a shareholder need not maintain his or her status as a shareholder in situations where a settlement agreement has been reached; holding, instead, that a settlement agreement "without a final judgment by the Court" does not terminate the litigation). The purpose of this rule is "to prevent what has been considered an evil, namely, the purchasing of shares in order to maintain a derivative action designed to attack a transaction which occurred prior to the purchase of stock." Burry Biscuit Corp., 60 A.2d at 111.

b. Exceptions To The Contemporaneous Ownership Rule

4. Standing For Derivative Action Involving Insolvent Company Subject to Bankruptcy Court Jurisdiction

a. Upon the commencement of a bankruptcy proceeding, derivative claims become the property of the bankruptcy estate and are subject to the control of the Bankruptcy Court. See, e.g., Thornton v. Bernard Tech., Inc., 2009 WL 426179, at *3 (Bankr. D. Del. Feb. 20, 2009); In re The 1031 Tax Group, LLC, 397 B.R. 670, 680-81 (Bankr. S.D.N.Y. 2008) (holding that breach of fiduciary duty and negligence claims are derivative and belong to the trustee). The right to bring a derivative action asserting claims for injury to the debtor corporation by its officers and directors vests exclusively to the trustee. Thornton, 2009 WL 426179, at *3 n.9.

b. If a derivative action is pending at the time the bankruptcy petition is filed, it must be dismissed unless the plaintiff is able to show: (1) the bankruptcy trustee has affirmatively assigned or abandoned the derivative claims to the plaintiff; and (2) the Bankruptcy Court approves of the plaintiff's continued prosecution of the derivative claims. Thornton, 2009 WL 426179, at *3-4 (dismissing derivative suit because the plaintiff failed to show that the trustee had abandoned or assigned the derivative claims).

1. As discussed above, a derivative action redresses harm to the corporation. See, e.g., H. F. Ahmanson & Co., 1 Cal. 3d at 93 ("A stockholder's derivative suit is brought to enforce a cause of action which the corporation itself possesses against some third party, a suit to recompense the corporation for injuries which it has suffered as a result of the acts of third parties."). Thus, there is a presumption that the corporation, through its directors and officers, controls the decision to pursue a claim on behalf of the company. Accordingly, a shareholder that wishes to maintain a derivative action must attempt to secure corporate action through a demand to the board that it initiate the litigation. See Grimes, 673 A.2d at 1207 (citing Kamen, 500 U.S. at 90); see also Delaware & Hudson Co. v. Albany & Susquehanna R.R. Co., 213 U.S. 435, 447 (1909) (demand requirement "recognizes the right of the corporate directory to corporate control; in other words, to make the corporation paramount, even when its rights are to be protected or sought through litigation"). The demand requirement is not limited to corporations, but also applies to business trusts and investment funds. See ING Principal Protection Funds Deriv. Litig., 369 F. Supp. 2d 163, 171 (D. Mass. 2005) (applying universal demand requirement to derivative action brought on behalf of business trust). One way around this requirement, as discussed below, is to allege demand futility.

2. To satisfy the demand requirement, a complaint must "allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires . . . and the reasons for the plaintiff's failure to obtain the action or for not making the effort." Del. Ch. Ct. R. 23.1; see also Cal. Corp. Code § 800(b)(2) ("[P]laintiff [must] allege in the complaint with particularity plaintiff's efforts to secure from the board such action as plaintiff desires, or the reasons for not making such effort"); N.Y. Bus. Corp. Law § 626(c) ("The complaint shall set forth with particularity the efforts of the plaintiff to secure the initiation of such action by the board or the reasons for not making such effort"). Because of the particularity requirement, notice pleading is insufficient. Grobow v. Perot, 539 A.2d 180, 187 (Del. 1989) ("[C]onclusionary allegations of fact or law not supported by allegations of specific fact [are] not [to] be taken as true"); Allison ex rel. General Motors Corp. v. General Motors Corp., 604 F. Supp. 1106, 1112 (D. Del. 1985) (Rule 23.1 "is a marked departure from the 'notice' pleading philosophy of the Federal Rules of Civil Procedure").

a. In re Merck & Co., Inc. Sec., Deriv. & ERISA Litig., 493 F.3d 393 (3d Cir. 2007), shareholders filed a derivative action against the directors and officers of Merck. The District Court granted Merck's motion to dismiss and denied shareholders leave to amend their complaint. The shareholders appealed. The Third Circuit, "agree[d] with the District Court and Merck that, as a general rule, a plaintiff in a shareholder derivative suit may not use discovery to amend demand futility allegations. Whether the discovered materials existed before or after the filing of the operative complaint does not alter [the] analysis. However, this case presents a rare exception to this rule because both parties voluntarily entered into a stipulated discovery agreement that did not preclude the plaintiffs from using this after-acquired information in an amended complaint. Thus, the standard argument——that allowing discovery in demand futility scenarios undermines the authority of the corporation to decide whether to bring suit against itself and gives incentive to shareholder to engage in fishing expeditions——has no applicability when the plaintiffs and the corporation voluntarily agree to permit limited discovery." Id. at 401.

3. To make a demand a shareholder generally must send a letter or draft complaint or other comparable communication to the board of directors although some state statutes and Federal Rule 23.1 do allow a demand to be made on someone other than the board if that party is of "comparable authority." For a list of state statutes allowing demand on "comparable authority" see Ferrara, et al., § 3.03[1] n.11.

a. The following cases have considered the issue of who besides the board of directors may be served with a demand: Kaster v Modification Sys., Inc., 731 F.2d 1014, 1017-19 (2d Cir. 1984) (demand on individual who was president and chairman of the board and who owned 71% of voting stock was not sufficient); Greenspun v. Deb E. Webb Corp., 634 F.2d 1204, 1209 (9th Cir. 1980) (demand to individual who was president, director, and general counsel of company insufficient); In re Penn Cent. Sec. Litig., 335 F. Supp. at 1026 (demand on receiver or trustee for a bankrupt company sufficient); Kemper v. Am. Broad. Cos., 365 F. Supp. 1272, 1274 (S.D. Ohio 1973) (same); Womble v. Dixon, 585 F. Supp. 728, 731 (E.D. Va. 1983), aff'd in part, vacated in part 752 F.2d 80 (4th Cir. 1984) ("demand to bring suit on the savings and loan association's behalf must be made on the receiver or agency possessing the right to assert the associations claim").

b. The demand does not need to "assume a particular form . . . [or] be made in any special language." Stoner v. Walsh, 772 F. Supp. 790, 796 (S.D.N.Y. 1991); see also Khanna v. McMinn, 2006 WL 1388744, at *13 (Del. Ch. May 9, 2006) (there are no "magic words" that establish "that a communication is a demand for purposes of Court of Chancery Rule 23.1."). It must simply "fairly and adequately apprise the directors of the potential cause of action so that they, in the first instance, can discharge their duty of authorizing actions that 'in their considered opinion . . .[are] in the best interest of the corporation.'" Id. Accordingly, the demand typically must (1) identify the alleged wrongdoers; (2) describe the factual basis for the allegations; (3) describe the harm caused to the corporation; and (4) describe the request for relief. See, e.g., Levner v. Saud, 903 F. Supp. 452, 456 (S.D. N.Y. 1994), aff'd 61 F.3d 8 (2d Cir. 1995); Seidel v. Allegis Corp., 702 F. Supp. 1409, 1412 (N.D. Ill. 1989); Lewis ex rel. Nat'l Semiconductor Corp. v. Sporck, 646 F. Supp. 574, 578 (N.D. Cal. 1986).

4. A new demand is not typically required where there has been a change in the board's make-up. See Nelson v. Pac. Sw. Airlines Indus., Inc., S'holder Litig., 399 F. Supp. 1025 (S.D. Cal. 1975); In re Fuqua Indus., 1997 WL 257460 (Del. Ch. May 13, 1997) (new demand not required even where the entire membership of the board has changed). But where an amended complaint raises issues not previously included in the earlier demand, these issues need to be presented to the board, absent futility, before they can be litigated. In re Fuqua Indus., 1997 WL 257460, at *15.

a. "When an amended derivative complaint is filed, the existence of a new independent board of directors is relevant to a Rule 23.1 demand inquiry only as to derivative claims in the amended complaint that are not already validly in litigation." Braddock v. Zimmerman, 906 A.2d 776, 786 (Del. 2006). "Three circumstances must exist to excuse a plaintiff from making demand under Rule 23.1 when a complaint is amended after a new board of directors is in place: first, the original complaint was well pleaded as a derivative action; second, the original complaint satisfied the legal test for demand excusal; and third, the act or transaction complained of in the amendment is essentially the same as the act or transaction challenged in the original complaint." Id.

5. In assessing the reasonableness of the time between a demand and the filing of a derivative action, courts balance the needs of a corporation to make a conscientious decision against the potential desire of the corporation to delay the suit by engaging in "idle ceremony." See Mills v. Esmark, Inc., 91 F.R.D. 70, 73 (N.D. Ill. 1981) (failure to respond to demand within three months tantamount to admitting demand futility); but compare Recchion ex rel. Westinghouse Elec. Corp. v. Kirby, 637 F. Supp. 1309, 1319 (W.D. Pa. 1986) (two months deemed insufficient to complete adequate investigation); see also Mozes ex rel. General Elec. Co. v. Welch, 638 F. Supp. 215, 221 (D. Conn. 1986) (eight months deemed insufficient where investigation impeded by parallel criminal proceedings); Gen. Motors Corp., 604 F. Supp. at 1117-18 ("amount of time needed for a response will vary in direct proportion to the complexity of the technological, quantitative, and legal issues raised by the demand"); MacCoumber v. Austin, 2004 WL 1745751, at *4 (N.D. Ill. Aug. 2, 2004) ("[C]ourts have not formulated a specific rule as to what constitutes a reasonable response time," instead, they "determine reasonable response time by examining the complexity of the issues presented by the demand and the surrounding circumstances"); Piven v. Ryan, 2006 WL 756043, at *3-4 (N.D. Ill. Mar. 23, 2006) ("A board's decision to delay responding to a demand in order to focus on related litigation is reasonable"; until the related litigation is complete "it would be unreasonable to require the board to expend [the company's] resources unnecessarily.").