New decision shows importance of carefully analyzing shareholder grievance communications that may be "demands"
The corporation law of most states allows a shareholder who contends that the actions, decisions, or lack of oversight of a board of directors injured the corporation two mutually exclusive options: (i) demand that the corporation take legal action to redress the injury, and then file a derivative lawsuit if and only if the demand is wrongfully refused; or (ii) file a derivative lawsuit without making demand, on the basis that making a pre-suit demand would have been futile.
Most shareholders try option (ii), and there is a substantial body of case law on the standards to allege demand futility. Option (i) is less common and has produced less law. There is even less law on the issue of whether a shareholder communication expressing grievances against the corporation's fiduciaries constitutes a "demand" in the first place. (The category of shareholder communications at issue here is distinct from demands to include proposals on proxy statements and document inspection demands under Corporations Code Section 220 or its equivalents.)
A new Delaware Chancery Court decision, Solak v. Welch, C.A. No. 2018-0810-KSM (Del. Ch. Oct. 30, 2019) (McCormick, V.C.), adds to that law. Solak found that a shareholder-plaintiff's pre-suit letter to a corporation was a demand, after the shareholder filed a lawsuit under the assumption that it was not a demand. While the court explained the important consequences of this after-the-fact determination to the plaintiff, Solak's deeper lesson is that the corporation faces consequences as soon as it receives a shareholder grievance communication that might constitute a "demand," and must immediately analyze such communications and act accordingly.
In Solak, a shareholder sent a letter to the board of a biopharmaceutical corporation with the stated purpose "to suggest that [it] take corrective action to address excessive director compensation as well as compensation practices and policies pertaining to directors." The letter focused on an updated compensation policy disclosed in a proxy statement, and asserted that non-employee director compensation was excessive in comparison to an index. The letter also referenced Investors Bancorp, a Delaware Supreme Court decision allowing an excess compensation claim against outside directors. The letter ended by "suggesting" that the board take "immediate remedial measures" to reduce or modify compensation. The letter included a footnote that the shareholder did not seek or expect the board to initiate any legal action against its members and that it should not be construed as a demand. The letter concluded, however, that the shareholder "would consider all available shareholder remedies" if the corporation did not respond within 30 days.
The shareholder sued after the corporation construed the letter as a demand, investigated the issues it raised, and informed the shareholder that would not file a lawsuit or modify its compensation policy. The corporation moved to dismiss the lawsuit on the grounds that the complaint did not allege demand had been wrongfully refused. The plaintiff argued that his letter was not a demand at all, which created the issue the court had to decide.
The court's decision
The court first found that the letter's disclaimer of a demand did not obviate the need to analyze its contents. Relying on a shareholder's subjective or expressed intent as to whether a pre-suit communication was a "demand" would undermine the rule that making demand and attempting to allege demand futility are mutually exclusive.
On the merits, the court applied the criteria for a "demand" from a 1994 Chancery Court decision, Yaw v. Talley. The factor at issue was whether the letter set forth "the legal action the shareholder wants the board to take on the corporation’s behalf." Here, although the letter "avoids expressly demanding that the Board commence litigation," this was not dispositive. Rather, the elements of the letter set forth above constituted "strong overtures of litigation" that "very much make it look like" a demand despite the lack of an explicit demand to sue. The letter also "read like a complaint," as confirmed by comparison to the later-filed complaint. The letter also sought relief for the corporation as a whole, not the shareholder personally, through "requested remedial measures [that] resemble therapeutic benefits commonly achieved in derivative lawsuits challenging non-employee director compensation."
The court also considered Yaw's statement that ambiguous communications "ought not to be considered a demand" so as not to discourage shareholders from bringing potential wrongdoing to a corporation's attention. This precept did not apply in the "[u]nique circumstance of this action": the same shareholder (represented by the same law firm) had sent a nearly identical letter to a different corporation, and that letter had been held to be a demand when the shareholder sued. Thus, the shareholder and law firm were aware of the risk of sending the letter in the instant case, and their attempts to downplay its character as a demand were "tactical wordsmithing" rather than "the sort of 'ambiguity' warranting a plaintiff-friendly presumption."
The ostensible and deeper implications
As Solak explained, "a judicial determination that a plaintiff has made a demand carries with it significant legal consequences." At face value, those consequences fell upon the plaintiff. "Making a pre-suit demand … carries significant downsides affecting the viability of a derivative claim" because it is more difficult to plead wrongful refusal of demand than demand futility. Thus, plaintiff's lawsuit easily was dismissed once the court determined he had made a demand; the complaint did not even acknowledge that a demand had been made, let alone allege wrongful refusal.
Another salient facet of Solak is that the court's determination that a demand had been made was based in part on facts that did not exist at the time of the shareholder letter: the similarity between the letter and the later-filed complaint.
Solak's deeper lesson, however, is that there are consequences to the corporation when it receives a shareholder grievance communication that might constitute a demand, and the corporation must analyze whether a demand has been made at that time rather than later.
If a shareholder communication is a demand, the corporation cannot remain passive; it must investigate or otherwise inform itself about the substance of the demand, decide how to respond, and communicate its decision to the shareholder. If a corporation does not take these steps, it may be found to have wrongfully refused the demand. The corporation in Solak recognized this. It did not wait to see whether the shareholder would file a derivative lawsuit as one of the "available shareholder remedies" his letter threatened, or wait for the lawsuit to be filed to decide whether a demand had been made. Rather, the corporation decided at the start − ultimately, correctly − that the letter was a demand, and followed through on the implications of that finding by treating the demand seriously. Had the corporation not done this, it would not have prevailed so easily on the motion to dismiss − or the plaintiff would have been tempted to frame the complaint as a wrongful refusal of demand.
There also are consequences if a shareholder grievance communication claims to be a demand but is not. In some circumstances, an ostensible "demand" may not actually be a demand. For example, if the shareholder communication demands that a corporation sue to redress wrongdoing that occurred before he or she was a shareholder, the shareholder would lack standing to follow through with a derivative lawsuit if the corporation declined to sue, and hence the shareholder did not effectively make a demand at all. While Solak did not address these scenarios, its observation that the shareholder's denial that his communication was a "demand" − ie, a false negative − did not control the court's determination of the issue applies equally to false positives. If a demand has not actually been made, there is no obligation for the corporation to investigate and respond. Moreover, if the shareholder later files a derivative lawsuit framed as a wrongful refusal complaint, the corporation can defend by contending that demand had not been made at all.
One should not regard Solak as a one-off case due to the "unique" factor of a repeat player shareholder and law firm. The shareholder bar often targets multiple corporations when advancing their positions on nascent corporate governance issues, especially in the area of compensation. In any event, the consequences of a shareholder communication's status as a demand apply in every instance.
Solak reaffirms that corporations should carefully analyze shareholder grievance communications that either claim to be demands or may in fact constitute demands. This is not as simple as it may appear, because process matters in responding to a demand and there is a substantial body of case law providing elaborate guidance on process.
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