Article courtesy of Jeff Dutson of King & Spalding
Under Delaware law, requirement that a shareholder first make demand on the board before bringing suit is not excused on the basis of substantial likelihood of liability claim in the absence of showing that the board had actual knowledge of the alleged misconduct prior to the filing of the suit.
Whitten v. Clarke, 41 F.4th 1340 (11th Cir. 2022)
A Delaware corporation was the subject of numerous public reports and investigations questioning the corporation’s deceptive billing and sales practices to collect unwarranted fees in a scheme to inflate its stock price. A federal securities class action was subsequently filed against the corporation. Shortly thereafter, a shareholder of the corporation brought a derivative suit against the corporation’s directors and executives alleging breach of fiduciary duty by allowing the corporation to engage in a fraudulent scheme, approving false and misleading statements and for engaging in insider trading.
Under Delaware law, a shareholder is required to either make demand on the board before initiating a derivative action on behalf of a corporation or show that demand is excused. A demand is excused if that demand would be futile, which is a three-part test evaluated on a director-by-director basis, one of which whether the director would face a substantial likelihood of liability on any of the claim that are the subject of the litigation demand.
The shareholder failed to make a demand on the board before bringing a derivative suit against the directors and executives but argued that demand was excused because a majority of the board faced a substantial likelihood of liability for their breach of fiduciary duties on the basis of insider trading for selling stock during the alleged scheme period and that the defendants knowingly or recklessly approved false or misleading statements in the company’s 10-K filings by signing those filings. The District Court disagreed and held that while the board should have known about the corporation’s alleged fee scheme, the shareholder failed to adequately plead that the board actually knew about the fee scheme.
On appeal, the Eleventh Circuit affirmed, holding that the shareholder failed to show that the defendants as a group or individually knew of the alleged scheme and acted at the time for the shareholder’s demand on the board. The court found that the shareholder failed to provide any allegations showing that the board had actual knowledge of the alleged scheme until the reports were published, which was shortly before the shareholder filed the suit. The court noted that the derivative action was filed a few months after the publications began and less than a month after the federal securities class action was filed. Therefore, based on the timing of when the suit was filed and the occurrence of the alleged misconduct, the court could not infer that the defendant directors were actually aware of the scheme at the relevant time for the shareholder’s demand on the board which would subject the board to a substantial likelihood of liability. Accordingly, the court held that the shareholder was obligated to make demand before filing suit against the defendant directors, that demand was not excused and affirmed the district court’s dismissal of the derivative action.
