Commercial Division Applies Delaware Demand Futility Pleading Rules

On July 3, 2014, Justice Schweitzer of the New York County Commercial Division issued a decision in David Shaev Profit Sharing Account v. Riggio, 2014 NY Slip Op. 31776(U), dismissing a derivative action for failure adequately to plead demand futility.

In David Shaev Profit Sharing Account, the plaintiff filed a derivative action against the individual directors of Barnes & Noble, accusing them of failing properly to oversee the company's affairs. As evidence of this, the plaintiff pointed to errors in Barnes & Noble’s earnings reports and an SEC investigation arising from subsequent corrections. The defendants moved to dismiss on the grounds that the plaintiff had failed to plead demand futility with the necessary particularity.

Because Barnes & Noble is a Delaware corporation, the court applied Delaware law, specifically Delaware Chancery Court Rule 23.1, to the pleading question. Rule 23.1, like similar rules in New York and elsewhere, requires derivative plaintiffs claiming that pre-suit demand would have been futile to plead particularized facts, in a 'director-by-director' fashion, that would be sufficient to contradict the presumption that the directors were disinterested and independent when performing their duties.

Sorting through the many Delaware tests and precedents on the issue of demand futility, the court first determined that the Rales test applied to actions alleging a general failure of oversight rather than challenging specific business decisions. Under Rales,

A plaintiff must adequately plead that a majority of the company’s board of directors were incapable of objectively responding to a demand because they either (1) face a substantial threat of personal liability and are thus themselves interested, or (2) are compromised in their ability to act independently of the interested directors . . . . interestedness under Rales solely focuses on whether a director confronts a substantial likelihood of liability for Plaintiff’s proffered claims.

(Internal citations and quotations omitted.)

And because Barnes & Noble exculpates its directors from liability for breaches of the duty of care, the plaintiff was further restricted, having to show that the majority of the directors faced a substantial likelihood of personal liability for breach of their duty of good faith or loyalty to the corporation.

Claims that directors breached their duty of loyalty by failing to exercise oversight are known as Caremark claims, "which are recognized by Delaware courts as possibly the most difficult theory in corporate law upon which a plaintiff might hope to win judgment." In essence, to prevail under a Caremark analysis, the plaintiff would have to show that the Barnes & Noble directors "consciously failed to put forth any control systems, or knowingly refused to monitor those systems already in existence."

The court held that the plaintiff did not satisfy this demanding standard of pleading. Barnes & Noble's audit committee met regularly, and the existence of errors in audit statements or an SEC investigation are insufficient to show a breach of the duty of loyalty. Plaintiff alleged that a whistleblower had identified many control issues, but could not allege that any individual board member had known of the problems and intentionally ignored them. And because none of the directors could be shown to be interested, allegations that the directors were unable to act independently of one another were also unavailing. The court also noted that, for demand futility purposes, Delaware does not apply SEC or NYSE rules to determine whether directors are independent of one another, placing a higher burden on plaintiffs.

Finally, the court ruled that a prior insufficient complaint and the plaintiff's refusal to obtain pre-suit discovery of the corporate books and records under Delaware G.C.L. § 220—which the Delaware courts frequently emphasize as essential to a derivative action—warranted dismissal with prejudice.

This case is not interesting so much for the ultimate outcome—derivative actions are routinely dismissed for failure to plead demand futility—but for Justice Schweitzer's comprehensive summary of Delaware's demand futility precedents, which might be very useful to a practitioner unfamiliar with this area of the law.