Failure to Disclose Receipt of Wells Notice Does Not Support Demand Futility

Applying Delaware law, a federal judge ruled that a shareholder derivative action alleging proxy fraud in the company’s failure to disclose its receipt of a Wells Notice from the SEC could not proceed because of a failure to show demand futility. Demand on the directors was not futile, said the court, since there was no questioning of their disinterestedness or independence. (In re Morgan Stanley Derivative Litigation, SD NY, 05 Civ. 6516, Mar27, 2008).

When shareholders brings a derivative action on behalf of the companyagainst the directors, there is a threshold question of whether they made a demand on the board of directors. The federal judge identified two Delaware tests for assessing demand futility, both enunciated by the state Supreme Court. The Aronson test requires shareholders seeking to establish demand futility to create a reasonable doubt that the directors are disinterested and independent, or that the challenged transaction was a valid exercise of business judgment. The Rales test essentially eliminates the business judgment rule prong of the Aronson test and focuses solely on whether the pleadings create a reasonable doubt that a majority of directors are disinterested and independent.

In this case, the federal court applied the Rales standard because that is the test to use when the subject of the derivative suit is not a business decision of the board, thus not implicating the business judgment rule.

In attempting to explain why a demand would be futile, the shareholders made insufficient generalized allegations to the effect that most of the directors desired to maintain their offices and would never vote to sue themselves. The court concluded that the allegations failed to create a reasonable doubt as to whether a majority of the board would have been sufficiently disinterested and independent in deciding whether the company should pursue the claim.

Disinterested in this context means that directors can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from the transaction. There was no showing that the board members’ prospects of remaining in office would have been in serious doubt if the Wells Notice had been revealed to shareholders.

Similarly, the allegations did not create a reasonable doubt as to the board members’ independence in deciding whether to approve the pursuit of a proxy fraud claim. In the demand futility context, independent means that a director’s decision is based on the corporate merits of the subject before the board rather than extraneous considerations. The shareholder failed to allege any improper benefit that might accrue to a director-defendant for voting against a demand to sue a former or current director or officer. Thus, the proxy claim was dismissed for failure to plead demand futility under the Rales test.