Shareholders increasingly use derivative lawsuits to assert claims against a corporation's directors and officers. On May 21, 2009, the Washington Supreme Court handed down an important decision supporting the right of shareholders of Washington corporations to bring derivative lawsuits in some circumstances without first requesting relief from the company's board of directors. In re F5 Networks Derivative Litigation, No. 81817-7, 2009 WL 1412279 (Wash. May 21, 2009). Expressly following Delaware law, the Washington Supreme Court rejected arguments by directors and officers of F5 Networks that shareholders of Washington corporations should be required to make a presuit demand on the board of directors in virtually every derivative case.

This Update highlights key issues from the Washington Supreme Court's decision, which has important implications for directors and officers of Washington corporations.

The Case

In re F5 Networks arose from alleged stock option backdating at F5 Networks, a Washington corporation. After press reports identifying F5 as one of several companies likely to have backdated stock options, shareholders filed derivative claims in federal court alleging that 17 of the company's officers and directors breached their fiduciary duties by engaging in a "secret scheme" to grant in-the-money stock options to themselves and others. F5 moved to dismiss the claims on the ground that the plaintiffs had failed to make a presuit demand on the board of directors. F5 argued that Washington should impose a "universal demand" requirement compelling shareholders to make a presuit demand on the board before filing almost any derivative lawsuit. The plaintiffs opposed dismissal, arguing that Washington should follow Delaware's demand futility standard, under which no demand is required if there is a reasonable doubt that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment.

Rather than rule on the motion to dismiss, the federal court asked the Washington Supreme Court to determine whether Washington follows the universal demand requirement or the Delaware demand futility standard. The federal court posed two questions:

First, what test does Washington apply to determine whether a shareholder seeking to initiate derivative litigation on behalf of a Washington corporation is excused from first making demand on the board of directors to bring that litigation on behalf of the corporation?

Second, if Washington follows the demand futility standard, does it also follow the reasoning of the Delaware Chancery Court in Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), in cases where the improper backdating of stock options has been alleged?

The Washington Supreme Court's Decision

In a unanimous decision, the Washington Supreme Court sided with the F5 plaintiffs on all key issues.

First, the Washington Supreme Court rejected the assertion that Washington law imposes a universal demand standard. Acknowledging that the question was one of first impression, the court ruled that a universal demand requirement would be contrary to both the Washington Business Corporation Act (the "Act") and Washington case law predating the Act. The court acknowledged that a number of other states have adopted a universal demand requirement but noted that in almost every state, universal demand was the result of legislation, not court decision. In the absence of similar legislation in Washington, the court held that Washington would continue to follow the demand futility standard.

Second, the Washington Supreme Court ruled that Washington follows the Delaware demand futility standard, whereby demand is excused if there is a reasonable doubt that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. Noting that the Delaware courts are "well versed in this area," the court concluded that Washington "is a demand futility state and follows Delaware."

Finally, the Washington Supreme Court held that, with respect to derivative claims based on options granting practices, Washington courts should follow the reasoning in Ryan v. Gifford, 918 A.2d 341 (Del. Ch. 2007), in which the Delaware Chancery Court held, in the words of the Washington Supreme Court, that plaintiffs may "rely on circumstantial evidence that tends to show a pattern indicative of wrongdoing" to demonstrate that presuit demand is excused. The Washington Supreme Court reasoned that Ryan "follows naturally from Delaware's demand futility standard" and held that the types of statistical evidence at issue in Ryan were sufficient under Washington law "at least for the purposes of meeting the threshold burden of showing that a demand upon the board would be futile."

What the Decision Means

The fundamental principle that the board of directors—not an individual shareholder—controls most decisions as to corporate lawsuits survives the In re F5 Networks decision unscathed. The Delaware demand futility standard may not be as protective of boards as the universal demand requirement, but it requires presuit demand in most cases. Plaintiffs seeking to avoid such a demand will need to plead particularized facts creating a reasonable doubt that the directors are disinterested and independent or that the challenged transaction was otherwise the product of a valid exercise of business judgment. That is a heavy burden.

As for directors and officers, their best protection remains scrupulous adherence to the principles of good governance: avoid conflicts of interest, exercise care in the execution of their duties, and obtain professional advice when appropriate. As the then Chief Justice of the Delaware Supreme Court, E. Norman Veasey, has said:

I would urge boards of directors to demonstrate their independence, hold executive sessions, and follow governance procedures sincerely and effectively, not only as a guard against intrusion of the federal government, but as a guard against anything that might happen to them in court from a properly presented complaint.

Roundtable moderated by Charles Elson, What's Wrong with Executive Compensation?, Harv. Bus. Rev., January 2003, at 76.

Additional Information

This Update is intended to provide only a general summary of the Washington Supreme Court's decision in In re F5 Networks. Read the full text of the In re F5 Networks decision online. You can find discussions of other recent cases, laws, regulations and rule proposals of interest to Washington corporations on our website.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.