Derivative Actions: Pre-suit Demands And The Business Judgment Rule

Derivative lawsuits occur when a shareholder of a corporation or member of a limited liability pursues legal claims or relief on behalf of or for the entity’s benefit. There are strict procedural and substantive requirements that claimants must comply with before can bring a derivative lawsuit against a corporation’s executives or board members, or any third party. Included in this post is a brief discussion of some of these concepts and procedural requirements, as well as when the deference afforded to corporate officers and executives under the business judgment rule may preclude derivative actions.

Derivative actions on behalf of a corporation are permitted under Washington law.¹ In a derivative suit, a stockholder asserts rights or remedies belonging to the corporation for the corporation’s benefit.² However, “[d]erivative suits are disfavored and may be brought only in exceptional circumstances.³ Generally speaking, the corporation’s board and officers manage the corporation and make decisions like whether to file a lawsuit.⁴ But a corporation’s board members and officers manage the corporation on behalf of the shareholders and are answerable to them in a variety of ways.⁵

Shareholders have long had the power to assert a corporation’s rights on its behalf when its officers and directors have failed to do so or have done so improperly.⁶ This power is not unfettered; shareholders must do more than simply assert a corporation’s rights.⁷ As far back as 1907, the Washington Supreme Court has noted that generally, a shareholder “must show that he has exhausted all means within his reach to obtain within the corporation…action in conformity to his wishes, and that the managing body of the corporation has refused to sue or defend.”⁸ The Washington Supreme Court has long recognized that demand is not required if the plaintiffs can “clearly show that a demand for corporate action would have been useless.”⁹

The Washington Supreme Court in In Re F5 Networks adopted and applied the Delaware Supreme Court’s holding in Spiegel v. Buntrock regarding the procedural and substantive requirements for pre-suit demands as well as the effects and implications of submitting pre-suit demands in derivative actions.¹⁰ Many fundamental tenets and principles governing derivative actions were addressed and analyzed in Spiegel. In Spiegel, petitioner and shareholder Ted Spiegel appealed the Delaware Court of Chancery’s dismissal of a derivative action he filed against respondents Waste Management, Inc. (“Waste Management”) as well as Dean L. Buntrock (Chairman of the Board of Directors and Chief Executive Officer of Waste Management), Jerry E. Dempsey (Vice Chairman), Peter H. Huizenga (Vice President and Secretary) and James E. Koenig (Staff Vice President).¹¹ Mr. Spiegel alleged that respondents “improperly acquired stock in ChemLawn Corporation based upon inside information during the two years immediately preceding Waste Management’s tender offer for ChemLawn.”¹² Mr. Spiegel “sought to compel the management defendants to account to Waste Management for the personal profits they made upon the sale of their ChemLawn stock.”¹³

The underlying issue in Spiegel was “the often debated subject of when the requirement that a stockholder make a demand on a board of directors, prior to filing a derivative lawsuit for the benefit of a corporation, is excused and when a demand, which has been made, is properly refused.”¹⁴ Mr. Spiegel contended the pre-suit demand requirement was excused since it would have been futile notwithstanding the fact he submitted a post-suit demand after the Waste Management Board raised the failure to assert a pre-suit demand as a defense.¹⁵ The Waste Management Board asserted that it was “disinterested and capable of responding to Spiegel’s request for legal action,” and therefore a pre-suit demand was required.¹⁶ The Court of Chancery carefully reviewed the allegations in Spiegel’s Complaint and found that the demand requirement was not excused.¹⁷ The Court of Chancery also “proceeded to examine the post-suit demand for legal action” and “held that the decision to refuse Spiegel’s demand was subject to review according to the traditional business judgment rule.”¹⁸ The Delaware Supreme Court affirmed the Court of Chancery’s dismissal of Spiegel’s lawsuit based on: (1) his failure to submit a pre-suit demand; and (2) the application of the business judgment rule to the Waste Management Board’s refusal of the post-suit demand.¹⁹

The Delaware Courts in Spiegel and its predecessors as well as its progeny have elucidated several key principles and effects resulting from submission of a pre-suit demand in a derivative action. “Because the shareholders’ ability to institute an action on behalf of the corporation inherently impinges upon the directors’ powers to manage the affairs of the corporation the law imposes certain prerequisites on a stockholder’s right to sue derivatively.”²⁰ “Chancery Court Rule 23.1 requires that shareholders seeking to assert a claim on behalf of a corporation must first exhaust intra-corporate remedies by making a demand on the directors to obtain the action desired, or to plead with particularity why demand is excused.”²¹ “By electing to make a demand, a shareholder plaintiff tacitly concedes the independence of a majority of the board to respond.”²² “Stockholders who…make a demand which is refused, subject the board’s decision to judicial review according to the traditional business judgment rule.”²³ “Therefore, when a board refuses a demand, the only issues to be examined are the good faith and reasonableness of its investigation.”²⁴

Of the two potential routes presented by Rule 23.1 – pleading demand excusal with particularity or making a pre-suit demand – the former is a steep road, but the latter is “steeper yet.”²⁵ By electing to make a demand, a shareholder plaintiff tacitly concedes the independence of a majority of the board to respond.²⁶ The board’s decision to refuse the demand, therefore, is subject to the business judgment rule.²⁷ The business judgment rule protects management from liability stemming from a transaction “where a reasonable basis exists to indicate the transaction was made in good faith.”²⁸ Whenever any action or inaction by a board of directors is subject to review according to the traditional business judgment rule, the issues before the Court are independence, the reasonableness of its investigation and good faith.²⁹ Therefore, when a board refuses a demand, the only issues to be examined are the good faith and reasonableness of its investigation.³⁰

“[A] conscious decision by a board of directors to refrain from acting may be a valid exercise of business judgment,” and where “demand on a board has been made and refused, [courts] apply the business judgment rule in reviewing the board’s refusal to act pursuant to a stockholder’s demand.”³¹ Because the business judgment rule is the operative standard, a plaintiff stockholder asserting wrongful refusal of a demand must allege with particularity “facts that give rise to a reasonable doubt as to the good faith or reasonableness of [the Board’s] investigation” and deliberations.³² To do so, the plaintiff must plead particularized facts to support an inference that the board of directors committed gross negligence or acted in bad faith in rendering a decision to refuse a demand.³³

Absent an abuse of discretion, if the requirements of the traditional business judgment rule are met, the board of directors’ decision not to pursue the derivative claim will be respected by the courts.³⁴ Courts are reluctant to interfere with the internal management of corporations and generally refuse to substitute their judgment for that of the directors.³⁵ “Absent ‘evidence of fraud, dishonesty or incompetence,’ courts generally will not interfere with the judgment of corporate management.”³⁶ In such cases, a board of directors’ motion to dismiss an action filed by a shareholder, whose demand has been rejected, must be granted.³⁷ If Courts would not respect the directors’ decision not to file suit, then demand would be an empty formality.”³⁸

Derivative suits carry stringent procedural requirements that claimants must comply with in order to properly commence and pursue such claims. Further, a board’s decision not to take a particular course of action or pursue claims as demanded by a shareholder or member may be entitled to the deference of the business judgment rule which may render a derivative suit moot or otherwise unsustainable. Accordingly, it is important to consult with an attorney if you plan to pursue or are forced to defend against a derivative action.

Footnotes

1 See, e.g., CR 23.1, RCW 23B.07.400.

2 Haberman v. Wash. Pub. Power Supply Sys., 109 Wn.2d 107, 147, 744 P.2d 1032, 750 P.2d 254 (1987) (citing 12B W. Fletcher, Private Corporations §5907 (1984)).

3 Haberman, 109 Wn.2d at 147 (emphasis added).

4 See In Re F5 Networks Inc., 166 Wn.2d 229, 236, 207 P.3d 433 (2009) (internal citations omitted).

5 Id. (citing, e.g., RCW 23B.08.080, .090).

6 Id. (citing Williams v. Erie Mountain Consol. Min. Co., 47 Wn. 360, 362, 91 P. 1091 (1907); See also Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928).

7 In Re F5 Networks Inc., 166 Wn.2d at 236.

8 Id. (citing Williams, 47 Wn. at 361-62).

9 In Re F5 Networks Inc., 166 Wn.2d at 236-37 (citing Williams, 47 Wn. at 363 (quoting with approval 26 AM. ENG. ENC. OF LAW 978).

10 See See In Re F5 Networks Inc., 166 Wn.2d 229, 239-40, 207 P.3d 433 (2009) (“We turn now to whether we specifically follow Delaware’s demand futility standard. Delaware law, as the vice chancellor of the Delaware Chancery Courts noted, has at least ‘some modest importance in the American scheme of corporate governance.’ Leo E. Strine, Jr., The Inescapably Empirical Foundation of the Common Law of Corporations, 27 DEL. J. CORP. L. 499, 501 (2002) …In a well reasoned opinion, Judge Thomas Zilly of the federal trial bench concluded that Washington would likely follow Delaware’s demand futility standard. In re Cray, Inc., 431 F. Supp. 2d 1114, 1121 (W.D. Wash. 2006) (citing Rales, 624 A.2d at 934 and Aronson, 473 A.2d at 814). We agree. Delaware’s courts are well versed in this area. Until our legislature declares otherwise, Washington is a demand futility state and follows Delaware.”) (emphasis added); See also Spiegel v. Buntrock, 571 A.2d 767 (Del. 1990); See also Yi v. Wu Liao, LLC, Court of Appeals of Washington, Division One No. 86512-9-I (2025) at page 4, ¶15 (unpublished).

11 Spiegel, 571 A.2dat 769.

12 Id. at 769-70.

13 Id. at 770.

14 Id.

15 Id.

16 Id.

17 Id.

18 Id.

19 Id. at 770, 778.

20 Id. at 773 (citing Kaplan v. Peat, Marwick, Mitchell & Co., 540 A.2d 726, 730 (1988); See also Pogostin v. Rice, 480 A.2d 619, 624 (1984), Aronson v. Lewis, 473 A.2d 805, 811 (1984)).

21 Spiegel, 571 A.2d at 773.

22 Id. at 777.

23 Id. at 775-76 (citing Aronson, 473 A.2d at 813; Zapata Corp. v. Maldonado, 430 A.2d 779, 784 (1981)).

24 Id. at 777.

25 Solak v. Welch et al, C.A. No. 2018-0810-KSJM at 3-4 (2019), aff’d, 228 A.3d 690 (Del. 2020) (citing Zucker v. Hassell, C.A. No. 11625-VCG at 3 (Del. Ch. Nov. 30, 2016); See also City of Tamarac Firefighters’ Pension Trust Fund v. Corvi et al, No. 2017-0341-KSJM, 2019 WL 549938 at 14 (Del. Ch. Feb. 12, 2019).

26 Spiegel, 571 A.2d at 777.

27 Id. at 775-76 (citing Aronson, 473 A.2d at 813; Zapata Corp., 430 A.2d at 784.

28 Bangerter v. Hat Island Cmty. Ass’n, 199 Wn.2d 183, 192, 504 P.3d 813 (2022) (internal quotation marks omitted) (quoting Shinn v. Thrust IV, Inc., 56 Wn. App. 827, 833, 786 P.2d 285 (1990)).

29 Spiegel, 571 A.2d at 777.

30 Id.

31 Spiegel, 571 A.2d at 773-74 (alterations in original) (citing Aronson v. Lewis, 473 A.2d at 812; See also Zapata Corp. v. Maldonado, 430 A.2d at 784).

32 Espinoza ex rel. JPMorgan Chase & Co. v. Dimon, 124 A.3d 33, 36 N.10 (Del. 2015).

33 Solak, C.A. No. 2018-0810-KSJM at 16 (citing City of Tamarac, 2019 WL 549938 at page 6 (“Plaintiff must allege particularized facts that raise a reasonable doubt that (1) the board’s decision to deny the demand was consistent with its duty of care to act on an informed basis, that is, was not grossly negligent; or (2) the board acted in good faith, consistent with its duty of loyalty.” (quoting Busch, 2018 WL 507-776 at page 8)).

34 Aronson, 473 A.2d at 812; See also Zapata Corp. v. Maldonado, 430 A.2d at 784) (citing, e.g., United Copper Securities Co. v. Amalgamated Copper Co., 244 U.S. 261, 263-64, 37 S. Ct. 509, 510, 61 L. Ed. 1119, 1124 (1917); Stockholder Derivative Actions, supra note 5, 44 U.Chi. L.Rev. at 169, 191-92; Note, Demand on Directors and Shareholders as a Prerequisite to a Derivative Suit, 73 Har.L.Rev. 746, 748, 759 (1960); 13 W. Fletcher, Cyclopedia of the Law of Private Corporations § 5969 (rev.perm.ed. 1980).

35 Nursing Home Bldg. Corp. v. DeHart, 13 Wn. App. 489, 498, 535 P.2d 137 (1975).

36 Real Carriage Door Co. ex rel. Rees v. Rees, 17 Wn. App. 2d 449, 459. 486 P.3d 955 (2021) (quoting In re Spokane Concrete Prods., Inc., 126 Wn.2d 269, 279, 892 P.2d 98 (1995)).

37 Spiegel, 571 A.2d at 777.

38 Id. at 777-78(citing Starrels v. First Nat. Bank of Chicago, 870 F.2d 1168, 1174 (7^th Cir. 1989).

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