Dismissing Derivative Actions in the Federal Courts for Failure to Allege Demand Futility: Choosing a Standard of Appellate Review--abuse of Discretion or De Novo?

• Publication year: 2014

Dismissing Derivative Actions in the Federal Courts for Failure to Allege Demand Futility: Choosing a Standard of Appellate Review--Abuse of Discretion or De Novo?

Andrew S. Hirsch

DISMISSING DERIVATIVE ACTIONS IN THE FEDERAL COURTS FOR FAILURE TO ALLEGE DEMAND FUTILITY: CHOOSING A STANDARD OF APPELLATE REVIEW—ABUSE OF DISCRETION OR DE NOVO?

ABSTRACT

In the federal court system, when the district courts dismiss shareholders' derivative actions for failure to allege demand futility, the circuit courts have historically reviewed these dismissals for abuse of discretion. This started to change when the Supreme Court of Delaware converted from deferential to plenary review in 2000. Thereafter, many circuit courts expressed doubt about their historical standard of review. Finally, the First Circuit converted to de novo review in 2013, creating a definite circuit split and prompting the Supreme Court to take up the issue. Unfortunately, the case fell from the Court's docket because the plaintiffs lost standing. Thus, the issue continues to percolate in the circuit courts.

This Comment assembles all the information and analyses necessary for the reader to fully understand the issue and concludes that the courts should preserve the deferential standard. As an intermediate step to this conclusion, this Comment argues that Rule 23.1 of the Federal Rules of Civil Procedure itself—not Rule 12(b)(6) or any other rule—is the proper procedural vehicle for dismissing a case when a plaintiff fails to allege demand futility—the demand futility dismissal. This selection allows the courts to assign a standard of review to the demand futility dismissal independent of any preexisting standard, since the Rule 23.1 dismissal does not have a default standard of review.

After selecting the vehicle of dismissal, this Comment then turns to the task of assigning a standard of review. To do so, it employs the multifactor test that the Supreme Court handed down in Pierce v. Underwood. Analysis under this test reveals that the deferential standard's historical pedigree entitles it to a presumption of correctness that the plenary standard does not overcome. This Comment lastly shows that this historical standard is supported by the standards that apply to the other Rule 23.1 dismissals.

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Introduction..............................................................................................203

I. Conceptual Background..............................................................210

A. The Derivative Action and its Requirements..............................210
B. Standards of Review...................................................................213

II. Applying the State Standard of Review...................................215

A. Directly Applying the State Standard of Review.........................215
B. Indirectly Applying the State Standard of Review......................217

III. Vehicle of Dismissal......................................................................218

A. Vehicles of Dismissal Used by the Circuit Courts......................220
B. Rule 12(b)(1) as a Contender.....................................................223
C. Rule 12(b)(6) as a Contender.....................................................224
D. Rule 41(b) as a Contender..........................................................227

IV. Comparing the Demand Futility Dismissal to the Rule 12(b)(6) Dismissal: The Inertia Behind the De Novo Trend .... 229

A. Dismissal on the Pleadings for Lack of Legal Sufficiency.........229
B. Two Counterarguments .............................................................. 230

V. Underwood Analysis.....................................................................231

A. Historical Practice.....................................................................232

1. The Deferential Standard's Historical Pedigree..................233
2. The Plenary Standard's Arbitrary Usurpation.....................235
3. The Merger of Law and Equity as a Nonstarter for Plenary Review ..................................................................... 236

B. Language and Structure ............................................................. 237
C. Administration of Justice............................................................240
D. Rule Formation ........................................................................... 242
E. Financial Interests......................................................................242

VI. Other 23.1 Dismissals ....................................................................243

A. Fair-and-Adequate Representation............................................244
B. Verification ................................................................................. 245
C. Contemporaneous ownership .................................................... 246
D. Continuous ownership ............................................................... 246
E. Collusion ....................................................................................247

Conclusion..................................................................................................248

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Introduction

This Comment resolves a straightforward, but "uncommonly difficult,"¹ issue. It is an issue that currently splits the federal circuit courts and has made it all the way to the Supreme Court of the United States, but remains unsettled. The issue is this: In the federal court system, which standard of review—abuse of discretion or de novo—should a circuit court apply when reviewing a district court's dismissal of a shareholder's derivative action for failure to allege demand futility?²

Before moving forward, it is helpful to unpack the main issue. A "derivative action" is an action in which a shareholder causes his corporation to sue the corporation.³ In order to bring this action, the shareholder must meet certain requirements, one of which is to first make a demand on the board of directors to bring the action on the corporation's behalf. The directors usually reject the demand, since they are typically the ones being sued. To circumvent this predicament, the shareholder can abstain from making the demand and argue that so doing would have been futile, given the board's bias. At this critical point, the district court will either allow the action to proceed, or dismiss it for failure to allege demand futility. If the shareholder appeals, the circuit court will have to review the dismissal and choose a standard by which to do so. Under "abuse of discretion" review, also called "deferential" review, the circuit court reviews the district court's decision with deference.⁴ Under "de novo" review, also known as "plenary" review, the circuit court reviews the district court's action without deference.⁵ This Comment answers the question of which standard of review the circuit court should apply.

To resolve the main issue presented, this Comment must also resolve a sub-issue. The sub-issue—which also is unsettled in the courts—is this: what is the proper procedural vehicle for making the demand futility dismissal? Four contenders emerge from the Federal Rules of Civil Procedure (the Rules): (i) Rule 12(b)(1), providing for dismissal for lack of subject-matter jurisdiction; (ii) Rule 12(b)(6), providing for dismissal for failure to state a

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claim upon which relief may be granted; (iii) Rule 41(b), providing for dismissal for failure to comply with the Rules; and (iv) Rule 23.1,⁶ which provides the requirements to bring a derivative action. standards of review have already been assigned to the former three vehicles, so placing the demand futility dismissal under any of them would dispose of the main issue. However, no standard has been assigned to Rule 23.1 dismissals.

The main issue emerged only recently, but with great momentum. since the dawn of demand futility, the standard of review has been abuse of discretion. Delaware—"the Mother Court of corporate law"⁷ —changed this. The Supreme Court of that State, in its 2000 case of Brehm v. Eisner, abandoned deferential review in favor of plenary review.⁸ This decision, and the de novo trend in general, is supported by two arguments: (i) the demand futility dismissal is a dismissal on the pleadings for lack of legal sufficiency, which is reviewed de novo; and (ii) as a dismissal on the pleadings, the circuit court is in just as good a position to make the determination as is the district court. Brehm was met with an immediate and prolonged effect at both the state and federal levels. Outside of federal court, New Jersey,⁹ Nevada,¹⁰ and the District of columbia¹¹ have all followed Brehm.¹²

At the federal level, the response to Brehm started as talk, but then turned into action. Three circuits—the Second Circuit,¹³ the District of Columbia circuit,¹⁴ and the Ninth circuit¹⁵ —all spoke favorably of plenary review, but none abandoned their well-established deferential standards. Finally, in 2013, the First Circuit expressly adopted de novo review in Union de Empleados de Muelles de Puerto Rico PRSSA Welfare Plan v. UBS Financial Services Inc. of

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Puerto Rico (Union de Empleados).¹⁶ This created an apparent circuit split, prompting the Supreme Court to take up the issue.

Although the issue made it before the Nine Justices, it slipped out of their hands before they could decide on it. The Court granted certiorari in Union de Empleados on June 24, 2013.¹⁷ Meanwhile, the case was also on remand to the district court, which dismissed it on July 9, finding that the plaintiffs had lost their derivative standing by selling their shares.¹⁸ Accordingly, the Supreme Court dismissed the petition on August 26.¹⁹ This dismissal does not mean, however, that the issue is now either settled or unimportant. To the contrary, it is an issue that the Court deems worthy of discussion.

The Supreme Court deems the issue worthy of discussion not because of its academic...