The vanishing substance-procedure distinction in contemporary corporate litigation: an essay.

• Author: Jacobs, Jack B.

If any distinction in our law has survived the test of time, it is that between substance and procedure. That was true when I was a law student, and it is true today. The classic expression of that distinction is that substantive laws--whether statutory, administrative, or judge-made--are rules that are intended to guide the conduct of persons subject to the rule.

1. INTRODUCTION

   Substantive rules typically state the rights and duties as among citizens, and disclose the circumstances where courts redress violations of those rights and duties. Procedural laws, on the other hand, are rules of procedure that have been adopted by courts and legislatures, and that instruct persons on how to bring a controversy before a court, and how to proceed in that court to obtain redress. A workable description of procedural rules is that they prescribe the mechanics of litigation. (3)

   The substance-procedure distinction comes up in various areas of our law. Choice of law is a good example. Who can forget Erie Railroad Co. v. Tompkins (4) from our first year of law school? In Erie, the U.S. Supreme Court held that where federal court jurisdiction is grounded on diversity of citizenship, the federal court must apply the substantive law of the forum state as the rule of decision, and can apply federal common law only as to matters of procedure. (5)

   The substance-procedure distinction arises in state courts as well. Suppose, for example, that a lawsuit is brought in a court of state A to enforce a cause of action arising under the law of state B. The choice of law rule is that the law of the forum state governs procedural matters while the law of the state where the cause of action arose governs substantive matters. (6)

   Over the years, the substance-procedure distinction, although far from perfect, has, by and large, proved workable in most areas. Not surprisingly, where outcomes turn on choice of law matters, litigation inevitably has arisen over what issues are "procedural," and which are "substantive." (7) But, in at least one area--corporate law--the distinction has begun to fray around the edges. That development has become problematic for reasons I will later explain.

   The story that I come to tell is that, in the corporate law area, procedure has come to beget substance, and substance has begotten procedure. That development has unnecessarily complicated the efficient and speedy litigation of corporate and business law disputes. My message is that procedural rules are an important part of our legal dispute resolution system, and that for the system to operate satisfactorily, the crafting of procedural rules should be accomplished by an institutional process. Where possible, this process should remain separate from the articulation of substantive rules as part of the common law adjudication process.

   At first blush this statement undoubtedly sounds abstract. To bring the subject closer to earth, I will discuss selected Delaware corporate cases to illustrate the thought that I am trying to convey. After that, I will argue why what I describe as the "vanishing distinction" between substance and procedure merits our attention. Thereafter, I will conclude with some modest suggestions.

2. PROCEDURE BEGETTING, THEN BLENDING INTO, SUBSTANCE

   I start with a quintessentially procedural rule--Rule 23.1 of the Delaware Court of Chancery (Rule 23.1). That Rule, which governs derivative stockholder actions, is the substantially similar counterpart to Rule 23.1 of the Federal Rules of Civil Procedure. (8) Chancery Rule 23.1 directs that "[t]he complaint ... shall allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority ... and the reasons for the plaintiff's failure to obtain the action or for not making the effort." (9) Both federal and state courts have construed this language to mean that before filing a derivative action, a stockholder must make a demand on the board of directors to redress the wrong complained of. (10) If no demand is made, then the plaintiff must plead in the complaint, with particularized facts, why making a pre-suit demand before filing suit would have been futile. If the plaintiff does not make a demand or plead demand futility, then the case, on motion by the defendants, can be dismissed at the pleading stage. (11)

   Although both the Federal and Delaware Rule 23.1 contemplate the making of a demand, in most Delaware stockholder derivative actions, no demand is ever made. (12) In most cases, after a derivative action is filed, the defendant moves to dismiss the complaint under Rule 23.1 on the ground that a demand was required but not made. (13) In response, the plaintiff opposes the motion on the ground that a pre-suit demand on the board would have been futile because the board members would not have been motivated to sue their fellow directors.

   The reason a plaintiff's counsel usually does not make a demand is that doing so invites the board of directors to take the lawsuit out of counsel's hands. Once a demand is made, the board may then either substitute the corporation as the plaintiff or redress the alleged wrong in other ways without litigation. Either approach would eliminate the opportunity for plaintiffs' counsel to receive a court-awarded fee, which motivates most derivative lawsuits. Unwilling to take that risk, most plaintiffs' counsel resort to their only other option: to argue that a demand would have been futile and, therefore, was not required.

   This approach created a dilemma, because in Delaware, the facts establishing demand futility must be pled in the complaint with particularity, yet no discovery is permitted to develop those facts at the Rule 23.1 stage. The legal issue thus became: what level of factual specificity is required to plead successfully that a demand would have been futile? Until 1984, the case law provided no clear, definitive answer. Because the issue was procedural, one would expect that the answer would also be procedural, but that is not what happened. In 1984, the Delaware Supreme Court decided Aronson v. Lewis, (14) providing an answer that was both substantive and procedural. Aronson also spawned an entirely new area of substantive law that further blurred the substance-procedure distinction.

   Aronson was an appeal from a denial of a motion to dismiss a derivative action under Rule 23.1 for failure to make a pre-suit demand on the board of a company that owned a chain of parking lots. (15) The directors approved a consulting agreement with the company's retired seventy-five year-old founder and former chief executive officer, who owned forty-seven percent of the corporation's stock and thus had effective control. (16) Under the consulting agreement, he would receive $150,000 per year for the first three years, $125,000 for the next three years, and $100,000 thereafter for life. (17) The plaintiffs filed a derivative action, claiming that by approving this agreement, the directors had wasted corporate assets. The issue was whether a pre-suit demand on the board was required. If it was, dismissal would follow because the plaintiffs failed to make such a demand. (18)

   The complaint alleged that a demand on the board was not required because: (1) all the directors had been named as defendants and were liable for the wrongs complained of; (2) the former CEO dominated and controlled the board; and (3) having the corporation bring the lawsuit would require the directors to sue themselves, which no rational board would ever do. (19) The Court of Chancery found these allegations sufficient to establish demand futility, and denied the dismissal motion. (20) On appeal, the Delaware Supreme Court reversed. (21)

   Although the demand requirement is part of a rule of procedure, the Delaware Supreme Court described the Rule 23.1 demand requirement as "a rule of substantive right, designed to give a corporation the opportunity to rectify an alleged wrong without litigation, and to control any litigation which does arise." (22) The Supreme Court grounded the demand requirement upon a substantive rationale--that the statutory power of a corporate board to "manage the business and affairs of the corporation" included the power to bring, or refuse to bring, a lawsuit on the corporation's behalf. (23) Thus, the issue, as framed by the Delaware Supreme Court, was when may a court divest that decision-making power from the board and "re-vest" it in a stockholder. The Aronson court's answer was: only in cases where the board's decision not to sue would not be protected by the business judgment rule. Thus, to answer a procedural question--how to plead demand futility--a court would have to determine whether a doctrine of substantive law--the business judgment rule--would or would not apply to protect the complained of board action.

   But how can the business judgment rule help a plaintiff's lawyer to draft a complaint that will pass the demand futility test? The Aronson court answered that the plaintiff must "allege facts with particularity which, taken as true, support a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment." (24) Specifically, the pleaded facts must create a reasonable doubt either that "(1) the directors are disinterested and independent [or that] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment," meaning that the directors had either acted with appropriate due care, or that the transaction did not constitute corporate waste. (25)

   In adopting this test, the Aronson court blended together a procedural requirement with a substantive rule. It did so by characterizing the demand requirement as a substantive right and by infusing the term "demand futility" with substantive business judgment concepts such as disinterest, independence, and business judgment. Before Aronson, these...