Attorneys that represent shareholders of publicly traded companies in securities litigation are intimately familiar with the pre-suit demand required by the corporate law of many states. The purpose of the demand is to give the board of a company an opportunity to investigate and remedy alleged wrongdoing on the company’s behalf before a shareholder is permitted to bring a derivative action. In many states, including Delaware, a potential plaintiff is not required to make a pre-suit demand when the board is not capable of making an independent decision—typically because board members are accused of wrongdoing themselves. Pennsylvania’s business corporation law (“BCL”) does not include a “futility” exception and requires the prospective derivative plaintiff to make a pre-suit demand in nearly all circumstances.
Whatever the merits of Pennsylvania’s universal demand requirement for litigation involving companies with many shareholders, its justification breaks down in disputes involving closely held businesses. Absent a persuasive justification, it amounts to a procedural trap for the unwary practitioner. A recent decision from the Eastern District of Pennsylvania is a reminder of the hazard.
Pennsylvania’s “Universal Demand” Requirement
A fundamental principle of Pennsylvania corporate law is that a corporation’s board – not its shareholders – is responsible for the management of the company. This includes the decision to initiate litigation on behalf of the company against those who have damaged it. Pennsylvania’s corporate law, however, recognizes that members of the board and corporate officers themselves may cause harm to the company and are unlikely to cause the company initiate litigation against themselves. It allows shareholders to initiate derivative claims on behalf of the company in limited circumstances.
The 2016 revisions to the BCL require a prospective derivative plaintiff to make a written demand on a company’s board of directors prior to initiating suit. 15 Pa.C.S.A. § 1781(a). Upon receiving a demand, the board may choose to appoint an independent committee to investigate what action, if any, the corporation should take in response to the demand. For example, the committee might choose to have the corporation bring an action in its own name based on some or all the claims in the demand, or to allow the prospective derivative plaintiff to do so on its behalf. The committee is a surrogate decisionmaker for the board that allows it to make a business decision – whether and under what circumstances to initiate litigation. The demand is intended to give the board time to form a litigation committee and make this business decision prior to litigation.
Many states will excuse a plaintiff from the demand requirement when it would be futile. “Futility” means that the composition of the board is such that it is incapable of making an independent decision regarding the alleged wrongful conduct that would have been included in a pre-suit demand. For example, a demand would be futile if it alleged the entire board were engaged in self-dealing and there were no disinterested directors able to make a good faith decision on behalf of the company.
Litigating whether a demand is futile can be a complex, time consuming and expensive task. It is also ancillary to the merits of the ultimate issue of whether the corporation suffered harm because of a defendant’s conduct. For that reason, some states, including Pennsylvania, have no futility exception and require a pre-suit demand in nearly all circumstances. The BCL only excuses the demand requirement “if the plaintiff makes a specific showing that immediate and irreparable harm to the business corporation would otherwise result.” 15 Pa.C.S.A. § 1781(b)(1).
This “universal demand” requirement is defensible because the BCL allows the board to appoint a litigation committee comprised of independent third-party members. A demand in Pennsylvania should never, strictly speaking, be futile because it is always possible for a board to take good faith action in response to a demand, even if the entire board is conflicted. In contrast, many states require that a litigation committee be comprised of board members.
The Practical Reality in Closely Held Company Disputes
Practitioners that focus their practice on disputes among the owners of closely held companies may have trouble recalling a time where a client made a demand on a corporate board, which then diligently appointed an independent committee, retained independent counsel and performed a good faith investigation into the alleged wrongdoing. The practical reality is that demand futility is the norm in shareholder disputes involving closely held companies.
The prototypical fact pattern is a company with a majority / minority ownership structure. The majority owner is the sole director, president, treasurer and secretary of the company. The minority owner believes the majority owner is skimming from the company by having it pay him excessive compensation and his personal expenses. Notwithstanding the common-sense conclusion that the majority owner is unlikely to cause the company to hire an attorney to sue him or form a special committee to investigate his conduct, the BCL requires the minority owner to demand that he do just that. In fact, the BCL’s demand requirement appears to apply even when the board is deadlocked—which is common in closely held company litigation— and incapable of appointing a litigation committee.
Prior to the BCL’s 2016 amendments, Pennsylvania courts recognized that demand futility is common in closely held company disputes. The Superior Court put it bluntly: “[T]he demand requirement appears to be the very type of procedural rule that makes little sense in the context of a dispute between shareholders in a closely held corporation.” Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014)
A Trap for the Unwary
The 2016 amendments to the BCL leave no room for a futility exception. The Eastern District recently confirmed the same.
In Julabo USA, Inc. v. Juchheim, two brothers battled over how each of them ran their respective parts of the family business. One brother asserted a derivative claim against the other brother and an employee. The brothers each owned 50% of the company but the defendant brother served at the sole member of the board of directors, president, secretary and treasurer. The plaintiff brother did not make a demand prior to initiating the derivative action.
The Court, in what appears to be the first reported case on the issue, granted the defendant brother’s motion for summary judgment on that basis. In reaching its conclusion, the Court engaged in a plain-language reading of the BCL to conclude that it “does not include an exception [to the demand requirement] for closely-held corporations[;] And the Court has no basis to infer one.” The Court further rejected the plaintiff brother’s argument that pre-2016 cases, including Hill, predicted the Pennsylvania Supreme Court would adopt a futility exception as inconsistent with the 2016 amendments to the BCL. The Court ultimately concluded that the demand “requirements apply whether [a company] is a closely-held family business or a Fortune 500 company.”
Sidestepping the Trap
The demand requirement in the context of a closely held company dispute is the kind of procedural formality that keeps lawyers up at night. It is not intuitive and can have big consequences if ignored. Given that nearly all such demands will be ignored, the most efficient and safest way to comply with the requirement is to prepare a demand that references and attaches a copy of the complaint the derivative plaintiff intends to file.