Derivative Actions Carry Heightened Pleading Standard

Derivative actions are a mainstay of modern business litigation. They allow a shareholder of a corporation to enforce a right the corporation has but is wrongfully refusing to enforce. Normally, corporate management would be responsible for deciding whether to pursue litigation against someone, but sometimes it’s the management itself–such as an officer or director–that is causing the problem. In such situations, the board of directors may be reluctant to initiate a lawsuit against one of their own, so allowing a shareholder to bring the suit in the name of the corporation can be the only practical way to protect the interests of the corporation. Still, derivative suits are considered an extraordinary procedural device, permitted only when it is clear that the corporation will not act to enforce its rights. The pleading requirements are laid out in Federal Rule of Civil Procedure 23.1.

Because it’s normally up to the board of directors to decide whether to pursue litigation in the interest of the corporation or shareholders, it’s necessary to plead both the plaintiff’s demand on the corporation and the corporation’s refusal to comply. Under Rule 23.1, any complaint purporting to be a derivative action must state with particularity (a) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and (b) the reasons for not obtaining the action or not making the effort. The reason for this requirement is that derivative suits may proceed only if the shareholder shows that the board’s refusal was wrongful. If the board’s refusal to pursue litigation is justified, there will not be grounds for a derivative action.

A good example of this is provided by the case of Julia N. Rose v. J. Christian Bozorth, decided August 6, 2015, by the Western District of Virginia. In that case, the plaintiff was a shareholder in Kanawha-Gauley Coal and Coke Company, a coal and timber company incorporated in West Virginia. She was upset because Christian Bozorth, the company’s president, had allegedly been investing corporate funds into a number of speculative business endeavors, including high-risk unregistered securities offered by various start-up companies. She claimed Mr. Bozorth misrepresented the company’s status as an “accredited investor” to enable it to complete the purchases, which purchases were not in the company’s best interests and which violated the company’s own written Investment Policy. After she and other shareholders complained, the company formed an Investment Committee to review the legality and propriety of the investments. It also appointed two attorneys as ladder.jpg“special counsel” to investigate and make recommendations. Those attorneys advised the corporation that litigation was not in the company’s best interests. When it appeared to Ms. Rose that the corporation was not going to act, she filed a derivative action, alleging RICO violations.

The court granted the defendants’ motion to dismiss, holding that “Rose cannot satisfy the heightened pleading standard applicable to derivative actions.” In essence, there was no showing that the refusal to act was “wrongful.” Corporate directors are entitled to exercise their reasonable business judgment and waive a legal right vested in the corporation in the belief that its best interests will be promoted by not taking legal action to enforce the right. Moreover, the court held, directors are entitled to a presumption that they were faithful to their fiduciary duties. Thus, to state a viable derivative claim, a plaintiff must allege particularized facts rebutting this presumption, such as facts showing that the board was tainted by self-interest, acting in bad faith, or that it was grossly negligent. Ms. Rose failed to allege such facts, so the court dismissed her complaint with prejudice.

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