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A shareholder wishing to file a derivative suit must generally present that dispute to the board of directors with a demand prior to filing a shareholder’s derivative suit.  The way that this demand process works can vary between the states and can ultimately determine whether a shareholder is able to proceed with a lawsuit.  A recent decision from United States Court of Appeals for the Eleventh Circuit resolved this question by determining that law of the state of incorporation controls the demand requirements on a corporation even in disputes concerning federal law.  Peter Mavrick is a Fort Lauderdale business litigation lawyer, and also represents clients in business litigation in Miami, Boca Raton, and Palm Beach.  The Mavrick Law Firm represents clients in breach of contract litigation, non-compete agreement litigation, trade secret litigation, trademark infringement litigation, and other legal disputes in federal and state courts and in arbitration.

When a disgruntled shareholder for a corporation believes that the corporation should have taken legal action against another entity (including directors, officers, or employees of the company as well as any third-party), that shareholder can initiate a demand that the corporation take action.  The board of directors of that corporation has the opportunity to exercise its business judgment as to whether to take the requested action or to ignore it.  If the corporation refuses to act, the shareholder can sometimes file a derivative lawsuit, which is a type of business litigation where the shareholder steps into the shoes of a corporation and sues on the corporation’s behalf.  The derivative lawsuit can be dismissed if the court finds that the board of directors properly exercised their business judgment.  “The purpose of requiring a precomplaint demand is to protect the directors’ prerogative to take over the litigation or to oppose it.” Kamen v. Kemper Fin. Services, Inc., 500 U.S. 90 (1991).  Under many states’ laws, a shareholder can bypass this demand requirement by showing that the demand would have been futile.  “To the extent that a jurisdiction recognizes the futility exception to demand, the jurisdiction places a limit upon the directors’ usual power to control the initiation of corporate litigation […]. By permitting the shareholder to circumvent the board’s business judgment on the desirability of corporate litigation, the ‘futility’ exception defines the circumstances in which the shareholder may exercise this particular incident of managerial authority.”  Kamen v. Kemper Fin. Services, Inc., 500 U.S. 90 (1991).  Demand futility can usually be found when the decisionmakers are themselves personally interested in the outcome of the subject dispute.

Alternatively, in certain circumstances a shareholder who holds a claim can directly file a lawsuit against the corporation for a right that he himself owns, as opposed to the corporation.  This avenue of business litigation bypasses the requirement to make a demand.  The law concerning whether a board of directors properly exercises its business judgment after receiving a demand as well as the law concerning whether a cause of action should be “direct” or “derivative” varies between the states.  Accordingly, the question as to whether a shareholder will have an opportunity to seek relief in court will depend on which law applies in questions as to the board’s business judgment and whether the shareholder has a direct cause of action.

In almost every case, the state where the corporation was incorporated determines the law that applies to shareholder demands.  Burks v. Lasker, 441 U.S. 471 (1979) (“[T]he first place one must look to determine the powers of corporate directors is in the relevant [s]tate’s corporation law”); Conroy on behalf of Aflac, Inc. v. Amos, 785 F. App’x 751 (11th Cir. 2019) (“The law of the state of incorporation controls the contours of a demand against a corporation”); see § 607.1505, Florida Statutes (codifying the “internal affairs” doctrine that causes the state of incorporation to be the governing law in corporate governance matters).

While it is well established that the law of the state of incorporation applies to the derivative process in claims under state law, the question as to whether claims under federal law also must comply with the state-of-incorporation’s derivative process was only recently decided.  In Freedman v. MagicJack Vocaltec Ltd., 963 F.3d 1125 (11th Cir. 2020), the United States Court of Appeals for the Eleventh Circuit evaluated which law to apply when the plaintiff made claims under federal securities law.  The MagicJack plaintiff was a shareholder of the defendant company.  The company sent proxy statements to its shareholders that optimistically described an acquisition and compensation package changes. The plaintiff shareholder believed these notices were misleading and unlawful.  The plaintiff asserted that, to the contrary, the acquisition had significantly less value than claimed by the board and that the compensation comments were a cover-up to help the board entrench themselves concerning an upcoming takeover of the company.  The plaintiff brought a direct putative class-action complaint under Sections 14(a) and 20(a) of the Securities and Exchange Act of 1934 – a federal law.  MagicJack explained that “we hold – as a federal rule of decision – that federal courts should look to state law to decide the issue of whether a claim brought under a federal statute is direct or derivative.”  Freedman v. MagicJack Vocaltec Ltd., 963 F.3d 1125 (11th Cir. 2020).

Peter Mavrick is a Fort Lauderdale business litigation attorney who also practices business litigation in Miami, Boca Raton, and Palm Beach.  This article does not serve as a substitute for legal advice tailored to a particular situation.

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