Companies rely on their directors to advise on important issues and oversee the company’s senior executives to ensure the company continues to stay the correct course. In their advisory and oversight roles, directors may be called on to review a shareholder demand and determine whether to pursue the shareholder’s requested action. When a Board receives a shareholder demand, the Board must take important steps to analyze the demand and determine a proper course of action. Failure to take proper steps may create liability for directors, so it is crucial for directors to (1) know a shareholder demand when they see it and (2) take the proper steps to address a shareholder demand.
What Does it Mean When a Shareholder “Makes a Demand?”
A shareholder demand is frequently this first step in litigation by a shareholder against a corporation. In a derivative action, a shareholder has two options under Washington law when asserting its claims: (i) make demand and sue for wrongful refusal of this demand or (ii) allege in the complaint why demand would have been futile. RCW 23B.07.400(2). These options are mutually exclusive, so shareholders must choose carefully.
A shareholder demand usually takes the form of a letter requesting the Board take certain action on behalf of the company. Sometimes the requested action is legal action, such as suing a third party. However, most of the time, the letter specifically requests the Board initiate litigation in the company’s name against certain officers or directors. It is also important to note that just because the letter specifically says that it is “not a shareholder demand,” does not mean it is not a shareholder demand. Courts disagree with this so-called “Magritte defense,” stating it does not allow a shareholder to make demand on a Board while not calling it a demand.[1] In other words, just because a letter from a shareholder states it is not a demand does not necessarily mean it is not a demand.
If a shareholder is sending a letter to the Board requesting specific action from the Board, the communication more than likely constitutes “demand.”
How Should a Board Respond to a Shareholder Demand?
Boards have one, steadfast rule in responding to a shareholder demand: the Board must do something to consider the demand. The easiest way for a Board to expose themselves to fiduciary duties claims is to do nothing in response to a shareholder’s demand. Generally, Boards should meet to discuss the items discussed in a shareholder’s demand, and then choose to undertake some effort to investigate the issues raised in the demand. It is important to note, as well, that a “proper” investigation takes various forms depending on the demands made by a shareholder. That is why, at this point, it is crucial for Boards to engage competent counsel once demand is made. Competent counsel can advise Boards on how to properly investigate the shareholder demand to ensure Boards comply with their fiduciary duties.
Once the Board properly investigates the shareholder demand, the Board can either (1) reject the shareholder demand and do nothing further or (2) undertake the action demanded by the shareholder. If a Board decides to reject the shareholder demand, it is crucial that a Board responds to the shareholder to identify (1) the actions taken by the Board and (2) the reasons for why the Board rejected the shareholder demand. This correspondence rejecting demand frequently becomes central in post-demand litigation as a Board may be forced to defend itself against fiduciary duty claims. In short, Boards and their competent counsel should carefully consider every move after receiving a demand. A Board’s fiduciary duties hang on every move a Board makes after receiving a demand.
[1] This defense was adopted by a Delaware judge, Vice Chancellor Glasscock, who coined the term referencing a 1929 painting by the artiest Rene Magritte that portrays a smoking pipe, but bears the caption: “This is not a pipe.” See Dahle v. Pope, C.A. No. 2019-0136-SG, Dkt. 21 at 2 (Del. Ch. Oct. 17, 2019).
To learn more about What Happens When a Shareholder Makes a Demand?, please contact Beresford Booth at info@beresfordlaw.com or by phone at (425) 776-410