“Until our legislature declares otherwise, Washington is a demand futility state and follows Delaware.” This phrase in the Washington Supreme Court opinion In re F5 Networks, Inc., 166 Wn.2d 229, 240, 207 P.3d 433 (2009) had a significant impact on derivative action litigation throughout the State of Washington. I write this post in an effort to explain what the phrase means and how it is applied today in shareholder derivative litigation involving Zillow (yes, Zillow.com).
What is Demand Futility?
As discussed in last week’s post, a derivative action allows shareholders in a corporation to initiate litigation on behalf of a corporation. However, the mere fact that one is a shareholder does not automatically bestow a right to pursue and maintain a derivative action.
In Washington, shareholders seeking to bring a derivative lawsuit must “allege with particularity the demand made, if any, to obtain action by the board of directors and either that the demand was refused or ignored or why a demand was not made.” RCW 23B.07.400(2) (emphasis added). This procedure outlined in this statute is generally known as demand futility. In In re F5 Networks, the Washington Supreme Court confirmed that the statute does in fact imply that Washington “is a demand futility state,” just like Delaware.
The concept of demand futility is derived from the famous Delaware case Aronson v. Lewis, 473 A.2d 805 (Del.1984). Demand futility is best described as follows: shareholders may make a litigation demand to the board before initiating derivative proceedings, but the shareholders are not required to do so. If the shareholders fail to make a litigation demand, they must demonstrate why demand would be futile.
How Do Shareholders Prove Demand Would Be Futile?
The Aronson court developed a simple standard for proving a demand futility. Shareholders must allege facts that create a reasonable doubt that 1) the corporation’s directors have an interest in the transaction that is the subject of the derivative litigation OR 2) a majority of the corporation’s directors are dominated or controlled by a person interested in the transaction. A determination as to demand futility must occur before the derivative litigation can proceed.
These principles are best viewed through the lens of a recent federal case out of the Western District of Washington in Seattle, In re Zillow Group, Inc. Shareholder Derivative Litigation, C17-1568-JCC, 2020 WL 978503 (W.D. Wash. Feb. 28, 2020).
In Zillow, shareholders of Zillow brought a derivative action against current and former members of Zillow’s board of directors and officers for breach of fiduciary duties and unjust enrichment arising out of alleged securities fraud (see here for an article on the underlying facts behind these allegations). Shortly after the suit was filed, the defendants (the current and former officers and members of the board) moved to dismiss on the grounds that the shareholders failed to adequately plead demand futility. The opinion discussed herein is the district court’s analysis as to whether the shareholders did in fact fail to adequately plead demand futility.
At the time the shareholders filed the lawsuit, there were eight directors on Zillow’s board. As such, the shareholders needed to demonstrate facts creating a reasonable doubt that a majority of the eight directors were either interested or lacked independence (i.e. were controlled by someone with a financial interest). Both parties conceded that there were four directors who were either interested in the transaction or were not independent. Therefore, the shareholders only needed to establish the interestedness or lack of independence of one more director to establish demand futility. The shareholders ended up succeeding in their pursuit of two defendant directors: Blachford and Maffei.
The shareholders alleged that Blachford and Maffei were not “disinterested” on account of their membership on Zillow’s “audit committee.” This committee was responsible for reviewing and executing relevant documentation regarding Zillow’s compliance with federal securities law. In fact, both Blachford and Maffei’s signatures were on key securities’ law forms. These forms would be key to the shareholders’ claims that the directors breached fiduciary duties when they violated federal securities laws. As such, the shareholders argued Blachford and Maffei could not be “disinterested,” thereby satisfying the demand futility standard on that point. The district court agreed with the shareholders’ arguments and determined Blachford and Maffei were “interested” for purposes of demand futility. As a result, the district court denied the defendant directors’ motion to dismiss.
Considerations
The procedure for demand futility under In re F5 Networks and RCW 23B.07.400(2) are vital to the success of derivative actions. Failure to comply with the rules laid out therein will prove fatal to derivative claims. This lines up with other considerations throughout Washington corporate law (e.g. following the notice requirements in dissenting shareholder cases, see here). You must follow the rules if you want a chance to succeed.
Next week, this blog will discuss derivative actions as they relate to limited liability companies.