California Landmark Cases on Corporate Governance and Derivative Suits
It is a fundamental principle of corporate governance that the role of managing the business of the corporation is vested in its board of directors, not in its shareholders. (Grosset v. Wenaas (2008) 42 Cal.4th 1100, 1108.)
This responsibility includes the prosecution, defense, and control of corporate litigation. (Ibid.)
Judicial deference is accorded to directors under the "business judgment rule," which recognizes that where decisions are without fraud or breach of trust, "management of the corporation is best left to those to whom it has been entrusted, not to the courts. " (Desaigoudar v. Meyercord (2003) 108 Cal.App.4th 173, 183.)
As codified in section 309, the business judgment rule obligates a director to perform his or her duties "in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances" ( 309, subd. (a)); and it insulates a director from liability when he or she performs those obligations in the manner provided in the statute ( 309, subd. (c)).
Section 309 reads in full:
"(a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.
(b) In performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by any of the following:
(1) One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented.
(2) Counsel, independent accountants or other persons as to matters which the director believes to be within such person's professional or expert competence.
(3) A committee of the board upon which the director does not serve, as to matters within its designated authority, which committee the director believes to merit confidence, so long as, in any such case, the director acts in good faith, after reasonable inquiry when the need therefor is indicated by the circumstances and without knowledge that would cause such reliance to be unwarranted. (c) A person who performs the duties of a director in accordance with subdivisions (a) and (b) shall have no liability based upon any alleged failure to discharge the person's obligations as a director. In addition, the liability of a director for monetary damages may be eliminated or limited in a corporation's articles to the extent provided in paragraph (10) of subdivision (a) of Section 204."
In light of the directors' role in the operation of the business affairs of the corporation, where conduct, including mismanagement by corporate officers, causes damage to the corporation, it is the entity that must bring suit; the individual shareholder may not bring an action for indirect personal losses (i.e., decrease in stock value) sustained as a result of the overall harm to the entity. (Anderson v. Derrick (1934) 220 Cal. 770, 773-774; see also Nelson v. Anderson (1999) 72 Cal.App.4th 111, 127.)
A contrary rule "would 'authorize multitudinous litigation and ignore the corporate entity.' " (Schuster v. Gardner (2005) 127 Cal.App.4th 305, 312 25 Cal. Rptr. 3d 468 (Schuster).) And "directors have the same discretion with respect to the prosecution of claims on behalf of the corporation as they have in other business matters." (Findley v. Garrett (1952) 109 Cal.App.2d 166, 177 (Findley).)
Thus, the business judgment rule "protects a board's good faith decision to reject a derivative lawsuit" so long as the majority of the board does not have a personal interest in the lawsuit's outcome. (Desaigoudar v. Meyercord, supra, 108 Cal.App.4th at p. 184; see also 204, subd. (a)(10)(iii).)
This principle that the corporation must bring suit on its own behalf notwithstanding, where the directors fail or refuse to act, a shareholder has a sufficient interest in the entity "to justify the bringing of a ?propulsive' action, designed to set in motion the judicial machinery for the redress of the wrong to the corporation. " (Klopstock v. Superior Court (1941) 17 Cal.2d 13, 16-17 (Klopstock).)
"The corporation is the ultimate beneficiary of such a derivative suit ... ." (Id. at p. 21.)
A derivative lawsuit is in essence a consolidation in equity of two suits, one by the shareholder against the directors seeking an order that they sue those who have wronged the corporation, and the other by the corporation against the wrongdoers. (Daily Income Fund, Inc. v. Fox (1984) 464 U.S. 523, 529, fn. 4.) A presuit demand on the directors, however, is ordinarily required for the bringing of a derivative action.
As a precondition for bringing a derivative action on behalf of the corporation, the shareholder "should show to the satisfaction of the court that he has exhausted all the means within his reach to obtain, within the corporation itself, the redress of his grievances, or action in conformity to his wishes. He must make an earnest, not a simulated effort, with the managing body of the corporation, to induce remedial action on their part, and this must be apparent to the court." (Hawes v. Oakland (1881) 104 U.S. 450 at pp. 460-461.)
The shareholder must demonstrate to the court "with particularity" the efforts he or she made to induce the directors to take action. (Id. at p. 461.)
As the Supreme Court later explained, Hawes "sought to maintain derivative suits as a limited exception to the usual rule that the proper party to bring a claim on behalf of a corporation is the corporation itself, acting through its directors or the majority of its shareholders. ... The principal means by which the Court in Hawes sought to vindicate this policy was, of course, its requirement that a shareholder seek action by the corporation itself before bringing a derivative suit. This 'demand requirement' affords the directors an opportunity 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 insisting on such right. They may regard the expense of enforcing the right or the furtherance of the general business of the corporation in determining whether to waive or insist upon the right.' On the other hand, if, in the view of the directors, 'litigation is appropriate, acceptance of the demand places the resources of the corporation, including its information, personnel, funds, and counsel, behind the suit.' " (Daily Income Fund, Inc. v. Fox (1984) 464 U.S. 523.)
This requirement that a shareholder establish that he or she made a " 'suitable demand, unless excused by extraordinary conditions ...' " (Kamen v. Kemper Financial Services, Inc. (1991) 500 U.S. 90, 96 (Kamen)), 'is to encourage intracorporate resolution of disputes and to protect the managerial freedom of those to whom the responsibility of running the business is delegated. ...' " (Shields v. Singleton (1993) 15 Cal.App.4th 1611, 1619 19 Cal. Rptr. 2d 459 (Shields).)
The demand requirement is also intended to prevent the abuse of the derivative suit remedy. (Kamen, at pp. 95-96.) The demand requirement under federal law is embodied in rule 23.1 of the Federal Rules of Civil Procedure (28 U.S.C.). (Kamen, at p. 96.)
California's demand requirement under section 800(b)(2) is similar to the federal rule and requires that the plaintiff in a shareholder derivative suit "allege in the complaint with particularity plaintiff's efforts to secure from the board such action as plaintiff desires, or the reasons for not making such effort, and allege further that plaintiff has either informed the corporation or the board in writing of the ultimate facts of each cause of action against each defendant or delivered to the corporation or the board a true copy of the complaint which plaintiff proposes to file."