On appeal from Superior Court of New Jersey, Law Division, Essex County, L-3510-05.
NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE APPELLATE DIVISION
Argued telephonically October 23, 2007
Before Judges Payne, Sapp-Peterson and Messano.
Plaintiffs, Carl Johnson and Jerry Foster, suing derivatively on behalf of Bradley Pharmaceuticals, Inc., appeal from the dismissal with prejudice of their consolidated actions against Bradley's officers and its Board of Directors*fn1 as the result of plaintiffs' failure to adequately plead that, because of their lack of independence and interest in the transactions at issue, Bradley's directors would have failed to act on the Company's behalf if a demand upon the Board to do so had been made at the time that suit was filed.
The parties agree that, because Bradley is a Delaware corporation, Delaware law applies to the issues on appeal. Kamen v. Kemper Fin. Serv's, Inc., 500 U.S. 90, 108-09, 111 S.Ct. 1711, 1723, 114 L.Ed. 2d 152, 172 (1991).
In a shareholder derivative action such as this, the shareholder asserts a claim that belongs to a corporation, on behalf of that corporation, in an attempt to compel alleged wrongdoers to compensate the corporation for the injury they have caused. However, as the New Jersey Supreme Court has recognized:
Derivative litigation raises difficult and sometimes controversial issues. [Bradley T. Ferrell, Note, A Hybrid Approach: Integrating the Delaware and the ALI Approaches to Shareholder Derivative Litigation, 50 Ohio St. L.J. 241, 242-43 (1999).] One difficulty is that, although such litigation may compensate the corporation for injuries sustained as a result of wrongful conduct, it also may have a negative effect on corporate governance when frivolous lawsuits initiated by opportunistic shareholders are brought. Id. at 243. If abused, derivative litigation can impede the best interests of the corporation. Ibid. See also James D. Cox, Searching for the Corporation's Voice in Derivative Suit Litigation: A Critique of Zapata and the ALI Project, 1982 Duke L.J. 959, 960 (noting that because derivative-suit plaintiff "usually has no significant financial interest in the corporation, the possibly harmful economic effects of prosecuting the suit cannot be expected to guide his decision to litigate") (footnote omitted). [In re PSE&G S'holder Litig., 173 N.J. 258, 278 (2002).]
The requirement that the Board of a corporation be called upon to act on the corporation's behalf before a shareholder derivative action can be filed, or that the shareholder demonstrate with particularity, in the complaint, why such a demand would be futile, arises in actions governed by Delaware law from Delaware Chancery Rule 23.1 and decisions of the Delaware Supreme Court in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (Del 2000), and Rales v. Easco Hand Tools, Inc., 634 A.2d 927 (1993).*fn2
The Chancery Rule provides, in pertinent part:
In a derivative action brought by 1 or more shareholders . . . to enforce a right of a corporation . . . , the corporation . . . having failed to enforce a right which may properly be asserted by it, the complaint shall allege that the plaintiff was a shareholder . . . at the time of the transaction of which he complains . . . . The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors . . . and the reasons for his failure to obtain the action or for not making the effort.
The rule is derived from a "cardinal precept" of Delaware corporation law that directors, rather than shareholders, manage the business and affairs of the corporation. Aronson, supra, 473 A.2d at 811. Under Delaware law, "the decision to bring a lawsuit or to refrain from litigating a claim on behalf of the corporation is a decision concerning the management of the corporation and consequently is the responsibility of the directors." Blasband v. Rales, 971 F.2d 1034, 1047 (3d Cir. 1993) (citing Levine v. Smith, 591 A.2d 194, 200 (Del. 1991), overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (Del. 2000), and Spiegel v. Buntrock, 571 A.2d 767, 773 (Del. 1990)). Thus, although a shareholder derivative action serves as a "potent tool to redress the conduct of a torpid or unfaithful management," Aronson, supra, 473 A.2d at 811, "[b]y its very nature the derivative action impinges on the managerial freedom of directors." Ibid. The demand requirement of Chancery Rule 23.1 insures that a stockholder exhausts his remedies within the corporate structure prior to suit, thereby permitting the corporation's board to fulfill its fiduciary duties, and the requirement acts as a safeguard against strike suits. Id. at 812.
A demand is excused if such a demand would be futile. However, in order to protect the demand requirement from erosion, a heightened pleading standard is imposed when the shareholder asserts demand futility, requiring a degree of particularity absent from traditional notions of notice pleading. Aronson established a standard for demand futility in instances in which board action is challenged, which was restated in Levine, supra, in the following terms:
In determining the sufficiency of a complaint to withstand dismissal under rule 23.1 based on a claim of demand futility . . . [t]he trial court is confronted with two related but distinct questions: (1) whether threshold presumptions of director disinterest or independence are rebutted by well-pleaded facts; and, if not, (2) whether the complaint pleads particularized facts sufficient to create a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment.*fn3
The second prong of Aronson permits a shareholder suing a corporate board that is structurally independent and presumptively capable of acting impartially on a demand to proceed with a lawsuit on the corporation's behalf if breach of fiduciary duty is pled with sufficient particularity.
In simple terms, the second prong of Aronson can be said to fulfill two important integrity-assuring functions in our law. First . . . the second Aronson prong addresses concerns regarding the inherent "structural bias" of corporate boards, by allowing suits to go forward even over a putatively independent board's objection if the plaintiff can meet a heightened pleading standard that provides confidence that there is a substantial basis for the suit.
Second . . . the second Aronson prong responds to the related concern that a derivative suit demand asks directors to authorize a suit against themselves -- i.e., asks them to take an act against their personal interests. If the legal rule was that demand was excused whenever, by mere notice pleading, the plaintiffs could state a breach of fiduciary duty claim against a majority of the board, the demand requirement of the law would be weakened and the settlement value of so-called "strike suits" would greatly increase, to the perceived detriment of the best interests of stockholders as investors. But, if the demand excusal test is too stringent, then stockholders may suffer as a class because the deterrence effects of meritorious derivative suits on faithless conduct may be too weak. The second prong of Aronson therefore balances the conflicting policy interests at stake by articulating a safety valve that releases a suit for prosecution when the complaint meets a heightened pleading standard of particularity, because in these circumstances the threat of liability to the directors required to act on the demand is sufficiently substantial to cast a reasonable doubt over their impartiality. [Guttman v. Huang, 823 A.2d 492, 500 (Del Ch. 2003) (footnotes omitted).]
In instances in which the board has made no decision relating to the subject of the derivative suit, the business judgment rule underlying Aronson is inapplicable.*fn4 In this circumstance, a court must determine whether or not the particularized factual allegations of a derivative stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand. If the derivative plaintiff satisfies this burden, then demand will be excused as futile. [Rales, supra, 634 A.2d at 934.]
As the Chancery court noted in Guttman, when there are allegations that a majority of the board acted wrongfully, for instance, by failing to accurately account for and disclose corporate financial results, "the Rales test sensibly addresses concerns similar to the second prong of Aronson. To wit, if the directors face a 'substantial likelihood' of personal liability, their ability to consider a demand impartially is compromised under Rales, excusing demand." 823 A.2d at 501.
It should also be noted that 8 Del. C. § 220 provides a mechanism by which a shareholder, who has met the statute's procedural requirements and shown a specific proper purpose, can summarily obtain relevant books and records of a corporation in order to establish particularized facts that would further an investigation of corporate wrongdoing and provide a foundation for a claim of demand futility. Rales, supra, 634 A.2d at 931 n.4 and 934 n.10. As noted by the Rales Court: Surprisingly, little use has been made of section 220 as an information-gathering tool in the derivative context. Perhaps the problem arises in some cases out of an unseemly race to the court house, chiefly generated by the "first to file" custom seemingly permitting the winner of the race to be named lead counsel. The result has been a plethora of superficial complaints that could not be sustained. [Ibid.]
See also Guttman, supra, 823 A.2d at 504 (noting that plaintiffs, in failing to utilize § 220 when amending their complaint, "ignored the repeated admonitions of the Delaware Supreme Court and this court for derivative plaintiffs to proceed deliberately and to use the books and ...