Who Decides if a Company Should Pursue a Shareholder Derivative Suit?

The Indiana Supreme Court recently provided important guidance as to who may decide whether a corporation should pursue a shareholder derivative suit in the case of In Re ITT Derivative Litigation, 932 N.E.2d 664 (Ind. 2010). The Court held that a director who is named as a defendant in such a suit is disqualified from serving on a special litigation committee (SLC) formed to consider the advisability of pursuing the case only if that director faces a substantial likelihood of personal liability in the litigation. This decision continues a trend in Indiana case law of affording broad deference to the directors of Indiana companies on matters relating to shareholder derivative suits.

This question came before the Indiana Supreme Court by way of certification from the U.S. District Court for the Southern District of New York, which presided over the underlying shareholder suits. The underlying suits arose when Night Vision, a division of ITT, committed several alleged violations of U.S. State Department restrictions on the export of technical data causing ITT to pay $50 million in fines and fees. The shareholders alleged that the directors violated fiduciary duties by failing to monitor and supervise the management unit responsible for the violations.

The plaintiff shareholder made a demand on the board of directors to pursue the cause of action based on these alleged breaches. Pursuant to the Indiana Business Corporation Law (BCL), a board of directors may form an SLC consisting of three disinterested directors to determine whether a shareholder derivative suit would be in the best interest of the corporation. ITT formed an SLC consisting of three outside directors who were named as defendants in the suit. The SLC decided that the company should not pursue the cause of action and ITT moved to dismiss the plaintiffs' claims.

The plaintiffs disputed the SLC's decision by arguing that the directors who served on the SLC were not "disinterested" because they were named parties to the suit. Under IC § 23-1-32-4, a director who is a party to the lawsuit may be deemed disinterested if she is a named party "only on the basis of a frivolous or insubstantial claim or for the sole purpose of seeking to disqualify the director or other person from serving on the committee." The plaintiff's asserted that their claims against the directors were not frivolous or insubstantial, thus the directors were not disinterested under the statute. The District Court agreed with the plaintiffs, and denied ITT's motion to dismiss the case, but certified the question to the Indiana Supreme Court for its guidance as to Indiana law.

Upon certification, the Indiana Supreme Court took a somewhat different approach and reached a different result. The Court focused on the statute's use of the term "insubstantial" and the need to reach an interpretation of the SLC provisions of the statute that was consistent with its overall purpose. The Court began by reaffirming that Indiana follows the standard for demand futility established in Rales v. Blasband, 634 A.2d 927 (Del. 1993) and codified in IC § 23-1-32-2. Under the Rales standard, a plaintiff must make a demand on the board of directors before pursuing a derivative suit unless the plaintiff can prove such a demand would be futile because a majority of the board faces a substantial likelihood of personal liability in the suit. The Court reasoned that an "insubstantial claim" under IC § 23-1-32-4 should be read as a claim that did not create a substantial likelihood of personal liability. Thus if a member of the board of directors meets the standard for disinterestedness in the demand futility context under the Rales standard, the board member should also meet the standard of disinterestedness required to serve on an SLC that is formed to consider a shareholder's demand. The Court reasoned that this reading of IC § 23-1-32-4 was the most consistent with the BCL's overall purpose to "allow corporations to operate efficiently and allow directors to exercise control over the corporation's activities."

The result of this decision is to make it easier for boards of directors of Indiana companies to establish special litigation committees to pass on the advisability of pursuing a shareholder derivative suit. Because of the extreme deference that the Indiana Business Corporation Law affords to the decisions of such an SLC, this decision provides considerable assistance to directors of Indiana corporations faced with shareholder derivative litigation.

If you have questions regarding shareholder derivative suits, please contact Philip Whistler, Richard Thrapp, Donald Snemis or Dominique Price.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.