Shareholder Derivative Actions (Part II): What Happens After the Demand Letter?

As we discussed in Part I of this series, shareholders of San Diego and California corporations can bring derivative lawsuits against members of the board of directors. Technically, these are lawsuits filed on behalf of the corporation seeking to benefit the corporation. Thus, they are called shareholder derivative actions. As we discussed previously, before a shareholder can bring a derivative action, the shareholder must make a “demand” for corrective action. See Cal. Corp. Code, § 800.

In this Part II of the series, we discuss what happens after the demand. In Part III, we will explore the doctrine of “demand futility.”

San Diego Corporate Law: What Happens After the Demand?

In general, after a demand for corrective action is sent by a shareholder, the board of directors has a certain amount of time to decide what to do. Unless there is an emergency, the amount of time is a “reasonable” amount of time, which is generally 30 to 90 days.

If the board does nothing at all, then the shareholder can file his or her or its derivative action. The case will test whether or not the board should have taken or avoided taking certain actions; Failure to respond to the demand letter can be evidence of corporate mismanagement. There is no guarantee of success, but your case will not be dismissed for failure to make a demand.

On the other hand, if the board actually undertakes some action in response to a shareholder’s demand, then matters are more complicated. At issue will be whether the action taken — or the “no-action” taken — in response to the shareholder demand satisfies the “business judgment rule.”

San Diego Corporate Law: What is the Business Judgment Rule?

The business judgment rule is a legal doctrine that says that when a corporation makes a business decision, the directors making the decision are assumed to have acted in the “best interests of the corporation.” In particular, the directors are assumed to have acted:

• In good faith
• With due investigation and information and
• With an honest belief that the action was the best action to take

In general, courts will defer to the decisions of a corporation unless there is some evidence that the decisions were made in bad faith, without investigation and/or made in some manner that was corrupt or wrongful.

San Diego Corporate Law: Bezirdjiam v. O’Reilly

A good example of how this works in practice is the case of Bezirdjian v. O’Reilly, 183 Cal. App. 4th 316 (Cal. App. 1st Dist. 2010). Bezirdjian was a shareholder who brought a derivative action against then-current and former board members of Chevron Corporation. According to the plaintiffs, various senior management employees of Chevron made illegal payments to Iraqi leader Saddam Hussein in exchange for oil in the early 2000s with the knowledge and complicity of the board members. The lawsuit alleged violation of fiduciary duties, fraud, waste of assets, and mismanagement.

In that case, the complaint itself was considered the “demand” that satisfied Cal. Corp. Code, § 800. Following receipt of the demand, Chevron’s board established a committee to investigate the allegations. After the investigation, the three-person committee made a determination that it would not be in the corporation’s best interest to pursue the claims made by the shareholders. Thereafter, Chevron asserted that its decision to take no action was protected by the business judgment rule. In amended pleadings, the shareholder plaintiffs alleged that the board’s refusal to initiate litigation against the wrongdoers was an additional instance of breach of fiduciary duty.

However, the trial court disagreed and the California Court of Appeals affirmed. Both held that it is well within a board’s power to refuse to undertake a lawsuit if it was deemed that the litigation would be contrary to the corporation’s best interests. To overcome the business judgment rule, it would have been necessary to prove some fraud or misconduct with respect to the decision. In the Bezirdjian case, the plaintiff shareholders made no such claim. As such, their case was dismissed.

Call San Diego Corporate Law Today

For further information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard can help if your San Diego corporation has received a demand letter from a shareholder. As the Bezirdjian case demonstrates, it is important to craft a proper response and take proper board action to ensure there is no corporate liability. Mr. Leonard can provide advice and guidance. Mr. Leonard has been named a “Rising Star” three years running by SuperLawyers.com and “Best of the Bar” by the San Diego Business Journal. Contact Mr. Leonard today by calling (858) 483-9200 or via email.

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