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Shareholder Derivative Actions (Part I): The “Demand” Requirement

Under California law, San Diego corporations have a duty to take actions that are in the best interest of the company and the investors. Failure by the board to do this will lead to litigation, in particular, shareholder derivative actions. However, before shareholders can bring a derivative action, they must make a “demand” on the board of directors and senior management that they correct the alleged wrongful conduct.

This is a three-part series: in Part II, we will discuss what happens after the demand and in Part III, we will provide some basic information on the concept of “demand futility.”

San Diego Corporate Law: The “Demand” Requirement for Derivative Lawsuits

In general, the role of conducting the business of the corporation is vested in its board of directors. If a shareholder in the corporation believes that the corporation is being mismanaged and that his or her investment is at risk, California law requires the shareholder to make “… an earnest, not a simulated effort, with the managing body of the corporation, to induce remedial action on their part …” See Bader v. Anderson, 101 Cal.Rptr.3d 821 (Cal.App. 4th Dist. 2009). The purpose of this “demand requirement” is three-fold:

To protect the managerial freedom of the board of directors
To allow the board to initiate litigation on behalf of the corporation and/or
To prevent the abuse of the derivative suit remedy

This demand requirement was established more than 120 years ago by the California Supreme Court and is now codified in Cal. Corp. Code, § 800. Subsection 800(b)(2) requires that a plaintiff filing a derivative lawsuit must plead “with particularity” the attempts that were made to secure board action before bringing suit, or, alternatively, must plead “demand futility.”

San Diego Corporate Law: What Should be in the Demand Letter?

To satisfy the demand requirement, written communication should be sent by the shareholder to the board of directors. Since California courts focus on individual directors, the best practice is to send the demand letter to the corporation and to each director. At minimum, the letter should indicate the following information:

The identity of the shareholder
At least one alleged wrong or misconduct — for example, breach of fiduciary duty, self-dealing, waste of corporate assets, etc.
A description of the alleged wrong or misconduct that is clear, particular, and sufficient enough to put the board of directors on notice and/or to allow the board to decide whether to initiate litigation
A demand that action be taken by the corporation to redress the alleged wrong

Under general legal principles, after a demand is made, the corporation must have some time to consider the demand. In addition, the wrongs and/or misconduct stated in the demand letter must “connect-up” to the issues brought if an eventual derivative action is filed. Thus, for example, if the demand letter identifies breaches of fiduciary duties with respect to tax returns and financial filings, a court will likely reject a derivative lawsuit based on claims of insider dealings or usurpation of corporation opportunities.

Call San Diego Corporate Law Today

For further information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard has the experience with California corporate law to help draft a demand letter or to help your company deal with a demand letter received from a shareholder. Mr. Leonard can also set up your corporation, review your bylaws and articles, draft minutes, and help meet the specific and unique legal needs of your business. Call Mr. Leonard today. He can be reached at (858) 483-9200 or via email.