Corporate Governance

Derivative Suits, Delaware and the Race to the Bottom: Schoon v. Smith (Part 4)

By J. Robert Brown

We have been discussing Schoon v. Smith, a case addressing whether a single director should have the right to bring a derivative suit.  We turn to the actual reasoning of the case. 

In many ways, the case was remarkable for what plaintiff was not seeking.  He argued that a director, as trustee, had an inherent right to bring a derivative suit in order to protect shareholders.  But at the same time, plaintiff conceded that the director would be subject to all of the demand futility restrictions.  In other words, a director could only maintain the suit if able to show that the board was otherwise not independent. 

Plaintiff noted that these suits were necessary both because of the director's obligation to watch out for the interests of shareholders and because there was often little alternative.  As the reply brief stated:

• While recognizing director derivative standing would have minimal impact, denying directors standing would send a significant message to directors, stockholders and corporate America.  It would create a "Wall Street Rule" for directors, in which a director who learns of board level misconduct and is stymied by a conflicted board must either turn a blind eye to the wrongdoing and or offer her resignation.  If the board remains conflicted and intransigent, she has no other option.  If she publicizes her concerns, she risks a lawsuit for defamation and breach of fiduciary duty.  If she seeks a stockholder champion, she faces the same risks.

Despite the limited extension sought by Plaintiff and the lack of sufficient alternatives for objecting directors, the Court concluded that a single director lacked the authority to initiate a derivative suite.  In doing so, the Court essentially found that Schoon's interests were aligned with a single shareholder and that shareholder was in the process of preparing its own derivative suit (the Court took judicial notice of the shareholder's efforts to exercise inspection rights).  Effectively, therefore, the Court made its own factual determination in a case resolved pursuant to a motion to dismiss.  The factual determination also failed to take into account the director's obligation to act in the best interests of all shareholders. 

The Court also disregarded the ALI Principles providing that a "director of a corporation has standing to commence and maintain a derivative action, unless the court finds that the director is unable to represent fairly and adequately the interests of shareholders."  The opinion essentially asserted that there was little or no authority supporting the principles, except for a Supreme Court of Pennsylvania case, an Indiana appellate decision, and the legislature of New York.  Given the domination of corporate law by Delaware, this could hardly be called a dearth of authority.   

In the end, the Court noted that a "stockholder derivative action would fully and adequately redress any injuries to Troy resulting from a breach of fiduciary duty by its board."  The Court did not address the informational advantages of a director or the difficulty incurred by a director when confronted with wrongdoing. 

The case has broad implications.  It is today the unusual case where a director will want to sue its brethren on the board in part because directors are vetted by management and have an incentive to appease management to retain their sinecure.  As shareholders increase their role in the nomination process, however, more directors will make it to the board who are not selected by management.  These directors will be in a better position to act independently and look out for the interests of shareholders.  The Delaware Supreme Court is aware of this phenomena and, likely anticipating the trend, is making sure that these directors in fact have little real power to protect shareholders.  Or so Schoon seems to suggest. 

We have posted the opinion and redacted briefs on the DU Corporate Governance web site. 

Full post as published by The Race to the Bottom on February 25, 2008 (boomark / email).