Aronson v. Lewis (Del. 1984)

Having learned the substantive law of fiduciary duties, you are prepared to finally read Aronson itself. As you know by now, the case contains Delaware’s canonical statement of the business judgment rule. What Aronson is really about, however, is a procedural overlay to the business judgment rule (and other substantive fiduciary law): the so-called demand futility test.

The demand futility test is Delaware’s main procedural filter to address the danger of nuisance suits described above. The original idea is simple: a shareholder will be allowed to prosecute the suit on behalf of the corporation only when a majority of the board is partial as to the outcome of the suit. Under Aronson, however, the test of partiality is not mechanical, and in an important subset of cases arguably morphs into a pre-discovery test of the seriousness of the allegations. Most importantly, merely naming a director as a defendant is not enough to disqualify that director as partial for purposes of deciding whether the suit should be allowed to proceed. Nor is it enough to make an abstract allegation that a director breached his or her duty (in a suit against him or her), or that the director is under the domination of a controlling shareholder (in a suit against the controlling shareholder). Rather, Aronson requires the shareholder-plaintiff to allege particularized facts that allow the reasonable inference that the director has indeed breached a duty, or that the director is indeed under the domination of the controlling shareholder. Courts address this question on a motion to dismiss. Even if they do not grant that motion, courts may dismiss the suit and any later time during discovery if a "special litigation committee" so recommends (see Zapata as reported by Aronson.)

The practical consequence of the demand futility test is that the shareholder-plaintiff must be in possession of at least some pertinent facts before even being allowed to enter discovery. In the case of a suit against the entire board for violation of their duties, the demand futility test is thus simply a heightened pleading standard: the complaint must allege particularized facts that suggest they may actually be liable.

Reading Aronson is complicated by arcane and even misleading terminology. Some signposts may be helpful. Formally, the case arises under Delaware Chancery Rule 23.1(a), which states:

“The [derivative] complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors [namely, to initiate the suit in the name of the corporation] … and the reasons for the plaintiff's failure to obtain the action or for not making the effort.” [emphasis added]

For this rule to make any sense, it must be read to require dismissal if (a) the board rightfully rejected the plaintiff’s demand, or (b) the plaintiff’s reasons for failing to make a demand were not legally compelling (why else insist that the reasons be stated?). In practice, serious derivative plaintiffs never make a formal demand — the directors will hardly agree to sue themselves, and the Delaware Supreme Court has ruled that making a demand waives the right to contest the independence of the board (such that challenging the demand refusal as “wrongful” is virtually impossible if the board does its homework and considers the demand with reasonable information – business judgment rule!). Hence the relevant question in Aronson and other cases is: when does the plaintiff have a legally compelling reason not to make a demand? Or, in the preferred terminology of the courts, when is demand “futile”? To answer that question, the Delaware courts have developed the test summarized in the paragraph above, and further explained in Aronson.

Both the demand requirement and the powers of the special litigation committee only apply to derivative suits; they do not apply to direct suits (which are usually filed as class actions). The test for distinguishing direct from derivative actions is “(1) who suffered the alleged harm (the corporation or the suing stock-holders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stock-holders, individually)?” Tooley v. Donaldson, Lufkin & Jenrette, 845 A. 2d 1031, at 1033 (Del. 2004). In practice, this means that shareholders can sue directly over mergers and other transactions that affect their status as shareholders, but not over transactions such as executive compensation that affect shareholders merely financially. For example, of the shareholder suit cases you have read so far, Van Gorkom was a direct (class) action, while Sinclair, Disney, and Stone were derivative actions.

1. What is worse for plaintiffs: dismissal because demand was not futile (as in Aronson) or later dismissal upon recommendation of a special litigation committee (as in Zapata)?
2. What is the difference between the standard articulated by the Supreme Court and the one applied by the Chancery Court below in Aronson? In other words, why did the Aronson Supreme Court reverse the Chancery Court?
3. The Aronson Supreme Court "reverse[d] the Court of Chancery's denial of the motion to dismiss, and remand[ed] with instructions that plaintiff be granted leave to amend his complain to bring it into compliance with Rule 23.1 based on the principles [the Supreme Court] announced." What did the plaintiff have to do to "bring the complaint into compliance," and do you think this was easily feasible in this case?
4. What if the alleged facts had been slightly different: Fink had owned 80% of the stock of Meyers, and the transaction at issue had been a sale of half of Meyers' business to Fink for several million dollars. Under Aronson, would demaned have been futile?
5. What if the facts had been different still: Fink had owned 80% but the transaction was a merger between Meyers and another corporation owned partially by Fink, in which Meyers shareholders had ceased to be shareholders of Meyers and instead received cash or stock of some other corporation?
6. In light of the foregoing questions, do you think Aronson's hurdle for derivative suits is appropriate, too high, or two low?