In a Case of First Impression, Delaware Chancery Court Holds It’s “Out with the Old (Board) and In With the New” When Considering Demand Futility

Chairs Around a Table

On May 31, 2016, the Delaware Chancery Court rejected shareholders’ allegations of corporate wrongdoing in a derivative suit against a national healthcare company, Bioscrip, holding that Plaintiff failed to adequately allege demand futility with respect to Bioscrip’s board of directors. For the first time, the Delaware Court found that Plaintiff was required to demonstrate demand futility with respect to the board of directors that was in place after shareholders filed their derivative complaint. Park Emps.’ & Ret. Bd. Emps.’ Annuity & Ben. Fund v. Smith, No. 11000-VCG (Ch. May 31, 2016).

On May 7, 2015, Plaintiff filed suit against Bioscrip, its board of directors, and several related companies, alleging corporate wrongdoing including Bioscrip’s participation in a kickback scheme, its fraudulent concealment of the health of its profit-making sectors, and various counts of insider trading. The shareholders claimed that making a demand on the Bioscrip board that was in place when the complaint was filed would have been futile due to certain members’ involvement with the suspected wrongdoing. Defendants moved to dismiss arguing, among other things, that the court’s demand-excusal analysis must consider the new Bioscrip board – which was elected four days after Plaintiff filed its complaint – rather than the board that was in place at the time the complaint was filed.

In the context of derivative suits, Rule 23.1 of the Delaware Chancery Court provides shareholders with two options: (1) make a demand on the board to take action against the corporation, or (2) demonstrate that making the demand would have been futile. Demand futility is typically assessed as to the board that was in place the time the complaint is filed – a standard known as the “date of filing” rule. Any changes to the composition of a board following the complaint are typically irrelevant to the court’s demand-excusal analysis.

In this case of first impression, however, Vice Chancellor Glasscock found that the distinctive circumstances of the case did not merit application of the “date of filing” rule, and that Plaintiff therefore did not meet its burden of showing demand futility. The court explained that it was the new board that was in a position to actually assess the Plaintiff’s complaint.  The complaint was filed just four days, and only two business days, before the change in board composition.  Thus, even if the former board received the demand prior to its elections, it would not have been able to assess the demand in such a short span of time.  Bolstering this line of reasoning was the fact that Plaintiff did not serve the complaint on the board for nearly three weeks after it was filed, and after the new board was in place. Moreover, a majority of the new board was comprised of non-Defendant directors who potentially could have evaluated the Plaintiff’s complaint.  These reasons led the Vice Chancellor to conclude that, “Under the unique facts presented by this case, a departure from the general rule is both equitable and in keeping with the policy behind Rule 23.1.”

The Delaware Court flatly rejected Plaintiffs’ arguments that the “date of filing” rule would spark gamesmanship by boards of directors, and that a departure from the rule would lead to a “slippery slope of a standard susceptible to manipulation” and “arbitrary Court analyses” of factors such as the number of days between the filing of a complaint and the change in the board. Vice Chancellor Glasscock held that such concerns would only apply where boards of directors intentionally manipulate their composition to prevent derivative suits, and proclaimed his confidence that “this Court can sniff out and preempt improper manipulation of board composition in this context.”

*This post was drafted with contribution from Yekaterina Reyzis, law clerk.