Key Takeaways

  • Demand futility allows shareholders to bypass the usual requirement of demanding that a company’s board address alleged wrongdoing before filing a derivative lawsuit.
  • Courts use two main tests — the Aronson test (for specific board decisions) and the Rales test (for broader claims about board impartiality) — to determine if demand futility applies.
  • The pleading standard is high: plaintiffs must provide detailed facts showing why demand would have been futile, not just conclusory statements.
  • Courts often examine board composition, conflicts of interest, independence, and business judgment to decide if demand futility is established.
  • A derivative complaint that fails to adequately plead demand futility is typically dismissed before trial.
  • Amendments to complaints may reset the relevant timeline for evaluating board composition and impartiality.
  • Judicial interpretations evolve through case law, and states often follow Delaware’s influential standards, though some jurisdictions have their own nuances.

Demand futility is a specific type of civil lawsuit in which a company's board decisions and/or decision-making skills, in general, are challenged. Essentially, the lawsuit will allege an individual decision was either made or not made based on bias, obstruction, or other unfair means. The issue is complex, and most of the United States' statutes hinge on Delaware's Standards, which have been set and revised over time through legal decisions.

Delaware Standards for Demand Futility

If a plaintiff alleges demand futility is at play, the court must first consider whether one specific decision is being challenged, or all decisions in general. The scope of the two options varies widely, but in both cases the composition of the board itself is important. If a specific decision is at question, the plaintiff must show invalid business judgment used by the board. This is known as the Aronson test.

If no specific decision is challenged, the plaintiff must show that the majority of the board is not impartial or is acting unfairly in some way. This is known as the Rales Test for demand futility cases. The tests are related and often applied in a 'two-pronged' fashion by civil court judges, as cases are not always clear from a judge's perspective whether the entire board demand or just a specific demand is in legal dispute.

Understanding the Demand Requirement and Its Exceptions

In shareholder derivative actions, the general rule is that a shareholder must first make a formal demand on the board of directors to take corrective action before filing suit. This requirement stems from the principle that corporate governance decisions — including whether to pursue litigation — lie primarily with the board. However, when such a demand would be futile or pointless, courts may excuse the requirement under the doctrine of demand futility.

Demand futility is not a mere allegation of wrongdoing; it requires specific factual allegations that demonstrate the board is unable to make an impartial decision regarding the litigation. These circumstances commonly include:

  • Conflicts of interest: A majority of board members are implicated in the alleged misconduct or face potential liability.
  • Lack of independence: Directors are controlled or dominated by those accused of wrongdoing.
  • Failure of oversight: The board knowingly ignored red flags or failed to act on significant risks.

Courts carefully scrutinize the complaint at the pleading stage. Simply stating that the board would not have acted is insufficient; plaintiffs must plead particularized facts that make demand clearly futile.

Judicial Decisions for Demand Futility

The Demand Futility standards originate from a collection of business decisions in business law throughout the years. Legal experts argue whether the main tests, Aronson and Rales, are fundamentally similar enough to combine, and new cases reach the courts regularly that advance the standards. Jurisdictions are also free to interpret the standards differently.

One aspect of demand futility cases nearly universally agreed upon is that court decisions are tested for demand from the date the complaint is filed. Unless the filing is amended or dropped and refiled, future composition or decisions of the board are not in question in demand futility. A plaintiff may validly amend the date of the filing, however, to include past and current compositions of the board. Often the court hears evidence for each test individually and if the case is currently in litigation the judge may amend previous decisions based on new evidence added by an amended date.

Procedural Consequences of Failing to Plead Demand Futility

A critical procedural risk in derivative litigation is the dismissal of the complaint for failing to properly plead demand futility. Courts routinely dismiss cases where plaintiffs provide only conclusory allegations or fail to address the board’s composition and potential conflicts at the time of filing. Because the demand futility analysis is conducted as of the complaint’s filing date, later changes to the board or corporate structure are typically irrelevant unless the complaint is amended.

Moreover, dismissal for inadequate pleading is often with prejudice, meaning the plaintiff may lose the right to bring the claim again. As such, plaintiffs should:

  • Conduct thorough pre-filing investigations into board membership, independence, and potential conflicts.
  • Include specific facts that support the inference that demand would have been futile.
  • Clearly connect alleged misconduct to the board’s inability to act impartially.

Courts have emphasized that the demand futility doctrine is not a procedural loophole but a narrow exception designed to protect both shareholder rights and board authority.

The Aronson Test for Demand Futility Cases

The Aronson test is the first basic test the court will need for a plaintiff's case to be demonstrated sufficiently. If the board members challenged are the same as those who made the decision, then only the decision in question need be addressed by the court, and the Aronson test is valid. The test hinges upon these questions:

  • Were the board members impartial and indifferent when the decision was made, or were they unduly influenced by outside factors into making a decision that was detrimental to the company?
  • Was the rationale for the decision based on sound business judgment, or was incomplete or otherwise flawed reasoning employed?

When the Aronson Test Applies and How to Meet It

The Aronson test is applied when a derivative action challenges a specific board decision made by the same directors currently in office. Under this test, demand is excused if a plaintiff pleads particularized facts creating a reasonable doubt that:

  1. The directors were disinterested and independent when approving the challenged transaction; or
  2. The decision was the product of a valid exercise of business judgment.

Satisfying either prong is sufficient. Importantly, courts presume that directors act in good faith and in the company’s best interest. Plaintiffs must overcome this presumption by showing evidence of self-dealing, bad faith, or egregious mismanagement. Allegations of poor business decisions alone typically do not meet the standard.

For example, if a board approves a transaction that directly benefits certain directors financially, or if directors knowingly ignore significant red flags, demand futility under Aronson is more likely to be established.

The Rales Test for Demand Futility Cases

Per the Rales test, the plaintiff enacting the test must show specific evidence of a pattern of past board decisions detrimental to the company. Often specific cases will be planned or are running concurrently in derivative suit, which can use the results of the Rales test as well.

The focus of the Rales test is impartiality, an important point in demand futility cases. Foremost, the Rales test determines if the board has jurisdiction over past or future decisions in question:

  • Is the current board comprised of members who have since been replaced from the time of the specific decision in question?
  • Are more than half the members of the board implicated in the demand futility case?
  • Does the board actually have the authority to make such a business decision?
  • Is/was the decision being made by the board of a different company?

The last question might seem obvious, but with mergers, buyouts, and acquisitions, the board of the company making the decision might be entirely the same but belonging to a different company at current time.

Strategic Considerations Under the Rales Test

The Rales test applies in situations where the board did not make the challenged decision — for example, when a decision was made by a prior board, a third party, or no formal decision was made at all. In these cases, the plaintiff must show that a majority of the current board could not impartially consider a demand due to conflicts, interests, or lack of independence.

Practical scenarios where the Rales test is often used include:

  • The alleged misconduct stems from board inaction or oversight failure.
  • The composition of the board has changed since the transaction occurred.
  • The decision was made by a subsidiary or external entity under the control of the parent board.

Because Rales focuses on the board’s current ability to act, plaintiffs must provide facts showing why today’s directors cannot fairly decide whether litigation is in the company’s best interest. This often involves examining business relationships, financial ties, or historical actions suggesting partiality.

Frequently Asked Questions

  1. What is demand futility in corporate law?
    Demand futility is a legal doctrine that excuses shareholders from first demanding that a company’s board pursue litigation before filing a derivative suit, typically because the board is conflicted or incapable of acting impartially.
  2. What happens if a complaint fails to plead demand futility?
    If the complaint lacks specific facts showing demand futility, the case is usually dismissed at the pleading stage, often with prejudice.
  3. How do courts decide if demand is futile?
    Courts apply either the Aronson or Rales tests to evaluate board independence, conflicts of interest, and whether decisions were made with valid business judgment.
  4. Can demand futility be claimed for board inaction?
    Yes. The Rales test often applies to claims based on oversight failures or situations where no specific decision was made.
  5. Does board composition after the lawsuit matter?
    Generally, no. Courts assess demand futility based on the board’s composition and circumstances when the complaint was filed.

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