Derivative Actions in Pennsylvania – Don’t Forget the Demand

By Joshua C. Lewis, Esq.

A derivative action typically is a lawsuit brought by a shareholder (or group of shareholders) of a corporation on behalf the corporation against a third party–often, against insiders of the corporation, such as its officers and directors.[1]  Unlike other actions, in order to initiate a derivative action, shareholders must first attempt to obtain compliance by the corporate officers and directors.  This is typically done through a formal demand made upon the officers and directors.

A central concept of the “demand rule” is that officers and directors are considered to be “best positioned” to determine whether pursuing a cause of action is in the best interest of the corporation, and deference should be given to their judgment on that matter.  See In re Westinghouse Sec. Litig., 832 F. Supp. 989, 994 (W.D. Pa. 1993).  This requires a shareholder to make a written demand upon the corporation’s board of directors and request it to prosecute the action or take corrective measures.  Drain v. Covenant Life Ins. Co., 712 A.2d 273, 278 (Pa. 1998).

Particularly in the context of closely-held businesses, plaintiff-shareholders often contend that making a demand would be futile.  After all, in most cases, the decision makers to whom a demand is made are often the targets of the potential lawsuit.  Such officers and directors are unlikely to authorize a suit against themselves, thereby rendering the making of a demand a futile exercise.

In Drain, the Pennsylvania Supreme Court analyzed the standing requirements for plaintiffs in derivative actions.  The Court acknowledged its adoption of the ALI Principles of Corporate Governance with respect to standing, explaining the Principles require a shareholder to “exhaust intracorporate remedies before filing suit.”  Drain, 712 A.2d at 278.

The Drain plaintiffs had not made demand and argued, instead, that making a demand would have been futile, therefore excusing the demand requirement.  According to the Pennsylvania Supreme Court, Cuker v. Mikalauskas, 692 A.2d 1042 (Pa. 1997), established that making a demand is excused only if irreparable harm to the corporation is shown.  Accordingly, the futility exception to demand no longer exists under Pennsylvania caselaw, and a Plaintiff must demonstrate irreparable injury to corporation in order to excuse the failure to make a demand on a corporation prior to filing a derivative action.  Moreover, even in the case of irreparable harm, plaintiffs must still make a demand “promptly after commencement of the action.”  Warden v. McLelland, 288 F.3d 105 (3d Cir. 2002)

Failure to comply with the demand requirements can have dire consequences to derivative plaintiffs, subjecting the complaint to dismissal through preliminary objections or a motion to dismiss.  Indeed, Pennsylvania rules require that a derivative complaint must set forth the efforts made to secure enforcement by the corporation, or the reason such efforts were not made.  Pa. R. Civ. P. 1506(a)(2).

To insure that a derivative action survives preliminary dispositive motions, plaintiffs must make a demand before filing suit.

[1]   Although derivative actions generally are thought of in the shareholder context, in bankruptcy cases creditors’ committees also may seek derivative standing to proceed with actions that otherwise belong to the debtor’s estate.

One Response to Derivative Actions in Pennsylvania – Don’t Forget the Demand

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