Generally, prior to bringing a derivative action and attempting to wrest control of a corporate claim from the board of directors, a stockholder must demand remedial action by the board. But because Maryland continues to recognize a very limited demand futility exception, we are frequently asked to consider: under what circumstances may demand be excused? The answer surprises many lawyers more familiar with Delaware practice: almost never.

In Delaware, demand futility is well-established and its two tests are clearly drawn. First, the test articulated in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), applies when a plaintiff challenges a decision of the current board of directors (i.e., the individuals upon which plaintiff must seek demand). Second, the test set forth in Rales v. Blasband, 634 A.2d 927 (Del. 1993), applies when a plaintiff does not challenge a decision of the board in place at the time the complaint is filed. In either case, to establish demand futility, a plaintiff-stockholder must plead particularized facts to impugn the ability of at least half of the directors in office when the complaint is filed to have considered a demand impartially, either by establishing reasonable doubt that the challenged transaction was a product of a valid exercise of business judgment (under Aronson) or by establishing reasonable doubt that the board could have exercised independent and disinterested business judgment (under Rales). Such allegations are reviewed under Court of Chancery Rule 23.1 and surrounding case law.

The oft-cited alternative to the Delaware approach is the Model Business Corporation Act (MBCA). Section 7.42 of the MBCA rejects the notion of demand futility and requires a written demand on the corporation in all cases (a so-called universal demand requirement). The justification for a universal demand requirement is two-fold. First, it allows directors to reexamine the act or omission that forms the gravamen of the demand. Second, it completely avoids the distraction of litigation involving questions related to the futility of demand.

In its seminal decision, Werbowsky v. Collumb, 362 Md. 581, 618 (2001), the Court of Appeals of Maryland expressly rejected both the Delaware demand futility exception and the MBCA universal demand requirement. Instead, the Court of Appeals held that Maryland law continues to recognize a “very limited exception” to the requirement. The two exceptions are as follows:

1. Where a demand, or a delay in waiting for a response to a demand, would cause irreparable harm to the corporation; or
2. Where a majority of the directors are so personally and directly conflicted or committed to a decision in dispute that they cannot reasonably be expected to respond to a demand in good faith and within the ambit of the business judgment rule.

While the second exception would seemingly align Maryland with Delaware on the subject of demand futility, it does not. The Court of Appeals explained that demand will not be excused “simply because a majority of the directors approved or participated in some way in the challenged transaction or decision or on the basis of generalized or speculative allegations that [the directors] are conflicted or are controlled by other conflicted persons, or because they are paid well for their services, were chosen as directors at the behest of controlling stockholders, or would be hostile to the action.” The Court of Appeals further cautioned that the demand futility inquiry should not address the merits of the underlying case. Indeed, the Court of Appeals relied upon one of the justifications for a universal demand requirement when it explained that the demand requirement affords the directors, even interested non-independent directors, the opportunity to reconsider the issue in dispute. Finally, the Court of Appeals acknowledged that, in most cases, pre-suit demand is simply not an onerous requirement and that the stockholder typically does not lose any substantive right because he or she can always challenge the board of director’s response to the demand. The limited nature of this exception is further informed by the fact that directors are presumed to act properly and in the best interest of the corporation and enjoy the benefit and protection of a statutory business judgment rule.

Thus, unlike under Delaware law, the demand requirement is not excused merely because a majority of the current board of directors may have participated in a questionable decision that forms the gravamen of the plaintiff-stockholder’s claim or otherwise may be interested in its outcome. And given the limiting guidance provided by the Court of Appeals, it is not surprising that, in the fourteen years since Werbowsky, no Maryland appellate court has recognized demand to have been futile.

The holding in Werbowsky and its subsequent application then beg the question: when will the very limited exception apply? Most practitioners point to closely-held corporations – particularly those comprised of two stockholders. But even in the context of closely-held corporations, demand can serve an important function. For example, while it may be unlikely that an entire set of demands will be adopted by a hostile board of a closely-held corporation, faced with the prospect of litigation it not only may be possible, but perhaps likely, that the board will concede certain issues for strategic and financial reasons. Thus, at a minimum, the demand requirement facilitates the winnowing of resulting derivative litigation. Further, for both the court and the parties, the demand requirement serves an important gate keeping function. Because issues that are not presented in the demand cannot later be added to derivative litigation, through an amended complaint or otherwise, it keeps both the parties and the court focused on matters of critical importance.

So when does the very limited exception to the demand requirement apply in Maryland? Rarely … and even then it depends.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.