Fed. Sec. L. Rep. P 99,106 Harry Lewis v. Charles L. Graves, James E. Cunningham, John A. Morgan, W.E. Earles, Charles L. Davis, James A. Hunt, John D. Ritchie, Robert K. Richie, Hosea W. Bailey, G.W. Douglas Carver, Graham D. Mattison, Morgan Stanley & Co., Incorporated, Smith Barney, Harris Upham & Co., the Babcock & Wilcox Company, and J. Ray McDermott & Co., Inc.

Citation: 701 F.2d 245Docket: 280

Court: Court of Appeals for the Second Circuit; February 27, 1983; Federal Appellate Court

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The case involves Harry Lewis as the plaintiff-appellant against multiple defendants, including J. Ray McDermott Co. Inc. and its directors. The appeal centers on the dismissal of Lewis's shareholder derivative suit for failing to make a demand on McDermott's board of directors. Derivative suits present conflicting perspectives between directors, who typically believe they manage corporate assets effectively, and plaintiffs, who doubt directors will seek remedies for alleged corporate wrongs.

Lewis initiated the action on March 28, 1978, alleging violations of the Securities Exchange Act of 1934 and common law, specifically related to McDermott's acquisition of The Babcock and Wilcox Company and stock issuance under McDermott's executive stock plans. Notably, Lewis did not demand that the board pursue the claims, arguing that such a demand was unnecessary due to the involvement of the individual defendants in the alleged wrongful acts and their vested interests in the transactions, which would render any demand futile.

In 1981, defendants filed for judgment on the pleadings under Federal Rules 12(c) and 23.1, arguing that the plaintiff failed to make a necessary demand on the board of directors. On February 4, 1982, Judge John M. Cannella ruled that the plaintiff's claims of futility did not excuse the lack of demand, granting the defendants' motion. The court allowed the plaintiff to replead if a demand made to McDermott's board was refused within 30 days. However, on April 1, 1982, the plaintiff informed the court that it would not make such a demand, leading to a judgment from which the plaintiff, Lewis, appealed.

Rule 23.1 mandates that derivative action complaints must specify efforts made by the plaintiff to obtain the desired action from the board and the reasons for any failure to do so. This demand requirement has been established for over a century and is intended to give the corporation the chance to address grievances internally before litigation. The rule promotes the principle that corporate management should be entrusted to the board of directors and allows corporations to manage derivative suits effectively, potentially avoiding costly litigation and enabling better resolution of issues due to superior resources and expertise.

Demand for intracorporate remedies under Rule 23.1 is generally required but can be excused if deemed "futile." The futility must be specifically pleaded in the complaint. The determination of whether allegations of futility justify bypassing the demand requirement is fact-specific and lies within the district court's discretion. A presumption of futility arises if directors are found to be antagonistic or involved in the challenged transactions. However, mere prior approval or acquiescence by directors is insufficient to establish futility unless there are specific allegations of self-dealing or bias. Other circuits have ruled that mere approval does not equate to futility. A corporation’s directors, bound by fiduciary duties, may still pursue claims despite previous approvals, especially if those approvals occurred under fraudulent circumstances or if the transactions later harmed the corporation. Allowing demand to be excused solely on prior board acquiescence would undermine Rule 23.1, as most derivative suits involve significant corporate decisions where directors are typically involved.

Naming all directors as defendants does not automatically excuse the demand requirement in derivative actions. The court emphasizes that merely including a majority or all directors does not suffice to circumvent this requirement, as it could allow plaintiffs to exploit the naming tactic to bypass Rule 23.1, which mandates that demand be made unless excused. The plaintiff alleged that five out of eleven directors received improper stock grants under McDermott's Stock Plans, indicating their personal involvement in the challenged transactions. However, the majority of the board was not alleged to have benefited, and the claims against the remaining directors were generalized, lacking specific allegations of bias or self-interest. Consequently, the district court's decision to require a demand was justified, as the plaintiff did not adequately demonstrate futility regarding the Stock Plans claims.

Plaintiff alleges that McDermott directors approved the acquisition of Babcock to protect their positions, which were purportedly threatened by past corporate misconduct. However, the court found that the complaint lacks specific allegations demonstrating how the acquisition secured the directors' positions, rendering the self-interest claims speculative and insufficient to bypass the demand requirement under Rule 23.1. The trial court did not abuse its discretion in determining that the plaintiff failed to plead the directors' bias or interest with the necessary particularity.

Additionally, the plaintiff's claims regarding the dismissal of his complaint based on prior similar actions (Stein I and Stein II) were unpersuasive, as the court analyzed his complaint independently. Events occurring after the filing, including McDermott's subsequent legal actions, do not retroactively establish futility of demand, as futility must be assessed at the time the derivative action is initiated.

Finally, the plaintiff's argument that requiring demand in this situation undermines Delaware law distinctions between demand-excused and demand-required cases is flawed, as the relevant case (Zapata) was decided after the plaintiff filed suit. The distinction applies to judicial review of independent director committee recommendations and is not relevant here since demand was not deemed futile. The court affirmed the trial court's decision.