COURT REVISES STANDARD OF REVIEW IN SHAREHOLDERS' DERIVATIVE SUIT

July 25, 2002

By Steven P. Garmisa
Hoey Farina & Downes
sgarmisa@felahfd.com

The deferential "abuse of discretion" standard of review sometimes creeps into places it doesn't logically belong. And disinfecting a line of cases can be difficult once the wrong standard of review is applied in appeals of certain orders. Judges and lawyers often wind up mechanically applying precedent on standards of review without considering whether the prior ruling was sensible.

Two years ago, though, the Delaware Supreme Court concluded that it made a mistake when it applied the abuse of discretion standard in reviewing whether the complaint in a shareholders' derivative case alleged, with sufficient particularity, facts showing "demand futility." A crucial hurdle in shareholders' derivative cases is the attempt to plead that there were proper grounds for excusing the requirement of demanding action by the board. Unless the demand is considered futile, the board gets to determine whether claims asserted by shareholders on behalf of the corporation should be prosecuted.

Unfortunately, before the Delaware court corrected its mistake, the Illinois Appellate Court and the 7th U.S. Circuit Court of Appeals replicated the error, applying the abuse of discretion standard in reviewing the validity of shareholder complaints that claimed demand futility.

The question of what standard of review to apply depends on the degree of deference that should be given to the ruling made by the trial judge.

With a host of rulings, like where to draw the line on long-winded cross- examination, the abuse of discretion standard applies. Rulings on questions of law, in contrast, are subject to full and independent review on appeal.

As the Delaware Supreme Court explained in Brehm v. Eisner (2000), a trial judge faced with the question of whether the complaint in a shareholders' derivative case alleges demand futility with the required degree of particularity has to (1) read English when reviewing the complaint, statutes, rules and cases, and (2) apply the law to the allegations in the complaint. Since reviewing court judges have also mastered reading English and applying law to the allegations in a complaint, the standard of review in such situations should be "de novo and plenary," not deferential. The Delaware Court therefore overruled cases that applied the abuse of discretion standard to demand futility appeals in shareholder derivative cases.

The 7th Circuit recently corrected the same error. In a new case involving Abbott Laboratories and Illinois law, the trial judge dismissed a case for failure to plead demand futility with the required degree of particularity.

The ruling stood a strong chance of being affirmed under the deferential abuse of discretion standard, since the question would have been whether any reasonable trial judge could have reached the same result (not whether the appellate judges, with all their reading skills, would have reached the same conclusion).

Rather than blindly following 7th Circuit and Illinois precedent that used the abuse of discretion standard in reviewing such decisions, the 7th Circuit decided the Delaware Supreme Court got it right in Brehm v. Eisner. The decision in the Abbott Labs case therefore received de novo review. In re Abbott Laboratories Derivative Shareholders Litigation, 2002 WL 1225183. This turned out to be crucial.

In 1999, after six years of critical reports from inspectors and four warning letters from the Food and Drug Administration, Abbott Laboratories wound up paying a record $100 million penalty. The consent decree also required Abbott to destroy millions of dollars worth of inventory and stop making various diagnostic kits until it corrected various manufacturing and quality-control problems.

A series of shareholder derivative lawsuits sought to hold the directors personally liable for these losses. The theory is that the directors aren't entitled to the protection of the business judgment rule because the circumstances alleged in the complaint (if true) show a reasonable likelihood that the directors were guilty of gross negligence or knowing misconduct in consciously disregarding warning signals about the problems brewing with the FDA.

Freed from the limitations of the abuse of discretion standard, the appellate judges independently reviewed the complaint, applied Illinois law (which in turn relies on Delaware precedent concerning demand futility), concluded the complaint alleged specific facts showing that the requirement of making a demand on the board should be excused, and reversed.

The lesson for appellants is to think carefully about whether "abuse of discretion" is the correct standard of review for a particular issue. Don't blindly assume precedent is right in saying the issue is reviewed only for abuse of discretion.

Back to Trial Notebook Main page