Board-Friendly Rales Test Determines Futility of Pre-Suit Demand When Challenged Decision Is Made by a Board Committee Comprised of a Minority of Board Members

Delaware courts have two tests for determining when it is futile for a plaintiff in a derivative action to make a pre-suit demand of the corporation’s board of directors under Court of Chancery Rule 23.1.

The Aronson v. Lewis test applies when the board which would consider the demand made the business decision challenged in the derivative action. Under that test, demand is futile if (1) there is a reasonable doubt that the directors are disinterested and independent or (2) there is a reasonable doubt that the challenged transaction was otherwise the product of a valid exercise of business judgment.

The Rales v. Blasband test, in contrast, applies when the board that would be considering the demand did not make a business decision which is being challenged and looks only at whether there is “a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” Significantly, no inquiry is made into whether the underlying transaction reflects a valid business judgment. As the Rales court noted, the board-friendly test it announced typically applies in three scenarios: 1) a majority of the board who made the challenged decision has been replaced by the time the suit is filed; 2) the challenged business decision was not a board decision; or 3) the challenged decision was made by the board of a different corporation.

But what about decisions made by a board committee in which the board’s decision making authority is vested under the corporation’s organic documents?

In Teamsters Union 25 Health Services & Ins. Plan v. Baiera, Chancellor Bouchard recently held that a decision made by a board committee comprised of a minority of the entire board is not considered a decision of the board for demand-futility purposes and that the Rales test must therefore be used to determine whether it would be futile to request the board to pursue an action in the name of the corporation challenging the committee’s decision. The tables are turned, however, if a committee comprised of a majority of the entire board approves the challenged transaction. In that instance, the committee’s decision “is imputed to the entire board and thus triggers the Aronson test.”

The practical upshot of Baiera is that, when assessing whether pre-suit demand may be excused as futile, it is important not only to determine whether the challenged decision was made by a committee or by the entire board, but also, if the decision was made by a committee, to determine how many board members on the committee voted for the transaction. The answers to those questions will determine which test for futility is used and could perhaps have a dispositive effect on your case.

Christopher Walsh is a Director in the Gibbons Business & Commercial Litigation Department.
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