LMPERS v. Wynn: The Ninth Circuit Clarifies When a Demand Futility Excuse Is Unavailable to Shareholders in a Derivative Action

July 25, 2016

On July 18, 2016, the United States Court of Appeals for the Ninth Circuit issued a decision in Louisiana Municipal Police Employees’ Retirement System (LMPERS) v. Wynn, Case No. 10-56187, affirming the United States District Court for the District of Nevada’s dismissal under Federal Rule of Civil Procedure 23.1 (“Rule 23.1”) of a shareholder derivative lawsuit alleging that Wynn Resorts’ board of director defendants breached their fiduciary duties to plaintiff shareholders.  This case highlights the importance for plaintiffs in shareholder derivative actions to make formal demands on the board to act to prevent and remedy alleged damage to the corporation, and for defendants to test derivative complaints filed without a demand through a Federal Rule of Civil Procedure 12(b)(6) motion to dismiss.

Rule 23.1 governs shareholder derivative actions in federal court.  To survive dismissal of their complaint, plaintiffs in a federal shareholder derivative lawsuit must state under penalty of perjury and with particularity: (1) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members, and (2) the reasons for not obtaining the action or not making the effort.  To satisfy (2), and avoiding having to do (1), the plaintiff may allege how making a demand on the board would be “futile.”  The rationale for requiring such a demand is that the board of directors controls a corporation, including the decision whether to pursue litigation when the corporation may have suffered harm.  Absent sufficient reason to doubt the directors’ ability to make disinterested and independent decisions, the board is empowered to make decisions on behalf of the corporation and, if appropriate, pursue, or reject, litigation.  The law of the corporation’s state of incorporation governs whether the shareholders have adequately alleged demand futility: in this case Nevada.

In LMPERS v. Wynn, the plaintiff-shareholders failed to make a demand on the board before filing suit, instead arguing that demand would have been futile.  The Ninth Circuit held that the district court did not abuse its discretion in determining that the shareholders failed to comply with Rule 23.1 or Nevada law governing demand futility.

First, the court held that the plaintiff-shareholders did not plead sufficiently particularized allegations in their complaint to support an inference that a majority of the board of directors lacked independence.  To show a lack of independence, shareholders must allege facts showing that the majority of directors is “beholden” to one or more directors who are unable to consider a demand on its merits (e.g., because of financial conflicts).  That there are some financial ties between the interested party and the director(s), however, will demonstrate a lack of independence.

Second, the Ninth Circuit rejected the plaintiff-shareholders’ theory that demand was excused based on allegations that the directors faced a substantial likelihood of personal liability for any wrongdoing, and thus pre-lawsuit demand on them would have been “futile.”  Even assuming that any particular action made by the corporation with the board’s blessing was illegal, the plaintiff-shareholders’ allegations did not create a reasonable inference that any of the individual directors intended or knew that it was illegal at the time of their approval of the action, as Nevada law requires, and thus no substantial likelihood of personal liability for any director’s alleged wrongdoing.

Third, the Ninth Circuit also rejected the plaintiff-shareholders’ argument that demand was futile because there was a reasonable doubt that the directors would be entitled to the business judgment rule if the stock redemption at issue in the case was challenged.  The Ninth Circuit found that the redemption, converting an equity holder into a debt holder, was actually likely under Nevada law to “leave[] the corporation’s gaming license more secure if a potentially unsuitable security-holder has debt rather than equity,” and thus the business judgment rule was likely to apply.

Finally, the Ninth Circuit held that there was no reversible error if the district court considered materials extraneous to the complaint, namely, a proxy statement and an SEC Form 8-K.

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