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Securities Regulation Daily Wrap Up, FIDUCIARY DUTIES—3d Cir.: Delaware’s circuit adopts de novo review for demand futility appeals, (May 6, 2024)

Law Firms Mentioned:Goodwin Procter LLP | Weiser Law Firm
Organizations Mentioned:Cognizant Technology Solutions | Cognizant Technology Solutions Corp. | Federman & Sherwood | Goodwin Procter, LLP | The Weiser Law Firm, PC

By Anne Sherry, J.D.

Federal courts in the circuit will now use the approach already followed by state courts in Delaware and New Jersey.

The Third Circuit adopted the de novo standard for reviewing dismissals of shareholder derivative actions for failure to plead demand ...

By Anne Sherry, J.D.

Federal courts in the circuit will now use the approach already followed by state courts in Delaware and New Jersey.

The Third Circuit adopted the de novo standard for reviewing dismissals of shareholder derivative actions for failure to plead demand futility. The decision overrules Blasband v. Rales (3d Cir. 1992) and other precedent to the extent they provide for abuse-of-discretion review in these cases (In re Cognizant Technology Solutions Corporation Derivative Litigation, No. 22-3027 (3d Cir. May 3, 2024)).

The court’s en banc decision aligns its thinking on demand futility appeals with its current practice of reviewing other dismissals on the pleadings de novo. It also aligns the federal-court standard within the circuit with the standard adopted by the supreme courts of two of its constituent states (Delaware and New Jersey). The First, Second, Seventh, Eighth, and Tenth Circuits also exercise de novo review in demand futility cases.

The plaintiffs argued that their appeal required de novo review because it challenged the district court’s inferences and analysis of Delaware law. Applying Blasband’s abuse-of-discretion standard to demand futility also raises practical issues, they argued, because a trial court applying Delaware law in this context exercises no discretion. The plaintiffs also pointed to a trend towards reviewing demand futility dismissals de novo.

The court agreed that this trend was persuasive. In fact, because other courts have abandoned the abuse-of-discretion standard, two of the out-of-circuit decisions relied upon in Blasband are no longer good law. The U.S. Supreme Court set out four factors for determining the standard of review of a district court decision, and each weighs in favor of de novo review in the demand futility context:

  1. Demand futility being a pleading issue, district courts are no better positioned than appellate courts to decide if demand is excused;

  2. Doctrines of demand futility are reasonably uniform and suited to general rules covering a wide range of circumstances;

  3. Nothing in the text of the applicable rules or state law indicates a preference for the trial court’s decision; and

  4. The substantial consequences of demand futility warrant more intensive review.

With regard to the second factor, the court observed that Blasband rested on the idea that demand futility “depends upon the facts of each case.” But this is also true of nearly every application of law to fact on a motion to dismiss, which are nevertheless reviewed de novo, even where particularized pleading requirements apply.

Otherwise, the appeals court wrote, “Blasband did not offer much, if any, rationale for adopting the abuse-of-discretion standard.” If the court then was following prevailing practice, the shift away from this practice in the interim undercuts stare decisis. The Supreme Court has also clarified that stare decisis is least consequential in cases involving procedural rules that tend not to produce reliance interests, and the en banc Third Circuit has never expressed a view on the issue presented here.

The court’s decision will be small comfort to the plaintiffs who advocated for it: even after de novo review, the court concluded that the plaintiffs had not shown demand futility. The plaintiffs never alleged that the directors who would have considered their demand knew that they were disseminating false or misleading information and thus faced liability for a breach of the duty of loyalty. Nor did they sufficiently allege that the directors faced a substantial likelihood of liability for engaging in corporate waste.

The case is No. 22-3027.

Judge: Fuentes, J.

Attorneys: William B. Federman (Federman & Sherwood) for John Lautzenheiser. James M. Ficaro (Weiser Law Firm) for Michael S. Graniero, III. Charles A. Brown (Goodwin Procter LLP) for Cognizant Technology Solutions Corp.

Companies: Cognizant Technology Solutions Corp.

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