Supreme Judicial Court reaffirms the plenary power of a board of directors to determine whether maintenance of a derivative lawsuit is in the best interest of the company and expands the Massachusetts Business Corporations Act to Massachusetts business trusts.
On August 23, 2010, the Massachusetts Supreme Judicial Court (SJC) ruled in Halebian v. Berv that the business judgment rule can be applied to a derivative complaint that is filed prior to a board's rejection of the demand that serves as the basis for the suit. The ruling reaffirmed the plenary power of a board to determine whether maintenance of a derivative lawsuit is in the best interest of the company, so long as the board is acting in good faith and after reasonable inquiry. The Halebian decision is also notable because it applied the derivative proceeding provisions of the Massachusetts Business Corporations Act to a mutual fund organized as a Massachusetts business trust, rather than a corporation.
The case arose from a shareholder suit brought against Citifunds Trust III, an investment company organized as a Massachusetts business trust. Following receipt of a demand letter from a shareholder, the board organized a special committee of independent trustees to consider the demand. More than ninety days after the date of the original demand letter, having received no definitive response from the board, the plaintiff filed suit. Six weeks later, the board rejected the shareholder's demand and formally declined to bring any action against the trustees. The district court then dismissed the case, citing Section 156D of the Massachusetts Business Corporations Act, which provides that "[a] derivative proceeding commenced after rejection of a demand" by the board shall be dismissed if the court finds that the independent members of the board have "determined in good faith after conducting a reasonable inquiry" that "the maintenance of the derivative proceeding is not in the best interests of the corporation."
The Court of Appeals for the Second Circuit declined to rule on the plaintiff's appeal, instead certifying to the SJC the question of whether the phrase "commenced after rejection of a demand" limits the power of a board where the derivative suit is commenced before rejection of a demand.
The question before the SJC, certified to it by the Second Circuit, was whether the business judgment rule, codified in the Massachusetts Business Corporation Act, G. L. c. 156D, applies to dismiss a shareholder derivative suit that was filed before the corporation's board of directors refused the demand underlying the suit. The "business judgment rule" is a legal concept that essentially protects directors from liability if they perform their duties in good faith and are mindful of protecting the interests of the corporation. More narrowly stated, the question posed to the SJC was whether the phrase "commenced after rejection of a demand" in the Act limits the power of a board where the derivative suit is commenced before rejection of a demand.
The defendants, the board of trustees of a Massachusetts mutual fund organized as a Massachusetts business trust, refused the shareholder demand underlying the derivative suit after the derivative suit was timely filed under the Act. The plaintiff, a shareholder in the mutual fund, argued that the Act restricts the business judgment rule to pre-suit refusals. The plaintiff relied on language in the Act that "[a] derivative proceeding commenced after rejection of a demand shall be dismissed by the court on motion by the corporation if the court finds that [the board of directors] has determined in good faith after conducting a reasonable inquiry upon which its conclusions are based that the maintenance of the derivative proceeding is not in the best interests of the corporation[.]" G. L. c. 156D, § 7.44(a) (emphasis added).
The SJC held that the statute was not intended to impose any temporal limit on the plenary authority of the board to reject a demand and affirmed that the business judgment rule should apply to such determinations. In doing so, the Court recognized the need to find a reasonable balance between the competing goals of corporate autonomy and corporate accountability when dealing with shareholder derivative suits. While the Act recognized and legitimizes a shareholder's role in holding directors accountable to their duties owed to the corporation and requires boards to respond promptly to shareholder demands, the Act also preserves management's autonomy by codifying the well-established business judgment rule and establishing a universal written demand requirement.
While prompt decisions by a board are encouraged, the reality is that boards may require more time to make that decision and need the latitude to make complete that decision-making process even after suit is brought. The balancing of interests that the Act provides would be skewed and thrown off if the Act were interpreted to arbitrarily limit the business judgment rule to a board's decision made only before the filing of a derivative suit. The decision in Halebian is consistent with the SJC's clear precedent recognizing that "[t]he business judgment rule affords protection to the business decisions of directors, including the decision to institute litigation, because directors are presumed to act in the best interests of the corporation."Harhen v. Brown, 431 Mass. 838, 845 (2000). Ultimately, the SJC recognized that there is no conceivable policy served in depriving management of the business judgment rule merely because a shareholder has filed a derivative suit before the board has reached a decision. Implicit in the ruling is the notion that the Act should not be interpreted to encourage judicial second-guessing of corporate litigation decisions and chill managerial autonomy.
In reaching its conclusion, the SJC also held that "[b]ecause a business trust ‘in practical effect is in many respects similar to a corporation,' . . . the statute regulating derivative actions applies to a shareholder bringing such a claim against a corporation or a business trust." Because there are a substantial number of mutual funds organized as Massachusetts business trusts, the Court's ruling in Halebian will have significant impact on derivative suits involving mutual funds, including numerous pending derivative claims concerning auction rate securities. Mutual fund companies organized in Massachusetts can depend on the predictable procedures and protections set forth in the framework of the Act.
As a practical matter both shareholders contemplating a demand of the board and derivative suit and Boards of Directors faced with shareholder demands should consult with counsel regarding issues of corporate governance, timing and duties and rights of the respective parties under the Act.
This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.
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