The U.S. District Court for the Western District of Tennessee (the “District Court”) (Judge Mays presiding) issued an order (the “Order”) that dismissed without prejudice claims brought by certain shareholders (the “Plaintiffs”) in an investor class action suit against the investment adviser (the “Former Adviser”) to four affiliated closed-end mutual funds (the “Funds”), certain personnel of the Former Adviser and the former directors of the Funds (the “Former Board”), alleging losses incurred as a result of investments in risky illiquid mortgage-related securities that were inconsistent with the Funds’ investment objective, and violated its industry concentration policy. Additionally, the complaint alleged that the Former Adviser failed to disclose the extent of the Funds’ investment in mortgage-related securities and artificially inflated the net asset value of the Funds’ by overstating the value of the mortgage-related securities. The allegations in the complaint generally track the findings made by the SEC and FINRA in settled administrative proceedings focused on the Funds’ investments in mortgage-related securities. Those administrative proceedings were described in the April 20, 2010 Financial Services Alert and the July 5, 2011 Financial Services Alert. The wrongdoing alleged by the Plaintiffs took place during the period between 2007 and 2009 when the Funds operated as part of the Former Adviser’s mutual fund complex under the oversight of the Former Board. The Funds currently operate under the oversight of an entirely new board of directors (the “New Board”) and the Funds’ investments are directed by a new investment adviser.
Background. The Plaintiffs filed the complaint (the “Complaint”) alleging damages on behalf of the Funds on March 18, 2010 and amended the Complaint on December 6, 2010. Prior to filing the Complaint, the Plaintiffs made demand on the New Board requesting that they bring an action on behalf of the Funds in November 2009. The New Board responded to the Plaintiffs by letter dated December 12, 2010 (the “Response Letter”) stating that:
“[I]n the course of related pending derivative litigation involving the former directors and/or officers and the former investment adviser of the Funds, the current Boards of Directors of the Funds are conducting an investigation to determine whether the Boards of Directors of the Funds should take action against the Funds’ former directors, officers or investment adviser with respect to similar allegations.”
The Plaintiffs filed the complaint approximately four months after the Demand and two months after delivery of the Response Letter.
Applicable Law. Based in large part on the fact that the Funds are organized as Maryland corporations, the District Court determined that Maryland law governed its decision. The District Court stated that because the action is derivative in nature and brought by shareholders on behalf of the Funds, Maryland law requires the Plaintiffs to “overcome a number of procedural hurdles and demonstrate that [they], rather than the corporation itself, should control the litigation.” The District Court explained that “[b]efore filing suit on the corporation’s behalf, the [Plaintiffs] must (1) ‘make a good faith effort to have the corporation act directly,’ an effort known as making demand on the corporation, or (2) demonstrate that making demand would be futile.” Further, the District Court explained that once demand has been made, the corporation’s board of directors must conduct an investigation into the allegations in the demand to determine whether bringing an action is in the best interests of the corporation, and that the courts will look to the timing of the filing of the plaintiff’s complaint to determine whether the demand was proper. If the corporation fails to take the action requested by the demand, the shareholders may then bring an action on a demand-refused basis.
The District Court noted that there is a limited futility of demand exception that applies “only when the allegations or evidence clearly demonstrate, in a very particular manner, either that (1) a demand, or a delay in awaiting a response to a demand, would cause irreparable harm to the corporation, or (2) a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to a demand in good faith and within the ambit of the business judgment rule.” The District Court observed that once shareholders have made a demand they may not claim that the board of directors was unable to act independently, but they may allege that the “board did not act independently or that demand was wrongfully refused.”
The District Court’s Analysis. In filing the Complaint, the Plaintiffs argued that the Response Letter demonstrated that the New Board had not conducted an investigation, did not intend to conduct an investigation and had not provided a “good faith response.” In dismissing this argument, the District Court stated that having made demand, the Plaintiffs could not bring the action until the New Board completed its investigation. The District Court also ruled that the futility of demand exception was not available to the Plaintiffs because (1) in making demand on the New Board, they waived any claim that they might have had that the New Board could not “independently act on the demand;” (2) the Plaintiffs could not show that “a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to [the demand] in good faith and within the ambit of the business judgment rule;” and (3) there were no allegations of irreparable harm to the Funds if Plaintiffs could not proceed with their derivative action before the New Board completed its investigation.
The District Court found that the Plaintiffs did not have standing to bring a “demand refused” action because they did not wait for the New Board to complete its investigation of the allegations before filing the Complaint. The District Court stated that in order to bring a “demand refused” action the Plaintiffs must “exhaust their intra-corporate remedies” before filing the Complaint, noting that “[n]othing in Maryland law suggests that plaintiffs who have made demand on a board of directors may bring a derivative action before the board has completed its investigation. Maryland law suggests the opposite.”
Dismissal of Complaint. Having determined that the Plaintiffs lacked standing to bring a demand refused action, the District Court considered whether to dismiss the complaint or to stay the proceeding. The District Court determined that there was no Maryland authority addressing the situation alleged in the Complaint in which a board had responded to a plaintiff’s demand. Observing that “[i]n the absence of authority, Maryland generally follows Delaware law,” the District Court looked to a Delaware decision dismissing a derivative action brought before a board of directors had completed its investigation. The District Court determined that because the New Board responded to the demand via the Response Letter and the Complaint was filed only two months after receipt of the Response Letter it was appropriate to dismiss the complaint without prejudice.