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Levine v. Smith

Supreme Court of Delaware
591 A.2d 194 (1991)
ELI5:

Rule of Law:

When a shareholder makes a pre-suit demand on a board of directors, the shareholder tacitly concedes the board's independence, and judicial review of the board's refusal is limited to the traditional business judgment rule, which examines the good faith and reasonableness of the board's investigation.


Facts:

  • In 1984, General Motors (GM) acquired Electronic Data Systems (EDS), a company founded by H. Ross Perot.
  • As part of the acquisition, Perot became GM's largest single shareholder and was appointed to the GM Board of Directors.
  • Numerous disputes arose between Perot and GM management, leading Perot to publicly criticize GM's leadership and product quality.
  • Perot demanded that GM either buy out his interests or allow him to operate EDS as he saw fit, and he also threatened to sue GM.
  • On November 30, 1986, an Oversight Subcommittee composed of GM's outside directors reviewed and unanimously recommended a repurchase of Perot's stock.
  • On December 1, 1986, the full GM Board (excluding Perot) unanimously approved the transaction to buy back all stock held by Perot and his associates for approximately $742.8 million.
  • The agreement included terms requiring Perot to refrain from future criticism of GM, not to compete with EDS for three years, and not to engage in a proxy contest against GM for five years.

Procedural Posture:

  • Shareholder Grobow filed a derivative suit in the Delaware Court of Chancery, alleging demand was futile. The court dismissed the complaint, and the dismissal was affirmed on appeal in Grobow I.
  • Grobow was granted leave to file a Second Amended Complaint based on newly discovered evidence, which the Court of Chancery then dismissed for again failing to plead demand futility.
  • Separately, shareholder Levine made a written demand on the GM Board to rescind the Perot repurchase transaction.
  • The GM Board considered the demand at its next meeting and unanimously voted to reject it.
  • Levine then filed a derivative suit in the Court of Chancery, alleging the board's refusal was wrongful.
  • The Court of Chancery denied Levine's request for discovery and subsequently granted GM's motion to dismiss the complaint for failure to state a claim under Rule 23.1.
  • Both Grobow and Levine appealed the dismissals of their respective complaints to the Delaware Supreme Court, which consolidated the cases.

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Issue:

Does a shareholder plaintiff who makes a pre-suit litigation demand on a board of directors thereby waive the right to challenge the board's independence, limiting judicial review of the board's refusal to the traditional business judgment rule's standards of good faith and reasonableness?


Opinions:

Majority - Horsey, Justice

Yes. By making a pre-suit demand, a shareholder plaintiff tacitly concedes the independence of a majority of the board to respond. Therefore, when a board refuses a demand, judicial review is limited to the traditional business judgment rule, and the only issues to be examined are the good faith and reasonableness of the board's investigation. The first part of the Aronson test, which examines director interest and independence, is not applicable in a demand-refused case. A plaintiff must plead particularized facts creating a reasonable doubt that the board acted on an informed basis and in good faith. Here, shareholder Levine, by making a demand, conceded the GM Board's independence. His claims that the board's refusal was uninformed—because it did not permit him to make an oral presentation and 'did nothing'—are conclusory and insufficient. A board is not obligated to hear oral presentations, and the board’s letter of refusal, stating it had reviewed the matter, contradicts the conclusory allegation that it did nothing, creating an inference that it acted on an informed basis. In the companion demand-futility case (Grobow II), the plaintiffs failed to plead particularized facts creating a reasonable doubt that a majority of GM's outside directors were either not independent or acted with gross negligence.



Analysis:

This decision solidifies the critical distinction between 'demand refused' and 'demand futility' derivative actions under Delaware law. It establishes that a shareholder's choice to make a demand is a pivotal strategic decision, as doing so constitutes a waiver of the right to challenge the board's independence. This significantly raises the pleading burden for shareholders in demand-refused cases, forcing them to attack the procedural soundness of the board's decision under the highly deferential business judgment rule, rather than attacking the substance of the underlying transaction or the board's conflicts of interest. The ruling strengthens the board's managerial authority and makes it more difficult for shareholders to proceed with derivative litigation once a board has formally rejected their demand.

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