You Need to Make a Demand First Before Filing a Derivative Claim

United States Court of Appeals for the Third Circuit. Robert FREEDMAN, Appellant v. Sumner M. REDSTONE; Philippe P. Dauman; Thomas E. Dooley; George S. Abrams; Alan C. Greenberg; Shari Redstone; Frederic V. Salerno; Blythe J. McGarvie; Charles E. Phillips, Jr.; William Schwartz; Robert K. Kraft; Viacom, Inc. No. 13–3372. Decided: May 30, 2014 

The United States Court of Appeals for the Third Circuit affirmed the Delaware District Court’s July 16, 2013 decision by further solidifying the most basic requirements for filing a derivative and direct claim. The plaintiff, Robert Freedman, as a stockholder, failed to make a pre-suit demand to Viacom’s Board of Directors in his derivative claim. Also, the plaintiff failed to state a cause of action in his direct claim against the defendant. As such, the District Court dismissed the case, which the Third Circuit affirmed.

On May 30, 2007, Viacom, a publicly traded entertainment corporation incorporated in Delaware, approved of a plan, the Senior Executive Short-Term Incentive Plan, which capped the eligibility of awards by executives at $51.2 million a year.  The compensation exceeding $1 million paid by a corporation to senior executives is not generally a deductible business expense under federal tax law; however, it could be deductible by adopting a specific compensation plan approved by both the board of directors and a shareholder vote.  Therefore, to make these awards tax deductible, Viacom tied provisions to its bonuses to the achievement of specific goals that related directly to its financial success. In 2012, following Treasury Regulations 26 C.F.R. § 1.162–27(e)(4)(vi) that require corporations to obtain stockholder approval every five years, Viacom’s board brought another compensation plan to its shareholders for a vote. Per Delaware law, Viacom provided shareholders the option of purchasing Class A Stocks, containing voting privileges, and Class B Stocks, that did not give shareholders the right to vote.

Robert Freedman purchased Class B Stocks of Viacom. Upon the implementation of the 2012 plan, Freedman filed a complaint in the Delaware District Court including both a direct and derivative claim. In his direct claim, Freedman alleged that the Committee failed to comply with the procedure by including non-financial qualitative factors to determine the percentage of bonus an executive would receive. Also, the 2012 plan violated 26 U.S.C § 162(m) by withholding the ability of Class B shareholders to participate in the vote, for he contends that a federal tax law requires, in allowing executive compensation over $1 million to be tax deductible, that the compensation be awarded with the inclusion of all shareholders, with or without voting rights. He sought over $36 million in damages, injunctive relief to prevent the enforcement of the 2012 Plan, and a new vote that would include Class B shareholders in the adoption of a new plan. Between 2007 and 2011, Freedman makes the point that the executives received an excess compensation of approximately $36 million.

The Internal Revenue Code, more specifically 26 U.S.C § 162(m), however, does not provide for voting rights to a stockholder holding a non-voting share. Continuing, §162 also does not mention any language of voting rights or the process of shareholder voting, but it only details the taxability of business expenses. Because Delaware corporate law expressly provides for the ability for corporations to sell stock without limitations, including non-voting shares of stock, the Viacom board was within its rights to exclude Class B stockholders from voting on the Plan.

Freedman also contends in his derivative claim that the shareholders were unjustly enriched due to the excessive payment that its executives received. Thus, the decision to allow certain bonuses was not a “valid exercise of business judgment” since Sumner Redstone (Board of Directors Chairman) owns 79.5% Class A shares, he argues it would be inevitable that such a compensation plan would be approved and adopted.

The Third Circuit agreed with the factual allegations of Freedman, and did interpret the complaint with favor towards Freedman. Before filing a derivative claim on behalf of a corporation, as Freedman sought to do, however, the plaintiff is required to first make a demand to the corporation’s board of directors. If the plaintiff does not first make this demand, the plaintiff must provide reasonable doubt why such a demand would be useless per Fed.R.Civ.P. 23.1(b)(3). Specifically, it must create reasonable doubt about whether the “directors are disinterested and independent” or “the challenged transaction was otherwise the product of a valid exercise of business judgment.” (citing Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984)).  Since Freedman did not make a pre-suit demand to the Board of Directors or present sufficient allegations explaining why a demand would have been futile, the Third Circuit said the District Court was correct in dismissing the derivative claim.

With this decision, the Third Circuit made a clear message to future corporate litigators on what minimum requirements must be met before bringing a substantive derivative claim.

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