Starrels v. First Nat. Bank of Chicago, 88-1586

• Decision Date: 24 February 1989
• Docket Number: No. 88-1586,88-1586
• Citation: 870 F.2d 1168
• Parties: Fed. Sec. L. Rep. P 94,354 Joel STARRELS, in a derivative capacity and individually and on behalf of all others similarly situated, Plaintiff, v. FIRST NATIONAL BANK OF CHICAGO, a national banking institution, et al., Defendants-Appellees. Appeal of Patricia Starrels BERNSTEIN, as Legatee of Joel Starrels, deceased, individually, and in a derivative capacity, and on behalf of all others similarly situated.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1168

870 F.2d 1168

Fed. Sec. L. Rep. P 94,354

Joel STARRELS, in a derivative capacity and individually and on behalf of all others similarly situated, Plaintiff, v. FIRST NATIONAL BANK OF CHICAGO, a national banking

institution, et al., Defendants-Appellees.

Appeal of Patricia Starrels BERNSTEIN, as Legatee of Joel

Starrels, deceased, individually, and in a

derivative capacity, and on behalf of

all others similarly situated.

No. 88-1586.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 1, 1988.

Decided Feb. 24, 1989.

Marshall Patner, Marshall Patner, P.C., Chicago, Ill., for appellant.

Charles W. Douglas, Sidley & Austin, Charles W. Boand, Burke, Wilson & McIlvaine, Chicago, Ill., for defendants-appellees.

Before WOOD and EASTERBROOK, Circuit Judges, and ESCHBACH, Senior Circuit Judge.

ESCHBACH, Senior Circuit Judge.

This appeal challenges the district court's dismissal with prejudice of the appellant's third amended and consolidated complaint. ¹ In essence, this is a shareholder derivative and class action suit asserting that the directors and officers of First Chicago Corporation ("FCC") and First National Bank of Chicago ("FNBC") have egregiously mismanaged the affairs of the corporations. The appellant raises two contentions on appeal. First, she argues that the district court erred in ruling that she was not a proper party plaintiff under Fed.R.Civ.P. 23.1. Second, the appellant contends that the district court erred in ruling that she should have made a demand upon the directors to bring this suit prior to the filing of this complaint. For the reasons stated below, we affirm the district court's dismissal with prejudice of the third amended and consolidated complaint for failure to make a demand upon the directors or to allege with particularity facts sufficient to excuse such a demand as futile. Because the appellant's failure to make a demand or allege specific facts excusing a demand prohibits her from maintaining this derivative suit, we do not need to reach the issue of whether she was a proper party plaintiff under Fed.R.Civ.P. 23.1.

I

On July 16, 1985, Joel Starrels, a shareholder of FCC, filed a derivative and class action suit in the Circuit Court of Cook County, Illinois. He sued the appellees, FCC, FNBC (a wholly-owned subsidiary of FCC), their officers and directors, and Arthur Andersen & Co. (accountants for FCC and FNBC), for negligence, mismanagement, malfeasance, bad faith, abuse of discretion, breach of fiduciary duty, and waste of corporate assets. Two days later, Starrels sued the appellees in federal district court for RICO violations.

After the appellees had the state court suit removed to the federal district court, they filed motions for dismissal based on various grounds, including that Starrels had failed to comply with the requirements of Fed.R.Civ.P. 23.1 and Delaware corporate law because he did not make a demand upon the directors to bring this suit or allege with particularity why such demand would be futile. Instead of responding to the motion to dismiss, on December 6, 1985, Starrels filed an amended and consolidated complaint. The defendants again filed motions to dismiss arguing in part that Starrels did not allege with particularity why demand upon the directors would be futile.

On January 30, 1986, Starrels died. Pursuant to the terms of his will, the executor assigned some of his stock in FCC to Patricia Starrels Bernstein, the appellant. On June 24, 1986, Bernstein filed a second amended and consolidated complaint naming herself as the substitute derivative plaintiff. Once again, the appellees responded by filing motions to dismiss for failing to allege with particularity why demand would be futile and by opposing the substitution of Bernstein as plaintiff.

On December 15, 1986, the district court dismissed without prejudice Bernstein's second amended and consolidated complaint for failing to comply with Fed.R.Civ.P. 23.1. First, the court found that under Rule 23.1 and Delaware law the plaintiff should have made a demand upon the directors to bring this suit. Second, the court found that Bernstein did not receive her stock in FCC "by operation of law" as required by Rule 23.1, therefore, she was not a proper party plaintiff. On February 18, 1987, Bernstein moved for leave to file a third amended and consolidated complaint. One year later, the district court dismissed her third amended and consolidated complaint with prejudice. ²

II

The appellant contends that the district court erred in ruling that under FED.R.CIV.P. 23.1 she should have made a demand on the directors to bring this suit. Bernstein does not claim that she had made such a demand upon the directors. Rather, she argues that a demand was excused because it would have been futile. ³ Whether the appellant was required to make a demand before bringing this suit is an issue left to the discretion of the district court. Therefore, assuming no error of law has been made, we review its determination under an abuse-of-discretion standard. Nussbacher v. Continental Ill. Nat'l Bank & Trust Co., 518 F.2d 873, 878 (7th Cir.1975), cert. denied, 424 U.S. 928, 96 S.Ct. 1142, 47 L.Ed.2d 338 (1976); Fields v. Fidelity Gen. Ins. Co., 454 F.2d 682, 684-85 (7th Cir.1972); accord Gaubert v. Federal Home Loan Bank Bd., 863 F.2d 59, 68 n. 10 (D.C.Cir.1988); Kaster v. Modification Sys., 731 F.2d 1014, 1018 (2d Cir.1984); Lewis v. Graves, 701 F.2d 245, 248 (2d Cir.1983); Greenspun v. Del E. Webb Corp., 634 F.2d 1204, 1208 (9th Cir.1980).

Rule 23.1 provides in pertinent part:

In a derivative action brought by one or more shareholders ... [t]he complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action he desires from the directors ... and the reasons for his failure to obtain the action or for not making the effort.

FED.R.CIV.P. 23.1 (emphasis added). This rule does not always require a shareholder to make a demand upon the directors in order to bring a derivative suit. If the shareholder does not make such a demand, he need only state with particularity why such a demand would have been futile. Nussbacher, 518 F.2d at 877; see Lewis, 701 F.2d at 248; Cramer v. General Tel. & Elecs. Corp., 582 F.2d 259, 276 (3d Cir.1978), cert. denied, 439 U.S. 1129, 99 S.Ct. 1048, 59 L.Ed.2d 90 (1979). It is not enough for the shareholder "to state in conclusory terms that he made no demand because it would have been futile." 7C C. WRIGHT, A. MILLER & M. KANE, FEDERAL PRACTICE AND PROCEDURE Sec. 1831, at 117 (1986).

Rule 23.1 "concerns itself solely with the adequacy of the pleadings; it creates no substantive rights." Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 544, 104 S.Ct. 831, 842, 78 L.Ed.2d 645 (1984) (Stevens, J., concurring). Any substantive rights that directors of a corporation may have in a demand requirement revolves around state law. See Burks v. Lasker, 441 U.S. 471, 477-78, 99 S.Ct. 1831, 1837, 60 L.Ed.2d 404 (1979) ("As we have said in the past, the first place one must look to determine the powers of corporate directors is in the relevant State's corporation law." (citations omitted)); Lewis v. Curtis, 671 F.2d 779, 785 (3d Cir.1982) (noting that a plaintiff's allegations must show under state law that the directors lacked disinterestedness). ⁴ Therefore, we must look to the law of Delaware, the state of incorporation of FCC, to determine the substantive rights of the appellees. The issue, then, is whether the appellant's third amended and consolidated complaint states with particularity (federal procedural requirement under Rule 23.1) facts which would excuse a demand upon the directors as futile under Delaware corporate law (substantive state law). See Cottle v. Hilton Hotels Corp., 635 F.Supp. 1094, 1097 (N.D.Ill.1986).

Under Delaware law, the rule that a shareholder must make a demand upon a corporation's directors before initiating a derivative suit, unless such demand would be futile, is more than a mere pleading requirement; it is a substantive right. Aronson v. Lewis, 473 A.2d 805, 809 (Del.1984); Haber v. Bell, 465 A.2d 353, 357 (Del.Ch.1983). The standard for determining whether a complaint adequately alleges demand futility is: "whether taking the well-pleaded facts as true, the allegations raise a reasonable doubt as to (i) director disinterest or independence or (ii) whether the directors exercised proper business judgment in approving the challenged transaction." Grobow v. Perot, 539 A.2d 180, 186 (Del.1988); accord Pogostin v. Rice, 480 A.2d 619, 624 (Del.1984); Aronson, 473 A.2d at 814; Good v. Getty Oil Co., 514 A.2d 1104, 1107 (Del.Ch.1986). Moreover, conclusory allegations of fact or law contained in the complaint need not be considered true in determining demand futility unless they are supported by specific facts. Grobow, 539 A.2d at 187; Kaufman v. Belmont, 479 A.2d 282, 285 (Del.Ch.1984).

In the case before us, the appellant does not claim that the directors were in any way interested in the transactions of which she complains. Rather, Bernstein asserts that the directors' actions were not the product of proper business judgment. Therefore, we need to examine Bernstein's third amended and consolidated complaint only to see if it raises a reasonable doubt that the directors exercised proper business judgment. Under Delaware law, this requires us to look at both the substantive due care (substance of the transaction) as well as the procedural due care (an informed decision) used by the directors. See Grobow, 539 A.2d at 189.

The appellant makes several allegations challenging the substantive due care used by the directors. In her third amended and consolidated complaint, Bernstein lists numerous transactions which she claims were not the product of proper business judgment. First, she alleges that FNBC and FCC, acting under the domination, direction, or control of the officers and directors, entered into a...