In a decision generally protective of directors and officers, a Seattle federal district court recently held that shareholders who seek to bring derivative claims under Washington law must meet requirements similar to those imposed under Delaware law. In re Cray, Inc., 431 F. Supp. 2d 1114 (W.D. Wash. 2006). In addition to answering important questions about Washington law, the case underscores the benefits of good corporate governance practices, including having truly independent directors on the board. This case will be important for corporations incorporated in Washington, as well as in Oregon and other Model Business Corporation Act states.

This Update summarizes the key elements of the court's decision in Cray, and offers practical advice.

Background on the Cray Case

Derivative cases, in which a shareholder sues a corporation's directors and/or officers on behalf of the corporation, have become more common in recent years. The scenario is regrettably familiar to many directors and officers, as well as their advisors. A public company announces bad news and its stock price drops. A shareholder files a derivative lawsuit claiming that the directors and officers breached their fiduciary duties to the corporation by failing to prevent or disclose the alleged wrongdoing and by subjecting the corporation to the costs and potential damages of securities lawsuits arising from the same facts.

The Cray decision involved just such a follow-on derivative action. During a two-month period in spring 2005, Cray announced that its management had concluded that the corporation did not maintain effective internal controls over financial reporting. Cray's stock price dropped by approximately 50%, and a regulatory investigation and securities class actions followed. A Cray shareholder then filed a derivative action claiming that twelve of Cray's directors and officers had breached their duties to the corporation by failing to disclose the deficiencies in its internal controls.

The Court's Decision in Cray

The corporation and the individual defendants moved to dismiss the derivative complaint on a variety of grounds, including the plaintiff's failure to make a pre-litigation demand on Cray's board of directors. Applying Washington law, because Cray was a Washington corporation, the court granted the motion to dismiss. The court's decision includes at least four notable holdings for directors and officers.

Washington Law Requires a Substantive Demand. The court first held that Washington law requires a substantive demand, similar to the demand requirement for derivative claims imposed under Delaware law. Under that demand requirement, a derivative plaintiff may not sue on behalf of the corporation unless the plaintiff either

• first demands that the corporation bring the action and the corporation wrongfully refuses to do so, or
• shows that demand is excused because the directors are incapable of making an impartial decision.

The court ruled that this demand requirement flows from the fundamental principle that directors manage the affairs of the corporation. Because the decision whether to bring a lawsuit on behalf of the corporation concerns the management of the corporation's affairs, the board has the right to make that decision unless demand is excused.

When Is Demand Excused? When Specific Allegations Create a Reasonable Doubt That a Majority of Directors Were Disinterested or Independent. The court next spelled out the test for determining whether demand is excused: a court should determine whether "the particularized factual allegations" of the complaint create "a reasonable doubt" that, at the time the complaint was filed, a majority of the directors could have properly exercised their independent and disinterested business judgment in responding to a demand. A plaintiff can meet this standard only with specific allegations that a majority of the directors were either interested or lacked independence.

The Test for Excusing Demand Has Teeth. The court gave teeth to the test for excusing demand. To show that a director is interested, a plaintiff must plead with particularity facts showing that a director faces a "substantial likelihood of liability." A director is not interested simply because the director is named as a defendant in the lawsuit, served on the audit committee or had general responsibility for the matters at issue. Conclusory allegations of modest sales of stock likewise fail to show a substantial likelihood of insider trading liability sufficient to establish that a director is interested. To show that a director lacks independence, a plaintiff must plead facts showing that the director is beholden to an interested director or so under the interested director's influence that his or her judgment would be affected. The court indicated that the fact that an inside director earns substantial income from the company (and hence relies on the goodwill of other directors) may be sufficient to establish that a director lacks independence.

Plaintiffs Must Allege Damages Beyond Potential Litigation Costs and Loss of Company Goodwill. In addition to dismissing the complaint for failure to make a demand, the court also rejected the plaintiff's damages claims. The plaintiff alleged two types of damages: (1) costs incurred to investigate and defend against potential legal liability from a regulatory investigation and class action lawsuits filed by shareholders; and (2) harm to the company's image and goodwill that would impair the company's ability to raise equity capital or debt. Relying on decisions from other districts, the court rejected the former because claims for damages based on potential costs of litigation fail to state a claim for relief. The court rejected the latter because the plaintiff's allegations of damage to business reputation and lost goodwill were speculative and conclusory.

What Does It Mean? Good Governance Matters

The key lesson of Cray is that good governance matters. An independent board that follows good governance practices will be better positioned to have a derivative case dismissed at the outset – a significant victory for both the company and its directors and officers. Shareholders cannot circumvent the demand requirement simply by naming directors as defendants or alleging that they have overall responsibility for the matters at issue. By rejecting a broad brush approach and requiring plaintiffs to plead particularized facts showing that directors face a substantial likelihood of liability or are otherwise interested or lack independence, Cray puts the spotlight on the board's actual composition and the actual conduct of directors.

Conclusion

The Cray decision addresses previously unanswered questions about Washington corporate law and will likely be frequently cited in litigation involving derivative claims. By observing the lessons of Cray, directors will be in the best position to ensure that their right to decide whether to file a lawsuit on behalf of the corporation will be upheld, and their good governance will increase the likelihood that derivative claims will be disposed of expeditiously.

Additional Information

You can find the full text of the federal district court's decision at In re Cray, Inc., 431 F. Supp. 2d 1114 (W.D. Wash. 2006). You can find discussion of other recent court decisions, laws, regulations and rule proposals of interest to public companies on our website.