Whether a shareholder derivative suit must be dismissed if the board of directors determines in good faith after the suit was filed that it is not in the best interests of the corporation.

The plaintiff, Halebian, is a shareholder in a mutual fund managed by the defendant CitiTrust. CitiTrust had contracts with another Citigroup subsidiary for asset management. In 2005, Citigroup sold the subsidiary to a third party, Legg Mason. CitiTrust terminated its old contract and entered a new contract for asset management with Legg Mason on the same terms. The CitiTrust shareholders approved the new agreement with Legg Mason using a procedure called “echo voting,” in which service agents would vote unvoted shares in the same proportion as the votes they had received.

Halebian sent a demand letter, arguing that the Board of CitiTrust should have sought to negotiate lower fees from Legg Mason or put the contract up for competitive bids. The letter also challenged the voting method used, apparently on the basis that echo voting was not permissible. The Board created a committee to review the demand.

When the committee did not respond within 90 days, Halebian filed (1) a derivative claim that the Board failed to act in the best interests of CitiTrust in entering the new agreement, and (2) a direct claim that voting procedures were improper, because the proxy statement failed to disclose that (a) the Legg Mason contract was unfair and (b) echo voting procedures are illegal. Six weeks later, the Board voted that the action was not in the best interests of CitiTrust. A federal district court concluded that the action must therefore be dismissed under Massachusetts law.

On appeal, the Second Circuit certified the following question to the SJC:

Under Massachusetts law, can the business judgment rule, established under Mass. Gen. Laws ch. 156D, § 7.44, be applied to dismiss a derivative complaint filed timely under section 7.42 but prior to a corporation’s rejection of the demand that serves as the basis for the suit?

1. Application of the business judgment rule. Under Massachusetts law, “A derivative proceeding commenced after rejection of a demand shall be dismissed by the court on motion by the corporation,” if the independent directors find that the suit is not in the best interests of the corporation. G.L. c. 156D, § 7.44(1). The question is whether this rule applies if the derivative suit is filed before rejection of the demand.
   
   The district court held that § 7.44 should also apply to derivative suits filed before rejection, on the basis of statutory commentaries, and also because the contrary rule would render meaningless the corporation’s ability to request a stay while it investigated the demand, pursuant to G.L. c. 156D, § 7.43. The Second Circuit was skeptical that the plain language of § 7.44 could be so easily overridden. It suggested that, reading the two sections harmoniously, rejection of a demand should bar suit only if the corporation actually does request a stay while it considers the demand.
2. Halebian’s direct claims. The Second Circuit held that Halebian’s first direct claim, that the proxy voting statement should have disclosed that the Legg Mason contract was unfair, was a derivative claim in disguise, and must be dismissed because it did not comply with the procedures for filing a derivative claim. Halebian’s second direct claim, that the proxy statement should have disclosed that echo voting is illegal, is hotly disputed by CitiTrust. The Second Circuit found that CitiTrust had no duty to disclose a fact it did not agree with, and planned to dismiss that claim as well.
   
   Regarding both direct claims, the Second Circuit delayed a final ruling and invited the SJC to weigh in. 

It was inevitable that the new Business Corporations Act, enacted in 2003, would introduce some uncertainties. In this case the question is whether a corporation should be able to avail itself of the same good faith defense when a plaintiff files on the basis of an ignored demand letter as on the basis of a rejected demand letter. The Second Circuit offers a functional compromise position: it would grant the corporation a § 7.44 dismissal when its proper evaluation takes longer than 90 days, and it therefore obtains a stay from the court, but not when it has simply ignored the demand letter until suit was filed. Although this position makes sense, and seems to harmonize § 7.44 with § 7.43, it will be interesting to see whether the SJC is willing to override the plain language of “A derivative proceeding commenced after rejection of a demand” in order to reach it.