Shareholder derivative lawsuits allow an individual shareholder to bring a lawsuit to assert claims on behalf of a corporation. To provide a corporation the opportunity to take control of proposed litigation, a shareholder must first make a demand to the board of directors to take a specified action or pursue legal claims before initiating a shareholder derivative lawsuit (FRCP 23.1(b)(3)).

If the board rejects the demand, the shareholder may only bring a derivative lawsuit if the board's rejection was wrongful. To show a wrongful rejection, a shareholder must overcome a presumption that in making a business decision, the board honestly believed that it has acted in the best interest of the corporation, on an informed basis and in good faith, afforded to corporate boards by the so-called business judgment rule. If the shareholder cannot demonstrate wrongful rejection of a demand, the court will dismiss the derivative complaint for failure to state a claim. While most Circuits review the dismissal of a shareholder derivative lawsuit for abuse of discretion, there is a growing consensus that the applicable standard of review should be de novo.

Because of the deference given to the decisions of a board of directors under the business judgment rule, shareholder derivative plaintiffs face an uphill climb when trying to demonstrate that the rejection of a demand was wrongful. A recent opinion from the US Court of Appeals for the Second Circuit demonstrates the difficulties shareholder face when a board rejects a demand, and when appealing a court order dismissing a shareholder derivative complaint, especially in the Circuits where the appellate court is bound by precedent to review the lower court's ruling under the abuse of discretion standard.

In Espinoza v. Dimon, the shareholder commenced a shareholder derivative action on behalf of JPMorgan Chase after the board rejected his demand that it investigate JPMorgan's actions related to the "London Whale debacle" (No. 14-1754, , at *2 (2d. Cir. June 16, 2015)). In his shareholder derivative complaint, the plaintiff alleged that Jamie Dimon, the CEO of JPMorgan, transformed JPMorgan's Chief Investment Office (CIO), the office charged with managing and investing excess cash from JPMorgan's other businesses, from a conservative risk-management unit into an aggressive proprietary-trading desk aimed to generate additional profit by taking riskier positions, specifically in the synthetic credit derivatives market (Espinoza, , at *1).

A group of traders led by a London trader Bruno Iksil, nicknamed the "London Whale," made large bets in the synthetic credit derivatives market, but once they started to sour, the plaintiff alleged that the CIO invested even more money in other risky derivatives to try to shore up the investments. The plaintiff also alleged that JPMorgan modified its "Variance at Risk" (VaR) model to conceal its losses and give the impression that its overall risk remained constant, even though an unmodified VaR model would show that JPMorgan's risk had doubled. (Espinoza, , at *1.)

While the media reported in early 2012 that the CIO's positions in the credit derivative market had become so large that they were driving price moves, JPMorgan's corporate executives repeatedly dismissed such reports in a conference call with analysts and investors and claimed that the CIO was conservatively investing in safe securities. Shortly thereafter, JPMorgan was forced to disclose the extent of the CIO's losses (which exceeded $6.25 billion) and how it had modified its VaR model to minimize the scale of the risks taken by the CIO. This incident prompted numerous regulatory and Congressional investigations into JPMorgan's oversight of the CIO. (Espinoza, , at *2.)

Less than two weeks after JPMorgan revealed the CIO's losses, Ernesto Espinoza, a JPMorgan shareholder, delivered a letter to the board of directors demanding that JPMorgan:

(Espinoza, , at *2.)

Responding to the shareholder's demand, JPMorgan created a review committee to investigate the incident and evaluate what actions JPMorgan might take in response. After the review committee concluded its investigation, the board informed the shareholder that it decided not to pursue litigation because various remedial measures had already been taken and because of the litigation's likely high costs and other adverse effects it may have on the company. (Espinoza, , at *3.)

The plaintiff filed a shareholder derivative complaint in the US District Court for the Southern District of New York and argued that the board had wrongfully refused his demand. The district court dismissed the complaint for failure to state a claim because it did not allege that the board failed to exercise proper business judgment when it rejected the plaintiff's demand. The court also refused to grant leave to amend. (Espinoza, , at *3.)

When evaluating whether a shareholder's demand was wrongfully refused for the purposes of the demand requirement in shareholder derivative litigation, courts look to state law (Espinoza, , at *3). Under Delaware law, the law applicable to this case, courts must evaluate whether the corporation's investigation was reasonable and performed in good faith (Espinoza, , at *4).

Before assessing whether the district court properly concluded that JPMorgan's investigation was reasonable and performed in good faith, the Second Circuit spent a great amount of time discussing the standard of review it uses when reviewing dismissals of derivative actions. While dismissals of civil complaints are usually reviewed de novo, dismissals of shareholder derivative complaints in the Second Circuit are reviewed under an abuse of discretion standard of review (Espinoza, , at *4). Referring to the First and Seventh Circuits' recent adoption of a de novo standard, as well as opinions in other circuits questioning the appropriateness of an abuse of discretion standard in shareholder derivative actions, the Second Circuit called for an adoption of the de novo standard of review for dismissals of derivative complaints because:

(Espinoza, , at *5-6.)

Despite its endorsement of a de novo review of dismissals of shareholder derivative actions, the Second Circuit had no choice but to review the dismissal of this shareholder derivative action under an abuse of discretion standard (Espinoza, , at *6).

After analyzing Delaware law on the issue of a board's wrongful rejection of a shareholder's demand, the Second Circuit limited its inquiry on whether the district court abused its discretion in finding that JPMorgan's board did not commit gross negligence in conducting its investigation. Guided by the business judgment rule, the Second Circuit found that the district court did not abuse its discretion when it dismissed the plaintiff's derivative complaint. (Espinoza, , at *8.)

However, based on the Second Circuit's strong endorsement of the de novo standard of review for dismissals of derivative complaints and its explicit refusal to affirm the dismissal under a de novo standard as well (as the appellees requested), the Second Circuit may have indicated that it may have reversed the district court's dismissal had it been able to review it de novo (see Espinoza, , at *6, fn. 5).

As this case shows, plaintiffs continue to face challenges when filing a derivative complaint after a board of directors rejects a pre-suit demand and appealing a dismissal of a derivative complaint, especially in the Circuits using an abuse of discretion standard of review. However, given that multiple Circuits have called for the adoption of a de novo standard of review for dismissals of shareholder derivative complaints, counsel should closely monitor federal appellate decisions in these cases.

For more information on shareholder derivative litigation, see Practice Note, Shareholder Derivative Litigation, Practice Note, Special Litigation Committees in Shareholder Derivative Litigation, and Article, Shareholder Derivative Litigation: Pre-suit Demands from Purported Shareholders.