It's time for federal judges to stop trying to guess what corporate boards would do in hypothetical situations.
That's the conclusion of the U.S. Court of Appeals in Chicago, which finally bowed to the criticisms of scores of legal commentators and threw out what is known as the "futility defense."
The issue comes up in derivative suits, those brought by a shareholder in the name of a company. Often such litigation claims the actions of top officials are in truth hurting the company.
Before a judge will hear such a case, he or she wants to know why the company isn't pursuing the claim itself instead of through a surrogate. Usually the plaintiff has to show that the company was told about the pending lawsuit, and chose not to bring it directly.
But if the plaintiffs have not made such a demand on the company, courts have allowed them to raise the futility defense -- to argue that the board would not have agreed to the suit, so it would have been a complete waste of time and effort to make the request.
It is that exception that the Chicago judges decided July 18 to do away with. In Kamen v. Kemper Financial Services, a suit in which a shareholder in a money market fund complained that fees charged by the fund's investment adviser were too high, the judges said that in most derivative suits the litigant must first go to the company's top brass with the dispute. The only exception: suits based on state laws in states that do not require such advance notice. The new rule gives companies a big break.
It's not just the lost time or a desire to avoid rejection that keeps dissident shareholders from asking company officials to bring their suits. A turndown actually makes it much harder to win a suit challenging the corporation's practices. Here's why: Courts generally will defer to the business judgment of a corporation's board, especially if the decision is made by a majority of the directors not directly affected.
So if a stockholder asked the company to institute a suit and the board turns down the proposal, in most instances judges will assume that they knew what they were doing. If they never considered the suit nor voted on the issue, of course, it is less clear what their business judgment is.
To try to soften the blow to aggressive shareholders from the end of the futility defense, the Chicago judges promised federal courts will not give too heavy weight to a board's rejection of a demand to sue.
But they admitted that in Delaware courts, such a formal rejection will almost always mean that the shareholder will not be able to continue a suit in the company's name.
In other cases, courts ruled that:
A company cannot insist on shutting a union out of discussions with workers over early retirement benefits. The National Labor Relations Board had called such a demand by the Toledo Blade a legitimate subject for collective bargaining, and, in fact, the newspaper had twice won union agreement to a contract clause freezing the union out of negotiations over retirement pay offers.
The publishers wanted the right to approach typographers individually to try to buy them out of a lifetime employment guarantee.
But when the union balked at continuing the provision in a new contract, the issue ended up in court. The U.S. Court of Appeals in Washington said that the NLRB was wrong, that the question strikes at the very heart of a union's role in representing its members and so is something that a company has no right to demand.
Toledo Typographical v. NLRB, July 17
It can be deemed deceptive for stores to advertise the net after-rebate price of merchandise. The Connecticut Supreme Court upheld a ruling by the state's commissioner of consumer protection outlawing such advertising unless the rebate is given to the customer at the time of purchase. Promoting the after-rebate price may be misleading, the justices noted, because a shopper would forget the costs of mailing in the necessary documents and waiting for the rebate check to arrive.
Caldor v. Heslin, July 10
Landowners may not block the view across their own land if doing so creates a hazard. An Indiana trial judge had ruled that owners have no obligation to let others see across their property, and so threw out a suit by a widow who claimed that her husband was struck by a train because the combination of a fertilizer plant built a few feet from the tracks and railroad cars parked on a spur made it impossible to see an oncoming train from the county road. The U.S. Court of Appeals in Chicago reinstated the case, holding that a visual obstacle can give rise to a tort claim just as a physical one can. The judges admitted that precedent on the point "are all over the lot," but decided that the fairest rule is to impose the obligation.
Justice v. CSX, July 10
Daniel B. Moskowitz is a Washington editor for Business Week newsletters.