Ruling in Apple case provides shareholder litigation guidance

At the end of 2017, the 6th District Court of Appeal issued a peremptory writ of mandate in Apple Inc. v. Superior Court of Santa Clara, providing guidance on three important questions of California corporate law. 2017 DJDAR 11709 (Dec. 12, 2017).

First, the court held that a superior court order overruling a demurrer based on a shareholder plaintiff's failure to make a demand should be reviewed through a writ proceeding. Second, the court held that, if a previously filed derivative complaint was not validly in litigation, California law requires a court to assess demand futility against the board in place when an amended derivative complaint is filed. Third, in holding that demand was not excused, the court provided guidance as to the allegations necessary to permit a reasonable inference of director liability for alleged corporate misconduct.

The case arose out of Apple's alleged pursuit and enforcement of anticompetitive agreements with other Silicon Valley companies to prohibit the recruitment or "cold calling" of each other's employees. Plaintiffs alleged that certain current and former members of Apple's board of directors breached their fiduciary duties because they were aware of and condoned these recruiting practices. Apple is a California corporation, and thus California law applied to plaintiffs' claims.

It is well-settled that, before filing a derivative complaint, a shareholder must either make a demand on the board of directors that it initiate the litigation, or plead particularized facts showing a majority of the board could not consider a demand. This demand requirement protects the managerial freedom of the board and prevents the abuse of derivative litigation. As is often the case with derivative litigation, Apple successfully demurred to plaintiffs' first two consolidated complaints on the grounds plaintiffs failed to comply with the demand requirement.

Plaintiffs filed a second amended complaint in April 2016, and the superior court overruled Apple's demurrer to that complaint. In overruling Apple's demurrer, the superior court held plaintiffs had pled demand futility against the Apple board in place as of the filing of the original complaint in 2014.

Writ Review of a Shareholder's Compliance with the Demand Requirement

Perhaps of greatest significance to practitioners may be the court's apparent deviation from the general principle that an order overruling a demurrer should not be reviewed by writ because an appeal after a final judgment would be adequate to correct any legal error.

While recognizing this principle, the court indicated that an order overruling a demurrer brought on the grounds of demand futility should be more readily available to review by writ. The court explained that a writ would ensure both consistency within California corporate law and between California and Delaware law. The court further emphasized the need for a corporation to contest a derivative plaintiff's standing at the pleading stage and through a writ, even if the corporation could otherwise employ tools, such as a special litigation committee, to control derivative litigation after an unsuccessful demurrer.

Given the scope of the court's ruling, the Apple decision should allow for increased appellate review of a derivative plaintiff's compliance with the demand requirement at the pleading standing.

California Adopts the Braddock Rule

The second ruling of significance in Apple was the court's adoption of the so-called "Braddock" rule, named after the Delaware Supreme Court's decision in Braddock v. Zimmerman, 906 A.2d 776 (Del. 2006).

Under the Braddock rule, a plaintiff is excused from making a demand against the board in place at the time of the filing of an amended complaint if three circumstances are met: "first, the original complaint was well pleaded as a derivative action; second, the original complaint satisfied the legal test for demand excusal; and third, the act or transaction complained of in the amendment is essentially the same as the act or transaction challenged in the original complaint."

In practice, the Braddock rule can increase a plaintiff's burden of pleading demand futility in an amended complaint because independent directors who join a board after the filing of an original, defective complaint should be able to evaluate a demand.

The court in Apple adopted the Braddock rule because the principles animating the demand requirement under California law were consistent with the Delaware court's reasoning in Braddock. Accordingly, the court held that the superior court should have assessed demand futility against the board of directors in place when the amended complaint was filed in 2016, and not against the 2014 board.

Given the normal turnover of corporate boards and the delay associated with state court litigation, the adoption of the Braddock rule under California law should see frequent application.

California Gets Closer to Adopting the Caremark Standard

The court's decision in Apple was significant for a third reason. After applying the Braddock rule, the court focused its analysis on just three of the directors on the Apple board, with plaintiffs having to plead demand futility as to two of them.

In holding that demand was not excused against two of these directors, the court brought California closer to adopting the test for director liability under In re Caremark International Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996), and its progeny. To be liable under Caremark, directors must have consciously abdicated their oversight duties, either by utterly failing to implement internal controls and reporting systems or by disregarding their oversight of those systems, such as by ignoring "red flags" revealing the alleged misconduct.

To date, no published California decision has adopted Caremark under California law. But while the Apple court never mentions Caremark by name, the court relied on decisions from both Delaware and federal courts applying Caremark. Applying that caselaw, the court held that routine oversight activities by directors would not support a reasonable inference they had knowledge of alleged misconduct.

The court further contrasted plaintiffs' conclusory allegations against the "battery of particularized factual allegations" that the 9th U.S. Circuit Court of Appeals held permitted the inference of director knowledge of misconduct in Rosenbloom v. Pyott, 765 F.3d 1137 (9th Cir. 2014) -- a case applying Caremark and Delaware law.

The Apple decision therefore suggests that a Caremark analysis is relevant for a finding of director liability for corporate misconduct under California law.