Brown v. Moll: Demand Futility and the Core Product Argument

In Brown v. Moll, 2010 WL 4704372 (N.D.Cal.), the US District Court in the Northern District of California dismissed a shareholder derivative action because the plaintiff failed to adequately allege demand futility. Michael Brown, a shareholder of Hansen Medical, Inc., brought the suit on behalf of the corporation against seven members of its Board of Directors (individual defendants).

The plaintiff alleged that Hansen Medical, Inc., which builds medical robots, improperly accounted for revenue from the sale of its primary product, the Sensei system. As a result, Hansen was required to restate and adjust various financial statements from 2007 through 2009. The plaintiff further alleged that the individual defendants caused Hansen to engage in the improper revenue recognition conduct, which lead to various false and misleading disclosures.

The plaintiff set out claims for breach of fiduciary duty, unjust enrichment, and waste of corporate assets against the individual defendants. The court dismissed an earlier version of the complaint for failure to allege demand futility, but granted leave to amend.

Under Delaware law, a shareholder may only bring a derivative suit after demanding that the directors pursue the claim and showing that they have wrongfully refused to do so. Del. Ch. Ct. R. 23.1. This demand is excused when the directors are incapable of making an impartial decision regarding the litigation. In order to show demand futility, the plaintiff must allege particularized facts showing that more than half of the board members have a personal and substantial interest in the subject matter of the proposed lawsuit that renders them unable to exercise independent judgment in responding to the demand. Facts specific to each director must be alleged in order to support a finding of demand futility.

The plaintiff highlighted a "core product" argument in his complaint. The argument was based on the following allegations: 1) Hansen is a small company that has one "core product," the Sensei system; 2) Hansen sells two or three systems a month; and 3) under its revenue recognition policy, Hansen can only recognize revenue when the systems have been fully installed and the end users trained. As a result, the plaintiff asserted, the method for recognizing revenue is of critical importance to the company and revenue recognition issues were discussed at board meetings.

Based on these allegations, the plaintiff asked the court to impute knowledge of the improper revenue recognition scheme to the individual defendants. The court characterized this argument as "generalized" and "insufficient to support an inference that the Outside Directors knew that employees in the company were misapplying the company's revenue recognition policy." The plaintiff's additional arguments were likewise rejected by the court.

Due to the plaintiff’s failure to adequately allege demand futility, the court dismissed the suit without leave to amend.

The primary materials for this case may be found on the DU Corporate Governance website.