On January 4, 2013, the U.S. Court of Appeals for the First Circuit overturned a district court’s dismissal of a shareholder derivative action against an investment adviser, applying a stricter independence standard for fund directors. Unión de Empleados de Muelles de Puerto Rico PRSSA Welfare Plan v. UBS Fin. Services Inc. of Puerto Rico, No. 11-1605, 2013 WL 49818 (1st Cir. Jan. 4, 2013). This ruling signals that the current and prospective business relationships of fund directors may be considered when evaluating their independence in shareholder derivative legislation.

The plaintiffs are two Puerto Rican pension plans that owned shares of certain closed-end investment funds (the “Funds”) with identical boards of directors. According to the plaintiffs, in 2008, the Funds’ investment adviser (the “Adviser”) purchased approximately $757 million worth of bonds from a series of issuances being underwritten by an affiliated broker-dealer (the “Broker-Dealer”) and then sold these bonds to the Funds—despite there being minimal global interest in the first issuance of bonds. The bonds lost more than 10% of their value within one year of issuance, resulting in substantial losses for the Funds. The plaintiffs brought a shareholder derivative action in 2010 against the Funds’ directors, the Adviser and the Broker-Dealer alleging that the institutional defendants had engaged in a scheme of manipulative trading aimed at manufacturing the appearance of market interest in the bonds and driving up the price of the bonds.

In order to assert a proper cause of action in a shareholder derivative suit, a shareholder must allege with particularity either that suitable demand was made on the board of directors to take corrective action or that such a demand would have been futile. The plaintiffs did not demand that the Funds’ directors take action before filing the suit on the grounds that such demand would have been futile given the relationships of a majority of the Funds’ directors with the Adviser and the Broker-Dealer. The district court dismissed the plaintiffs’ derivative claims for failure to properly plead demand futility.

In reviewing the decision of the district court de novo, the court of appeals first determined that the Delaware law3 demand futility test from Rales v. Blasband, 634 A.2d 927 (Del. 1993) was the appropriate test in this case.4 Under the Rales test, a plaintiff must allege facts creating “a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.” The court of appeals then determined that, in evaluating the independence and disinterest of the Funds’ directors, the district court had focused too narrowly on whether each director had received a financial benefit from the bond transaction. Rather, according to the court of appeals, the Rales test requires an analysis of whether each director has such significant personal, financial or other connections to the defendants that the director could not “impartially consider [demand] without being influenced by improper considerations.”

Applying the Rales test to the Funds’ eleven directors, the court of appeals determined that the plaintiffs had established a reasonable doubt as to the independence and disinterest of a majority of the directors. The court concluded that four directors may have lacked the requisite independence because they were employed by the Adviser, the Broker-Dealer or one of their respective affiliates at the time that the plaintiffs’ complaint was filed. More importantly, the court further concluded that two directors, whose principal employer was the largest managed care company in Puerto Rico, also may have lacked the requisite independence. The court reasoned that the directors’ employer had enjoyed a lucrative relationship with the Adviser and the Broker-Dealer in the recent past, including engaging in a similar bond transaction as the one at issue. In addition, this prior business dealing gave the two directors particular reason to discourage scrutiny of similar related-party transactions. The court also noted that the institutional defendants were powerful actors in Puerto Rico that were heavily involved in the directors’ lives as underwriter, investor and “gate-keeper” to Puerto Rico’s capital markets. It reasoned that, in such an environment, maintaining a good relationship with the institutional defendants could yield benefits to the two directors, including assistance in future business ventures. Thus, the court concluded that the prior business dealings between the directors’ employer and the Adviser, the Broker-Dealer and their affiliates, as well as the potential for future business dealings, created a reasonable doubt as to the independence of the directors.

This ruling is notable because in evaluating fund director independence, the court of appeals looked at broader considerations of the business relationship between the fund directors and the fund adviser and how such a relationship could affect current and prospective business opportunities for the directors.

While certain facts and circumstances, such as the overwhelming influence of the institutional defendants in the Puerto Rican financial markets, are particular to this case, this decision may nevertheless cause increased scrutiny of the influence that prospective business opportunities have on fund directors.