US SUPREME COURT DECISIONS

Petitioner Kamen is a shareholder of respondent Cash Equivalent Fund, Inc. (Fund), a mutual fund whose investment adviser is respondent Kemper Financial Services, Inc. (KFS). The Fund is registered under the Investment Company Act of 1940 (ICA), which requires, inter alia, that at least 40% of a mutual fund's directors be financially independent of the investment adviser, that shareholders approve the contract between a fund and an adviser, and that dealings between the fund and the adviser measure up to a fiduciary standard. In a shareholder's derivative action brought on behalf of the Fund against KFS, Kamen alleged that KFS had obtained shareholder approval of the investment adviser contract by causing the Fund to issue a materially misleading proxy statement in violation of the ICA, and that she had made no precomplaint demand on the Fund's board of directors because doing so would have been futile. The District Court granted KFS' motion to dismiss on the ground that she had failed to plead the facts excusing demand with sufficient particularity for purposes of Federal Rule of Civil Procedure 23.1. The Court of Appeals affirmed, concluding that her failure to make a precomplaint demand was fatal and adopting as a rule of federal common law the American Law Institute's "universal demand" rule, which abolishes the futility exception to demand. While acknowledging that courts should incorporate state law when fashioning federal common law rules to fill the interstices of private causes of action brought under federal security laws, the court held that, because Kamen had not until her reply brief adverted to the established status of the futility exception under the law of Maryland, the Fund's State of incorporation, her challenge to the court's power to adopt a universal demand rule came too late to be considered.

Held: A court entertaining a derivative action under the ICA must apply the demand futility exception as it is defined by the law of the State of incorporation. Pp. 500 U. S. 95-109.

(a) The scope of the demand requirement determines when a shareholder can initiate corporate litigation against the directors' wishes. This function clearly is a matter of substance, not procedure. Rule 23.1 speaks chanrobles.com-redchanrobles.com-red

Page 500 U. S. 91

only to the adequacy of a shareholder's pleadings, and cannot be understood to abridge, enlarge, or modify a substantive right. Pp. 500 U. S. 95-97.

(b) Where a gap in the federal securities laws must be bridged by a rule bearing on the allocation of governing power within the corporation, federal courts should incorporate state law into federal common law unless the particular state law in question is inconsistent with the policies underlying the federal statute. Burks v. Lasker, 441 U. S. 471, 441 U. S. 477-480. It is immaterial that Kamen failed to advert to state law until her reply brief in the proceedings below, since once an issue or claim is properly before a court, the court is not limited to the particular legal theories advanced by the parties, but retains the independent power to identify and apply the proper construction of governing law. Having undertaken to decide whether federal common law allows a shareholder plaintiff to forgo demand as futile, the Court of Appeals was not free to promulgate a federal common law demand rule without identifying the proper source of federal common law in this area. Pp. 500 U. S. 97-100.

(c) The Court of Appeals drew its demand rule from an improper source when it disregarded state law relating to the futility exception. The demand requirement determines who -- the directors or the individual shareholder -- has the power to control corporate litigation, and thus clearly relates to the allocation of governing powers within the corporation. States recognizing the futility exception place a limit upon the directors' usual power to control the initiation of corporate litigation. In many States, the futility exception also determines the directors' power to terminate corporate litigation once initiated. Superimposing a universal demand rule over these States' corporate doctrine would clearly upset the balance that they have struck between the individual shareholder's power and the directors' power to control corporate litigation. KFS' proposal to detach the demand requirement from the standard for reviewing the directors' action would require federal courts to develop a body of review principles that would replicate the substantive effect of the States' demand futility doctrine, thus imposing on federal courts the very duty to fashion an entire body of federal corporate law that Burks sought to avoid. Moreover, such a project would infuse corporate decisionmaking with uncertainty, and any likely judicial economies associated with the proposal do not justify replacing the entire corpus of state corporation law relating to demand futility. Pp. 500 U. S. 101-107.

(d) The futility exception is not inconsistent with the policies underlying the ICA. KFS mistakenly argues that allowing shareholders to bring suit without a board's permission permits them to usurp the independent directors' managerial oversight responsibility. The ICA embodies a congressional expectation that the independent directors will look after a fund's interests by exercising only the authority granted to chanrobles.com-redchanrobles.com-red

Page 500 U. S. 92

them under state law, and clearly envisions a role for shareholders in protecting funds from conflicts of interest. Pp. 500 U. S. 107-108.

908 F.2d 1338 (CA7 1990), reversed and remanded.

MARSHALL, J., delivered the opinion for a unanimous Court.