Answering a question from the Ninth Circuit Court of Appeals, the en banc Delaware Supreme Court ruled that shareholders cannot maintain a derivative action under the fraud exception to Delaware’s continuous ownership rule after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims. At the same time, the Court, in an opinion by Justice Holland, reaffirmed the continuous ownership rule, and the limited fraud exception to that rule, recognized by its 1984 holding in Lewis v. Anderson. (Arkansas Teacher Retirement System, et al. v. Countrywide Financial Corporation, et al., Delaware Supreme Court, No. 14, 2013, September 10, 2013, Holland, J.)
The derivative action was brought in federal court by five institutional investors asserting state and federal derivative claims for breach of fiduciary duty and securities law violations. While the suit was pending in the federal district court, the company merged into a wholly-owned subsidiary of Bank of America Corporation in a stock-for-stock transaction that divested the plaintiffs of their shares.
Continuous ownership rule. In Anderson, the Court held that for a shareholder to have standing to maintain a derivative action, the plaintiff must not only be a stockholder at the time of the alleged wrong and at the time of commencement of suit but must also maintain shareholder status throughout the litigation. These two conditions precedent to initiating and maintaining a derivative action are referred to as the contemporaneous ownership and the continuous ownership requirements. The contemporaneous ownership requirement is imposed by statute, noted the Court, while the continuous ownership requirement is a matter of common law. But the Court also recognized a narrow exception to the loss-of-standing rule when the merger itself is the subject of a claim of fraud, being perpetrated merely to deprive shareholders of their standing to bring or maintain a derivative action.
Fraud exception. The Court emphasized that Lewis v. Anderson is settled Delaware law and has been consistently followed since 1984. The Court said that its 2010 decision in Arkansas Teacher Retirement Systems v. Caiafa, which arose from the same underlying facts and involved the parties to this appeal, did not change the Lewis v. Anderson equation.
Moreover, in Arkansas Teacher, the Court unequivocally stated that the company’s merger with BofA had extinguished the plaintiffs’ standing to pursue derivative claims. After that ruling, the Court discussed, in dictum, certain direct claims that the plaintiffs could have brought, but did not. But the Court emphasized here that that dictum did not overrule sub silentio more than twenty-five years of precedent that consistently held that the fraud exception applies only where the sole purpose of a merger is to extinguish shareholders’ derivative standing.