The Second Circuit affirmed a district court’s dismissal of a shareholder’s complaint for wrongful dismissal of his demand that JPMorgan’s board investigate the London Whale debacle. While the panel followed the rule of the circuit that dismissals of derivative actions be reviewed for abuse of discretion, it urged that the standard of review be changed to de novo as it is for other dismissals (Espinoza v. Dimon, June 16, 2015, Katzmann, R.).
Background. In 2012 Ernesto Espinoza, a JPMorgan shareholder, sent a letter to the board of directors demanding that they investigate aspects of the London Whale scandal, specifically the underlying trading losses and the alleged dissemination of misleading statements. A review committee considered the demand (among others) and concluded that litigation was not in the company’s best interests. Espinoza then sued on the basis that his demand had been wrongfully refused, asking the district court for leave to amend if his complaint were to be dismissed. The district court dismissed the complaint for failure to state a claim and entered judgment for the defendants immediately, without allowing leave to amend.
Standard of review. The panel made a forceful detour by arguing that dismissals under Federal Rule of Civil Procedure 23.1, dealing with derivative actions, should be reviewed de novo, like other dismissals, rather than for abuse of discretion. Thirty years of case law in the circuit holds that determining the sufficiency of allegations depends on the circumstances of the individual case and is within the discretion of the district court. But the First and Seventh Circuits recently adopted a de novo standard, and judges in the Ninth Circuit and D.C. Circuit have questioned the wisdom of deferential review in this context. The Delaware Supreme Court also discarded abuse-of-discretion review of dismissals under the Chancery Court’s version of Rule 23.1.
The Second Circuit panel cited three reasons for its endorsement of de novo review. First, none of the usual justifications for deferring to district courts are present; in determining pleading sufficiency under Rule 23.1, the lower court and appellate court both are simply reading the language of a pleading and applying it to the pleading statutes, case law, and Rule 23.1 requirements. Second, abuse-of-discretion review is illogical: questions of fact drop out on a motion to dismiss because the court accepts a complaint’s factual allegations as true. Therefore, a dismissal is based on a purely legal determination that would ordinarily be reviewed de novo under the usual abuse-of-discretion standard. In other words, the panel maintains, abuse-of-discretion review encompasses de novo review of issues of law, and because a dismissal is based only on issues of law, it should collapse into pure de novo review.
Finally, the panel wrote, abuse-of-discretion review could destabilize the law of derivative action because deferring to a district court’s discretion implies that the court could have come to a number of permissible decisions. Under abuse-of-discretion review, the different conclusions of two district courts reviewing the same complaint could both be acceptable and affirmed on appeal. “Permitting such divergent results does a disservice to shareholders and corporate boards alike by depriving them of clear rules to guide the management of corporate affairs,” the panel concluded.
District court’s discretion. Absent intervention by the U.S. Supreme Court or the Second Circuit acting en banc, however, the panel was bound to review the dismissal for abuse of discretion. Espinoza conceded that the JPMorgan board adequately investigated the underlying trading losses, but his demand and complaint also took issue with the dissemination of public statements minimizing the scale of the London Whale losses, in particular Jamie Dimon’s statement that the media attention was “a complete tempest in a teapot.” The board’s response to his demand letter, however, made no mention of the misstatements and characterized the demand as solely relating to the trading losses. The panel determined that the district court did not abuse its discretion. A corporate board must investigate before refusing a demand, but directors have substantial leeway over how to conduct that investigation. In light of the presumption that directors act on an informed and good-faith basis when making a business decision, the district court could reasonably conclude that the board’s decision to focus on the crux of the demand, even if it did not address every topic in the demand letter, did not rise to the level of gross negligence.
Furthermore, the district court did not err by entering judgment for the defendants immediately without addressing Espinoza’s request for leave to amend. Amendment would have been futile because Espinoza failed to identify additional allegations that would fix the issues with his first complaint.
The case is No. 14-1754.