Thursday, July 27, 2017

Delaware court endorses stricter standard for preclusion of derivative suits

By Anne Sherry, J.D.

The Delaware Supreme Court seems poised to adopt a rule that could give shareholders a second bite at derivative complaints. After the chancery court dismissed a derivative suit as precluded by the dismissal of a similar suit in federal court, the Supreme Court remanded to ask whether it should adopt the chancery court’s holding in EZCORP. The EZCORP court held that subsequent shareholders are not precluded until a derivative complaint overcomes a motion to dismiss or the board declines to oppose the litigation (In re Wal-Mart Stores, Inc. Delaware Derivative Litigation, July 25, 2017, Bouchard, A.).

The case involves two derivative suits arising from an alleged bribery scandal at a Wal-Mart subsidiary that was reported in the New York Times. Believing they had learned enough from the Times article to proceed, a group of plaintiffs filed a derivative action in district court in Arkansas without first demanding to inspect the company’s books and records. A second group filed a derivative action in the chancery court in Delaware, but when then-Chancellor Strine warned them that their complaints would likely be dismissed, they took his advice to pursue a books-and-records demand. The books-and-records lawsuit lasted nearly three years. Meanwhile, in Arkansas, the judge dismissed the complaint.

Back in Delaware, Chancellor Bouchard also dismissed the derivative suit there. “Subject to Constitutional standards of due process,” he wrote, “Arkansas law governs the question of issue preclusion.” Although Arkansas courts had not addressed issue preclusion in the context of derivative suits, the chancellor reasoned that an Arkansas court would likely find privity between the two groups of plaintiffs.

Appeal to Delaware Supreme Court. In its remand order, the Supreme Court gave credence to the Delaware plaintiffs’ argument that the chancery court conflated privity and due process analyses. The appellants argued that, while acknowledging that privity is a matter of Arkansas law as long as federal constitutional due process is not offended, the court focused almost exclusively on privity as a matter of state law and never addressed the due process analysis as it related to nonparty preclusion.

The appellants offered instead a more refined argument based on the chancery court’s EZCORP opinion. The court there noted that in the first phase of derivative litigation, the stockholder is suing individually to obtain authority to assert the corporation’s claim. He then held that “until the derivative action passes the Rule 23.1 stage, the named plaintiff does not have authority to sue on behalf of the corporation or anyone else.” It then followed that subsequent shareholders are not precluded—privity does not attach—unless and until a derivative plaintiff survives a motion to dismiss or the board declines to oppose the suit. The Supreme Court remanded the case so that the chancellor could express his views on this reasoning.

A troubling case. On remand, the chancellor concurred in the Supreme Court’s view that it is “a troubling case.” The trouble, he said, “arises from a tension in competing policies.” Delaware courts encourage stockholders to inspect books and records before filing a derivative suit to develop a factual record for purposes of the demand futility inquiry. But on the other hand, public policy discourages duplicative litigation, and contingent fee arrangements create incentives to be the first to file.

The chancellor recommended that the Supreme Court adopt the EZCORP rule, reasoning that it would better safeguard the due process rights of stockholder plaintiffs while mitigating fast-filer problems. Derivative suits and class actions share similarities, and both were governed by Federal Rule of Civil Procedure 23 until Rule 23.1 was adopted. Unlike with class actions, however, a court does not do a front-end evaluation of a derivative plaintiff’s adequacy as representative. The current state of the law, “automatic privity” with other stockholders the moment a derivative suit is filed, is far less favorable to would-be derivative plaintiffs than it is to unnamed members in class actions.

The EZCORP approach would also further public policy. The court noted that when a stockholder fails to establish demand futility, it’s rare that another stockholder simply files a substantially similar complaint. Instead, the second plaintiff will file a more refined complaint with particularized allegations or more tailored legal theories, perhaps after obtaining books and records. A court presumably would be cautious about following earlier rulings in cases brought by less prepared stockholders.

The case is No. 7455-CB.