Dismissal of One Derivative Lawsuit Not Bar to Second Derivative Claim by Second Stockholder
Louisiana Municipal Police Employees’ Retirement Systems v. Pyott, C.A. 5795-VCL (Del. Ch. June 11, 2012).
Whether collateral estoppel, Rule 23.1 or Rule 12(b)(6) apply to require the dismissal of a Delaware derivative suit based on the dismissal in California of a related derivative suit in which a federal court granted a Rule 23.1 motion to dismiss for failure to make a pre-suit demand.
The Court of Chancery reasoned that collateral estoppel would not apply, and motions to dismiss based on Rule 23.1 and Rule 12(b)(6) were both denied. But see: Delaware Supreme Court’s reversal of this Chancery decision by opinion dated April 4, 2013.
Post-Decision Procedural History
See transcript of bench ruling on July 6, 2012 granting a motion for interlocutory appeal of this opinion and rebutting the online criticism of the decision. Alison Frankel of Thomson Reuters provides an insightful article about the oral argument on the motion. The Delaware Supreme Court next makes an independent decision whether or not to accept the interlocutory appeal.
This decision by the Court of Chancery is an iconic statement of the law relating to Delaware corporate litigation on several different levels. Much has already been written about this decision that was issued earlier this month and much more will be written, but in these brief comments I focus on two aspects of the decision that may help to place it in context. First, this opinion can be read as part of a continuing effort by the Delaware Court of Chancery to raise the bar and to establish and enforce the highest standards for derivative litigation and class action suits by shareholders against officers and directors. In that vein, this decision is part of an evolutionary process which was preceded by other decisions that heralded its coming. See, e.g., prior decision by the author of this Chancery decision highlighted here.
Another of the many noteworthy aspects of this decision is the principled manner in which the Court of Chancery has asserted its right to decide important issues of Delaware corporate law without deferring to the decisions of non-Delaware courts who either “get it wrong” or cannot be expected to address the issues with the same care and concern as the experts of the Delaware bench can bring to bear. [This should be contrasted with very recent decisions where the Delaware Court of Chancery has deferred to a first-filed lawsuit in another jurisdiction even when Delaware law applied (see, e.g., recent decision highlighted here), and a recent Chancery decision that deferred to a federal court on an issue of federal law. (See recent case highlighted here.)]
I make an additional preliminary comment with the respectful caution of someone who makes his living by, at least in part, practicing before the Court that issued this opinion. This decision extols the virtues of using § 220 of the Delaware General Corporation Law in order to obtain books and records of a corporation before filing a plenary lawsuit. I have written often about the less than simple and less than completely predictable aspects of § 220. For example, a recent decision by the Delaware Supreme Court rejected a § 220 request after more than a year of litigation. (See recent case highlighted here). In addition, a recent law review article I co-authored observed that there is no directly controlling authority in Delaware that requires a corporation to provide, in response to a Section 220 demand, electronically stored information, which comprises the majority of business data which is never printed in hard copy. See article here. So, even though on an epistemological level, it makes eminent sense to advance the position that one should use Section 220 to obtain as much information as possible before preparing and filing a plenary complaint, on a practical level “from the trenches,” my experience and my close reading of § 220 cases, persuades me that § 220 can often be an expensive and lengthy process that does not always bear fruit or does not bear sufficient fruit to fulfill the promise of § 220 – – or make it worth the effort.
Aside: Some of the issues addressed in this case are at least tangentially related to the school of thought which argues that plaintiffs are increasingly choosing a forum outside of Delaware, even when Delaware law applies, in order to “try their luck” with judges who are less likely to apply the same degree of specialized close scrutiny that members of the Delaware Court of Chancery apply to the pleadings and lawyers before them. See, e.g., a recent essay on the topic published on the Foley & Lardner website. Sometimes referred to as “ABC” (anywhere but Chancery), a termed coined by Ted Mirvis, the highly-regarded Wachtell Lipton lawyer who is frequently involved in many high profile Chancery cases, we have written often on these pages about that phenomenon. E.g., here and here.
Finally, a review of the details of the decision follows:
Background of Pyott case:
In September 2010, Allergan, Inc. entered into a settlement with the United States Department of Justice and pled guilty to criminal misdemeanor misbranding and paid a total of $600 million in civil and criminal fees. Allergan, Inc., a Delaware corporation which develops and commercializes specialty pharmaceuticals, biologics, and medical devices, specifically Botox Therapeutic, entered into the settlement after admitting that they illegally promoted off-label uses of their popular drug.
The public announcement of this settlement prompted Louisiana Municipal Police Employees’ Retirement System (‘LAMPERS’) to file this action. Similar claims were filed in Federal Court in California which dismissed with prejudice that suit for failure to plead demand futility. The defendants supplemented their motion to dismiss in this action to invoke collateral estoppel.
The Court rejected the 3 arguments of defendants why this Delaware derivative suit should be dismissed in light of the dismissal of a very similar derivative suit in California: collateral estoppel, Rule 23.1, and Rule 12(b)(6). The Court of Chancery disagreed with many of the California Federal Court’s holdings, and held that the plaintiffs were not collaterally estopped from asserting demand futility in the Delaware derivative action. The Court focused on privity, not on whether the prior Rule 23.1 dismissal was on the merits.
Choice of Law
The Court emphasized that whether or not successive stockholders in a subsequent suit are in privity with the corporation and each other is a matter of Delaware law under the internal affairs doctrine and, thus, state law will govern. The Court reasoned that “whether a stockholder can sue derivatively after another stockholder attempted to plead demand futility is equally a matter involving the managerial prerogatives within a corporation,” and should not be governed by potentially different rules across the federal circuits, states, and territories. The ability of a stockholder in a Delaware corporation to bring such a suit should be governed uniformly by Delaware law.
The Same Party or a Party in Privity
Under Delaware precedent, the Court explained that until a derivative action passes the Rule 23.1 motion to dismiss stage, the stockholder is asking the Court for authority to sue in the name of the corporation. Where a Rule 23.1 motion is granted, the lack of authority to sue in the name of the corporation should be clear. Without authority to assert a corporation’s claim, the shareholder in the first case was asserting their own claim to obtain equitable authority to sue. The Court of Chancery previously has ”squarely” held that the adjudication of one stockholder’s individual claim does not have preclusive effect on a second stockholder’s ability to assert the claim.
When a stockholder representative pursues claims in a derivative action, authority for that action can be determined in the following ways: (1) the board of directors or an empowered committee can approve the litigation expressly or by failing to oppose it; (2) a court can determine that the stockholder plaintiff has the authority to proceed by denying a Rule 23.1 motion because the complaint adequately pleads either that demand should be excused as futile or that demand was made and wrongfully refused.
Moreover, when the same stockholder responds to a Rule 23.1 dismissal by filing a second complaint alleging demand futility, that same party may be confronted with the preclusive effect of a Rule 23.1 dismissal. However, when a different stockholder attempts to plead demand excusal, an earlier Rule 23.1 dismissal should not be preclusive; because the previous plaintiff lacked the authority to sue on behalf of the corporation and was not in privity with the corporation or stockholders.
The Court of Chancery found that the California plaintiffs did not adequately represent the stockholders of Allegan or Allergan itself (if they were eventually given approval to represent Allergan). The decisions that offer a preclusive effect to a Rule 23.1 dismissal “universally recognize that another stockholder still can sue if the first plaintiff provided inadequate representation.” This inadequate representation was an independent basis to reject the argument that the California dismissal had a preclusive effect on the Delaware action.
Exception to First-Filed Rule
Many jurisdictions follow a “first-filed” rule which defers to the forum where the first action is filed, and entices fast filing to gain litigation control. Under this rule, the Court explained that plaintiffs’ lawyers cannot act appropriately as stockholders would want them to because by carefully and deliberately proceeding with the claim, the law firm risks losing control over the case to another who would file more immediately.
However, previously the Court of Chancery has clearly held that when a stockholder plaintiff sues in a representative capacity, the first-filed rule does not control which plaintiff has the substantive right to proceed. This case seems to exemplify this race to file. Within 48 hours of Allergan announcing their settlement, LAMPERS filed a complaint, without using Section 220, without conducting an investigation, and without any real allegations which could potentially defeat a demand-futility motion. In California, the plaintiffs’ firms failed to fulfill their duties, motivated by the desire to gain control of the case, and in turn failed to provide adequate representation. Since the plaintiffs in the California action provided inadequate representation for Allergan, the Court concluded that the dismissal of the Delaware case is not required.
Rule 23.1 Inferences Permissible
A reasonable inference can be made from the allegations of the Delaware complaint and the documents presented, that the board knowingly approved and oversaw the business plan which endorsed illegal off-label marketing of Botox. They held presentations, seminars, funded facilities, and incentivized physicians who would use Botox in these off-label capacities. The complaint only needs to make a “threshold showing, through the allegation of particularized facts, that their claim had some merit.” While the California Federal Court felt the complaint fell short because it lacked evidence of a decision by board members to promote any off-label marketing, this Court believes that at the pleadings stage, a court can draw inferences which are supported by particularized allegations of fact. While at later stages of the case the plaintiffs will not be entitled to these presumptions and will need to prove their claims, at the pleadings stage, particularized allegations which support reasonable inferences suffice. Because this standard is met here, the Rule 23.1 motion to dismiss was denied.
One of many observations about this case is that Delaware Courts are not often persuaded by the rulings of non-Delaware courts on the finer points of Delaware law.
Because a complaint that “pleads a substantial threat of liability” for purposes of Rule 23.1 “will also survive a 12(b)(6) motion to dismiss,” this motion was also denied.
Additional highlights of the Court’s legal analysis follow the conclusion below.
Collateral estoppel, under Delaware precedent, does not mandate dismissal of this case. (1) The California plaintiffs acted in a self-serving way which ultimately meant inadequate representation. The California dismissal based on Rule 23.1 was not persuasive because it adopted a defendant-friendly inference, but the particularized allegations supported reasonable inferences of the board’s knowledge. The motion to dismiss pursuant to Rule 12(b)(6) was also denied for the same reasons.
(1) [This is my own footnote, not from the Court of Chancery’s opinion]. See generally, Smith v. Bayer Corp., 131 S. Ct. 2368 (2011)(collateral estoppel does not bar unnamed members of a putative class action from refiling a second class action if class certification in the first action is denied).
Highlights of Substantive Law that Make this Decision Iconic
The Preclusive Effect of a Dismissal Based on Rule 23.1
The Court of Chancery acknowledged substantial case law both in other jurisdictions and in prior decisions in Chancery that give preclusive effect to dismissals of derivative complaints pursuant to Rule 23.1. See cases cited in footnotes 1 and 11. The Court carefully distinguished those cases based on several principles. For example, citing decisions of the U.S. Supreme Court and the Delaware Supreme Court, the Court invoked the internal affairs doctrine. The Court described the internal affairs doctrine as a choice of law concept which applies the law of the state where a corporation was formed to matters related to the relationships among the corporation and its officers, directors and shareholders.
The Court spent a substantial part of the opinion describing collateral estoppel and the privity element of collateral estoppel. The opinion is must reading on this nuance of Delaware law. The Court only needed to address the privity requirement because that requirement for the application of collateral estoppel was not satisfied and, therefore, it was unnecessary to address the other two elements which involve whether a final judgment was on the merits, and whether the issue decided in the prior proceeding was identical. Because the defendants only invoked collateral estoppel (i.e., issue preclusion), the Court did not consider the more expansive doctrine of res judicata (i.e., claim preclusion). See footnote 6.
Nature of Derivative Action
The Court regarded the issue of pre-suit demand to be a matter of substantive law governed by the internal affairs doctrine, based on decisions of the U.S. Supreme Court and the Delaware Supreme Court.
The Court cited to a number of federal cases that “missed the point” as a matter of Delaware law, on representative litigation. Namely, the Court instructed that: “A stockholder whose litigation efforts are opposed by the corporation does not have authority to sue on behalf of the corporation until there has been a finding of demand excusal or wrongful refusal.” (citing Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993)). That is, the derivative plaintiff lacks authority to sue on behalf of the corporation until the denial of a Rule 23.1 motion to dismiss. This is because of the two-fold nature of a derivative action which is as follows. First, “it is the equivalent of a suit by the shareholders to compel the corporation to sue.” Second, “it is a suit by the corporation, asserted by the shareholders on its behalf, against those liable to it.” See Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984). See footnote 8 and accompanying text in the Pyott opinion.
The Court emphasized that simply because the underlying claim in a derivative action belongs to the corporation and ultimately will be asserted in the name of the corporation if the stockholder receives permission to sue, it does not support the proposition the stockholders are in privity for purposes of the preclusive effect of an order granting a Rule 23.1 motion to dismiss. The Court observed that: “At that phase of the case, the competing stockholders are asserting only their individual claim to obtain equitable authority to sue.”
The Court at footnote 10 provides extensive authority on the concept of judicial estoppel which prevents a party from asserting in a legal proceeding, a position inconsistent with a position previously taken by him in the same or in an earlier proceeding. As applied to this case, the defendants previously argued in California that the plaintiff lacked authority to assert claims derivatively on behalf of the corporation based on Rule 23.1; and after having prevailed on that point, the same defendants now argue that the stockholder in that case did have authority to assert the claims on behalf of the corporation sufficient to bind all the other stockholders. The Court applied judicial estoppel to prevent this reversal of position from being argued.
Why Prior Rule 23.1 California Dismissal did not have Preclusive Effect in Delaware
The Court relied on black letter law regarding the preclusive effect of a Rule 23.1 dismissal only when the plaintiff has the authority to assert the claims of the corporation, which would be true in three circumstances: (1) When the corporation has brought the case or taken it over via a special litigation committee process; (2) The derivative plaintiff survived a Rule 23.1 motion to dismiss, thereby gaining authority to sue and then obtained a decision on summary judgment or at trial; or (3) A court has approved a derivative action settlement and made the determinations required by Rule 23.1.
However, the preclusive effect does not apply when the stockholder plaintiff lacks the authority to sue on behalf of the corporation, and it “particularly does not hold true for a decision determining that the stockholder plaintiff lacks authority to sue.” The Court cited prior Chancery decisions that squarely held that the decision on one stockholder’s individual claim does not have preclusive effect on a second stockholder’s ability to assert the claim. Kohls v. Kenetech Corp., 791 A.2d 763 (Del. Ch. 2000) aff’d 794 A.2d 1160 (Del. 2002). Compare Beiser v. PMC-Sierra, Inc., 2009 WL 483321, at *3 (Del. Ch. Feb. 26, 2009) (one stockholder’s efforts to use Section 220 was limited by a different stockholder’s filing of a federal securities action that triggered the automatic stay under the Private Securities Litigation Reform Act).
The Court specifically disagreed with the prior Chancery decision in Career Education, specifically the part of the decision that followed federal cases holding that Rule 23.1 dismissal has a preclusive effect. See 2007 WL 2875203, at *10.
Declining to follow the Chancery decision in Career Education, the Court explained that an earlier Rule 23.1 dismissal “does not have a preclusive effect on a subsequent derivative action brought by a different plaintiff because, as the earlier Rule 23.1 decision itself established, the prior plaintiff lacked authority to sue on behalf of the corporation and therefore was not in privity with the corporation or other stockholders.” Following the decision in the Kohls case, however, the Court recognized that an earlier decision may by persuasive authority and could have an impact based on stare decisis.
The Fast-Filing Problem
The extensive citations in this opinion to scholarly articles and commentary by practitioners and academics on the role that derivative actions play in the “big picture” of corporate governance and in the enforcement of fiduciary obligations, demonstrates that the Court has thought long and hard about these issues, and this opinion demonstrates the care and attention with which the Court is addressing the larger issues raised in, and the societal consequences of, representative corporate litigation. See footnotes 17 through 19 and accompanying text. After discussing the “big picture” and the problems with derivative suits that are filed quickly without adequate investigation in order to give the plaintiffs’ firm the control that historically has come with filing the first complaint, the Court described a more ideal approach which it referred to as the “idealized derivative action.”
A thorough discussion of the concept of derivative actions and the Court’s description of the most ideal way for a derivative action to be prepared and investigated in a careful, methodical way, is juxtaposed with the approach of being the first to file a complaint without having the time for a proper investigation. The Court describes its preferences for how a derivative action should be prepared and investigated prior to filing. This case must be read by anyone planning to file a derivative action in Delaware.
The Court provides a “how-to manual” that explains how to properly file a Caremark claim, and also provides an exemplary exegesis of Caremark jurisprudence. A Caremark claim is a breach of fiduciary duty claim that seeks to hold directors accountable for the consequences of a corporate trauma that results from an environment that the directors set in motion or “allowed a situation to develop and continue which exposed the corporation to enormous legal liability, and that in doing so they violated a duty to be active monitors of corporate performance.” See In Re Caremark Int’l, Inc. Deriv. Litig., 698 A.2d 959, 967 (Del. Ch. 1996). The Court discussed the extensive case law interpreting the Caremark decision and provided tips and suggestions for properly pleading a Caremark claim.
This opinion should be required reading for any lawyer who plans to file a Caremark complaint in Delaware. The Court observed that the standard for Caremark liability is a high one that “parallels the standard for imposing damages when a corporation has an exculpatory provision adopted pursuant to 8 Del. C. § 102(b)(7).” That is: “Such a provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty.” (See Stone, 911 A.2d at 367, in connection with the explanation of the Court about the lack of good faith conduct that is a necessary condition for director oversight liability). A citation in the text of the opinion (not a mere footnote) referred to “friend of this blog” Professor Stephen M. Bainbridge’s article entitled A Convergence of Good Faith and Oversight, 55 UCLA L. Rev. 559 (2008) (discussing the re-interpretation of Caremark as a good faith case and the potential liability risks to directors that result.) See Slip op. at 50. Professor Bainbridge is often cited in Delaware corporate decisions.
DGCL Section 220
In connection with explaining how a successful Caremark claim can be plead, the Court spent a considerable amount of time exhorting the use of DGCL § 220. As I have indicated elsewhere, on a conceptual level, it is hard to disagree with the wisdom of using § 220 in the hope of obtaining as much information as possible about the details and the factual basis for a Caremark claim. My reservation is based on my experience and my knowledge of many of the Delaware decisions on § 220 which have (on occasion, at least), resulted in a denial of any right to books and records under § 220 after expensive trials and lengthy and expensive appeals, or the judicial determination that parties are entitled to documents under § 220 but being confronted with the reality that as of this writing there is no controlling Delaware authority to require the production of electronically stored information, which represents the vast majority of business data created today.