Chancery Finds Inadequate Representation by Derivative Plaintiff; Dismisses Complaint with Prejudice
South v. Baker, C.A. No. 7294-VCL (Del. Ch. Sept. 25, 2012).
Issues Addressed: This decision is a candidate for inclusion in the pantheon of iconic Delaware Court of Chancery opinions addressing the following issues: (1) When derivative plaintiffs and their counsel will be presumptively found to provide inadequate representation resulting in the complaint’s dismissal with prejudice; (2) When dismissal of one derivative suit will not bar another derivative suit involving the same corporation; (3) When a Caremark claim will be dismissed with prejudice if Section 220 is not used beforehand; and (4) How to successfully allege pre-suit demand futility in connection with making a Caremark claim.
UPDATE: On April 4, 2013, the Delaware Supreme Court published the Pyott opinion, highlighted on these pages here, which arguably lessens the impact of the Court of Chancery’s pronouncements in this opinion regarding the required use of Section 220.
This derivative case involves a company that is engaged in the mining of silver in Idaho and Alaska. Shortly after several unfortunate mining incidents within one year, and after several federal securities suits were filed, this and other derivative suits were filed invoking the legal theory first recognized in the Delaware case styled as In Re Caremark International Inc. Derivative Litigation, 690 A.2d 959 (Del. Ch. 1996). In connection with explaining its disapproval of the hastily filed complaint, the Court cited a plethora of Delaware cases admonishing stockholders to avail themselves of DGCL Section 220 in order to obtain books and records to investigate their claims before filing a suit based on a Caremark claim.
A Caremark claim refers to directors being held liable for knowingly causing or consciously permitting a corporation to violate positive law, or for failing utterly to attempt to establish a reporting system or other oversight mechanism to monitor the corporation’s legal compliance. The plaintiffs in this case did not heed that advice, and having failed to satisfy the pre-suit demand futility requirements of Rule 23.1, the Court dismissed the complaint with prejudice and without leave to amend as to the named plaintiff.
The Court found that the plaintiffs and their counsel failed to provide adequate representation in their derivative claim on behalf of Hecla Mining Company.
The Court clarified that the dismissal of the complaint should not have any preclusive effect on the efforts of other stockholders to investigate potential claims. The Court explained that:
“Uncertainty exists about the degree to which with-prejudice dismissal of one stockholder’s lawsuit could have preclusive effect on the litigation effects efforts of other stockholders. There is a broad consensus, however, that a with-prejudice dismissal does not have preclusive effect if the initial plaintiff failed to provide adequate representation for the corporation.”
The Court ordered supplemental briefing on the issue of whether the plaintiffs and their counsel had represented the corporation adequately. Preliminarily the Court wrote that: “Recent decisions by this Court have suggested a presumption that when a stockholder hastily files a Caremark claim after the public announcement of a corporate trauma, in an effort to shift the still-developing losses to the corporation’s fiduciaries, without first conducting a meaningful investigation, the plaintiff has not adequately represented the corporation.” See footnote 2 for supporting cases (e.g., La. Mun. Police Empls.’ Ret. Sys. v. Pyott, 46 A.3d 313, 335-36 (Del. Ch. 2012) (appeal pending) [hereinafter Allergan] See highlights of that decision on these pages available here.).
This case clearly enunciates when that presumption will apply–as opposed merely to “suggesting” when inadequate representation in this context will be found.
The opinion provides copious citations in footnote 4 to cases that support the Court’s pronouncement that: “Decisions that give preclusive effect to a Rule 23.1 dismissal universally recognize that another stockholder still can sue if the first plaintiff provided inadequate representation. ”
This decision provides an exemplary overview of the fundamental basis of director primacy principles in Delaware including the following articulation: “A cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation.” Slip op. at 15. The Court cites to statutes and case law which form the basis of the authority of the board of directors to determine what action the corporation will take regarding litigation just as with other corporate decisions. By contrast, in a derivative suit, a stockholder seeks to displace that authority of the board. Id.
Thus, in order for a derivative plaintiff to wrest that authority from the board, it must satisfy Court of Chancery Rule 23.1’s heightened pleading standard which requires that a plaintiff allege: “with particularity . . . reasons for the plaintiff’s failure to obtain the action [of the board] or for not making the effort.”
The Court provides a scholarly explanation of those situations in which presuit demand on the board is considered futile and the pleading requirements that must be satisfied under the Aronson and Rales tests. See Slip op. at 16.
A presuit demand in the context of a case alleging Caremark claims requires much more skill and attention. For example, in order to plead demand futility in the Caremark context, a stockholder plaintiff must plead facts establishing a sufficient connection between the corporate trauma and the board such that at least half of the directors face a “substantial likelihood of personal liability.”
The Court recites additional various nuances that must be addressed in order to successfully plead presuit demand futility in the context of a Caremark claim. See, e.g., Slip op. at 18.
Caremark claims are one of the most difficult claims to successfully plead in order to survive a motion to dismiss, and perhaps even more difficult to prevail on. An example of the somewhat extreme type of facts that would be needed for a successful Caremark claim include contentions that a company lacked an audit committee or that the audit committee only met sporadically and devoted patently inadequate time to its work or that: “the audit committee had clear notice of serious accounting irregularities and simply chose to ignore them, or even worse, to encourage their continuation.”
The Court explained that, in part, the claim failed in the instant case because the complaint relied merely or largely on the reports of a mining safety agency press release and report as opposed to board minutes and related materials that might have resulted from the use of Section 220. The Court remarked that neither of the two public documents relied on supported a reasonable inference that the board “consciously decided to violate positive law.” Nor did the safety agency report support a reasonable inference of conscious board action or intentional inaction.
The Court added that the complaint “nowhere alleges anything that the directors were told about the incidents, nor what the board’s response was, or even that the incidents were connected in any way.” Moreover, there was no evidence that the board knew of or consciously disregarded the problems that led to the corporate trauma. See footnote 6. The simple fact that three mining accidents in a year occurred did not support a reasonable inference of board involvement, much less bad faith, conscious wrongdoing of knowing indifference on the part of the board. Unlike other typical derivative claims, a Caremark claim must plead a connection between the board and the underlying corporate trauma.
Neither did the complaint contain allegations from which the Court could infer: “A sustained or systemic failure of the board to exercise oversight – - such as an utter failure to attempt to assure reasonable information and reporting system exists.” Caremark, 698 A.2d at 971.
Dismissal with Prejudice as to the Named Plaintiff
The Delaware Supreme Court in the King v. VeriFone Holdings, Inc. (“King II”) decision (highlighted here), provided three options available to a trial court confronted with a hastily filed derivative complaint that failed to pass muster under Rule 23.1. One of those options was dismissal of the complaint with prejudice as to the named plaintiff. The trial court in this case explained why that would be an appropriate option and consistent with Court of Chancery Rule 15(aaa). For example, the Court explained that there appeared to be at least two other stockholders who had served Section 220 demands and who appeared to be proceeding to conduct a presuit investigation before filing a lawsuit. In addition, it did not appear that a statute of limitations bar loomed, or that due to the passage of time no other plaintiff would likely be available. The Court cited at footnote 7 to several transcript rulings in which the Court of Chancery sought to avoid foreclosing the ability of other stockholders to investigate and pursue bona fide claims in the context of hastily filed derivative actions.
Message Sent to Derivative Plaintiffs
This opinion sends a stentorian warning to potential plaintiffs who would file derivative claims without employing the tools of Section 220 or otherwise conducting a thorough presuit investigation. This decision establishes a high (and perhaps elusive) threshold for plaintiffs who seek to survive a motion to dismiss when asserting Caremark claims if Section 220 is not first employed.
Standard for Evaluating Adequacy of Representation
The Court reviewed the doctrinal underpinings that allow derivative plaintiffs to: (1) serve in a fiduciary capacity as a representative of persons whose interests are in the hands of the plaintiff; and (2) proceed when the redress of his injuries is dependent upon the diligence, wisdom and integrity of the plaintiff. The Court further referred to multiple Delaware decisions that recognize the fiduciary obligations of the plaintiff who seeks to maintain a derivative claim, which duties include satisfying the adequacy requirements implicit in Court of Chancery Rule 23.1.
The Court emphasized the critical difference between a plaintiff in a class action who bears the burden of proving adequate representation, as compared to the plaintiff in a derivative action. Although the Delaware Supreme Court has not yet ruled on the issue, several decisions in the Court of Chancery have held that: “The defendant must show a substantial likelihood that the derivative action is not being maintained for the benefit of the shareholders.” Slip op. at 31.
The Court recited a non-exhaustive list of eight factors that the Court will consider when determining the adequacy of a derivative plaintiff. Slip op. at 32.
Presumption of Disloyalty
The iconic nature of this decision may, in part, be due to the bright line presumption of disloyalty described and underscored in this decision. Although other Chancery decisions are cited in support of that stated presumption, the Court described prior decisions as merely “suggesting” the following presumption of disloyalty in the context of a derivative plaintiff, which is now established as a rule:
“An evidentiary presumption that a plaintiff who files a Caremark claim hastily and without using Section 220 or otherwise conducting a meaningful investigation has acted disloyally to the corporation and served instead the interests of the law firm who filed suit.” See Allergan, 46 A.2d at 335-36.
The Court then went on to describe the two-parts of an evidentiary presumption being that they are both mandatory and rebuttable. Referring to Delaware Rule of Evidence 301, the Court referred to a presumption as imposing on the party against whom it is directed the burden of proving that the non-existence of the presumed facts is more probable than its existence.
In the context of a stockholder who rushes to file a Caremark claim: “without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and the director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests’ of the plaintiff firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.” See Allergan, 46 A.2d at 335-36.
The Court added that if a plaintiff seeks to plead a Caremark claim without using Section 220 that it may still survive a Rule 23.1 motion to dismiss by pleading the majority of the directors are not independent and disinterested (as when directors vote on their own compensation). See cases cited at footnote 8.
This decision also provides guidance to those who would seek to rebut the presumption of disloyalty when they have not availed themselves of Section 220 or otherwise engage in inadequate presuit investigation. See Slip op. at 36.
Applying the Presumption to this Case
In applying the presumption of disloyalty to this case, the Court reasoned first that the plaintiffs filed the case hastily. The Court next observed that Caremark claims were the central allegation. Finally, and just as importantly, the Court concluded that there was an absence of a deliberate and thorough presuit investigation, and because the claims are premised on corporate liability, pursuing a Caremark claim during the pendency of the underlying litigation or governmental investigation “may well compromise the corporation’s positions on the merits, thereby causing or exacerbating precisely the harm that the Caremark plaintiff ostensibly seeks to remedy.”
The plaintiffs in this case failed to rebut the presumption. The Court concluded that instead of acting in the best interest of the corporation, the plaintiffs filed hastily for the primary benefit of serving the interests of their attorneys instead of the corporation.
The Court found these circumstances to support an inference of disloyalty and a finding of inadequacy. Moreover, the dismissal of the complaint should not have any preclusive effect on the litigation efforts of other stockholders. The Court dismissed this case with prejudice and without leave to amend as to the named plaintiff.