Dubroff v. Wren Holdings, LLC, C.A. No. 3940-VCN (Del. Ch. Aug. 20, 2010), read opinion here. See summary of prior Chancery decision in this matter here.
The issue addressed in this case is whether the prerequisites for class certification were satisfied in connection with a claim alleging inadequate disclosure of a corporate action approved by written consent of less than all the shareholders pursuant to DGCL Section 228.
Because no shareholder approval was sought through the challenged disclosure, Delaware requires that reliance and causation be alleged and proven. The Court ruled that: “ . . . the highly individualized nature of these elements demonstrates that the potential class members do not share common claims” and, therefore, the requirements of Court of Chancery Rule 23 were not fully satisfied. This opinion clarifies and confirms Delaware law on the duty of disclosure absent shareholder action.
A recapitalization plan by which certain defendants converted their preferred debt into preferred stock resulted in a dilution of the minority shareholders, and an increase in the equity holdings of the defendants from 56% to 80% of the stock of a company called Nine Systems Corporation, which is now a privately-held Delaware corporation formerly known as Streaming Media Corporation. The interested directors approved the recapitalization and then the plan was subsequently approved by written consents pursuant to Section 228 of the DGCL. Consistent with the statutory requirement for shareholder action by written consent, the company then sent a notice to the minority shareholders who did not participate in the written consent. That notice disclosed that an exchange of subordinated debt for preferred shares had occurred, along with a 1-for-20 reverse stock split. The notice did not disclose the identity of the debt holders or their connections to the board members, nor the price at which the debt was exchanged. See prior decision in this case linked above for more complete background details. There was substantial prior litigation involving this matter that was filed both in California and in New York that ended prior to the instant litigation.
Class Certification Requirements
Court of Chancery Rule 23(a) has four basic prerequisites for obtaining class certification: (1) The class is so numerous that joinder of all members is impracticable; (2) There are questions of law or fact common to the class; (3) The claims or defenses of the representative parties are typical of the claims or defenses of the class; and (4) The representative parties will fairly and adequately protect the interests of the class.
The Court discussed cases in which as few as 23 class members were deemed sufficiently numerous to satisfy the numerosity requirement although other Chancery cases have indicated that classes of fewer than 25 members are generally not permitted absent special circumstances in favor of certifying the class. See cases cited at footnotes 19 and 20.
This is the element that the plaintiffs failed to satisfy, due to the individualized nature of a claim for breach of the duty of disclosure absent shareholder action.
Delaware Law on Disclosure Duty Absent Shareholder Action
This decision is noteworthy for its discussion of Delaware law in connection with the elements of a claim for the breach of the duty of disclosure when no shareholder action is requested. Specifically, in order to prevail on a claim for breach of a duty to disclose absent a request for shareholder action, Delaware law requires “individualized proof of certain elements, including reliance, loss causation, and damages . . ..” See cases cited at footnotes 25 and 30. The Court discussed the Delaware Supreme Court decision of Malone v. Brincat, 722 A.2d 5 (Del. 1988). This Delaware Supreme Court decision confirmed that directors must be candid in their communication with stockholders “even in the absence of a request for shareholder action.” Id. at 14. The Court in Malone emphasized that the fiduciary duty of candor “does not operate intermittently but is the constant compass by which all director actions for the corporation and interactions with its shareholders must be guided.” Id. at 10. Nevertheless, the Malone Court added that: “an action for a breach of fiduciary duty arising out of disclosure violations in connection with a stockholder action does not include the elements of reliance, causation and actual quantifiable money damages. Instead, such actions require the challenged disclosure to have a connection to the request for shareholder action.” Id. at 12. (emphasis added.)
Courts and commentators have interpreted this language to mean that in disclosure suits not involving a request for shareholder action, each plaintiff must make an individualized showing of reliance, causation, and damages.” See cases cited at footnote 30.
The Court in the instant opinion observed that prior Delaware cases have interpreted Malone as preventing class certification in a common law fraud claim. See footnote 30. Moreover, the related case of Gaffin v. Teledyne, Inc., 611 A.2d 467, 474 (Del. 1992) has been commonly cited for its refusal to adopt the “fraud-on-the-market” presumption of reliance. See footnote 32.
Although the Court reads both Malone and Gaffin as theoretically leaving open the possibility of certifying a class for disclosure claims that do not involve shareholder action, those claims require individual proof of reliance, causation and damages. See footnote 34 for article cited therein. See also footnote 36 (noting that Section 228 notices do not involve a request for shareholder action, but merely function to inform shareholders after an action has taken place).
In sum, regarding the commonality requirement under Rule 23, the Court reasoned that because the elements of reliance, causation, and damages will need to be individually established, it cannot be said that relevant questions of law or fact are commonly shared by the preferred class.
Regarding the typicality requirement, which requires that the legal and factual position of the class representative must not to be markedly different from that of the members of the class, the Court in this case determined that this element was not satisfied by one of the proposed representatives.
Rule 23(a)(4) requires that the class representatives be capable of fairly and adequately protecting the interests of the class. Although this prong normally focuses on whether the plaintiffs have any serious conflicts of interest with other class members and whether they are represented by qualified and experienced counsel, and these factors appear to be met here, because the Court did not certify the class, it did not need to address the issue of whether the firm that sought to be lead counsel was the appropriate firm. The Court noted that it was not dissuaded from its conclusion on this particular element by the lack of specific information that the plaintiffs demonstrated at their deposition because it is sufficient for a named plaintiff to “demonstrate a knowledge of the underlying facts” or a “keen interest in the progress of the litigation,” even if they rely on their attorneys for the prosecution of the matter.
The Court also described the “second step” for class certification pursuant to Rule 23(b) which provides that an action may be maintained as a class action where the prerequisites of paragraph (a) are satisfied. The Court considered both Rule 23(b)(1)(A) and Rule 23(b)(3) and determined that the class could not be certified under either subsection.
The Court concluded that even though most of the requirements under Rule 23 may have been met, based on the interpretation of Malone as imposing individual requirements for establishing a disclosure claim absent the request for shareholder action, the Court refused to certify the class, and therefore, the application to designate a particular firm as class counsel was moot.