Clearing the Path for Double Derivative Suits
By Brian J. Robbins and Gregory E. Del Gaizo
Shareholder derivative actions are one of the chief means the owners of a company have for enforcing high standards of conduct by corporate fiduciaries. In a shareholder derivative action, a company’s shareholder can stand in the place of the company and take action against the company’s officers and/or directors who have harmed it. The courts have long recognized that these suits encourage shareholders to seek redress for corporate mismanagement, and serve as important considerations of public policy. Because shareholder derivative actions can be powerful tools to police corporate mismanagement, corporate fiduciaries have been creative in finding ways to get them dismissed.
One common way corporate fiduciaries have tried to extinguish their liability in derivative actions is by exploiting the requirement in most jurisdictions that the shareholder plaintiff continue to own stock in the company throughout the course of the litigation. Defendants argue that once a merger or acquisition occurs, the plaintiff no longer holds stock in the subject company, and therefore, cannot pursue the litigation. The Delaware Supreme Court recently issued two rulings — concerning shareholder plaintiffs’ standing to continue to pursue derivative actions after the company is acquired — that largely close this loophole.
The first ruling concerned Bank of America Corp.’s acquisition of Countrywide Financial Corp. and the viability of the derivative claim against Countrywide’s former directors and officers after closure of the acquisition. As mentioned, shareholders lose the ability to pursue a derivative action on behalf of an acquired company in most circumstances because they can no longer satisfy the requirement that they contemporaneously own stock in the company. One of the recognized exceptions to this loss of standing, however, is when there is fraud in the actual merger. Under traditional Delaware law, when the purpose of the merger is to deprive the shareholder of his derivative standing, a merger is considered fraudulent, and thus, a shareholder can maintain standing to sue derivatively. In Arkansas Teacher Retirement System v. Caiafa, 996 A.2d 321 (2010), the Delaware Supreme Court explained that fiduciaries who damage a company to such an extent that it has to be acquired by a white knight cannot then claim they no longer face liability for their actions.
Based on the record in front of it, the court explained that while the directors of Countrywide did not seek out the acquisition solely to deprive the plaintiffs of standing to sue, these fiduciaries’ misconduct necessitated that they seek out a corporate rescue and individual legal protection. An acquisition by Bank of America was one of the only ways that Countrywide’s board of directors could accomplish both of these goals. Therefore, since there was no actual fraud in the merger, under the traditional view, a shareholder would have lost derivative standing. The court explained, however, that “[a]n otherwise pristine merger cannot absolve fiduciaries from accountability for fraudulent conduct that necessitated that merger.” Rather, Delaware law will recognize the merger as part of one single, inseparable fraud connected with the prior bad acts that actually necessitated the corporate rescue. In such situations, shareholders will be able to continue to hold the directors and officers liable, and the recovery will go to the company’s former shareholders, instead of to the company, as in normal derivative actions.
A few months later, the same court issued a second ruling that profoundly affected the ability of a shareholder to bring a suit after the company was acquired. This decision concerned a double derivative lawsuit, an action in which a shareholder of a parent corporation brings an action on behalf of a wholly owned subsidiary for alleged wrongs to the subsidiary. For at least the past six years, defendants have argued that, absent exceptional circumstances, a shareholder plaintiff in a derivative suit on behalf of a company loses standing to sue after an acquisition of that company, unless (a) the plaintiff was a shareholder in both companies at the time of the wrongdoing, and (b) the acquiring company was also a shareholder of the acquired company at the time of the wrongdoing. This argument, used as an escape hatch by corporate fiduciaries that have breached their fiduciary duties, was based on the 2004 Delaware Chancery Court decision of Saito v. McCall , 2004 WL 3029876.
The Saito argument was made by defendants in a case involving Bank of America’s acquisition of Merrill Lynch & Co. Inc. In re Merrill Lynch & Co., Securities, Derivative & ERISA Litig. , 692 F.Supp.2d 370 (S.D.N.Y. 2010). In this case, the plaintiffs attempted to pursue a double derivative action on behalf of Bank of America against certain former officers and directors of Merrill Lynch for the alleged harm they caused Merrill Lynch. The defendants moved to dismiss the action, stating that the plaintiffs lost standing because they could not satisfy both prongs of the test stated above. Instead of following Saito blindly, however, Judge Jed Rakoff explained that the defendants’ argument “make[s] no sense” from a policy standpoint and decided to certify the question to the Delaware Supreme Court. When doing so, Rakoff pointed out the Saito test rendered “double derivative lawsuits virtually impossible to bring except in bizarrely happenstance circumstances.”
On Aug. 27, the Delaware Supreme Court agreed with Rakoff and rejected the Merrill Lynch defendants’ argument. Lambrecht v. O’Neal , 3 A.3d 277 (2010). It went through a long line of previous Delaware decisions, pointing out that Delaware law “clearly endorses” and, in fact, “encourage[s]” shareholder plaintiffs to bring double derivative actions as a post-merger remedy. The court then addressed the defendants’ argument that the acquiring company, Bank of America, needed to own stock of the target company, Merrill Lynch, while the wrongdoing was occurring. The court explained that a derivative claim becomes an asset of the acquiring corporation, and as an asset of the corporation, the corporation has the ability to assert the derivative claim directly. Therefore, there is no need for the acquiring company to own stock of the acquired company at the time of the wrongdoing.
Next, the court addressed defendants’ argument that the shareholder plaintiffs needed to hold stock in both Bank of America and Merrill Lynch at the time of the wrongdoing. Drawing on the fundamentals of a derivative lawsuit, the court explained that when a shareholder brings a derivative action, the shareholder is acting on behalf of the company. In turn, when a shareholder brings a double derivative action, the shareholder stands in the shoes of the acquiring corporation. Thus, the shareholder in a double derivative suit is enforcing the right of the acquiring company. “Just as [the acquirer] is not required to have owned [the acquired company's] shares at the time of the alleged wrongdoing, neither are the plaintiffs required to have owned [acquirer's] shares at that point in time.” The plaintiffs’ claim was that Bank of America’s board of directors improperly failed to prosecute Merrill Lynch’s pre-merger claim, and it was decided that the plaintiffs only needed to be current shareholders of Bank of America, the acquiring company, to maintain standing.
The Delaware Supreme Court’s clarification of the law provides that shareholders must simply hold stock in the acquiring company, giving them a simple method to seek redress and hold fiduciaries accountable when justified.
These two recent decisions have breathed new life into post-acquisition shareholder derivative cases. Directors and officers can no longer hide behind the law of Saito after the closing of an acquisition or merger. Further, if their breaches of fiduciary duty necessitated the acquisition, shareholders can maintain a suit to hold the directors and officers liable. As courts in California and other states often look to Delaware jurisprudence on issues of corporate law, and with approximately 500 California-based, Delaware-incorporated, public companies traded on the Nasdaq and NYSE markets alone, the impact of these rulings is substantial for California-based lawyers involved in the litigation of shareholder derivative actions. When considering Delaware’s influence on other states’ corporate law, the importance of these decisions is multiplied.
Reprinted with permission from the November 1 issue of The Recorder. © 2010 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
* The firm name changed from Robbins Umeda LLP to Robbins Arroyo LLP on January 1, 2013.
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