Directors And Officers Can’t Hide In Del.
As featured in Securities Law360 on January 14, 2011.
While 2010 saw a number of decisions concerning director and officer liability in matters arising out of the financial crisis, none were more important than two decisions from the Delaware Supreme Court touching on “double derivative actions.” After losing billions of dollars, investors have sought to hold accountable the fiduciaries that engaged in ruinous practices that drove their companies into the ground and in the process misled investors as to the risks they faced.
With a lack of criminal prosecutions, investors have instead turned to class actions and, increasingly, shareholder derivative actions. Often, a sale of the company they control was seen as an exit strategy for these officers and directors to escape liability for the harm they wrought. These fiduciaries would argue that once the sale was complete the company’s former shareholders ran afoul of the continuous ownership because they no longer owned stock in the company at issue, and thus, the court must dismiss any pending derivative actions. In 2010, however, the Delaware Supreme Court issued two opinions that expanded shareholder rights in such situations and largely closed this escape hatch.
The first ruling concerned the viability of a derivative claim filed by a shareholder of Countrywide Financial Corp. against Countrywide’s directors and officers after Bank of America Corp. acquired the company. Under normal circumstances and based on prior decisions, the Countrywide shareholder would lose standing in this situation to continue its action.
A fraudulent merger, however, represents one exception to the general continuous ownership rule. Under Delaware law, a shareholder can still sue derivatively when the purpose of the merger is to deprive the shareholder of his derivative standing. In Arkansas Teacher Retirement System v. Caiafa, the Delaware Supreme Court expanded this concept, stating 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. 996 A.2d 321 (Del. 2010).
The Delaware Supreme Court explained that while the directors of Countrywide did not seek out the acquisition for the sole reason of depriving the plaintiffs of their standing to sue, their misconduct required them to find 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. Since there was no actual fraud in the merger, under the traditional view a shareholder would lose derivative standing. The Delaware Supreme Court explained, however, that “[a]n otherwise pristine merger cannot absolve fiduciaries from accountability for fraudulent conduct that necessitated that merger.” Id. at 323.
Rather, Delaware law will recognize the merger as part of one single, continuous 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 second ruling by the Delaware Supreme Court regarding Bank of America’s acquisition of Merrill Lynch & Co. Inc. profoundly affected the ability of a shareholder to bring a suit after the company was acquired. In In re Merrill Lynch & Co., Securities, Derivative & ERISA Litig., 692 F. Supp. 2d 370 (S.D.N.Y. 2010) plaintiffs attempted to pursue a double derivative action (in which a shareholder of a parent corporation brings a lawsuit on behalf of a wholly owned subsidiary for alleged wrongs to the subsidiary) on behalf of Bank of America against certain former officers and directors of Merrill Lynch for the alleged harm they caused Merrill Lynch.
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 was based on the 2004 Delaware Chancery Court decision, Saito v. McCall, No. 17132-NC, 2004 WL 3029876, at *9 (Del. Ch. Dec. 20, 2004).
Using the Saito argument, 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. In a clear move away from the Saito precedent, Judge Jed S. 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. Merrill Lynch, 692 F. Supp. 2d at 372-73. In doing so, Judge Rakoff pointed out the Saito test rendered “double derivative lawsuits virtually impossible to bring except in bizarrely happenstance circumstances.” Id. at 373.
On Aug. 27, 2010, the Delaware Supreme Court agreed with Judge Rakoff and rejected the Merrill Lynch defendants’ argument. Lambrecht v. O’Neal, 3 A.3d 277, 293 (Del. 2010). In going through a long line of previous Delaware decisions, the Delaware Supreme Court pointed out that Delaware law “clearly endorses” and, in fact, “encourage[s]” shareholder plaintiffs to bring double derivative actions as a post-merger remedy. Id. at 286, 288.
In addressing 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. There is no need, therefore, for the acquiring company to own stock of the acquired company at the time of the wrongdoing.
When addressing the defendants’ argument that the shareholder plaintiffs needed to hold stock in both the Bank of America and Merrill Lynch at the time of the wrongdoing, the court explained that when a shareholder brings a derivative action, the shareholder is acting on behalf of the company. Therefore, when a shareholder brings a double derivative action, the shareholder stands in the shoes of the acquiring corporation and 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.” Id. at 289. Thus, the plaintiffs only needed to be current shareholders of Bank of America, the acquiring company, to maintain standing.
With two recent decisions by the Delaware Supreme Court, 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 across the country often look to Delaware jurisprudence on issues of corporate law, the impact of these rulings is substantial for lawyers everywhere involved in the litigation of shareholder derivative actions. Further, given the volume of derivative cases filed following the financial crisis and the heightened merger and acquisition activity that is continuing into the new year, we can expect to see these two rulings play a major role in shareholder litigation in 2011.
Brian Robbins is the co-founder and managing partner of Robbins Umeda in San Diego. Gregory Del Gaizo is an associate with the firm focusing on shareholder rights litigation.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media, publisher of Law360.
* The firm name changed from Robbins Umeda LLP to Robbins Arroyo LLP on January 1, 2013.