Dela. high court to rule: Can derivative fraud suits outlive mergers?

January 11, 2013

If ever there was a corporate board that should have been worried about breach-of-duty accusations, it was the directors of Countrywide in 2007 and 2008, after the collapsing real estate market exposed fatal flaws in the mortgage lender’s business model. Shareholder lawyers, always quick to sense opportunity in corporate scandal, began to file derivative suits accusing Countrywide directors of countenancing fraud in the fall of 2007. By May 2008, the cases had been consolidated in federal court in Los Angeles, and lead counsel at Bernstein Litowitz Berger & Grossmann and Grant & Eisenhofer had successfully countered most of the defendants’ dismissal arguments. At that point, it appeared that the Countrywide case could turn out to be a true rarity: a derivative suit that actually generated money damages.

Then Bank of America rode in and bought Countrywide for $2.5 billion. Regardless of what you think of that acquisition, which has been dubbed the worst banking deal of all time, the merger offered at least one very distinct benefit for Countrywide board members. Because the deal was structured as a stock-for-stock transaction, the Countrywide shareholders who had brought derivative breach-of-duty claims against the board, and had survived a motion to dismiss most of those claims, no longer held Countrywide stock. That meant they no longer had standing to assert their case on behalf of Countrywide. After the merger was completed in July 2008, Bank of America, not the former Countrywide shareholders, owned claims against Countrywide board members — and BofA certainly wasn’t going to assert them, since the merger agreement specifically indemnified the board.

The merger, in other words, seemed to spell the end of the derivative suit. In December 2008, U.S. District Judge Mariana Pfaelzer of Los Angeles said as much when she dismissed the case. The judge quoted from the Delaware Supreme Court’s 1984 ruling in Lewis v. Anderson: “It is well established that a merger which eliminates a derivative plaintiff’s ownership of shares of the corporation for whose benefit she has sued terminates her standing to pursue those derivative claims.” Lewis included an exception for cases in which the entire merger is a fraud engineered to protect the board, but Pfaelzer said the fraud exception doesn’t encompass the BofA deal, in which the directors’ escape from liability was the side effect of a legitimate merger.

Or does it? On Thursday, the 9th Circuit Court of Appeals breathed life into the former Countrywide shareholders’ derivative claims, with an order asking the Delaware Supreme Court to clarify the scope of the fraud exception. The 9th Circuit order frames the question legalistically, but it comes down to this: If shareholders plausibly allege that the board’s fraud made the company vulnerable to an acquisition at fire-sale prices, can they maintain derivative claims?

The Delaware Supreme Court’s answer could have consequences way beyond the Countrywide case. Countrywide, after all, is hardly the only company to end up in an acquirer’s hands after a corporate scandal depresses its share price. (Think of Bear Stearns, Washington Mutual and Massey Energy, for instance.) If the Delaware Supreme Court holds that in order to proceed with derivative claims, it’s enough for shareholders to assert that the board’s wrongful conduct led directly to the acquisition, we could see a spike in significant derivative cases.

Plaintiffs’ lawyers in the Countrywide case think there’s good reason to believe the Delaware court will side with them. As Bernstein Litowitz and Grant & Eisenhofer explained in their brief to the 9th Circuit, the Delaware justices already hinted at their thinking in an en banc opinion in March 2011, in yet another branch of the Countrywide litigation. (The background of the Delaware ruling is a bit complicated but it’s relevant, so bear with me.) The Delaware case was filed by a different set of Countrywide shareholders, who sued to enjoin the merger between Countrywide and BofA. That case reached a proposed settlement that included no consideration for derivative claims against the board. The shareholders from the derivative case in California objected to the settlement, arguing that their derivative claims should be preserved. But the Chancery Court approved the deal anyway, holding that the merger wasn’t primarily motivated by a desire to cover up supposed wrongdoing by the Countrywide directors but by economic necessity.

The Delaware Supreme Court said that was the proper outcome and affirmed approval of the settlement. Then, however, the court went on to muse, in dicta, about the fraud exception. “Although we agree that the Countrywide directors and stockholders ran from the crest of a ruinous wave of losses, we cannot ignore the close connection between that wave’s crest and its underlying trough,” wrote Chief Justice Myron Steele. “No one disputes that Countrywide needed to sell itself, and at a price significantly below its recent share price. An otherwise pristine merger cannot absolve fiduciaries from accountability for fraudulent conduct that necessitated that merger.” Whether the merger that resulted from the supposed fraud was part of the board’s plan (a scenario already encompassed by the fraud exception) or “merely ties together, like patchwork, a snowballing pattern of fraudulent conduct and conscious neglect,” the Delaware court said, “the result is the same and would not fairly constitute a proper discharge of the fiduciary duties of directors of a Delaware corporation.”

And in those circumstances, the Delaware court concluded, shareholders from the acquired corporation — and not the corporation itself — can recover from board members. “The injured parties would be the shareholders who would have post-merger standing to recover damages instead of the corporation,” the opinion said.

The language in the March 2011 opinion certainly seems to presage an expansion of the fraud exception when the Delaware high court responds to the 9th Circuit’s certification. Countrywide shareholder counsel Blair Nicholas of Bernstein Litowitz told me in an email that he expects no less. “The Delaware Supreme Court got it absolutely right the first time when it clearly indicated that Delaware law recognizes a single, inseparable fraud when directors cover massive wrongdoing with an otherwise permissible merger,” he said. “I fully expect the Delaware Supreme Court will reiterate that under Delaware law, corporate officers cannot simply find a white knight to purchase the company and bail them out of their shareholder derivative liability.”

In Countrywide’s brief at the 9th Circuit, its lawyers at Goodwin Procter argued that the Delaware Court’s ruling in March 2011 addressed direct claims by shareholders and not the sort of derivative claims asserted in the California case. The 9th Circuit’s request for clarification should resolve any uncertainty on that point.

A Bank of America representative declined comment.

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