Delaware justices: Do we need new vehicle for post-merger derivative suits?
You might not expect Dr. Seuss and Jekyll & Hyde to be invoked in oral arguments before the Delaware Supreme Court on the question of whether shareholder derivative breach-of-duty claims against corporate directors can survive a merger when that merger is allegedly the result of the directors’ misconduct. But indeed they were, amid discussion of slippery, transmogrified claims that left four Delaware justices (as well as lawyers on both sides) searching for analogies.
If I had to proffer a prediction, I’d guess that the Supreme Court will adopt the Jekyll & Hyde model – finding that shareholders have a surviving claim under the fraud exception Delaware justices already carved out in the court’s seminal 1984 decision in Lewis v. Anderson – rather than create a new, Seussian “quasi-derivative” cause of action. Either way, I think that oral arguments, which I was able to watch live courtesy of Courtroom View Network, boded well for shareholders trying to revive a derivative suit against Countrywide’s directors and officers, and not so well for Countrywide, despite the best efforts of its counsel Brian Pastuszenski of Goodwin Procter.
As it happens, the shareholder derivative suit came to the Delaware Supreme Court by way of the 9th Circuit Court of Appeals, which certified a question to the state justices in January: “Whether, under the ‘fraud exception’ to Delaware’s continuous ownership rule, shareholder plaintiffs may maintain a derivative suit after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims.” The 9th Circuit said it needed an answer from Delaware in order to decide whether to reanimate a years-old shareholder suit against Countrywide’s board that had been dismissed by a district judge in Los Angeles after Bank of America acquired the mortgage lender.
Under Delaware precedent in Lewis v. Anderson, shareholders lose standing to pursue derivative claims on behalf of the corporation when a merger eliminates their ownership interest. The only exception noted in Anderson is when the entire merger is a fraud intended only to protect the board, which BofA’s acquisition of Countrywide was not. But in dicta in a 2011 ruling in a tangentially related case against Countrywide, the Delaware Supreme Court had mused about whether shareholders should still have a cause of action when the merger that deprived them of standing was actually the inevitable result of corporate malfeasance. That dicta led the 9th Circuit to seek additional instruction from the Delaware court.
In the 2011 decision, the Delaware justices didn’t specify any particular vehicle for hypothetically surviving shareholder derivative claims, but at oral arguments on Wednesday, Stuart Grant of Grant & Eisenhofer, arguing on behalf of the Arkansas Teacher Retirement System and other onetime Countrywide shareholders, said the form of the suit was a matter of mere labeling. He quoted the court’s strong language about Countrywide’s conduct back to the four justices sitting on the bench (Chief Justice Myron Steele, who wrote the 2011 opinion, was absent) and paraphrased Dr. Seuss: “I said what I said and I meant what I meant, Delaware is faithful 100 percent.” Grant urged the justices to abide by their dicta and permit shareholders with derivative claims to hold directors accountable for their breaches of duty.
Justice Jack Jacobs pressed Grant on what form those claims should take after the merger. Derivative suits, after all, are brought by shareholders on behalf of the corporation itself. Should post-merger claims be derivative? Or should they be direct claims by shareholders acting on their own behalf? (That’s a crucial question in this case, in which a different set of shareholders released direct claims against the Countrywide board in connection with the settlement of deal-related litigation.) Grant said the Delaware Supreme Court could hold that a derivative action converts into a direct action in the unusual circumstances presented in this case. Or, Grant suggested, the court could create “a new animal,” calling post-merger breach-of-duty claims by former shareholders a “quasi-derivative” action.
Jacobs said he was concerned that it would take years of litigation to set the parameters of such a new kind of suit, which he said was “hard to conceptualize.” Grant reminded the court that it needed some new thinking to square litigation with economic realities. The reality, he said, is that Countrywide shareholders were injured when the actions of the board drove the company into a disadvantageous deal with Bank of America. Countrywide received no benefit for the shareholders’ pre-merger derivative claims in the BofA deal because the company had no choice but to agree to the acquisition. Those circumstances would also argue against any direct claim by shareholders related to the merger price, Grant said. Bank of America certainly wasn’t going to pursue derivative claims against Countrywide’s board, which it indemnified. And even if it did, Grant said, that benefit would accrue to BofA’s current shareholders, most of whom are not former Countrywide shareholders.
Countrywide counsel Pastuszenski picked up on Justice Jacobs’s concerns about creating a new vehicle. “The concept of a quasi-derivative claim, as far as I know, has no foundation, no underpinning in Delaware law,” he told the court, adding that “there is no need and no basis” to change the interpretation of derivative standing that Delaware courts put in place in the Anderson decision back in 1984. If shareholders want to sue their directors for driving a company into a firesale merger, they can and should bring direct claims in connection with the transaction, the Countrywide lawyer said.
Justice Jacobs pointed out that breach-of-duty claims are typically asserted through derivative litigation, not direct suits. Justice Carolyn Berger asked Pastuszenski why derivative claims should not flow to former shareholders after a deal. The Countrywide lawyer said Delaware law doesn’t provide for that eventuality. Derivative claims, he said, cannot “change stripes almost magically.” (Soon thereafter, Jacobs made the Jekyll & Hyde analogy, wondering if shareholder breach of duty claims are both direct and derivative at the same time.)
During Grant’s rebuttal, the court picked up on a potential way to resolve the dilemma of giving former shareholders accountability without creating a whole new category of litigation. Anderson, remember, contains a carve-out permitting former shareholders to maintain derivative claims if the merger that wipes out their interest is a fraud. That fraud exception has never actually come into play in derivative litigation in the 30 years since the Anderson ruling. So when one of the justices asked Pastuszenski where the money would flow if former shareholders obtained an award under the fraud exception, the Countrywide lawyer said there’s no precedent. Then, during Grant’s rebuttal, one of the justices wondered aloud whether claims by the former Countrywide shareholders could be considered another exception within the Anderson framework. Justice Berger saw where that question led. Since the Delaware court never explained in Anderson how recovery under the surviving derivative claims would flow under the fraud exception, and hasn’t explained it since because the exception hasn’t been litigated, she said, shouldn’t it be assumed that the money would flow to former shareholders? And if that’s the case, couldn’t the derivative claims of the former Countrywide shareholders be considered akin to carved-out derivative claims by defrauded shareholders in Anderson?
A beaming Stuart Grant knew when to take the win: “Exactly,” he said.
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