Boards dodge bullet: Dela. justices retain limits on derivative suits
In July, the justices of the Delaware Supreme Court entertained oral arguments on a question the 9th Circuit Court of Appeals asked them to answer: Can shareholders maintain post-merger derivative claims against officers and directors whose alleged misconduct drove their company into a disadvantageous deal? In ordinary circumstances, shareholders lose the right to assert derivative breach-of-duty claims on behalf of the corporation when a merger ends their stock ownership. There’s only one exception to that rule of continuous ownership, under 30-year-old Delaware precedent, for sham mergers undertaken specifically to end the threat of liability against the board. But shareholders in a Los Angeles federal court case against Countrywide persuaded the 9th Circuit that the Delaware Supreme Court, in dicta in a separate but related Countrywide case, may have widened the exception. The federal appeals court asked the state court to clarify its position.
For corporate boards, there was considerable danger in this seemingly technical question. Corporate directors have duties to the companies they serve, but it’s exceedingly rare for companies to sue their own board members for breaching those duties. Shareholders are far, far more likely to bring breach-of-duty cases against directors, acting derivatively on behalf of the corporation. Merger announcements, for instance, are almost always followed by shareholder derivative suits asserting that the target company’s board didn’t get a good enough price. Derivative suits are very tough for shareholders to win, given Delaware’s deference to the business judgment of corporate boards, but they can be useful for leverage in settlement talks, especially when companies are eager to resolve M&A litigation and wrap up their deals. Corporations have leverage, too, however: If shareholders don’t settle derivative claims before deals go through, their cases are over because they no longer have standing to sue on behalf of the acquired corporation.
That delicate balance of power would shift if shareholders could continue to press their derivative cases after mergers go through, boosting the value of their cases and almost certainly guaranteeing more breach-of-duty complaints. Certainly, if the Delaware Supreme Court expanded the narrow exception permitting shareholders to maintain post-merger derivative claims, shareholders and corporate defendants would spend years in Chancery Court litigation to define the new borders of breach-of-duty litigation.
Nevertheless, at oral arguments in July, the state Supreme Court justices seemed disturbed that directors can evade liability to shareholders through the very merger their misconduct necessitated – and intrigued by the prospect of holding boards accountable. They pelted shareholder lawyer Stuart Grant of Grant & Eisenhofer with questions about what form post-merger breach-of-duty claims might take. Would they be derivative or direct – or an entirely new hybrid of derivative and direct claims? Should the right to a cause of action somehow transfer to former shareholders after a merger? How would money flow from the now-disintegrated board, since recoveries in typical derivative litigation belong to the corporation, not to shareholders?
At the end of the argument, Justice Carolyn Berger seemed to find a path through the thicket. Perhaps, she suggested, post-merger derivative claims are already covered by the 30-year-old fraud exception to the continuous ownership rule. (That theoretical exception has apparently never been litigated in a reported case.) That would permit shareholders to recover under post-merger claims without creating a whole new category of litigation in Delaware or otherwise redefining the meaning of a derivative claim.
Countrywide’s lawyer, Brian Pastuszenski of Goodwin Proctor, told the justices there’s no need to meddle with shareholders’ causes of action. They can bring derivative claims when they own stock in the corporation. Or they can assert direct claims against board members under Chancery Court precedent in a 1964 case called Braasch v. Goldschmidt. (Indeed, he said, Countrywide shareholders settled direct breach-of-duty claims against the board as part of Delaware litigation related to its merger with Bank of America.) Pastuszenski said the court should not invent a new form of litigation that “magically” converts a pre-merger derivative claim into a post-merger direct claim when there is already a means for shareholders to hold boards accountable.
In a 20-page ruling Tuesday, the en banc Delaware Supreme Court agreed. After devoting most of the decision to a discussion of the long history of intersecting Delaware and California derivative claims against Countrywide’s board, the state justices said tersely that they never intended, in the 2011 opinion that led to the 9th Circuit’s request for clarification, to suggest that Countrywide shareholders should be permitted to maintain post-merger derivative claims. Dicta in that ruling, the court said, was intended to refer to direct claims by shareholders, not to expand the fraud exception to the rule of continuous ownership or to suggest a material change in the longstanding definition of derivative claims.
So that’s that. The status quo holds. Board members who drive their companies into fire sale mergers can rest easy, but so can board members who would face groundless derivative claims under an expanded fraud exception. (The ruling proved me wrong: After oral arguments, I thought the court was poised to give shareholders alleging that director misconduct forced a merger a right to proceed with post-merger claims under the fraud exception.)
Shareholder lawyer Stuart Grant didn’t respond to my email request for comment, but he told Am Law’s Litigation Daily that the Supreme Court’s ruling was “incomprehensible,” unjust and at odds with dicta in its own earlier decision. Countrywide counsel Pastuszenski declined comment.