Chancery’s message to shareholders: Race to the courthouse is back on

June 15, 2016

(Reuters) – When plaintiffs’ lawyers contemplate the filing of a shareholder derivative complaint, they have to make a fundamental choice: They can rush to the courthouse with easily obtained information from news stories and public filings or they can conduct an investigation before they sue, using corporate books and records that shareholders are entitled to see in order to inform their allegations.

Historically, the shareholder bar took the first approach. In derivative litigation, shareholders stand in the shoes of the corporation to accuse directors and officers of breaching their duties. To survive a motion to dismiss, plaintiffs have to show it would have been futile to demand that the board bring a lawsuit on behalf of the corporation because board members cannot be trusted to act independently and against their personal interests. Demand futility, as this element is known, is typically litigated right off the bat. So the incentive for plaintiffs’ lawyers who wanted to seize control of the litigation was to force defendants to litigate demand futility in their case. Waiting to conduct a pre-suit investigation meant ceding control to fast filers.

A few years ago, when corporate defense complaints about multijurisdictional shareholder litigation were at a crescendo, Delaware’s Chancery Court tried to realign incentives for the shareholder bar. Instead of rewarding fast filers, Delaware judges encouraged plaintiffs’ lawyers to demand to see corporate books and records – the “tools at hand,” in Chancery lingo – before drafting derivative complaints. In 2012, for instance, then Chancellor Leo Strine, who is now the Chief Justice of Delaware’s Supreme Court, flat-out refused to appoint lead counsel in a promising derivative case against Wal-Mart board members because none of the contenders had asked for books and records. His implicit promise was that the shareholder firm Grant & Eisenhofer, which had taken Chancery’s hints and filed a books and records case, would eventually get to be in charge of the derivative suit. At the time, plaintiffs’ lawyer Frederic Fox of Kaplan Fox told me the chancellor had “created a new dynamic.”

Well, the new dynamic didn’t last long. In two recent opinions – a decision last month in Grant & Eisenhofer’s Wal-Mart case and a ruling yesterday in a Delaware derivative case against Lululemon board members – Strine’s successor, Chancellor Andre Bouchard, has declined to reward plaintiffs’ firms for conducting pre-suit books and records investigations. In both opinions, Chancellor Bouchard said Delaware derivative suits filed after long, fierce litigation to obtain corporate records were precluded by demand futility decisions in cases brought by fast filers in other jurisdictions.

And in both rulings, the chancellor rejected arguments that shareholders were not adequately represented in the fast-filed cases because their lawyers did not wait to examine corporate books and records. (I’ve previously written about the fight between plaintiffs lawyers in the two-pronged Wal-Mart derivative litigation, which involved claims in Arkansas federal court and Delaware Chancery Court that board members failed shareholders in their handling of allegations of bribery in Wal-Mart’s Mexican operation.)

“It is certainly better practice for stockholder plaintiffs to use ‘the tools at hand’ to investigate their claims thoroughly before launching derivative suits, and I share the concerns Delaware courts have expressed regarding the risk of diligent derivative plaintiffs being collaterally estopped by fast filers,” Chancellor Bouchard wrote in the Wal-Mart decision. “Indeed, it may turn out  that the Arkansas plaintiffs’ assessment of their ability to establish demand futility without pursuing books and records from Wal-Mart was ill-advised. But, in my opinion, that decision falls into the category of an imperfect legal strategy and does not rise to the level of litigation management that was so grossly deficient as to render them inadequate representatives.” (Hat tip to The Chancery Daily, which was the first to report on both the Lululemon and Wal-Mart opinions.)

The two decisions, according to plaintiffs’ lawyers in the Lululemon case, will discourage shareholder lawyers from investigating before they file derivative claims – and will encourage corporate defendants facing claims in multiple jurisdictions to pick on their weakest opponents. Both developments are bad for investors and their lawyers. “You cannot have the stick without the carrot,” said Gustavo Bruckner of Pomerantz. “Giving preclusive effect to inadequate representatives who race to the courthouse with incomplete information and undeveloped claims encourages defendants to cherry pick their plaintiffs. Valid claims will never be litigated or even investigated.”

Bruckner and his co-counsel from Motley Rice and Rosenthal, Monhait & Goddess thought they had particularly strong arguments about why plaintiffs’ lawyers in a Manhattan federal court derivative case against the Lululemon board had not adequately represented shareholders. (Both the New York and Delaware cases broadly involved allegations that the board messed up the handling of a crisis over see-through fabric in Lululemon yoga pants; the Delaware suit specifically homed in on claims the company’s founder engaged in insider trading in advance of news the CEO was resigning.)

As Delaware Lululemon plaintiffs’ lawyers detailed in their opposition to the board’s motion to dismiss the case, the Delaware lawyers faulted their New York rivals for failing to investigate before rushing to file a skimpy complaint, opposing the intervention of Delaware counsel armed with additional information and then amending their complaint with allegations lifted directly from a parallel securities fraud class action. When U.S. District Judge Katherine Forrest of Manhattan dismissed the New York derivative case for failure to plead demand futility, she specifically referred in a footnote to passages in the amended complaint that were “copied verbatim or with minimal conforming changes” from the class action pleading.

In his ruling Tuesday to toss the Delaware derivative suit, Chancellor Bouchard agreed that allegations about the conduct of the New York plaintiffs’ firms were “unfortunately, reflective of undesirable practices that pervade representative litigation as lawyers for stockholders jockey for control of a case in an effort to secure a payday for themselves, assuming they ultimately can confer a benefit upon the stockholders or the corporation.” If the accusation about copying the amended New York derivative complaint from another pleading was true, the chancellor said, it “reflects poorly on how counsel for the NY plaintiffs litigated their case.”

But in the end, Bouchard said, the New York firms adequately represented Lululemon shareholders standing in the shoes of the corporation. “No contention has been made that their counsel are not experienced in corporate litigation, even if they did commit plagiarism,” he wrote. “Nor have plaintiffs identified any striking differences between the factual allegations that form the basis of the relevant claims asserted in either action.”

Bouchard suggested in the Lululemon ruling that to keep the Delaware case alive, plaintiffs’ lawyers would have had to show the interests of their New York counterparts were not aligned with those of the corporation, not just that the New York lawyers were (allegedly) sloppy and selfish. The chancellor is setting an awfully high bar, considering that contingency fee lawyers can always argue their interest is in recovery for the corporation.

I called the three plaintiffs’ firms listed as counsel on the brief opposing dismissal of the New York derivative suit. David Katz of Weisslaw and Robert Weiser of the Weiser Law Firm did not call me back. Curtis Trinko of The Law Offices of Curtis V. Trinko said he “wasn’t in the derivative case” so he could not be responsible for alleged plagiarism.

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