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5 Tools for Defending Against Copycat Derivative Suits
Its tough enough dealing with a class action or whistleblower suit targeting your company. The situation gets much more complex when a shareholder simultaneously pursues a copycat derivative action. These derivative suits repeat the allegations from another direct suit against the company, but assert them on behalf of the company against its officers and directors, claiming that they breached their fiduciary duties by participating in or failing to prevent the wrongdoing alleged in the initial suit. Although the shareholder plaintiffs who bring these copycat derivative suits purport to be acting in the corporations best interest, they presume that the corporation is culpable for the wrongdoing alleged in the underlying litigation, even while the corporation is still contesting that claim.
1. Responding to a Shareholder Demand Letter
To bring a derivative suit on behalf of the corporation, a shareholder must first make a demand on the board, calling upon it to prosecute claims on behalf of the company against the alleged wrongdoers, or (where the applicable law permits it) show why this demand requirement should be excused. If the board refuses a demand and the shareholder still files a derivative complaint, the boards decision is typically entitled to deference under the business judgment rule, and the court will dismiss the demand-refused suit unless the shareholder can demonstrate that the refusal was wrongful.
2. Moving to Dismiss the Demand-Excused Derivative Suit
Under some states lawmost notably Delawareshareholders can bring a derivative suit without making a pre-suit demand on the corporations board if they can show why the demand requirement should be excused. In the most common copycat derivative complaint, for example, the shareholder claims that the directors and officers breached their fiduciary duties by failing to provide sufficient oversight to prevent the wrongdoing alleged in the underlying litigation. The shareholder then argues that the directors cannot consider a pre-suit demand impartially because they themselves would face personal liability if the suit went forward.
3. Seeking a Stay
It may also make sense to ask the court to stay the derivative suit until the related direct litigation is resolved. For example, earlier this year the Delaware Court of Chancery stayed a derivative suit on the ground that party admissions and adverse judicial rulings in that case, if it proceeded, might prejudice the companys defense in a related securities class action. The court also noted that staying the derivative suit was reasonable because the primary relief requestedindemnification from the officers and directors for anticipated damages in the securities class actionwas necessarily contingent on the outcome of that action. See Brenner v. Albrecht, 2012 WL 252286 (Del. Ch. Jan. 27, 2012).
4. Forming a Special Litigation Committee
Motions to dismiss a derivative suit may not be practical, or successful, in every case. Where a majority of directors are concededly not disinterested and independent, or where a motion to dismiss fails, the board can still maintain some control over a derivative action by appointing a special litigation committee (SLC) of disinterested and independent directors to review the allegations in the shareholders derivative complaint. Courts will ordinarily stay the derivative action while the SLC conducts its investigation. If the SLC concludes that pursuit of the derivative suit is not in the corporations best interest, and the SLCs report passes the courts review, then the suit will be dismissed.
5. Deferring Discovery
Aggressive plaintiffs counsel may seek early document discovery to bolster an amended complaint. Courts in Delaware and elsewhere, however, have held that derivative plaintiffs are not entitled to discovery to support claims that the demand requirement should be excused or that a demand was wrongfully refused. Accordingly, while not all jurisdictions agree, many courts will stay discovery in derivative suits until shareholder plaintiffs have established their standing in the face of a motion to dismiss. In addition, where a state derivative suit parallels a federal securities suit, federal courts have discretionary authority to stay discovery in the state derivative suit while a motion to dismiss the federal securities suit is pending.
Copycat derivative suits are much easier to manage when they are delayed until after the underlying litigation has been resolved. If the corporation successfully defends the direct claims against it, then a plaintiff shareholder will be hard pressed to assert in a related derivative action that the corporation has been harmed. And even if the corporation settles or loses the direct suit, the scope of liability and damages for misconduct will be clearer and the board can then address a shareholders related derivative demand or suit without fear of undermining the corporations litigation position in the direct suit.