5 Tools for Defending Against Copycat Derivative Suits

Michael S. Gardener and A. W. "Chip" Phinney

Corporate Counsel

2012-10-08 00:00:00.0

It’s 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 corporation’s 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.

These copycat derivative suits can be a huge headache for corporate counsel. They can multiply litigation costs, distract the company’s leaders, and subject the company to duplicative discovery from different plaintiffs and inconsistent rulings from different courts. Worse still, they can potentially jeopardize the company’s defense in the underlying direct suit. But there are tools to stop or stay these copycat derivative suits early in the litigation process and prevent them from interfering with the company’s defense in the underlying proceedings.

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 board’s 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.

While the pre-suit demand requirement protects the board’s prerogative to manage the corporation’s affairs, it puts directors in a difficult position when a shareholder asks the board to pursue claims concerning alleged corporate wrongdoing that is already the subject of pending litigation or government inquiry. If the board fails to investigate and respond to the demand, a court may permit the shareholder to proceed with the derivative action. But if the board investigates, uncovers misconduct, and files suit against company insiders, that will likely be treated as an admission of liability in the underlying litigation and compromise the company’s defense.

Fortunately, courts have acknowledged that where a company is already defending itself against litigation or a government investigation, it is a reasonable exercise of business judgment for the board to reject a shareholder’s demand on the ground that concurrently pursuing related claims against directors or officers could adversely affect the company’s position in the pending proceedings.

For example, courts have dismissed derivative suits concerning Merrill Lynch’s losses on subprime mortgage securities and the nationwide sex discrimination class action against Wal-Mart, based upon the boards’ determinations in those cases that further action on the shareholders’ demands would not be in the companies’ best interests while the underlying litigation was continuing. See In re Merrill Lynch, 773 F.Supp.2d 330 (S.D.N.Y. 2011), appeal docketed, (2d Cir. April 1, 2011); and Furman v. Walton, 2007 WL 1455904 (N.D. Cal. May 16, 2007), aff’d, 320 Fed.Appx. 638 (9th Cir. 2009).

Where a shareholder makes a demand—and the board decides that bringing suit is not in the company’s best interest due to potential conflicts with other pending litigation against the company—the board should respond promptly in a letter that explains its reasoning. The letter should describe the pending litigation and how the company’s defense of that litigation would be harmed by the pursuit of related claims against its officers and/or directors. The letter should analyze any weaknesses in the shareholder’s proposed claims and consider whether any possible recovery against directors and officers may be far outweighed by the company’s potential exposure in the underlying litigation. Where a good faith review of these issues supports the board’s decision not to pursue litigation, that decision is more likely to be respected by the court if the shareholder subsequently files a derivative action.

2. Moving to Dismiss the Demand-Excused Derivative Suit

Under some states’ law—most notably Delaware—shareholders can bring a derivative suit without making a pre-suit demand on the corporation’s 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.

It is often possible to win dismissal of such “demand-excused” derivative suits because they have failed to plead the particularized factual allegations that are usually required to demonstrate that a demand would be futile. Where a shareholder plaintiff claims that directors cannot fairly evaluate a demand because they would be defendants themselves in the proposed suit, the complaint must contain specific allegations showing on a director-by-director basis that they face a substantial likelihood of liability. This is hard for shareholder plaintiffs, because most corporate charters limit directors’ liability for monetary damages to cases where the directors breached their duty of loyalty, which requires a showing that they acted with scienter; mere negligence is not enough.

Thus, in a complaint claiming inadequate oversight, the plaintiff must allege facts showing that the directors consciously disregarded their duty by utterly failing to implement any kind of compliance system, consciously failing to monitor it, or consciously ignoring known red flags that should have alerted them to corporate misconduct. Knowledge of a particular problem will not be imputed to the directors merely because of their board roles. While copycat derivative complaints often repeat ad nauseam the allegations from the underlying litigation, they often have great difficulty presenting facts sufficient to show that a majority of directors consciously disregarded their duty.

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 company’s defense in a related securities class action. The court also noted that staying the derivative suit was reasonable because the primary relief requested—indemnification from the officers and directors for anticipated damages in the securities class action—was 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 corporation’s best interest, and the SLC’s report passes the court’s 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.

Conclusion

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 shareholder’s related derivative demand or suit without fear of undermining the corporation’s litigation position in the direct suit.

It rarely makes sense for derivative actions to proceed while related direct claims against the corporation are still being litigated. Using the five tools outlined above can help corporations, their counsel, and their boards avoid concurrent litigation of copycat derivative suits and prevent these nuisances from turning into nightmares.

Michael S. Gardener and Chip Phinney are members in the litigation section of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo. They have extensive experience in derivative litigation, including cases in which they have won dismissal of derivative suits of the sort described above.