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Shareholder derivative actions have become increasingly more commonplace in New Jersey courts for a variety of reasons, including the bursting of the stock market bubble in 2000 and the high-profile corporate scandals that have rocked the financial world over the past two years. Given the nature of these actions, it is important for commercial litigators to be prepared very early in such cases to address certain critical issues to assist corporations, and their directors, in possibly avoiding protracted litigation. In defending such cases, the early stages are crucial. There are both procedural and substantive issues that must be addressed at the outset. The procedural issues include whether the plaintiff possesses requisite standing to assert the claims (that is, whether the plaintiff was even a shareholder at the time of the alleged conduct) and whether the plaintiff made the appropriate demand upon the corporation (or can demonstrate futility in doing so) prior to instituting the action. Other issues include choice of law and whether the plaintiff has pleaded certain claims with requisite particularity. All of these issues must be analyzed so that the corporation can determine how to proceed. Will it attempt to dismiss the action or stay the action and exercise its right to form a special committee and investigate the claims? Or even do both? Background A shareholder derivative action is a lawsuit initiated by a shareholder to enforce a corporate cause of action against officers, directors and third parties when the corporation has failed or refused to assert its rights in this regard. Kamen v. Kemper Financial Services, Inc., 500 U.S. 90 (1991). Shareholder derivative lawsuits have been described as “double suits” or “two suits in one” because, in essence, the plaintiff sues to compel the corporation to assert the cause of action and also brings suit on behalf of the corporation against the third party that has caused harm to the corporation. Kramer v. Western Pacific Industries, Inc., 546 A.2d 348, 351 (Del. 1988). Such actions act as both a sword and a shield; a sword for shareholders to remedy an alleged wrong against the corporation and a shield for directors and officers from direct shareholder actions for certain injuries. Strasenburgh v. Straubmuller, 146 N.J. 527, 549 (1996). As described in the New Jersey Court Rules, a shareholder derivative action is “an action brought to enforce a secondary right on the part of one or more shareholders in an association, incorporated or unincorporated, because the association refuses to enforce rights which may properly be asserted by it.” R. 4:32-5. To initiate a shareholder derivative action in New Jersey, certain specific procedures must be followed. A shareholder derivative action must be initiated by the filing of a verified complaint which alleges “that the plaintiff was a shareholder at the time of the transaction complained of, or that the share thereafter devolved by operation of law.” Additionally, the plaintiff is required to set forth with particularity what efforts were made to secure — from the managing directors or trustees and, if necessary, from the shareholders — such action as is desired, but was unable to obtain (or the reasons for failing to make such efforts). Furthermore, once the complaint is filed and a summons is issued, the plaintiff must give notice of the pendency and object of the action to other shareholders as the court, by order, directs. For the plaintiff to be able to maintain the action, the rule states that the plaintiff must be able to “fairly represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association.” Thus, prior to considering substantive issues of law that may arise in a derivative action, there are procedural issues that are specific to derivative actions, which defense counsel must address early in the litigation. The Internal Affairs Doctrine One issue to address is what law applies. It is well settled that the internal affairs of a corporation are to be governed by the law of the state in which the corporation is incorporated. This principle, known generally as the “internal affairs doctrine,” reflects the practical recognition that the relationship between a corporation, its directors and its shareholders should be regulated by the laws of one state — the state in which it has chosen to incorporate — and not through a patchwork of different states’ laws. Accordingly, even though a lawsuit is filed in New Jersey and the corporation’s principal place of business might be New Jersey, if the corporation was incorporated in another state, the law of the state of incorporation should control. Unlike with many other general civil actions, courts have rejected the garden variety “significant relationship” conflicts-of-law mode of analysis when lawsuits, such as shareholder derivative actions, involve the internal affairs of a corporation. See McDermott Inc. v. Lewis, 531 A.2d 206 (Del. 1987). In fact, the McDermott court explained that such an analysis is not appropriate where the internal affairs of a corporation are involved: Corporations and individuals alike enter into contracts, commit torts, and deal in personal and real property. Choice of law decisions relating to such corporate activities are usually determined after consideration of the facts of each transaction. In such cases, the choice of law determination often turns on whether the corporation had sufficient contacts with the forum state, in relation to the act or transaction in question, to satisfy the constitutional requirements of due process. The internal affairs doctrine has no applicability in these situations. Rather, this doctrine governs the choice of law determinations involving matters peculiar to corporations, that is, those activities concerning the relationships inter se of the corporation, its directors, officers and shareholders. According to the McDermott court, this doctrine is of “serious constitutional proportions” — under the due process, commerce and full faith and credit clauses — and promotes certainty and stability in regulating corporate internal affairs, as well as the relationships between and among shareholders and directors. In the absence of the internal affairs doctrine, or if it were to be ignored, the resulting application of multiple state laws to a corporation’s internal affairs would result in an intolerable burden on the corporate form. See In re Oracle Corp. Derivative Litigation, 808 A.2d 1206 (Ch. Del. 2002). Accordingly, since the law of the state of incorporation controls in shareholder derivative actions (and that law might be more or less beneficial to your client), conflicts of law analysis is a critical part of defending such cases. Contemporaneous Ownership Rule Another area to consider at the very outset of a derivative action is the issue of whether the plaintiff was actually a shareholder at the time that the alleged wrongdoing occurred. For a plaintiff to have standing to bring a derivative action, New Jersey law requires that the plaintiff be a shareholder at the time the wrongdoing of which he complains occurred. R. 4:32-5; N.J.S.A. 14A: 3-6(1). This rule is commonly referred to as the contemporaneous ownership rule and is not only reflected in the New Jersey Rules and statutes, but has been affirmed by New Jersey courts and has been adopted by most states. See Pogostin v. Leighton, 216 N.J. Super. 363 (App. Div. 1987), Kramer v. Western Pacific Indus., Inc., 546 A.2d 348 (Del. 1988) and Ettridge v. TSI Group, Inc., 548 A.2d 813 (Md. 1988). As the Pogostin court noted, the purpose of this rule “is to eliminate strike suits and other abuses which developed along with derivative suits.” The contemporaneous ownership rule can be a powerful tool in defending derivative actions because courts will usually strictly enforce it. This strict enforcement is justified because: (1) a stockholder bringing suit after acquiring his shares has sustained no injury because he received what he paid for; (2) to permit such an action would result in a windfall to the subsequent stockholder; and (3) permitting such action would allow the stockholder to reap a profit from wrongs done to others, thus furthering speculative litigation. See Bangor Punta Operations, Inc. v. Bangor & Aroostook R. Co., 417 U.S. 703 (1974). New Jersey courts do, however, recognize an exception to the contemporaneous ownership rule, commonly referred to as the “continuing wrong exception,” which allows a shareholder to maintain a derivative suit on the theory that although the alleged wrong commenced before the stock was acquired, it continued until sometime after the stock acquisition. See Valle v. North New Jersey Automobile Club, 74 N.J. 109, 112 (1977), and 13 Fletcher Cyclopedia of Private Corp. �5982 (2002). Thus, given the contemporaneous ownership rule, it is important to discern at the outset of the litigation whether the plaintiff actually possesses the requisite standing to pursue the claims asserted in the derivative action. If not, a motion to dismiss on this basis may be appropriate. One of the reasons that conflicts of law is such a crucial threshold issue in derivative actions is that courts readily apply the law of the state of incorporation in determining the substantive requirements for (1) making a demand on a corporation prior to instituting derivative litigation and (2) determining whether lawsuits assert direct or derivative claims. See Kamen, RCM Sec. Fund, Inc. v. Stanton, 928 F.2d 1318 (2d Cir. 1991) and Saxe v. World Wide Press, Inc., 809 F.2d 610 (9th Cir. 1987). Demand-Futility Unlike some states, New Jersey follows Delaware case law regarding the law of demand-futility. The seminal New Jersey case on demand-futility is In re PSE&G Shareholder Litigation, 173 N.J. 258 (2002). (For a detailed analysis of the Supreme Court’s decision, see “Court Endorses the Business-Judgment Rule,” 170 N.J.L.J. 953, Dec. 16, 2002.) In PSE&G, the Court accepted the demand-futility analysis that the Delaware Supreme Court established in Aronson v. Lewis, 473 A.2d 805 (1984). In its holding, the Court stated: [w]e are satisfied that the Aronson two-prong inquiry, as illustrated in In re Prudential, represents the appropriate standard for evaluating demand futility. The test strikes the appropriate balance between the director autonomy and the interests of shareholders in this context … Accordingly, for shareholder plaintiffs in New Jersey to withstand a motion to dismiss for failure to make a demand, they must plead with particularity facts creating a reasonable doubt that: (1) the directors are disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. If either prong is satisfied, demand will be excused under Rule 4: 32-5. This view, however, is not universally followed. Indeed, the American Bar Association section on Business Law and the American Law Institute have stated that there should be a universal demand requirement in all cases. See Werbowsky v. Collomb, 766 A.2d 123 (Md. 2001)(providing a history of the demand-futility rule and its exceptions, citing the ALI’s Principles of Corporate Governance: Analysis and Recommendations �7.03). The demand, however, would not be required if making a demand and awaiting the board’s response would result in irreparable injury to the corporation. Id. Other states, however, have different views on demand futility. For example, Maryland follows a stricter view then that of the Delaware approach, and while it leans toward the ABA/ALI approach, it falls short of abolishing the futility exception. In Werbowsky v. Collomb, 766 A.2d 123 (Md. 2001), the court held that futility was a very narrow exception; that courts will not excuse demand merely because a majority of the directors approved of or participated in the transaction or decision; and that demand will not be excused merely because the directors would be hostile to the proposed action. Accordingly, given the varied possibilities regarding demand-futility, choice of law can be a very significant issue. Direct vs. Derivative Claims In the initial analysis of shareholder derivative actions, it is important to distinguish between claims that are truly derivative and those that actually belong to the individual shareholder — personal claims. Many times, shareholders will seek damages based on causes of action that actually belong to the corporation — derivative claims. As the Strasenburgh Court stated, in derivative actions, since “[a] corporation is regarded as an entity separate and distinct from its shareholders. … the corporate personality demands that suits to redress corporate injuries which secondarily harm all shareholders alike are brought only by corporations.” As with most general legal principles, there is an exception. The Strasenburgh Court noted that “[T]o determine whether a complaint states a derivative or an individual cause of action, courts examine the nature of the wrongs alleged in the body of the complaint, not the plaintiff’s designation or stated intention.” Further, to establish a personal cause of action as opposed to a derivative cause of action, the injury must be a special injury that is “distinct from that suffered by other shareholders or a wrong involving one of his contractual rights as a shareholder.” Common examples in this regard involve issues arising from patents or employment agreements held by the plaintiff, thus creating a distinct claim separate and apart from the other shareholders. As a result, upon presentation of a complaint against a corporate client, if there are claims being asserted as individual rather than derivative claims, defense counsel must make an initial determination as to whether the claims belong to the individual or to the corporation. If there are derivative claims being asserted as individual claims, a motion to dismiss such claims is certainly appropriate. Claims of Waste Many times, plaintiffs will claim that the directors and officers of a corporation caused funds or property belonging to the corporation to be wasted through gross or culpable negligence. Similar to claims of fraud, however, courts have recognized that such claims should be pleaded with particularity. See Brehm v. Eisner, 746 A.2d 244 (Del. 2000) and Werbosky v. Collomb, 766 A.2d 123 (Md. 2001). Indeed, while granting the defendants’ motion to dismiss, the Eisner court found: [w]aste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade. Most often the claim is associated with a transfer of corporate assets that serves no corporate purpose; or for which no consideration at all is received. Such a transfer is in effect a gift … Courts are ill-fitted to attempt to weigh the “adequacy” of consideration under the waste standard or, ex post, to judge appropriate degrees of business risk. Accordingly, should a derivative shareholder complaint set forth nothing more than conclusory allegations in support of its waste claim, it would be appropriate to challenge such a claim by way of a motion to dismiss based upon a lack of specificity. Special Litigation Committees A unique aspect to representing a corporation or its individual directors and officers in a derivative action is the opportunity to have the lawsuit examined by the corporation to determine whether it is in the best interests of the corporation to pursue the litigation. As set forth above, a derivative action is a lawsuit that is brought by a shareholder on behalf of the corporation. Thus, procedures have been created that permit the corporation to appoint a special litigation committee even if the litigation commenced. The procedure to evaluate the litigation begins with the formation of a special litigation committee. A special litigation committee is “a committee comprised of disinterested, nondefendant directors that investigate a plaintiff’s allegations and decide whether to pursue the claim [that] provides a mechanism by which a corporation can retain control over a demand excused derivative action.” Robert A. Rosenfeld, “Defense of Derivative Claims,” 400 PLI/Lit 137, 144 (1990). The New Jersey Supreme Court recently confirmed that a corporation’s board of directors can appoint a special litigation committee to act on behalf of the corporation and exercise control over a shareholder derivative action. See PSE&G. Based on PSE&G, it would appear that New Jersey courts would follow Delaware law regarding the applicable standards for use of a special litigation committee with some modification. Pursuant to Delaware law, there is a two step procedure that is followed. Zapata v. Maldonado, 430 A.2d 779 (Del. 1981). Under the Zapata standard, the members of the special litigation committee must be independent and they must conduct “an objective and thorough investigation” of the merits of the derivative action. If, after the investigation is complete and the committee determines that it is not in the best interests of the corporation to pursue the litigation, the committee can authorize the filing of a motion to dismiss. The second step of the Zapata procedure is for the court to determine whether the motion to dismiss (or for summary judgment) should be granted. In this second step, the court will analyze this through two elements. “First, the Court should inquire into the independence and good faith of the committee and the bases supporting its conclusions.” With respect to the second part of the test, “[t]he Court should determine, applying its own independent business judgment, whether the motion should be granted.” In accordance with the Supreme Court’s ruling in PSE&G, however, the New Jersey Supreme Court chose to adopt a modified business judgment rule, [t]hat imposes an initial burden on a corporation to demonstrate that in deciding to reject or terminate a shareholder’s suit the members of the board (1) were independent and disinterested, (2) acted in good faith and with due care in their investigation of the shareholder’s allegations, and that (3) the board’s decision was reasonable. PSE&G, supra, 315 N.J. Super. at 335, 718 A.2d 254. All three elements must be satisfied. Accordingly, should plaintiffs fail to make a demand, a number of options exist. One attractive avenue, applying the above considerations, is to attempt to dismiss the action by motion (which could end the case or limit the issues), and if any issues survive, then and thereafter form a special litigation committee and then stay the action pending the investigation. See Zapata and In re Oracle. Kole is a partner in the commercial litigation practice and Mannion is an associate in the practice at Wilentz, Goldman & Spitzer of Woodbridge.

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