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In another ruling arising from the 2002 WorldCom bankruptcy, Southern District of New York Bankruptcy Judge Arthur Gonzalez has turned down plaintiff shareholders’ claims against the company’s former directors. What sets his most recent decision apart is the judge’s exploration of exactly what constitutes a derivative action and how it differs from a direct action. WorldCom emerged from bankruptcy last year as MCI, and has been the target of takeover talks for weeks. Tuesday, its former auditor, Arthur Andersen, paid $65 million to settle claims arising from its role in the company’s $11 billion accounting fraud. And former directors and underwriters who helped WorldCom issue bonds have settled for more than $6 billion. Earlier this year, the company’s former CEO, Bernard Ebbers, was found guilty of securities fraud and could face the rest of his life in prison. The facts before Judge Gonzalez in In Re WorldCom, Inc., 02-13533, were more pedestrian. The suit involved a WorldCom shareholder, Richard Reynolds, who sued 11 former directors of the company in 2003. The suit listed four counts with similar underlying facts: The directors allegedly breached their fiduciary duties by declaring a dividend to be paid in July 2002 and then later canceled the payment when revelations about the company’s weakening finances became known. WorldCom, the defendant, argued that the injunction granted to it as a debtor in Chapter 11 bankruptcy blocked certain lawsuits directed at the company. Because the claims were derivative in nature, WorldCom argued, they could not go forward. Reynolds, who was suing on behalf of similarly situated shareholders, countered that this was a direct claim and should therefore proceed unhindered by the injunction. “The distinction between derivative and direct action claims is often convoluted and confusing,” Gonzalez wrote. He cast aside several older tests, and referred to a two-part test declared in Tooley v. Donaldson, Lufkin & Jenrette, a 2004 Delaware Supreme Court decision to determine whether this case involved derivative or direct action claims. The Tooley test considered a) who suffered the harm and b) who would receive the benefit of recovery: the corporation or individual shareholders. After applying the test, the judge dismissed each of the four counts individually. In one instance, the judge called the plaintiff’s claims of liability “convoluted.” In another, the judge wrote that the “circular nature of the construct,” referring to a line of argument made by Reynolds, “demonstrates its absurdity.” The court repeated that the “determination of whether an action is derivative is made by looking at the nature of the wrong alleged and not the pleader’s designation or stated intention.” Applying this standard, Gonzalez found that each of the counts fell back to the same argument. They were essentially a claim for the diminution of value of Reynolds’ shares and involved the breach of fiduciary duty by WorldCom’s former board of directors, according to the court. Such claims were derivative in nature, the judge said. In the first count, for instance, Reynolds claimed shareholders had a right to receive an unpaid dividend and wanted to compel payment. The allegations, Gonzalez found, “if true are breach of the Board’s fiduciary duty.” Such a breach, he held, “generally runs to the corporation and not the shareholders.” In a direct action, the shareholders have the grounds to make these claims. Other claims involved shareholders’ voting rights and investment decisions made with false information. “[E]xamination of each count reveals that claims are based upon allegations of fraud and misrepresentation on the corporation that resulted in its diminution of value … [and] for breach of fiduciary duties,” he wrote. The complaint, Gonzalez concluded, “is, in essence, a derivative action.” Weil, Gotshal & Manges, WorldCom’s lead counsel in the bankruptcy, represented the debtor. Arent Fox represented Reynolds.

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