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.
These copycat derivative suits can be a huge headache for corporate counsel. They can multiply litigation costs, distract the companys leaders, and subject the company to duplicative discovery from different plaintiffs and inconsistent rulings from different courts. Worse still, they can potentially jeopardize the companys 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 companys 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 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.
While the pre-suit demand requirement protects the boards prerogative to manage the corporations 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 companys 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 shareholders demand on the ground that concurrently pursuing related claims against directors or officers could adversely affect the companys position in the pending proceedings.
For example, courts have dismissed derivative suits concerning Merrill Lynchs 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), affd, 320 Fed.Appx. 638 (9th Cir. 2009).
Where a shareholder makes a demandand the board decides that bringing suit is not in the companys best interest due to potential conflicts with other pending litigation against the companythe board should respond promptly in a letter that explains its reasoning. The letter should describe the pending litigation and how the companys 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 shareholders proposed claims and consider whether any possible recovery against directors and officers may be far outweighed by the companys potential exposure in the underlying litigation. Where a good faith review of these issues supports the boards decision not to pursue litigation, that decision is more likely to be respected by the court if the shareholder subsequently files a derivative action.
