Joseph M. McLaughlin and Yafit Cohn ()
The dismissal of a putative stockholder derivative complaint for failure to make pre-suit demand has long been understood to have preclusive effect against attempts by different stockholders to relitigate the demand issue in another court. These decisions recognize that because a stockholder derivative plaintiff sues in the company’s name, privity for preclusion purposes exists between the plaintiffs in the first and subsequent actions making similar allegations because in both, the company is the real party in interest. Two recent Court of Chancery decisions have introduced uncertainty in Delaware and potentially elsewhere by urging that this long-standing derivative preclusion rule violates due process. In In re EZCORP Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016), the court stated in dictum that the reasoning of the U.S. Supreme Court’s Smith v. Bayer, 564 U.S. 299 (2011), which held that absent class members are non-parties who are not bound by any rulings in the case unless and until a class is certified, should mean that stockholders pursuing derivative actions are not in privity with each other until the action has survived a motion to dismiss for failure to adequately plead demand futility under Rule 23.1. Under this approach, due process would foreclose any preclusive effect of a prior demand futility determination on anyone other than the named stockholder plaintiff. Last month, In re Wal-Mart Stores Delaware Deriv. Litig., 2017 WL 3138201 (Del. Ch. July 25, 2017), adopted and amplified EZCORP, recommending that the Delaware Supreme Court adopt a non-preclusion rule that would permit successive derivative litigation.
Pre-Suit Demand and Preclusion
Derivative claims belong to the corporation, which is why a stockholder must make a demand on the company’s board or adequately allege demand futility to pursue derivative claims on the company’s behalf. To prevent abuse of the derivative form of suit, as a precondition to seeking to enforce a right of a corporation a stockholder must demonstrate that the corporation refused to proceed as requested after suitable demand, unless demand is excused because particularized allegations create reasonable doubt that a majority of the board could impartially consider a demand.
Parallel lawsuits regarding the same allegations are a familiar dynamic in stockholder litigation. In derivative litigation, recent Delaware decisions have sought to curb fast-filed, inadequately-investigated complaints by emphasizing that when stockholders sue in Delaware in a representative capacity, “first-to-file” does not control which plaintiff and their counsel will be granted the leadership role. When suits are filed in more than one forum, a key strategic objective for defendants is avoiding the burden and expense of litigating the same issues in multiple jurisdictions. Once the first final decision on demand-related allegations is rendered, preclusion doctrine protects these interests by prohibiting different stockholders from relitigating the derivative claim.
A request that one court give preclusive effect to a judgment entered in another court invokes constitutional full faith and credit principles. The preclusive effect of a judgment is determined by the law of the forum in which the judgment was rendered. In Delaware and elsewhere, subject to due process, courts give the same preclusive effect to the judgment of another state or federal court as the original court would give. Pyott v. La. Mun. Police Empls.’ Ret. Sys., 74 A.3d 612, 615-16 (Del. 2013).
In response to a Supreme Court remand from a prior dismissal asking the court to address “the complex question” of whether the demand futility preclusion rule violates due process, Chancellor Andre Bouchard reconsidered and changed his prior ruling and recommended that the Supreme Court adopt the rule proposed in EZCORP. In Wal-Mart, allegations of a bribery scheme engendered derivative suits by different stockholders in Arkansas federal court and Delaware. The Arkansas suit was dismissed for failure to plead demand futility while the Delaware plaintiffs were litigating a books and records demand in an effort to bolster their complaint. The Chancellor dismissed the Delaware action based on the issue-preclusive effect of the Arkansas decision. On appeal, the Delaware Supreme Court stated that it was “presently satisfied” that the Chancellor properly applied Arkansas privity law and correctly determined that the stockholders in both suits were in privity because in both, the corporation was the real party in interest. The Supreme Court noted that the Delaware plaintiffs could have intervened in the Arkansas suit, but did not. It ruled, however, that the Chancellor had not sufficiently addressed whether precluding the subsequent suit was consistent with due process, specifically pointing to EZCORP, and remanded for consideration of that question.
In approaching the due process question, the Chancellor acknowledged that the prevailing preclusion approach includes a due process safeguard derived from the Restatement (Second) of Judgments: Preclusion based on a prior judgment attaches to parties and their privies unless the representative plaintiff’s handling of the first derivative action was “so grossly deficient as to be apparent to the opposing party” or failed to meet one of the Restatement’s other criteria for determining adequate representation. “[C]onsidering afresh the question presented,” the Chancellor concluded that the existence of a due-process protective test “does not mean that a better approach is not worthy of consideration.” It bears emphasis that Delaware does not approach the due process issue in derivative preclusion on a blank slate. In Pyott v. La. Mun. Police Empls.’ Ret. Sys., the Delaware Supreme Court rejected a “fast-filer irrebuttable presumption of inadequacy,” stating that absent “record support for the … premise that stockholders who file quickly, without bringing a §220 books and records action, are a priori acting on behalf of their law firms instead of the corporation,” counsel bringing such derivative litigation are not presumptively inadequate. And “[a]bsent the presumption, there was no basis on which to conclude that the [prior suit's] plaintiffs were inadequate.”
The Chancellor nevertheless recommended that the Supreme Court adopt the bright-line rule proposed in EZCORP: A prior derivative suit should not bind the corporation or other stockholders in another derivative action until either (1) the prior suit has survived a Rule 23.1 motion to dismiss asserting failure to make pre-suit demand by demonstrating demand futility, or (2) the board of directors authorizes the plaintiff to proceed by declining to oppose the suit. The Chancellor grounded his recommendation in “(1) the similarities between class actions and derivative actions, (2) some of the realities of derivative litigation, and (3) public policy considerations.” While Delaware recognizes no presumption of inadequate representation where a case is brought without a pre-filing books and records collection, the Chancellor asserted that the rule he recommends “should go a long way to addressing the ‘fast-filer’ problem and ensuring better protection of due process rights for stockholder plaintiffs.” The court acknowledged that the rationale for its due process ruling was policy-based—a judgment that a blanket rule against preclusion is needed to foreclose the possibility that dismissal of a prior derivative complaint filed without adequate investigation will preclude a parallel complaint that may reflect greater investigation. This policy-driven approach to due process closely resembles the fast-filer presumption of inadequacy rejected by the Delaware Supreme Court in Pyott.
Recommending that Delaware withhold preclusive effect from a prior derivative suit unless and until the plaintiff in the prior suit has acquired authority to proceed on behalf of the corporation (typically by showing that pre-suit demand was excused as futile or that demand was wrongfully refused), the Chancellor extended the U.S. Supreme Court’s holding in Bayer that a putative class action is non-binding on absent class members until class certification is granted. The Wal-Mart court noted that class and derivative actions are both representative suits, and the rules governing them share similar texts and structures. These include an adequate representation requirement to maintenance, and court approval and notice requirements in the settlement context. The Chancellor reasoned that “[w]hen a court denies a stockholder the authority to sue on behalf of the corporation by granting a Rule 23.1 motion to dismiss, the purported derivative action is no more a representative action than the proposed class action in Bayer that was denied certification.” Bayer, however, was not a due process decision, relying instead “on the Anti-Injunction Act and the principles of issue preclusion that inform it,” and expressing no view “on the Due Process Clause.” In addition, Bayer announced a rule against non-party preclusion. Its holding that a decision denying class certification does not bind absent putative class members or affect their individual interests does not address whether stockholders are bound by a ruling that control of the corporation’s claim remains with the board—a ruling binding on a party that appears and is represented in derivative litigation, i.e., the corporation.
The court next pointed to differences in how courts in class and derivative actions assess the adequate representation requirement. In class actions, the plaintiff has the burden of demonstrating its adequacy; in derivative actions the burden is on the defendant to show that the plaintiff is an inadequate representative. This difference, the court asserted, translates into a material difference in judicial scrutiny. An initial adequacy determination in class actions usually occurs as part of an early motion for lead counsel status. Adequacy in a derivative suit, however, ordinarily is not a focus until the action’s resolution. “Class actions also frequently engender competition at the front-end in the appointment of class counsel where the Court considers, among other things, the quality of the pleadings and the vigorousness of plaintiff’s counsel. “Such competition,” the Chancellor commented, “is less common, at least in my experience, in derivative litigation, where plaintiff’s counsel invariably have the option to file suit in a second forum and begin a race to the courthouse rather than to compete for leadership.” And, the Chancellor perceived, once multi-forum derivative litigation is a real prospect, “defendants often have an incentive not to challenge adequacy in an initial derivative action (e.g., if the plaintiff’s demand futility allegations appear weak) in the hope of obtaining a favorable determination on demand futility to bar re-litigation of the issue in a later proceeding against a more formidable adversary, i.e., one who has undertaken additional due diligence and filed a more factually-developed pleading.”
Finally, the Chancellor weighed the competing public policy objectives of (1) preventing duplicative litigation and (2) “addressing the ‘fast-filer’ problem and ensuring better protection of due process rights for stockholder plaintiffs.” As the U.S. Supreme Court determined in Bayer, the Chancellor concluded that principles of stare decisis and comity are adequate to the task of discouraging successive attempts to litigate the same controversy. Reasonable plaintiffs’ counsel, the court stated, will not routinely pursue weak derivative cases after another plaintiff has failed to secure the right to proceed derivatively. Rather, “[w]hat can and does happen is that a second stockholder plaintiff will file a more refined complaint with more particularized allegations or more tailored legal theories after doing additional homework, such as obtaining corporate books and records through a Section 220 proceeding.” The Chancellor recommended a blanket rule that due process prevents a judgment from binding the corporation or other stockholders in a derivative action until the action has survived a Rule 23.1 motion to dismiss or the board of directors has authorized the plaintiff to proceed by declining to oppose the suit.
The Wal-Mart case now returns to the Delaware Supreme Court where, “[i]f the Court agrees with this recommendation, the case will need to be remanded again … to decide the issue of demand futility based on the allegations in plaintiffs’ complaint. If the Court disagrees,” the Chancellor recommended that his prior dismissal on preclusion grounds be affirmed.
The rule giving preclusive effect to the first final decision on demand-related allegations is fair and efficient and promotes the vital interests of respect for judicial rulings, finality and prevention of relitigation of issues decided. If the approach proposed in Wal-Mart prevails, preclusion will no longer bar attempts by different stockholders to relitigate in Delaware the demand futility issue decided by a prior court or courts.
Importing law that absent class members are not bound by class proceedings until a class is certified into the meaningfully different shareholder derivative context is of doubtful validity. While class and shareholder derivative actions are both forms of representative actions, the two are not interchangeable. They arise from different substantive laws and are subject to different procedural rules. Putative members of a class are wholly absent and usually unaware of the case until a class is certified. In a derivative suit, the corporation is present. It is a necessary party in the case—initially as a nominal defendant and, if demand is later excused, as a plaintiff. As numerous cases have correctly recognized, it is the corporation’s status as a party that matters for preclusion purposes. The proposition that due process requires relitigation of whether a company has the right to control its own legal claims is at odds with the central premise of demand futility law recognizing that the demand futility ruling adjudicates the corporation’s rights, and not only the individual stockholder-plaintiff’s standing to sue. The corporation is the only real party in interest. The board controls the claim unless the court determines it cannot impartially consider the claim, and judicially transfers the control right to a stockholder in order to protect the corporation’s interests. If the first court holds that demand is not excused, i.e. that the board continues to control the claim, the corporation’s rights have been decided once and for all. As the First Circuit noted, whether the board can manage its legal claim is an issue that is “the same no matter which shareholder served as nominal plaintiff.” For purposes of demand futility, stockholders are in privity with each other because they act on behalf of the defendant corporation. The corporation can defend that right through issue preclusion against other stockholders who again seek to strip it of that right.
Moreover, key differences in the inquiries conducted at the relevant stages of class and derivative proceedings render questionable the extension of the pre-class certification non-preclusion rule for absent class members to derivative suits. In order to certify a class, the court must actually determine the proposed representative’s adequacy. Ordinarily, no similar inquiry is undertaken on a demand futility motion; the inquiry focuses entirely on whether the board is capable of impartially considering a pre-suit demand. Rule 23.1 also approaches adequacy quite differently. Rather than requiring a plaintiff to demonstrate adequacy, the rule bars maintenance only “if it appears that the plaintiff does not fairly and adequately represent the interests of shareholders or members who are similarly situated … .”
Until the Delaware Supreme Court provides definitive word, managers and stockholders of Delaware corporations must make strategic decisions based on conflicting guidance on whether successive stockholders are barred from seeking to relitigate demand futility allegations.