The Delaware Supreme Court recently issued a significant decision on issue preclusion with regard to derivative actions. See California State Teachers’ Ret. Sys. v. Alvarez, 2018 WL 547768 (Del. Jan. 25, 2018). The court held that the dismissal of a shareholder derivative action for lack of demand futility can preclude later derivative actions, as long as the plaintiffs in the dismissed case adequately represented the corporation’s interests. The court rejected a standard proposed by the Delaware Court of Chancery, under which a judgment in one derivative action would bind later plaintiffs only if the first action survived a motion to dismiss for lack of demand futility, or if the board gave the plaintiff authority to proceed on behalf of the corporation. In recognition of the important issues involved, this column covered an earlier decision in this case; we now report on the final chapter. See Mark D. Harris & Margaret A. Dale, “Due Process Rights in Multi-Jurisdiction Shareholder Derivative Actions, N.Y.L.J. Feb. 15, 2017.
The case originated in an April 2012 story in the New York Times that described a bribery scheme to gain market dominance perpetrated by executives at Wal-Mart’s Mexican subsidiary, Wal-Mart de Mexico. According to the Times, Wal-Mart de Mexico’s top executives were aware of bribes totaling over $24 million and took steps to conceal the payments from executives at Wal-Mart’s headquarters. Reportedly, Wal-Mart executives shut down an internal investigation into the issue and later promoted a chief executive at the subsidiary who was involved with the scandal.
In response to the story, lawsuits asserting claims for breach of fiduciary duty by Wal-Mart’s directors and officers were filed in Arkansas federal court and in the Delaware Court of Chancery. The two cases moved forward at different paces, as the Arkansas plaintiffs opted to proceed using only publicly available information, while the Delaware plaintiffs spent roughly three years litigating a demand for corporate records. An Arkansas court dismissed the first action, finding that the plaintiffs there failed to show that a demand on Wal-Mart’s board would have been futile. This set the stage for the primary issue in the Delaware litigation—namely, what is the proper standard to decide whether the Delaware plaintiffs should be collaterally estopped from raising their own claim for demand futility?
The Court of Chancery determined that collateral estoppel should apply under Arkansas law. On appeal, the Delaware Supreme Court agreed, holding that the issue was “actually litigated” and that the parties subject to preclusion had adequate representation in the first proceeding. Furthermore, the Delaware plaintiffs were found to be in privity with the Arkansas plaintiffs. The Supreme Court held that the Chancellor had not sufficiently considered the Delaware plaintiffs’ federal due process rights, however, and remanded the case for further consideration of that issue. At the time of our previous column, that was the latest decision in the case.
On remand, the Chancery Court again held that the due process rights of the Delaware plaintiffs were not violated. In doing so, the Chancellor suggested that the Delaware Supreme Court adopt a rule based on the state-law principles articulated in In re EZCORP Inc. Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016), which held that a judgment in a derivative action does not enjoy preclusive effect against a corporation or other stockholders until that first suit survives a motion to dismiss. That rule would afford a fair amount of leeway to plaintiffs in a later action by denying preclusion unless and until the earlier action reached a certain level of maturity.
In its recent decision, the Delaware Supreme Court declined to adopt that rule, while agreeing that the motion to dismiss should be granted. Rather than fashioning a new standard, the court adverted to the decisions of three federal circuit courts that had addressed similar questions. It held that preclusion depends on whether the two sets of plaintiffs were in privity with one another and whether the plaintiff against which preclusion is being claimed had adequate representation in the first suit.
Here, the court found privity satisfied because both sets of plaintiffs sought to represent the same party in their claims—the corporation. At each stage of the derivative action, the plaintiffs’ right to litigate stemmed from the claims of the corporation. The court rejected the Chancery Court’s view that a plaintiff does not actually assume that interest until the action has survived a motion to dismiss, or until the board of directors has given the plaintiff authority to proceed by declining to oppose the suit.
On the question of adequate representation, the Delaware Supreme Court cited the three-part test articulated by the U.S. Supreme Court in Taylor v. Sturgel, 553 U.S. 880 (2008). To have adequate representation, first, there must be an alignment of interest between the parties. Second, the earlier plaintiff must have understood itself to serve in a representative capacity or the original court must have taken care to protect the interests of the nonparty. Third, notice to the party at risk of preclusion may be required.
The Delaware Supreme Court quickly disposed of the first and third factors. Its ruling that the parties were in privity satisfied the alignment factor. Since notice was undisputedly given, that factor was satisfied as well. On the second factor, the court paid particular mind to the fact that the Delaware plaintiffs were aware of the significant risk that they would be precluded by the Arkansas court decision, and that the Arkansas court took care to protect their interests in deciding whether to grant the defendant’s motion to stay the proceeding. In evaluating the Delaware plaintiffs’ conduct, the court specifically mentioned their failure to take measures to avoid preclusion, or at least to argue that the Arkansas plaintiffs did not adequately represent them. In a footnote, the court noted that while the Delaware plaintiffs need not have formally intervened in the Arkansas action, their failure to take further steps there—such as filing a statement of interest, participating as amici curiae, or making a more significant effort at coordination with the Arkansas plaintiffs—led the court to disfavor their arguments.
Finally, the Delaware Supreme Court noted that the representation was “adequate” under the Restatement (Second) of Judgments, because the representation was of a sufficient quality (or at least not “grossly deficient”) and there were no conflicts of interest. Accordingly, the court dismissed the complaint of the Delaware plaintiffs.
Lessons From the Decision
The primary, if obvious, lesson from Alvarez is that where multiple plaintiffs vie to bring derivative claims, time is of the essence. Plaintiffs risk leaving themselves more vulnerable to collateral estoppel if another suit against the defendant proceeds at a faster pace. That danger creates a threshold incentive to seek collaboration with other parties to bring aligned claims. If the attempt to collaborate fails, the plaintiff with the slower-moving litigation should take every opportunity available to involve itself in the faster-moving litigation. In both its initial and most recent decisions, the Delaware Supreme Court criticized the Delaware plaintiffs’ failure to intervene or take alternative action to preserve their interest in the Arkansas case. Notably, that critique included a footnote in its initial decision citing non-binding New York precedent that plaintiffs who do move to intervene and are denied leave to do so may earn an exemption from ordinary preclusion principles.
For defendants, the decision encourages them to shop for the most favorable forum when sued in multiple jurisdictions. Defendants may seek to cooperate with the plaintiff party in their preferred jurisdiction on information requests as a means to incentivize the progress of that litigation, with an eye toward gaining leverage through a preclusion defense elsewhere. Questions remain over what the threshold is for a claim to be “actually litigated,” and how courts will handle matters where the “representative” factor is not clearly met, among other issues.
In conclusion, the principles set forth in Alvarez create many opportunities for strategic litigation. The decision makes it abundantly clear that both plaintiffs and defendants will need to be extremely diligent at the outset of a lawsuit to utilize the advantage or defeat the threat of collateral estoppel.
Mark D. Harris and Margaret A. Dale are partners at Proskauer Rose. Peter S. Fishkind, an associate, assisted in the preparation of this article.