Much has been written about the wave of shareholder strike suits that follow the announcement of every merger and acquisition of a publicly held company. However, there is little written about the unique procedural hurdles that are not addressed in the Rules of Civil Procedure, which must be navigated when such lawsuits are filed in Pennsylvania state court. These hurdles include the litigation process adopted by the Pennsylvania Supreme Court, the lack of procedural rules governing that process, and how some courts of common pleas have reconciled the case law with the Rules of Civil Procedure.
In Pennsylvania, a shareholder must comply with certain requirements before commencing a derivative suit. These requirements are found in the American Law Institute Principles of Corporate Governance (the ALI Principles) and were adopted by the Pennsylvania Supreme Court in Cuker v. Mikalauskas, 692 A.2d 1042 (Pa. 1997).
In short summary, the shareholder must first make a written and specific demand upon the board before filing suit. The shareholder must then afford the board a reasonable amount of time to form a special litigation committee (SLC) composed of disinterested and independent directors to investigate and respond to the demands. Plaintiffs often serve the demand upon the board to comply with this requirement, but then file suit shortly thereafter without allowing the SLC sufficient time to investigate and respond. Recognizing that strike suits should not advance beyond the pleadings stage while the SLC is still conducting its investigation, the ALI Principles allow the court to stay all discovery pending the conclusion of the SLC’s investigation. To the extent any discovery is permitted at all, it is limited in scope to the process of the SLC investigation and does not include the underlying merits of the action.
As is the case in traditional lawsuits, the first opportunity to defeat a shareholder suit is to file preliminary objections under Rule 1028 of the Pennsylvania Rules of Civil Procedure. Rule 1028 specifically sets forth a list of various objections, some of which are pertinent to merger litigation such as failure to state a claim, failure to exhaust a statutory remedy and lack of standing, among others. Thus, the target company can assert that the shareholder fails to overcome the protections of the business judgment rule, fails to demonstrate the materiality of any alleged omissions in public filings, fails to comply with the demand requirements and lacks standing should the shareholder allege a direct claim for breach of fiduciary duty (something that may be permitted in other jurisdictions but not in Pennsylvania). The acquiring company, if it is alleged to have aided and abetted the target company’s breach of fiduciary duty, may assert that the claim is legally insufficient under Pennsylvania law.
Under Rule 1028, all preliminary objections must be raised at the same time and filed within 20 days after service of the complaint. After that 20-day period expires, defendants typically do not have any further opportunity to strike or dismiss the operative complaint until pleadings have closed. In shareholder derivative suits, however, companies have another pleadings-stage dispositive motion they can later file that may not yet be ripe for filing at the time preliminary objections are filed. This second motion is the motion to dismiss, generally known as a Cuker motion, in which the court assesses whether the decision of the SLC with regard to whether it is in the best interests of the company to allow the suit to go further is entitled to protection under the ALI Principles.
For example, if the SLC determines that a derivative action is not in the best interest of the corporation, the board, pursuant to Cuker, may reject the shareholder’s demand and move to dismiss the suit pursuant to ALI Principle 7.05(a)(3). This particular section provides that the board of a corporation, in whose name or right a derivative action is brought, has standing on behalf of the corporation to move to dismiss the action as contrary to the best interests of the corporation. To achieve this, the SLC must prepare a written report of its conclusions and detail the procedures used in its investigation. The SLC report must be filed with the court, usually under seal as an attachment to the Cuker motion, so that the court can determine if the SLC’s determinations are entitled to deference. The ALI Principles instruct the court to defer to the SLC’s conclusions and dismiss the complaint if the SLC was independent, composed of two or more disinterested persons, assisted by counsel, conducted an adequate investigation and acted in good faith. The acquiring company can, and typically does, file a joinder to the motion to dismiss.
However, the filing of a motion to dismiss under Cuker, distinct from preliminary objections, is a foreign concept under the Pennsylvania Rules of Civil Procedure. And even though the authority for filing a Cuker motion in a derivative action is set forth explicitly in Supreme Court case law, it can be difficult to convince a prothonotary to accept a motion that has no basis in the Rules of Civil Procedure, especially if the local rules require the motion to identify the specific rule upon which the motion is based.
In implementing the procedures adopted by the Pennsylvania Supreme Court in Cuker, the judges of the Philadelphia Court of Common Pleas’ commerce program and surrounding counties have recognized that the most optimal approach for shareholder derivative suits is to allow the filing of preliminary objections and a Cuker motion to dismiss seriatim. Where the SLC has issued its report quickly enough, preliminary objections and the Cuker motion can be filed simultaneously. However, where the SLC has not issued its report, the common pleas judges have permitted defendants to file their preliminary objections first to comply with the 20-day requirement, and then subsequently file their Cuker motion after the SLC report is issued.
Although Cuker did not address whether the motion to dismiss should be in lieu of preliminary objections or in addition to them, the seriatim approach taken by Philadelphia Court of Common Pleas Judges Patricia McInerney and Arnold New of the commerce program reconciles the incongruity between the timing and exclusivity issues under Rule 1028 and the need to file a separate motion to dismiss under Cuker. In essence, this approach allows defendants two separate opportunities to dismiss the lawsuit without reaching the underlying merits of the action. In particular, the preliminary objections are first decided on the face of the complaint and, if the complaint is not dismissed in its entirety on preliminary objections, the court reviews the Cuker motion by conducting a precise and “preliminary examination” of the SLC’s conclusions to determine whether they are entitled to deference under the ALI Principles.
Should a company find itself defending a strike suit in a court not familiar with the procedural hurdles attendant to suits that are subject both to preliminary objections and a Cuker motion, counsel should submit a request for an immediate conference so that the parties can advise the court of the timing issues with regard to the merger at issue, the status of the appointment/evaluation by the SLC, what motions are to be expected, what needs to be filed under seal and why, the response dates for each given the limited time available and, finally, the scope of any permissible discovery while motions are pending. •
Theresa E. Loscalzo is co-managing partner of Schnader Harrison Segal & Lewis and a partner in the litigation department of the firm’s Philadelphia office.
Han Nguyen is a partner in the litigation department of the firm’s Philadelphia office.