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DBCI: Rebecca Butcher on Court of Chancery Elaborates Stance on Demand Futility Dismissals from Other Jurisdictions for Purposes of Claim Preclusion

In the August 3, 2016 edition of the Delaware Business Court Insider, LRC partner Rebecca Butcher writes on the Chancery Court Elaborates Stance on Demand Futility Dismissals, noting that in two recent opinions the dismissal of similar derivative claims in another jurisdiction mandated dismissal of the Delaware suits.

Court of Chancery Elaborates Stance on Demand Futility Dismissals from Other Jurisdictions for Purposes of Claim Preclusion

By Rebecca Butcher

In two recent decisions—In re Wal-Mart Stores Inc. Delaware Derivative Litigation, 2016 Del. Ch. LEXIS 75 (Del. Ch. May 13, 2016) (“Wal-Mart”) and Laborers’ District Council Construction Industry Pension Fund v. Bensoussan, 2016 Del. Ch. LEXIS 87 (Del. Ch. June 14, 2016) (“Lululemon”)—the Court of Chancery has addressed the preclusive effect of a dismissal for failure to adequately plead demand futility under Rule 23.1 from another jurisdiction on a pending stockholder complaint in Delaware.  In these opinions the dismissal of similar derivative claims in another jurisdiction mandated dismissal of the Delaware suits.

As frequently occurs in derivative litigation, both the Wal-mart and the Lululemon cases involved well-publicized, potentially improper activities by publicly traded companies that spawned stockholder derivative suits in multiple jurisdictions.  In Wal-mart, the alleged wrongdoing was bribery in violation of the Foreign Corrupt Practices Act regarding Wal-Mart’s operations in Mexico.  In Lululemon, it was a sale of stock by a corporate director that potentially implicated material nonpublic information regarding the resignation of the chief executive officer.  In each case, a stockholder representative initiated an action with both securities and derivative claims in federal court and a separate stockholder plaintiff later initiated a derivative action for breach of fiduciary duties in the Court of Chancery.  In each case, the Delaware stockholder representative first pursued a Section 220 action to acquire books and records from the subject company regarding the alleged improper activities.  In both Wal-mart and Lululemon, the federal derivative suit was dismissed for failure to adequately plead demand futility under Rule 23.1 and the Court of Chancery took up the question of whether those dismissals precluded the stockholder suits in Delaware.

In determining claim preclusion, the standard for preclusion in the jurisdiction issuing the prior judgment controls.  Therefore the Court of Chancery applied different standards in Wal-mart (Arkansas law) and Lululemon (New York law).  However, despite any differences in how those standards are articulated, both decisions address three common considerations of claim preclusion: (i) whether the issue to be litigated is the same, (ii) whether the derivative stockholder plaintiffs are adequate representatives of the class, and (iii) whether the stockholder plaintiffs in the different suits are in privity.

In Wal-Mart and Lululemon, the Delaware stockholder plaintiffs argued that there was not an identity of issues in the different jurisdictions suits because the Section 220 actions revealed additional facts that had been added to the demand futility arguments in the Delaware complaints.  Chancellor Bouchard flatly rejected this reasoning in both opinions.  The Court of Chancery held that under both New York and Arkansas law the inclusion of additional facts regarding the issue of demand futility did not affect the similarity of the issue ruled upon between the two cases.  The underlying demand futility issues were identical even though the related facts were not.  These rulings are consistent with Delaware precedent in Asbestos Workers Local 42 Pension Fund v. Bammann, 2015 Del. Ch. LEXIS 142 (Del. Ch. May 21, 2015), aff’d 132 A.3d 749 (Del. Supr. 2015) (applying New York law).  While the Arkansas courts have not directly opined on the identity issue in the Rule 23.1 context, the court in Wal-mart held that Arkansas would likely follow this reasoning—that assertion of additional facts does not affect identity of issues between cases.

However, in Wal-Mart and Lululemon, the stockholder plaintiffs did not just argue that the newly-added facts defeated the identity of issues between the suits in Delaware and other jurisdictions.  The plaintiffs in both cases argued that these additional facts demonstrated the inadequate representation of the non-Delaware plaintiffs.  In Pyott v. Louisiana Municipal Police Employees Retirement System, 74 A.3d 612, 618 (Del. Supr. 2013) (“Pyott II”), the Delaware Supreme Court reversed the Court of Chancery’s holding that the failure to pursue a Section 220 action prior to filing a stockholder derivative complaint shortly after the announcement of a corporate trauma in and of itself was sufficient to disqualify a stockholder plaintiff as inadequate.  The Delaware Supreme Court left open the possibility that there could be a case where a fast-filing stockholder is deemed an inadequate representative; but, the Supreme Court simply would not presume them to be inadequate.  The Wal-Mart and Lululemon decisions narrow that potential for inadequate representation by limiting the circumstances that would constitute grossly deficient representation.  The court in Wal-Mart rejected the argument that counsel’s financial incentive to retain jurisdiction in its own case creates a conflict of interest among stockholder plaintiffs negating adequate representation.  The court made clear that only if the stockholder plaintiff’s interests were not aligned with the company’s financial interests that it purportedly represented would there be a disabling conflict.  Wal-mart and Lululemon also rejected the argument that the failure to seek books and records made the stockholder plaintiffs’ prosecution of the derivative claim grossly deficient.  Chancellor Bouchard opined that the Restatement of Judgments made clear that failure to assert all possible legal theories did not make a plaintiff a deficient representative.  A mere tactical error was not sufficient to establish a grossly negligent representation.  The Court of Chancery further clarified that it would not engage in an inquiry to compare the facts uncovered in a Section 220 action or the facts asserted in different jurisdictions’ complaints to determine inadequacy.  The failure to pursue a Section 220 action would be reviewed based on the facts the plaintiff had at the time the decision was made and only if the act of failing to do so at that time was grossly negligent would the court find a deficiency in representation.  The court refused to undertake a hindsight review of what facts a Section 220 action revealed.  The Wal-mart and Lululemon courts both held that the non-Delaware plaintiffs were adequate, albeit not perfect, representatives.

The Wal-mart plaintiffs also challenged privity between the Arkansas and Delaware plaintiffs in their attempt to thwart claim preclusion (the stockholder plaintiffs in Lululemon conceded privity).  Relying on Louisiana Municipal Police Employees’ Retirement System v. Pyott, 46 A. 3d 313 (Del. Ch. 2012) (“Pyott I”) reversed on other grounds in Pyott II, the Wal-mart plaintiffs argued that at the demand futility determination stage of litigation, the stockholder plaintiff does not yet represent the interests of the corporation, it is merely in the process of seeking equitable standing to sue on behalf of the corporation.  Therefore, until the stockholder plaintiff is deemed to be representing the interests of the corporation there can be no privity among separate stockholder plaintiffs and no preclusive effect.  Wal-mart acknowledged the merits of the reasoning of this decision, but ultimately determined that there was privity between the stockholder plaintiffs.  While Arkansas law had not directly addressed the issue of privity of stockholder plaintiffs, the Wal-mart opinion detailed that the following jurisdictions, California, Illinois, Massachusetts, Nevada, New York, Texas and the Third, Sixth and Ninth Circuits, found privity among stockholder plaintiffs even at the demand futility stage.  In the absence of clear direction from the Restatement of Judgments or public policy, the Wal-mart court concluded that Arkansas would likely follow the weight of precedent from these jurisdictions rather than the Delaware Court of Chancery’s holding in Pyott I.

The Wal-mart and Lululemon decisions demonstrate that in absence of clear direction from the state issuing the arguably preclusive decision, the stockholder plaintiff will be assumed to have privity with all other stockholders even at the earliest stages of a case.  Further these decisions demonstrate that the Court of Chancery is disinclined to question a derivative plaintiff’s strategy decisions in assessing adequacy of representation.  Taken together these decisions increase the likelihood that a derivative plaintiff will be bound by a prior dismissal thereby heightening the tension of competing interests in the prosecution of derivative claims.  Delaware precedent advises that the best practice for pursuing derivative claims is first gathering information through a Section 220 action.  However, that strategy risks an adverse decision from another jurisdiction on demand futility precluding a Delaware plaintiff from proceeding with its case.  Both decisions are currently on appeal to the Delaware Supreme Court, so ultimately their effect on both the prosecution and defense of derivative actions is yet to be determined.

 

Rebecca Butcher is a Partner at Landis Rath & Cobb LLP, where she focuses on Corporate, Commercial and Bankruptcy litigation. She can be contacted at 302-467-4415 or at butcher@lrclaw.com.

Reprinted with permission from the August 3, 2016 issue of the Delaware Business Court Insider. © 2016 ALM Media Properties. Further duplication without permission is prohibited.