The Delaware Supreme Court requested further consideration of the federal due-process issues that might arise where a court is asked to hold that a shareholder derivative action is precluded because a prior derivative action was dismissed based on the first plaintiff’s failure to make a demand on the company’s board before filing suit. The Court’s January 18, 2017 decision in California State Teachers’ Retirement System v. Alvarez squarely focuses on an issue that has been raised several times in the Delaware Court of Chancery: whether federal due-process principles prevent the actions of a named plaintiff in a derivative action from binding other shareholders unless and until a court holds that the plaintiff has authority to sue on behalf of the corporation.
The ultimate resolution of this question could affect the strategy decisions confronting plaintiffs and defendants when multiple shareholder derivative actions are filed in two or more forums.
The dueling derivative actions at issue here began in the wake of an alleged bribery scandal involving a Wal-Mart subsidiary. The cases were filed in Arkansas federal court and in the Delaware Court of Chancery.
During an initial conference in Delaware, the then-Chancellor “explicitly warned plaintiffs’ counsel that the extant complaints before him likely would not survive a motion to dismiss,” and he urged counsel to take the time to examine Wal-Mart’s books and records pursuant to § 220 of the Delaware General Corporation Law because the case was not an expedited matter. The Delaware plaintiffs heeded the Chancellor’s warning and spent nearly three years litigating their demand for corporate books and records.
The Arkansas plaintiffs, in contrast, chose to proceed solely on the basis of publicly available information (including internal corporate documents that had been provided to The New York Times), and they asserted claims under Delaware and federal law. The defendants sought to stay the Arkansas case pending the Delaware proceeding, but the Arkansas court ultimately denied the stay – and also stated that “[i]t is likely that the first decision on demand futility will be entitled to collateral estoppel effect.” The Delaware plaintiffs were alarmed by that statement, but they did not attempt to intervene in the Arkansas litigation. Instead, they tried – unsuccessfully – to convince the Arkansas plaintiffs to join the Delaware action.
The Arkansas court eventually dismissed the case based on the plaintiffs’ failure to show that making a demand on Wal-Mart’s board before suing would have been futile. Defendants then argued in Delaware that the Arkansas decision collaterally estopped the Delaware plaintiffs from raising demand futility in response to defendants’ motion to dismiss. The Chancellor applied Arkansas preclusion principles and agreed that the Delaware plaintiffs’ derivative claims were barred.
The plaintiffs appealed, and the Delaware Supreme Court remanded the case for further consideration.
Delaware Supreme Court’s Decision
The Delaware Supreme Court concluded that it “presently ha[d] no disagreement with the Court of Chancery’s analysis of Arkansas [preclusion] law” as to two key elements of collateral estoppel: “whether the issue to be precluded [i.e., demand futility] was actually litigated” and whether the parties potentially subject to preclusion had been adequately represented in the first proceeding. (The Court reserved final judgment on these questions pending its ruling after remand.)
The Court observed that it had “some sympathy” for the Delaware plaintiffs’ plight, because those plaintiffs had “heeded the Chancellor’s advice” to take the time to demand corporate books and records, while “the [Arkansas] plaintiffs who did not heed those warnings suffered dismissal of their complaint with the ultimate effect of barring the action of the Delaware Plaintiffs, who spent nearly three years fighting the books and records battle.” However, the Court criticized the Delaware plaintiffs for not seeking to intervene or otherwise participate in the Arkansas litigation “once it became apparent that the stay of the Arkansas litigation would be lifted and the judge warned that her decision would likely have preclusive effect . . . .” “Once the litigation train began going down the Arkansas tracks, it would seem to have been incumbent upon the Delaware Plaintiffs to take steps there to attempt to prevent foreclosure of their action in Delaware. Instead, they took no action in the Arkansas court – leaving them to address the litigation fallout in Delaware.”
The Court stated that, even if an intervention attempt had failed in Arkansas, the effort could have ensured that the Arkansas court “would take into account the litigation pending elsewhere and make a determination as to whether any dismissal should be with or without prejudice, and as to the named plaintiff only, and what provision, if any, should be made to protect the interests of other shareholders litigating in other fora.” Although New York preclusion law did not apply to this case, the Court observed that New York law “provides an exception to claim preclusion in derivative actions where a stockholder seeks to intervene in the prior action to protect its interests but is denied leave to participate.” This exception “is intended to protect against the risk that the first-filing stockholders fail to proceed with adequate diligence.”
The Court also was “presently satisfied” (again, pending a final ruling after remand) that the Chancellor had correctly applied Arkansas law on privity in holding that the Delaware shareholders were in privity with the Arkansas shareholders inasmuch as the real party in interest in both cases was the corporation. However, the Court held that the Chancellor had not sufficiently addressed the Delaware plaintiffs’ federal due-process argument, which is separate from the state-law privity analysis.
The Court turned to a different Court of Chancery decision holding that, as a matter of federal due process, a judgment in one derivative action cannot bind the corporation or stockholders in another derivative action unless and until the plaintiff in the first case has been given authority to sue on behalf of the corporation – either because a court has held that a pre-suit demand would have been futile or because the board of directors has given the plaintiff authority to proceed by declining to oppose the suit. That case had relied on the U.S. Supreme Court’s 2011 decision in Smith v. Bayer, which held that, although a class-action judgment can bind unnamed members of a certified class, it cannot bind unnamed members of either an uncertified class or a putative class whose certification has been denied.
The Delaware Supreme Court ruled that “there may be benefit to having the parties more squarely present the Due Process issue to the Chancellor in order to allow the Chancellor to express his views.” The Court therefore remanded the case and asked the parties and the Chancellor to focus on the question: In a situation where dismissal by the federal court in Arkansas of a stockholder plaintiff’s derivative action for failure to plead demand futility is held by the Delaware Court of Chancery to preclude subsequent stockholders from pursuing derivative litigation, have the subsequent stockholders’ Due Process rights been violated? See Smith v. Bayer Corp., 564 U.S. 299 (2011).”
The ultimate resolution of this due-process issue could have a significant impact on plaintiffs’ and defendants’ strategic decisions in contexts involving multiple derivative actions in different courts. But the potential impacts are not necessarily predictable or consistent with each other.
The decision raises a number of strategic issues for the plaintiffs’ bar, including the following:
- The Court emphasized what Delaware courts have said repeatedly for many years: in derivative actions that do not involve emergencies or require expedition, shareholders should take time to examine the corporation’s books and records instead of firing off a lawsuit. Will the Court’s renewed warning affect the race to the courthouse that often ensues in derivative actions?
- Will the Court’s agreement (at least for now) with the Chancellor’s analysis of the adequacy-of-representation issue be read to apply only to the perhaps unusual circumstances presented here, where internal corporate documents had been available on a public website? In such a situation, a books-and-records demand might be less important than in the normal case, where internal corporate records are not publicly available. But in those other cases, might a dismissed plaintiff’s failure to seek books and records before suing be viewed as inadequate representation?
- Will the Court’s criticism of the Delaware plaintiffs’ failure to participate in the Arkansas litigation trigger a host of intervention motions whenever multiple derivative actions are filed? The Court’s discussion of otherwise inapplicable New York preclusion law could cause such a reaction.
- If the Court of Chancery and the Supreme Court conclude that due-process concerns prohibit precluding other shareholders where a derivative suit has been dismissed based on the first plaintiff’s failure to show that a pre-suit demand would have been futile, will shareholders and their lawyers be more careful about pressing forward in first-filed cases? Or will they be less fearful of doing so if they think that their actions will not preclude subsequent litigation?
The decision also raises some strategic issues for corporations and their directors and officers, including the following:
- If due-process concerns prohibit preclusion of subsequent derivative actions where a prior derivative action has been dismissed for lack of demand futility, will defendants have less incentive to press for a ruling on demand futility in the first case in situations where (i) other shareholders are pursuing books-and-records demands before suing and/or (ii) shareholders who have obtained books and records have filed a more detailed complaint in another action? Or will defendants conclude that a victory in the first case is worthwhile, even if not technically preclusive, and therefore push for an early decision?
- The case again illustrates the importance of forum-selection bylaws, which the Delaware courts have repeatedly upheld. Such bylaws could concentrate the litigation in a single forum. However, those bylaws will not necessarily work where, as here, one case (the Delaware action) asserts only state-law claims, while another case (the Arkansas action) pleads both state-law claims as well as federal-law claims that are subject to exclusive federal jurisdiction.
We will continue to follow the Wal-Mart litigation.