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Delaware Court of Chancery Sets New Rules for Derivative Claims

June 20, 2012
Edward M. McNally

The Delaware Court of Chancery just issued possibly the most important decision in the last 10 years on derivative claims. In Louisiana Municipal Police Employees' Retirement System v. Pyott, Del. Ch. Ct. 5795-VCL (June 11, 2012), the court clarified when a previously dismissed derivative suit may be refiled and what plaintiffs should do to properly satisfy the requirement that individual stockholder plaintiffs adequately allege why they, rather than a corporation's board of directors, should control derivative claims brought on behalf of the corporation. Because derivative litigation is a principal tool to ensure proper corporate governance, this decision has large implications.

BACKGROUND TO THE DECISION

Derivative actions are filed by stockholders to recover against directors or officers for their culpable mismanagement of the corporation they are to serve. For many years and in many jurisdictions, the stockholder plaintiffs lawyer who filed the first complaint attacking alleged director misdeeds was able to control the course of the litigation and any settlement, even if other plaintiffs filed other derivative suits over the same director conduct. Known as the "first-filed rule," this led to a race to file litigation, often within hours of the public announcement of a transaction.

Plaintiffs in these hasty suits often failed to plead sufficient facts to meet the demand rules of state and federal courts. Briefly, the demand rules required a plaintiff to show why he or she should not make a demand on the board of directors to have the corporation file the suit or that, if a demand had been made, the board wrongly refused to sue. The pleading rules to show demand excused or wrongly rejected are often not easy to meet. Unless the majority of the board profited from the transaction under attack or had some other disabling characteristic (such as a serious threat of personal liability), the complaint would be dismissed for failure to meet the demand rules.

Together the rush to the courthouse and the difficulty of pleading enough to satisfy the demand rules led to many derivative suits being dismissed. That may well have had bad consequences for corporate governance because the dismissal of a derivative suit was often held to bar other, meritorious derivative suits as a matter of stare decisis. The theory was that the other stockholder plaintiffs were in privity (and thus bound) with the stockholder whose suit was dismissed with prejudice. The Pyott decision addressed all these problems.

IMPACT OF A PRIOR DISMISSAL

Pyott involved multi-state litigation, with derivative suits filed in California and Delaware. The complaints alleged that the board of directors of Allergan Inc. was liable for failing to prevent Allergan from improperly marketing its Botox drug and thereby incurring a massive fine for doing so. The initial complaints were filed quickly and lacked much detail. Later, a union pension fund (the UFCW) successfully sued to inspect Allergan records and then filed a much more detailed complaint based on what it discovered in those records. Meanwhile, the California derivative suit was dismissed with prejudice for failing to meet the demand rules. The defendants then moved to also dismiss the Delaware UFCW complaint, arguing it was precluded by the dismissal of the California case.

The Delaware Court of Chancery refused to dismiss the Delaware litigation. In its 80-page decision, the court reasoned that until a derivative plaintiff established the right to control litigation on behalf of the corporation, the plaintiff was acting only for itself and not in privity with all the other stockholders. Hence, the dismissal of the complaint for failure to meet the demand rules did not bar some other stockholder from proceedings if he or she could satisfy those demand rules.

That decision is new law. Indeed, the Pyott decision not only refused to follow non-Delaware law, but arguably overruled prior Delaware decisions. The Court of Chancery freely acknowledged it was setting new law. Its careful, detailed analysis supports its conclusion. And in letting the UFCW suit proceed, the court also effectively ended the first-filed rule in favor of having the plaintiff with the best complaint control the litigation.

END OF THE FIRST-FILED RULE

The Court of Chancery more recently has been critical of litigation filed soon after a transaction is announced and with little investigation beyond reading any public filings with the SEC. In considering whether those complaints that won the race to the courthouse meet the demand rule, the court has declined to give such plaintiffs the benefit of the doubt in considering allegations of directors' disqualification. The Pyott decision effectively discourages fast-filers by criticizing plaintiffs counsel's motives for not first seeking to inspect corporate records. It is now doubtful that plaintiffs will want to suffer that criticism by rushing to the courthouse.

CAREMARK EXPLANATION

Finally, the Pyott decision is also the latest, most complete explanation of a valid Caremark claim. Again and again, plaintiffs have filed derivative suits seeking to hold directors liable for corporate losses on their watch, almost always unsuccessfully. No matter how big the loss suffered, that alone does not prove a Caremark claim that the directors are liable for those losses. Pyott collects all the types of conduct or nonfeasance that may constitute a Caremark claim. Most importantly, Pyott illustrates how such a difficult claim to prove can at least get past the pleading stage. This may be Pyott's most lasting effect.

To meet the demand rules in a complaint alleging a Caremark claim, a plaintiff must show with well-pleaded facts that there is a serious risk the directors will be held personally liable for what they failed to prevent. In short, the plaintiff must plead sufficient facts to show he or she has a good case on the merits. Just about the only way to do that is to get into the corporation's records to get the facts, and not rely on mere suspicion. Thus, well-pleaded Caremark claims almost always will require a corporate records inspection.

Pyott is an important decision. It has protected the proper derivative suit from dismissal because of the abuse of the fast filers. It lays out how to state a Caremark claim. It is the guideline subsequent litigation must follow.