Print PDF

Stockholder Derivative Actions With Pending Federal Securities Actions

July 9, 2014
Albert Manwaring
Delaware Business Court Insider

While not adhering to the first-to-file rule, Delaware courts have long
recognized that a stay of an action in favor of another action may be appropriate in the interests of comity and judicial efficiency when there is identity of the parties and issues in the two actions. The Court of Chancery has frequently stayed derivative actions (in favor of federal securities fraud actions) where the derivative action simultaneously seeks to prosecute fiduciary-duty claims based on similar facts and claims for misrepresentations and insider trading, or seeks indemnification from the directors based on a company's potential liability in the federal securities action.

In these circumstances, the court has recognized a company may be unfairly prejudiced if forced to adopt conflicting positions and litigation strategies where the company is simultaneously a defendant in the federal securities action and a nominal plaintiff in the stockholder derivative action. Indeed, a company faces an inherent litigation conflict if forced to simultaneously defend against allegations that the directors and the company lacked knowledge of purported wrongdoing in a federal securities action while at the same time, a stockholder asserts derivative claims, on behalf of the same company, against the directors, alleging that they had knowledge of the wrongdoing.

But, a stockholder derivative action that seeks distinct damages based on different claims and theories of liability, and does not seek indemnification contingent on liability in a federal securities action, does not implicate the same comity and judicial-efficiency considerations that might justify a stay in favor of a federal securities action. In its recent decision, In re Molycorp Shareholder Derivative Litigation, C.A. No. 7282-VCN (Del. Ch. May 12, 2014) (Noble, V.C.), the Court of Chancery granted the plaintiff stockholders' motion to lift a stay of a stockholder derivative action, which had been previously stayed by the court based on an overlapping federal securities-fraud class action pending in the U.S. District Court for the District of Colorado. In Molycorp, the court found "good cause" to lift the stay because the plaintiff stockholders' amended complaint no longer contained overlapping claims and theories of liability with the federal securities action.

Background

The Court of Chancery had stayed the plaintiff stockholders' derivative action based on a pending federal securities-fraud class action. The initial plaintiffs' derivative complaint asserted claims for breach of fiduciary duty against the directors and officers for permitting expedited stock offerings without allowing the company to participate in such equity financings, for material misstatements in the offerings, for indemnification for potential liability that the company may incur in the federal securities action, and a Brophy insider-trading claim. Similarly, the federal securities action asserted securities fraud and insider-trading claims. In granting the stay, the court had found that both the derivative stockholder and federal securities actions implicated a substantially similar scheme of securities fraud and insider trading, and that the derivative indemnification claims were dependent upon a finding of liability against the company in the federal securities action. The plaintiffs subsequently amended their complaint to eliminate their fiduciary-duty claims for material misstatements, indemnification and Brophy insider-trading claims, and on this basis, the plaintiffs subsequently moved to lift the stay of their stockholder derivative action.

Motion to Lift Stay

While there was still some factual overlap with the federal securities action, the plaintiff stockholders had eliminated their overlapping misrepresentation, insider trading and indemnifications claims from their amended complaint. The focus of the plaintiffs in their amended complaint was the alleged duty of loyalty violation of the directors for unfairly favoring the preferred stockholders over the company and the other stockholders by not permitting the company to participate in reasonably-priced equity financing that was critical for the company to modernize and expand its capacity at a Mountain Pass facility that was its primary asset and business focus. A number of recent Court of Chancery decisions have emphasized the board's potential violation of its fiduciary duty of loyalty by unfairly discriminating in favor of the preferred stockholders, with whom the majority of the board members were aligned, at the expense of common stockholders. (See, for example, In re Trados Shareholder Litigation, 73 A.3d 17, 46-47 (Del. Ch. 2013), and Carsanaro v. Bloodhound Technologies, 65 A.3d 618, 638 (Del. Ch. 2013).) This important Delaware corporate-law claim was not raised in the federal securities action, and is not a claim governed by federal securities laws—laws that are rooted in regulating disclosures, reporting, and securities manipulation in public companies.

In sum, the court concluded that Delaware's interest in deciding this important question of Delaware corporate law "promptly, uniformly, and authoritatively" militated in favor of the court's lifting the stay. The court reasoned that liability under the plaintiff stockholders' amended complaint was separate from, and not contingent upon, a finding of liability in the federal securities action, and that lifting the stay would therefore not offend the principles of comity or judicial efficiency.

Lessons Learned

The Court of Chancery will likely not stay a stockholder derivative action with closely related factual underpinnings to a pending federal securities action where neither the claims nor the theories of liability overlap. Thus, directors of publicly traded Delaware corporations may face the inherent risk of being defendants in two simultaneous lawsuits with the same factual underpinnings, where the claims and theories of liability do not overlap.

Delaware Business Court Insider | July 9, 2014