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Chancery Dismisses Derivative and Direct Claims Claims Upon Finding Shareholder Plaintiffs Sold Shares Without Preserving Rights to Continue to Assert Direct Claims

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September 5, 2019
Delaware Business Court Insider

It is well-settled in Delaware that a stockholder seeking to pursue derivative claims must own shares at the time of the wrong and continuously through the life of any litigation. Similarly, direct claims based on injury to the shares generally pass to a buyer. These principles, in combination with the public policy against issuing advisory opinions, mean that stockholders who sell all their shares and any right, title and interest in those shares after initiation of litigation generally will lose their standing to assert claims based on injury sustained as a shareholder or to those shares. The Delaware Court of Chancery applied those principles in Urdan v. WR Capital, C. A. No. 2018-0343-JTL (Del. Ch. August 19, 2019) and dismissed claims of breach of fiduciary duty and self-dealing because the stockholder-plaintiffs sold all of their shares after initiation of the litigation and thus lost standing to pursue their claims both derivatively and directly.  What makes this case particularly interesting was how the court determined that plaintiffs’ effort through a settlement agreement to preserve at least the direct claims by contract was ineffective due to the failure to incorporate by reference that preservation of rights in a companion Repurchase Agreement by which plaintiffs in fact sold their shares.

Two aspects of the parties’ repurchase agreement were fatal to the plaintiffs’ claim. First, no language in the repurchase agreement incorporated by reference the language in the settlement agreement in which the parties agreed that nothing in the settlement agreement “shall affect any claims any of the Delaware Plaintiffs may have against any of the [identified defendants] or the defenses or counterclaims that any of the [identified defendants] may have to the claims of the Delaware plaintiffs.” Moreover, the repurchase agreement contained an integration clause that provided that in the event of any inconsistency between the repurchase agreement and the settlement agreement, “the terms and provisions in the body of [the repurchase agreement] shall control.” The court found that the contention that “the settlement agreement withheld litigation rights associated with the shares conflicts with the all-encompassing transfer of rights contemplated by the repurchase agreement … .” Similarly, the court held that language limiting the effect of the releases the parties exchanged in the settlement agreement “did not address the scope of the rights that the plaintiffs transferred when they sold their shares pursuant to the repurchase agreement. “

The court also found ineffective to preserve standing a waiver provision in the settlement agreement in which defendants agreed not to assert or otherwise raise any defense related to the Delaware plaintiffs’ agreement to sell their shares in the company, including without limitation a defense of lack of standing. For derivative claims, the court held that “the question of whether the plaintiffs lost standing to maintain their claims by selling their shares is a jurisdictional issue that cannot be avoided.” The court held that defendants were entitled to raise the lack of standing defense, notwithstanding the Waiver Provision, because “To do otherwise would permit the parties to establish jurisdiction by agreement, which is contrary to law.“ The court held that once plaintiffs voluntarily divested themselves of their shares, they gave up not only any basis to maintain derivative claims but also any basis to receive the benefit of any recovery which would flow to a company in which plaintiffs no longer had any interest. For similar reasons, the court held that once the plaintiffs sold all their right, title and interest in the shares, “the plaintiffs were no longer beneficiaries of the fiduciary duties that they sought to invoke, and they would not receive the benefit of any recovery, which would go to the then-current owners of the shares.  Having transferred their shares, the plaintiffs no longer had any interest in the dispute.” Because the court also held that plaintiffs’ remaining claims of fraud and unjust enrichment lacked merit, the court granted the motion to dismiss.

The Urdan decision reflects the application of the contemporaneous and continuous ownership rules regarding a plaintiff’s standing to pursue derivative claims. While the court expressed a personal preference for doing away with the contemporaneous ownership rule he nonetheless applied that rule as he was bound by Delaware statute to do. A plaintiff who wishes to pursue derivative claims but also sell shares should consider retaining some of her shares if she wishes to maintain standing to pursue a derivative claim. Also, a party selling shares and wishing to preserve rights to continue to pursue direct claims must “provide specifically for that outcome” (Id. at 24) or the right to assert those claims directly passes to the new owner. For transactional attorneys, a clear lesson of this case is to incorporate by reference in transactional documents or expressly repeat any carve outs meant to preserve rights that otherwise would be lost when a party sells all right, title and interest in shares.

Delaware Business Court Insider l September 5, 2019

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