Delaware law has long required that a stockholder own shares on the date of an alleged wrongful act of which he or she complains and continue to own shares during the course of a derivative action. The principles of contemporaneous ownership and continuous ownership lead to the well-settled rule that a merger in which a stockholder's shares are extinguished results in that stockholder losing standing to pursue the derivative claim, as seen in Lewis v. Anderson, 477 A.2d 1040 (Del. 1984). This is the case because a derivative plaintiff cannot satisfy the continuous-ownership requirement following such a merger. The derivative claim instead is transferred to the acquiring corporation, which can choose to dismiss the action. An exception exists where the merger was accomplished "merely" to destroy derivative standing. The so-called fraud exception to the Anderson rule is narrow, as the Delaware Supreme Court reaffirmed in Arkansas Teacher Retirement System v. Countrywide Financial, No. 14, 2013 (Del. Sept. 10, 2013) (en banc). This clear reaffirmance eliminates any argument that the Delaware Supreme Court's dictum in a prior decision involving the same merger transaction was intended to broaden or change the scope of the fraud exception to the Anderson rule.
The Certified Question and Procedural Background
Arkansas Teacher arose out of a certified question from the U.S. Court of Appeals for the Ninth Circuit. The certified question was:
Whether, under the "fraud exception" to Delaware's continuous-ownership rule, shareholder plaintiffs may maintain a derivative suit after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims.
The claims at issue were asserted derivatively by five institutional investors in the U.S. District Court for the Central District of California. The investors alleged breach of fiduciary duty and securities violations against former Countrywide officers and directors. Thereafter, Countrywide was merged into a wholly-owned subsidiary of Bank of America Corp. Following the merger, Countrywide moved to dismiss the derivative claims on the ground that the merger terminated the plaintiffs' standing under Anderson. Although the plaintiffs challenged the applicability of the continuous-ownership rule, they did not argue that they could satisfy the fraud exception. The district court granted the motion to dismiss and the plaintiffs appealed to the Ninth Circuit. In the meantime, whatever direct claims the plaintiffs may have had were settled in a putative class action alleging similar claims in the Court of Chancery. When the parties to that action announced a settlement, the district court directed the California plaintiffs to object in Delaware over the scope of any release in that action. Plaintiffs objected that the Countrywide directors had breached their fiduciary duties by failing to value the plaintiffs' shareholder derivative claims in carving them out of the merger and by failing to preserve the value of those claims either by extracting additional consideration from Bank of America or by assigning the derivative claims to a litigation trust that could pursue the claims for the benefit of Countrywide's shareholders. The Court of Chancery rejected the plaintiffs' failure to value and failure to preserve objections as unsupported by Delaware law. The court went on to find that "avoiding derivative liability was neither the only nor the principal reason for supporting the transaction" and that the merger consideration paid to the Countrywide shareholders was fair. The plaintiffs appealed and the Delaware Supreme Court affirmed in Arkansas Teacher Retirement System v. Caiafa, 996 A.2d 321 (Del. 2010).
The Caiafa Dictum
In upholding the Court of Chancery's approval of the class settlement over the objections of the California plaintiffs, the Delaware Supreme Court in Caiafa discussed several claims that the plaintiffs could have pleaded but did not. The Supreme Court in Arkansas Teacher explained its Caiafa dictum as follows:
"In particular, this court stated that the plaintiffs theoretically could have pled a claim for 'a single, inseparable fraud' alleging that pre-merger fraudulent conduct made the merger 'a fait accompli.' This court stated that, in any such claim, 'the injured parties would be the shareholders who would have post-merger standing to recover [the] damages instead of the corporation.' This court noted, however, that the plaintiffs 'did not present this claim to the vice chancellor.' Therefore, we held 'that the vice chancellor did not abuse his discretion in approving the settlement, despite facts in the complaint suggesting that the Countrywide directors' pre-merger agreement fraud severely depressed the company's value at the time of BOA's acquisition and arguably necessitated a fire sale merger."
The California plaintiffs seized upon the Caiafa dictum in a motion for reconsideration of the district court's dismissal of their derivative claims to argue that it "expanded the post-merger standing fraud exception to include situations where, as here, the plaintiffs sufficiently allege fraudulent conduct that necessitated that merger." After the district court rejected that argument, the plaintiffs appealed to the Ninth Circuit, and the Ninth Circuit then certified the above-quoted question to the Delaware Supreme Court.
Delaware Supreme Court Reaffirms Anderson
The key to the Supreme Court's answer to the certified question was its distinction between direct claims, which if properly pleaded can survive a merger, and derivative claims, which cannot. The Supreme Court's favorable citation to Braasch v. Goldschmidt, 199 A.2d 760, 764 (Del. Ch. 1964), in both Anderson and Caiafa, illustrates the distinction. In Braasch, a majority stockholder acquired over 90 percent of American Sumatra Tobacco Corp. by a tender offer and then used a short-form merger to complete the acquisition. The plaintiffs alleged fraud in connection with the tender offer but did not challenge the regularity of the merger proceedings themselves. The Court of Chancery held that the merger extinguished the stockholders' derivative claims but permitted the stockholders' direct post-merger claims to proceed. The Court of Chancery held that "if the means employed to accomplish that [lawful] end [of a statutory merger] were unlawful, the whole might be so tainted with illegality as to require invalidation of the merger." Braasch therefore "supports the conclusion that where pre-merger fraudulent conduct makes a merger inevitable, that conduct gives rise to a direct claim that can survive the merger, but not a derivative claim." Thus, the Supreme Court held that the inseparable fraud referenced in Caiafa refers to direct, not derivative claims.
Supreme Court's Answer Not Surprising
In light of the Delaware Supreme Court's negative answer to the question from the Ninth Circuit, it appears unlikely that the Ninth Circuit will reverse the decision of the district court dismissing plaintiffs' derivative claims for lack of standing under Anderson. This is not only because of the force of the Anderson rule itself, but also because of the procedural record. Plaintiffs in California did not assert as part of their objection to the release in the Court of Chancery class action that their claims came within the fraud exception to the Anderson rule. Moreover, the Court of Chancery found on a well-developed record that the merger was neither the only, nor the principal, reason for the merger. Viewed in that light, the Supreme Court's answer is not surprising — the plaintiffs did not timely assert the fraud exception and the Caiafa dictum did not expand it. For practitioners, the reaffirmance makes clear that the Anderson fraud exception is narrow and that plaintiff stockholders will lose standing to pursue derivative claims upon a merger unless they properly allege that the merger was accomplished solely to deprive them of derivative standing.