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Derivative Action Stayed Pending $228.9M Appeal

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March 4, 2015
By: Lewis H. Lazarus
Delaware Business Court Insider

When a company receives an adverse judgment holding it responsible for hundreds of millions in damages, shareholder derivative suits often follow. A typical claim is that had the board exercised proper oversight, the company and its stockholders would not have suffered such severe monetary losses. When a stockholder makes a demand on a board that it take action against the officers and directors allegedly responsible for the company's losses, the board is obligated to take a position on the demand following appropriate investigation. When and for how long the company is entitled to investigate depends upon the context. If, for example, a stockholder receives no response from a company for six or more months after delivery of a demand, the stockholder can file a derivative action and claim that the board's refusal to investigate is wrongful. Where the factual predicate underlying the claimed injury is not finally determined, however, as when a judgment for monetary liability is on appeal or the claimed losses are the subject of ongoing securities claims, the Delaware Court of Chancery typically will stay the derivative action. The Court of Chancery's well-reasoned transcript decision in Hays v. Dvorak, C.A. No. 9768-CB (December 15, 2014), illustrates the practical approach that guides the court's resolution of a motion to stay when the underlying factual predicate for the plaintiff's claim of injury may be reversed or substantially modified on appeal.

Background Facts

In February 2013, a jury in a patent infringement action in federal court in Michigan found that Zimmer Holdings Inc. had infringed certain patents of Stryker Corp. and its affiliates and awarded $70 million in damages. In August 2013, the judge found that Zimmer's infringement had been willful and awarded treble and other damages. Zimmer appealed to the U.S. Court of Appeals for the Federal Circuit. Oral argument occurred Sept. 8, 2014. Judgment in the trial court was stayed pending resolution of the appeal. By the time of the motion to stay in Delaware, Zimmer was liable for $228.9 million plus Stryker's attorney fees if the Federal Circuit were to affirm the judgment.

Shortly after the federal court ruled on post-trial motions, James Hays, a stockholder of Zimmer, sent a letter to the Zimmer board asserting that Zimmer's management had breached their fiduciary duties by causing or allowing Zimmer to infringe on Stryker's patents. Hays claimed that Zimmer had been damaged by an amount equal to the judgment in Stryker's favor in the Michigan federal court. Accordingly, he asked the Zimmer board to investigate and to commence an action to recover the damages Zimmer suffered.

Company counsel and counsel for Hays exchanged letters regarding the demand. In a letter dated Oct. 8, Zimmer's counsel stated that Zimmer believed it wise to defer consideration of plaintiff's demand until the resolution of the company's appeal. On June 16, 2014, the plaintiff filed his derivative action in the Court of Chancery. He asserted claims premised fundamentally on the idea that the activities that resulted in liability in the Michigan patent action also constituted a breach of fiduciary duty. Zimmer moved to stay or dismiss pending resolution of the appeal of the Michigan judgment.

Derivative Action Stayed Pending Resolution of Appeal

Both parties recognized the inherent power of the court to stay a proceeding in the interest of judicial economy for the court, litigants and counsel. The dispute revolved around whether a stay was appropriate in light of the jury's finding of willful infringement and the passage of nine months from the service of the demand. The court held that "the harm at the core of this derivative action is dependent on the outcome of the patent infringement case." Therefore, the resolution of the appeal could eliminate or modify in some significant way the scope of the issues in the derivative action. Further, the court was sensitive to not wanting to put Zimmer in a position of having simultaneously to assert inconsistent positions, i.e., in the Federal Circuit that it has no liability for patent infringement while in Delaware that it is investigating potential wrongdoing by officers and directors relating to the same conduct.

Court Distinguishes 'Rich v. Chong'

The court rejected the plaintiff's argument that by allowing so much time to transpire without any investigation the Zimmer board had effectively demonstrated that it had no intent to investigate the plaintiff's claims. In so doing, the court distinguished Rich v. Chong, 66 A.3d 963 (Del. Ch. 2013), where the court denied a motion to stay. The primary distinguishing facts were that in Rich, one or more of the committee members the company had appointed to investigate the derivative claims had resigned and that the company refused to pay advisers to continue the investigation. The court concluded that those facts reflected abandonment of potential pursuit of the derivative claim. In contrast, the court found that the Zimmer board had acted responsibly in deferring consideration of the plaintiff's demand until resolution of the Federal Circuit appeal.

Lessons Learned

A jury or court finding of significant monetary liability does not translate into an automatic conclusion that a company has been harmed by the amount of the judgment when the judgment is subject to appeal. As long as a defendant timely responds to a shareholder demand that it investigate the officers and directors allegedly responsible for the adverse verdict by letting the shareholder know the reasons why the law and the facts warrant deferring an investigation, the Hays case illustrates that pendency of an appeal generally provides a sound basis to defer having even to incur the expense of an investigation. In such circumstances, a shareholder plaintiff may be better advised to stipulate to a stay of the derivative action pending resolution of the appeal contesting the judgment that forms the basis of the plaintiff's claim of damages.

Delaware Business Court Insider  |  March 4, 2015

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