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Dismissal of Shareholder Derivative Action on Rule 23.1 Grounds Precludes Relitigation of Different Del. Plaintiffs

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February 14, 2018

The Delaware Supreme Court recently issued an important corporate law decision addressing issue preclusion in the context of multiple shareholder derivative actions. The court ruled in California State Teachers’ Retirement System v. Alvarez, No. 295, 2016 (Del. Jan. 25), that an Arkansas federal court’s dismissal of a shareholder derivative suit for failure to plead adequately demand futility precluded Walmart stockholders from attempting to prosecute derivative claims in Delaware arising from the same misconduct. The court rejected the argument that the failure of the Arkansas plaintiffs to have used books-and-records discovery under Section 220 to assemble their complaint rendered their representation inadequate, or that applying issue preclusion in this context violated the stockholders’ due process rights. Although Delaware strongly encourages plaintiffs to use books-and-records requests to prepare a shareholder derivative complaint, the court concluded that Delaware’s substantial interest in governing the internal affairs of Delaware corporations must yield to the stronger national interests that all state and federal courts have in respecting each other’s judgments.

Background

Following reports in The New York Times in April 2012 of an alleged bribery scheme and cover-up carried on by executives of Walmart’s Mexican unit, Walmart de Mexico (Wal Mex) shareholder derivative suits followed in Arkansas and Delaware. The claims in both jurisdictions were similar, involving breach of fiduciary duty related to the Walmart board’s oversight of Wal Mex. The Arkansas litigation also included federal securities law claims. The Arkansas court initially stayed its proceedings pending the litigation in Delaware.

Following the urging of then Chancellor Leo Strine to examine the Walmart books and records and file the strongest operative complaint they could, the Delaware plaintiffs pursued Section 220 litigation. That became exceptionally contentious and lengthy, lasting almost three years.

In the meantime, the U.S. Court of Appeals for the Eighth Circuit vacated the Arkansas stay as overbroad because it encompassed securities law claims not pending in Delaware and over which the Court of Chancery had no jurisdiction. The defendants in Arkansas then moved for a stay that would expire upon the Delaware court’s ruling on demand futility. But the Arkansas court denied defendants’ further stay request, and defendants moved to dismiss for failure to plead demand futility under Rule 23.1. Although aware that a ruling by the Arkansas court on demand futility would likely have preclusive effect, the Delaware plaintiffs did not seek to intervene in Arkansas or otherwise voice their concerns to the Arkansas court. In March 2015, the Arkansas court granted defendants’ motion to dismiss with prejudice.

Approximately one month later, the Delaware plaintiffs amended the operative complaint to assert a single claim for breach of fiduciary duty. The defendants moved to dismiss and argued that the Arkansas decision collaterally estopped the plaintiffs from re-litigating the issue of demand futility. The Court of Chancery granted the motion to dismiss based on issue preclusion.

The plaintiffs appealed, claiming the Court of Chancery erred in finding: privity between the Arkansas and Delaware plaintiffs; adequate representation by the Arkansas plaintiffs; and that the issue of demand futility was actually litigated in Arkansas. They also argued that the dismissal violated their due process rights.

Initially, troubled on appeal by the due process arguments, the Supreme Court remanded the matter to the Court of Chancery for a supplemental opinion on the issue. The Court of Chancery’s supplemental opinion ruled that the weight of authority supports preclusion based on a demand futility dismissal unless the prior representation was inadequate. The chancellor went on to recommend departure from the majority rule, however, and adoption of a rule earlier proposed in dicta in EZCORP Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016): namely, a derivative plaintiff may not bind a later derivative plaintiff unless and until the first derivative plaintiff survives a motion to dismiss, or the board of directors has given the plaintiff authority to proceed by declining to oppose the suit.

The Delaware Supreme Court ultimately declined to adopt the EZCORP approach ruled that due process was satisfied and upheld the original dismissal based on the preclusive effect of the earlier Arkansas dismissal.

Discussion

The Delaware Supreme Court rejected the analogy between putative class actions and shareholder derivative actions when it comes to issue preclusion. Acknowledging their similarities and that the due process clause prevents a judgment from binding absent class members before a class has been certified, the court found important differences that justified rejecting the EZCORP approach. A fundamental distinction concerns the rights being asserted.  In a class action, the named plaintiff initially asserts an individual claim and only acts in a representative capacity after the court certifies that the requirements for a class action have been met. In contrast, the named derivative plaintiff never has an individual cause of action; it only has standing to seek to bring an action by and in the right of the corporation. As a result, the Arkansas and Delaware plaintiffs sought to enforce the same legal right (the right of the corporation as the real party in interest). This placed both stockholder groups in privity, and permitted the nonparty Delaware plaintiffs to be bound by the Arkansas dismissal.

As to the requirement that issue preclusion comport with due process, the court found it satisfied because the nonparty Delaware plaintiffs had the same interests as the Arkansas plaintiffs, and the Arkansas plaintiffs adequately represented those interests. The failure of the Arkansas plaintiffs to seek books and records under Section 220 was determined not to render them “grossly deficient” representatives. Because the Arkansas counsel were experienced and had underlying documents from the Times article, the court found their decision to forego a Section 220 demand did not rise to the level of constitutional inadequacy “in this instance,” leaving open the possibility that it might not meet the standard under different facts.

Lessons Learned

This case provides important insights into the operation of issue preclusion in multi-forum shareholder derivative litigation. For plaintiffs it serves as a cautionary tale of being unable to coordinate their litigation strategies to advance the single best operative complaint utilizing the tools at hand. Failing such coordination, successor plaintiffs will need to consider intervention to assure the early-moving court knows of additional evidence and arguments bearing on the demand futility argument. For the defendants, the case turned out well despite their failed efforts to have demand futility decided by the Delaware courts in the first instance. Although complicated by the presence of securities claims in the Arkansas proceeding, Walmart’s use of forum selection bylaws designating Delaware state or federal forums may have enabled them to avoid the multi-forum litigation and to have had the Rule 23.1 motion decided in the forum of its choice.

Delaware Business Court Insider l February 14, 2018

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