Delaware Chancellor Urges Revision of Preclusion Principles in Derivative Actions
The Chancellor of Delaware’s Court of Chancery yesterday urged the Delaware Supreme Court to revise Delaware law on preclusion in shareholder derivative actions. The court’s July 25, 2017 decision in In re Wal-Mart Stores, Inc. Delaware Derivative Litigation recommended that the Supreme Court adopt a rule that a judgment in one derivative action cannot bind the corporation or its stockholders in another derivative action unless either (i) the first action has survived a motion to dismiss because a pre-suit demand on the corporation’s board of directors would have been futile or (ii) the board has given the plaintiff authority to proceed on the corporation’s behalf by declining to oppose the derivative suit. In other words, preclusion would not apply unless the stockholder in the first case had been empowered by either a court or the board to assert the corporation’s claims.
The Chancellor’s proposal, if adopted by the Delaware Supreme Court, could increase the difficulty of obtaining dismissal of subsequent derivative actions based on preclusion principles. The Delaware Supreme Court has so far declined to adopt such a rule, but the Chancellor’s decision – and the Supreme Court’s prior concerns about federal due-process issues – could lead the Court to reevaluate its approach.
Court of Chancery’s Original Decision
The dueling derivative actions at issue here began in the wake of an alleged bribery scandal involving a Wal-Mart subsidiary. The cases were filed in Arkansas federal court and in the Delaware Court of Chancery.
During an initial conference in Delaware, the then-Chancellor warned plaintiffs’ counsel that their complaints likely would not survive a motion to dismiss, and he urged counsel to take the time to examine Wal-Mart’s books and records pursuant to § 220 of the Delaware General Corporation Law. The Delaware plaintiffs did so and spent nearly three years litigating their demand for corporate books and records.
The Arkansas plaintiffs, in contrast, chose to proceed solely on the basis of publicly available information, and they asserted claims under Delaware and federal law. The Arkansas court eventually dismissed the case based on the plaintiffs’ failure to show that making a demand on Wal-Mart’s board before suing would have been futile.
Defendants then argued in Delaware that the Arkansas decision collaterally estopped the Delaware plaintiffs from raising demand futility in response to defendants’ motion to dismiss. Chancellor Bouchard applied Arkansas preclusion principles and agreed that the Delaware plaintiffs’ derivative claims were barred. The Delaware plaintiffs appealed.
Delaware Supreme Court’s Decision
The Delaware Supreme Court concluded that it “presently ha[d] no disagreement with the Court of Chancery’s analysis of Arkansas [preclusion] law” as to two key elements of collateral estoppel: “whether the issue to be precluded [i.e., demand futility] was actually litigated” and whether the parties potentially subject to preclusion had been adequately represented in the first proceeding.
The Court observed that it had “some sympathy” for the Delaware plaintiffs’ plight, because those plaintiffs had “heeded the Chancellor’s advice” to take the time to demand corporate books and records, while “the [Arkansas] plaintiffs who did not heed those warnings suffered dismissal of their complaint with the ultimate effect of barring the action of the Delaware Plaintiffs, who spent nearly three years fighting the books and records battle.” However, the Court criticized the Delaware plaintiffs for not seeking to intervene or otherwise participate in the Arkansas litigation “once it became apparent that the stay of the Arkansas litigation would be lifted and the judge warned that her decision would likely have preclusive effect.”
The Court also was “presently satisfied” that the Chancellor had correctly applied Arkansas law on privity in holding that the Delaware shareholders were in privity with the Arkansas shareholders inasmuch as the real party in interest in both cases was the corporation. But the Court held that the Chancellor had not sufficiently addressed the Delaware plaintiffs’ federal due-process argument, which is separate from the state-law privity analysis.
The Supreme Court turned to an earlier Court of Chancery decision in In re EZCORP., Inc. Consulting Agreement Derivative Litigation, which had urged that, as a matter of federal due process, a judgment in one derivative action should not bind the corporation or its stockholders in another derivative action unless and until the plaintiff in the first case has been given authority to sue on behalf of the corporation – either because a court has held that a pre-suit demand would have been futile or because the board of directors has declined to oppose the suit and thus has at least implicitly given the plaintiff authority to proceed. EZCORP had relied on the U.S. Supreme Court’s 2011 decision in Smith v. Bayer, which held that, although a class-action judgment can bind unnamed members of a certified class, it cannot bind unnamed members of either an uncertified class or a putative class whose certification has been denied.
The Delaware Supreme Court ruled that “there may be benefit to having the parties more squarely present the Due Process issue to the Chancellor in order to allow the Chancellor to express his views.” Citing the Bayer decision, the Court remanded the case so the Chancellor could focus on the question: “In a situation where dismissal by the federal court in Arkansas of a stockholder plaintiff’s derivative action for failure to plead demand futility is held by the Delaware Court of Chancery to preclude subsequent stockholders from pursuing derivative litigation, have the subsequent stockholders’ Due Process rights been violated?”
Court of Chancery’s Decision on Remand
On remand, the Chancellor appears to have felt that his hands were somewhat tied, because he had in fact considered the federal due-process issue posed by the Delaware Supreme Court. The due-process analysis had been “embedded” in the Chancellor’s conclusion that the Arkansas plaintiffs had been adequately represented. The Chancellor had applied the applicable standard for assessing adequacy of representation – whether “the representative plaintiff’s management of the first derivative action was so grossly deficient as to be apparent to the opposing party or failed to satisfy one of the Restatement’s other criteria for determining adequacy of representation” – and had concluded that the representation had not been inadequate. And the Supreme Court had expressed “no disagreement with the Court of Chancery’s analysis of Arkansas [preclusion] law,” which included the issue whether the parties potentially subject to preclusion had been adequately represented in the first proceeding.
However, “considering afresh the question presented” in the Supreme Court’s remand order, the Chancellor recommended that the Court adopt the bright-line rule that Vice Chancellor Laster had proposed in EZCORP: a judgment in one derivative case should not bind the corporation or other stockholders in another derivative action “until the [first] action has survived a Rule 23.1 motion to dismiss [because of demand futility], or the board of directors has given the plaintiff authority to proceed by declining to oppose the suit.” The Chancellor based his recommendation on “(1) the similarities between class actions and derivative actions, (2) some of the realities of derivative litigation, and (3) public policy considerations.”
First, the Chancellor noted “significant similarities between class and derivative actions,” including their common roots, their similar procedural protections for unnamed class members or stockholders, and the dual nature of derivative litigation. Although the corporation is the real party in interest in a derivative action, that principle “does not answer who has the authority to represent the corporation.” The Chancellor explained: “When a court denies a stockholder the authority to sue on behalf of the corporation by granting a Rule 23.1 motion to dismiss, the purported derivative action is no more a representative action than the proposed class action in Bayer that was denied certification. Thus, a strong case can be made that a derivative action that has not survived a Rule 23.1 motion to dismiss should not fall under the representative action exception” by which preclusion principles can be applied to nonparties.
Second, the Chancellor observed that “[t]he need for a more rigorous preclusion rule in the derivative action context is heightened by the disparity between class and derivative actions in terms of how adequacy of representation is assessed in practice.” A putative class representative must establish that he, she, or it can adequately represent the putative class. But in a derivative action, “the burden is on the defendant to show that the plaintiff is an inadequate representative.” That assessment is often not made until the back end of litigation, under a “grossly deficient” standard. Moreover, “defendants often have an incentive not to challenge adequacy in an initial derivative action” if they believe that the first case is vulnerable to a motion to dismiss, with the possibility of precluding subsequent derivative actions.
Third, the Chancellor was concerned about the public-policy issues that arise in “fast-filer” situations, where one plaintiff hastily files a potentially weak derivative action while another plaintiff – as here – takes time to go through the more arduous process of obtaining corporate books and records in order to prepare a more detailed and refined complaint. “In these cases, the second court presumably would be understandably cautious about following earlier rulings in cases brought by less prepared stockholders.”
For all of these reasons, the Chancellor urged the Supreme Court to adopt the rule proposed in EZCORP and to remand the case for a ruling on the Delaware plaintiffs’ allegations of demand futility, without regard to preclusion. But without an adoption of EZCORP, the Chancellor concluded that he had correctly dismissed the Delaware plaintiffs’ claims based on existing preclusion principles.
The Delaware Supreme Court’s ultimate resolution of the due-process preclusion issue could affect defendants’ ability to preclude subsequent derivative actions based on dismissals of prior cases. Adoption of EZCORP would increase the difficulty of obtaining such dismissals.
The Chancellor’s decision and the Supreme Court’s eventual ruling could also influence all parties’ strategic decisions. For example:
- If the Supreme Court concludes that due-process concerns prohibit precluding other shareholders where a derivative suit has been dismissed based on the first plaintiff’s failure to establish demand futility, will shareholders and their lawyers be more careful about pressing forward in first-filed cases, especially fast-filed ones? Or will they be less fearful of doing so if they think that their actions will not preclude subsequent litigation?
- The Supreme Court’s decision had criticized the Delaware plaintiffs’ failure to participate in the Arkansas litigation and had cited otherwise inapplicable New York law holding that shareholders who are denied intervention will not be precluded in subsequent derivative actions. The Court of Chancery responded in a footnote (quoting a U.S. Supreme Court case) that “‘[t]he general rule is that the law does not impose upon any person absolutely entitled to a hearing the burden of voluntary intervention in a suit to which he is a stranger.’” Will this dialogue between the Delaware Supreme Court and the Court of Chancery trigger a host of protective intervention motions whenever multiple derivative actions are filed?
- If the Supreme Court holds that due-process concerns prohibit preclusion of subsequent derivative actions where a prior derivative action has been dismissed for lack of demand futility, will defendants have less incentive to press for a ruling on demand futility in the first case in situations where (i) other shareholders are pursuing books-and-records demands before suing and/or (ii) shareholders who have obtained books and records have filed a more detailed complaint in another action? Or will defendants conclude that a victory in the first case is worthwhile, even if not technically preclusive, and therefore push for an early decision? The Chancellor’s decision notes in several places that stare decisis can be valuable even if outright preclusion is not available.
- The case illustrates the importance of forum-selection bylaws, which Delaware courts have repeatedly upheld. Such bylaws could concentrate the litigation in a single forum. However, those bylaws will not necessarily work where, as here, one case (the Delaware action) asserts only state-law claims, while another case (the Arkansas action) pleads both state-law claims as well as federal-law claims that are subject to exclusive federal jurisdiction.
We will see whether, on further review, the Delaware Supreme Court tries to avoid the federal due-process issues in EZCORP and Bayer by revisiting its earlier pronouncements on adequacy of representation and/or privity. The Supreme Court had said only that it “presently ha[d] no disagreement with the Court of Chancery’s analysis of Arkansas [preclusion] law” and that it was “presently satisfied” with the Chancellor’s application of Arkansas privity law (emphasis added). The Court appears to have left itself some leeway for the final appeal. If the Court ultimately disagrees with the Chancellor’s application of Arkansas preclusion law, it could decide the case on that ground, without reaching the federal constitutional issues and propounding new Delaware law (although, as the Chancellor noted, the due-process issues can be “embedded” in the state-law preclusion analysis).
For now, however, controlling Delaware law remains unchanged. EZCORP is not binding authority unless and until the Supreme Court adopts its. But at least two jurists on the Court of Chancery – Chancellor Bouchard and Vice Chancellor Laster – are on record as favoring the EZCORP standard for preclusion in derivative actions.
We will continue to follow the Wal-Mart litigation.