Attorney: H. Adam Prussin
Pomerantz Monitor November/December 2016
In 1998, Arthur and Angela Williams became investors in Citigroup. They planned to sell all their shares in 2007; but because the company’s financial disclosures looked good at that time, they sold only 1 million shares, at a price of $55 per share, holding onto their other 16.6 million shares. 22 months later, after the financial meltdown of 2008, they sold the rest of their shares, for $3.09 per share, $800 million less than they would have received had they sold those shares when they originally planned. They then sued Citigroup and several of its officers and directors in federal court for failing to disclose Citigroup’s true financial condition, and thereby inducing them not to sell their shares.
One of the many issues in the case was whether their claim belonged to them or, rather, was a “derivative” claim that belonged to Citigroup. Because Citigroup is a Delaware corporation, the federal courts turned, for the answer to this question, to the Delaware Supreme Court. Its answer, in a recent en banc decision called AHW investment Partnership, was that the Williams’ claim was a direct claim that they could assert themselves.
In hindsight, this decision looks like a no-brainer. How could Citigroup be the owner of a claim seeking recovery from Citigroup, for false public statements Citigroup itself issued, which allegedly injured investors directly?
But here is the problem: Citigroup also suffered from whatever wrongdoing its officers and directors committed that led to the meltdown of its share price, including the financial misrepresentations made to its investors. So, could the same wrongs produce separate injuries and separate claims belonging to entirely different people? There was case law that suggested that the answer was no: a claim either belonged to the company or its shareholders, but not both. AHW says that, at least where the claims do not involve breaches of fiduciary duty, separate claims based on the same wrongdoing can belong to both.
A Distinction With a Difference. One of the many esoteric distinctions made by Delaware corporate law is between “direct” and “derivative” investor claims. Direct claims are those that belong to the investors personally, involving injuries that they have suffered directly. Derivative claims are those that belong to the company in which they have invested, and affect its investors only as an indirect result of injury to the company. Of course, anything that injures the company also injures its shareholders – but only indirectly. For example, if officers mismanage the company, that injures the company directly. Investors suffer the consequences, but, usually, only indirectly.
From a litigation standpoint this distinction has major consequences. In a direct suit any damages recovered go to the investors; but in a derivative suit, damages go to the company, not the investors. Moreover, from a tactical standpoint, while investors may pursue their own “direct” claims without restriction, they can prosecute derivative claims only if they can surmount the “demand” hurdle. Normally, investors are allowed to pursue derivative claims only if they can show that the directors are so conflicted that they cannot independently decide whether to pursue those claims. In such cases, demanding that the board bring a lawsuit would be “futile.” This “demand” requirement is often an insurmountable obstacle.
Many investor suits involve claims that the company’s directors have breached their fiduciary duties. Some of those duties run to the company itself, such as the duties of loyalty and care; others run to the shareholders directly, such as the duty of “candor” in communications made to investors. Sometimes these same duties can run in both directions. So Delaware law devised a legal test to distinguish whether fiduciary duty claims in a particular case are direct or derivative. In a 2004 decision named Tooley the Delaware Supreme Court held that this test involves two questions:
((1) who suffered the alleged harm (the corporation or the suing stock-holders, individually): and (2) who would receive the benefit of any recovery or other remedy (the corporation or the suing stock-holders, individually)?
The question, then, is either or: either the corporation owns the claim, or the investors do, but not both.
In Tooley, the investors claimed that the directors breached their fiduciary duties by improperly agreeing to postpone the closing of a merger, which delayed the payout of the merger consideration to the shareholders. The Court held that this was not a derivative claim because “there is no derivative claim asserting injury to the corporate entity. There is no relief that would go to the corporation.”
Since Tooley, many Delaware cases have held, or implied, that if the alleged injury is caused by a drop in the company’s stock price, the investors’ losses flowed from an injury to the corporation, and that under Tooley the claims must be derivative.
In AHW, for example, Citigroup argued that plaintiffs’ losses flowed from injuries suffered by the corporation, which caused the price of its stock to collapse. Nonetheless, AHW held that these individual investors had their own direct claim, based on representations made to investors. The court held that the Tooley “either/or” analysis for claims involving fiduciary duties did not apply to other types of claims.
AHW involved claims of common law fraud and negligent misrepresentation. These are typically considered to be direct claims that investors can pursue on their own behalf. If the Williamses had purchased or sold their shares based on these misrepresentations, there would have been no confusion; but because they were asserting so-called “holder” claims, alleging that they were misled into holding onto their shares, their losses were traceable to injuries suffered by the company. AHW held that the Tooley analysis did not apply to claims that do not involve alleged breaches of fiduciary duty. The Court rejected the assertion that Tooley
was ―intended to be a general statement requiring all claims, whether based on a tort, contract, or statutory cause of action . . . to be brought derivatively whenever the corporation of which the plaintiff is a stockholder suffered the alleged harm. . . . when a plaintiff asserts a claim based on the plaintiff‘s own right, such as a claim for breach of a commercial contract, Tooley does not apply.
In other words, the Court is saying that if an investor asserts a non-fiduciary duty claim that is clearly personal to him, it makes no difference whether the investor’s losses flowed from an injury to the company.