Pomerantz LLP

Why Bother To Investigate Before Bringing A Derivative Action?

Attorney: Gabriel Henriquez
Pomerantz Monitor July/August 2016

State law allows shareholders to bring derivative actions, under certain circumstances, seeking recovery on behalf of their corporations. Usually those cases allege that the directors of the corporation have breached their fiduciary duties to the company. Typically the directors, not shareholders, have the responsibility of deciding whether to bring such cases. Shareholders can “demand” that directors bring such a case, but if they do that, and the directors refuse, it is next to impossible for shareholders to pursue their case. But there are exceptions to this “demand” requirement in cases where plaintiffs can show that demand would be “futile.”

Although one might assume that it would always be “futile” to demand that directors sue themselves, the law does not start with that assumption. To the contrary, Delaware courts, for example, require that plaintiffs plead specific facts establishing, in essence, that it is likely that the directors have done something wrong, justifying bringing an action against them. “Conclusory,” non-specific allegations are not enough. Unless shareholders have access to inside information from the company, it is often difficult to satisfy this standard; and courts have dismissed such cases with depressing regularity.

About 20 years ago, the Delaware Supreme Court started suggesting, in its opinions affirming dismissal of such cases, that the result might have been different if the shareholders had only done a better investigation of the facts before bringing the action. In particular, it pointed to Section 220 of the Delaware Corporation Act, which allows shareholders of Delaware corporations, before bringing a lawsuit, to demand the right to inspect the books and records of the corporation concerning potentially dubious transactions. Such inspections, the court noted, are the “tools at hand” that could in many cases provide the specific facts necessary to establish demand futility and allow a derivative case to go forward. The Delaware Chancery Court has exclusive jurisdiction to grant relief under Section 220.

But this prescription ignores the practicalities of derivative litigation. News of potential corporate wrongdoing typically leads to multiple lawsuits brought by shareholders, sometimes in different states. Because there is no law requiring that investors bring a books and records proceeding before filing a derivative case, some of these cases will be filed without a pre-filing inspection and they will proceed quickly, while shareholders who do file a books and records demand are still waiting for a resolution of that proceeding.

If all the relevant proceedings are brought in the same jurisdiction, such as Delaware, the courts will often stay the quick-filing cases to allow the books and records plaintiffs to catch up. But what happens if the first filed cases are brought out of state, are not stayed, and are dismissed on “demand futility” grounds before the books and records plaintiffs have had a chance to build their case?

Two recent opinions from Delaware’s Court of Chancery are likely to change the ground rules in such situations.

In cases involving Lululemon and Wal-Mart, plaintiffs who had not availed themselves of Section 220 filed “conclusory” complaints outside of Delaware that were dismissed for failure to make demand on the directors to bring an action. At the same time, two different sets of plaintiffs completed their books and records inspections and then filed their respective derivative complaints in Delaware. Because the Section 220 actions took several years to complete, by the time these investors were able to bring their actions, the other, out of state derivative cases had already been dismissed. With the benefit of their inspection of corporate records, the complaints in the Delaware actions were far more specific and detailed than the out of state complaints had been.

Nevertheless, the Chancery Court dismissed the Delaware derivative lawsuits because it found that the courts in the non-Delaware proceedings had already decided that demand on the directors to bring these claims was not excused. As a result, the Delaware plaintiffs gained nothing from their years’-long efforts to investigate the case by using Section 220.

In Lululemon, the company’s founder was accused of insider trading after unloading a bulk of his shares the day after finding out that the company’s CEO intended to resign, but before that information was released to the public. In order to investigate diligently, one of the shareholder plaintiffs, represented by Pomerantz, filed a Section 220 action demanding corporate records from Lululemon in May 2013. Another Section 220 action was brought by another shareholder plaintiff in Delaware in October later that year. On April 2, 2014, the Chancery Court ordered Lululemon to produce documents relating to the sale of shares that occurred just before the public announcement of the CEO’s resignation. In July 2015, the Delaware plaintiffs filed their derivative lawsuit against Lululemon for breaches of fiduciary duties.

The first derivative lawsuits against Lululemon alleging breaches of fiduciary duties were filed in New York federal court after Pomerantz filed its Section 220 action in Delaware. Separate New York suits by two shareholder plaintiffs were filed in August 2013, but an amended complaint consolidating the two was filed January 17, 2014. In response to the New York case, Lululemon filed a motion to dismiss, arguing that the New York plaintiffs failed to adequately allege demand futility. Pomerantz, on behalf of the Delaware plaintiffs, sought to intervene in the New York matter, requesting that the New York court stay the case pending resolution of the Section 220 action in Delaware, or in the alternative, to dismiss one of the breach of fiduciary duty claims without prejudice in order to allow it to move forward in Delaware.

The New York federal court denied Pomerantz’s requests and granted defendant’s motion to dismiss. Shortly thereafter, the Chancery Court in Delaware dismissed the Delaware derivative complaint, finding that the same claims and issues had already been adjudicated in New York.

The Lululemon decision comes on the heels of the Wal-Mart decision, rendered two months before, where diligent plaintiffs in Delaware got the short end of the stick following the dismissal of an analogous but poorly researched case in an Arkansas federal court. In 2012, a widely-publicized bribery scandal led shareholder plaintiffs to file lawsuits against Wal-Mart. In Delaware, the plaintiffs first filed a Section 220 action that took three years to resolve. They did not file their derivative action until July 2015. The Arkansas plaintiffs filed their derivative action without the benefit of making a books and records demand. Much like in Lululemon, Wal-Mart filed a motion to dismiss attacking the Arkansas plaintiffs’ failure to allege demand futility with sufficient facts. The Arkansas federal court agreed with Wal-Mart and dismissed the complaint; shortly thereafter, the Delaware Chancery Court dismissed its derivative complaint on the grounds of issue preclusion.

Key to both decisions was the finding that there is no presumption of inadequacy for fast-filing plaintiffs, and that the level of detail between the competing complaints is irrelevant to the issue preclusion analysis. In other words, diligent plaintiffs who sought books and records before suing are stuck with the results of the quick-filing cases.

At the time, the distinctive circumstances of the Wal-Mart case tempered arguments in favor of de-emphasizing Section 220 actions. Indeed, rarely do Section 220 actions drag on for three years. However, coupled with the Lululemon decision, plaintiffs faced with the prospect of multi-jurisdiction litigation need to analyze the practical benefits of filing an action quickly rather than waiting for a books and records action to conclude—even if the former goes against the advice of the Chancery Court to make use of the “tools at hand.”