Saturday, January 27, 2018

The Race Continues

The Delaware Supreme Court finally issued its decision in Cal. State Teachers Ret. Sys. v. Alvarez, and it appears we don’t have one neat trick for dealing with races to the courthouse in derivative litigation after all.

As I’ve discussed in previous blog posts, Delaware has a substance and procedure problem.  Namely, it uses its own court procedures as supplemental mechanisms to substantively police the behavior of corporate actors, but those procedures don’t apply in non-Delaware forums.  That leaves Delaware vulnerable to being undercut by other states – and encourages an unhealthy race to the courthouse in other jurisdictions. 

As I explained before, in the context of derivative cases, “Delaware’s recommendation that derivative plaintiffs seek books and records before proceeding with their claims simply invites faster filers to sue in other jurisdictions – and invites defendants to seek dismissals against the weakest plaintiffs, which will then act as res judicata against the stronger/more careful ones.” 

That’s what happened in Alvarez.  While the Delaware plaintiffs spent years litigating a books and records request, defendants won a dismissal for failure to plead demand futility against a competing plaintiff group in Arkansas.  The Chancery court then held that the dismissal was res judicata against the Delaware plaintiffs.

On appeal, the Supreme Court remanded with a curious request: to determine whether the dismissal violated the Delaware plaintiffs’ federal Due Process rights.  The reasoning, first articulated by VC Laster in In re EZCORP Inc. Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016), was that until a court concludes demand is futile, the plaintiff has no right to bring suit on the corporation’s behalf, and therefore acts individually.  Laster analogized to the Supreme Court’s decision in Smith v. Bayer Corp., 564 U.S. 299 (2011), which held that a named plaintiff in a class action cannot bind the class until after certification.

On remand the Chancery court couldn’t quite bring itself to hold that federal Due Process was violated, exactly, but did suggest that the Delaware Supreme Court adopt a rule prohibiting preclusion in these circumstances, in part because such a rule would further public policy.

That decision was appealed back up to the Delaware Supreme Court, which has now rejected the recommendation.  The Supreme Court concluded that a derivative case is unlike a class action, because in a class action, pre-certification, the named plaintiff is suing on his or her own behalf, bringing a claim that he or she is entitled to bring individually.  By contrast, in a derivative action, the stockholder plaintiff never has the right to bring a claim individually; the claim always belongs to the corporation.  Thus, even absent demand futility, the plaintiff must be viewed as standing in the corporate shoes.  By this reasoning, derivative plaintiffs are in privity with each other, and there is a sufficient alignment of interests to satisfy Due Process.

In short, absent a showing of inadequate representation by the first plaintiffs, res judicata applies.

The Delaware Supreme Court did have a curious footnote though and I wonder if it provides an opening in future cases.  The Court noted that had Delaware plaintiffs attempted to intervene in the Arkansas action – or, failing grounds to intervene, at least filed a statement of interest or sought to participate as amici – they might “have a more compelling argument before this Court that the Arkansas Plaintiffs failed to adequately represent them.”  We’ll see if anyone tries to take advantage of that going forward.

Ann Lipton | Permalink


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