In this en banc decision, the Delaware Supreme Court answered a certified question of law from the United States Court of Appeals for the Ninth Circuit. The certified question was whether, under the “fraud exception” to Delaware’s continuous ownership rule, shareholder plaintiffs may maintain a derivative suit after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims. The Supreme Court answered the question in the negative and ratified and reaffirmed the continuous ownership rule and the “fraud exception” recognized by its holding in Lewis v. Anderson, 477 A.2d 1040 (Del. 1984).
Plaintiffs in the underlying federal action filed their derivative claims on behalf of Countrywide Financial Corporation (“Countrywide”) in California in October 2007. On July 1, 2008, a stock-for-stock merger between Countrywide and Bank of America (“BofA”) closed, and all outstanding Countrywide shares were exchanged for BofA shares. Defendants in the federal action then moved for judgment on the pleadings on the grounds that plaintiffs lost derivative standing as a result of the merger. On December 11, 2008, the district court granted defendants’ motion for judgment on the pleadings and dismissed all the derivative claims.
Following the district court’s ruling, the Court of Chancery approved the settlement of direct claims challenging the merger that were pending in Delaware. In approving the settlement, the Court of Chancery found that the merger had not been motivated by any desire to eliminate derivative standing. The derivative plaintiffs objected to the settlement and appealed the Court of Chancery’s approval to the Delaware Supreme Court. In affirming the approval of the settlement, the Supreme Court, in a decision captioned Arkansas Teacher Retirement Systems v. Caiafa,stated that the Vice Chancellor had “denied the objection and approved the settlement, allowing [BofA] to close its acquisition of Countrywide, thus extinguishing [the plaintiffs’] standing to pursue derivative claims.” The Supreme Court explained that the conditions to satisfy the “fraud exception” were not present because the record did “not reflect that the [Countrywide] directors prospectively sought and approved a merger, solely to deprive stockholders of standing to bring a derivative action.”
In its Arkansas Teacher decision, the Supreme Court in dictum discussed certain direct claims that the plaintiffs could have but did not present to the Court of Chancery. The Supreme Court stated that the plaintiffs theoretically could have pled a claim for a single, inseparable fraud alleging that pre-merger fraudulent conduct made the merger a fait accompli. Based on the dictum in the Supreme Court’s ruling, the derivative plaintiffs returned to the district court in California and sought reconsideration of the order dismissing their derivative claims. They argued that in Arkansas Teacher the Delaware Supreme Court clarified the scope of the “fraud exception” to Delaware’s continuous ownership rule and confirmed that the derivative plaintiffs had post-merger derivative standing. The district court denied the plaintiffs’ motion for reconsideration, the plaintiffs appealed to the Ninth Circuit, and the Ninth Circuit certified the above question regarding continuous ownership and the “fraud exception” to the Delaware Supreme Court.
In answering the certified question, the Supreme Court reaffirmed that the “fraud exception” to the continuous ownership rule is available only if the merger itself is subject to a claim of fraud, being perpetrated merely to deprive stockholders of standing to bring a derivative action. The Court clarified that its discussion of “inseparable fraud” in dictum in the Arkansas Teacher decision was different. The discussion of “inseparable fraud” referred to a situation where pre-merger conduct makes a merger inevitable. Such conduct gives rise to a direct claim that can survive the merger, but not a derivative claim. The Supreme Court pointed out that its discussion in Arkansas Teacher recognized that any injury flowing from the “inseparable fraud” would be suffered by the stockholders rather than the corporation and any recovery would go to the stockholders rather than the corporation, thus supporting its conclusion that an “inseparable fraud” claim would be a direct claim. The Court observed that the plaintiffs had not alleged an “inseparable fraud” claim and that the Arkansas Teacher decision unequivocally held that the Countrywide-BofA merger had extinguished the plaintiffs’ derivative standing. The Court ultimately held that Arkansas Teacher did not clarify, expand, or constitute a new material change in Lewis v. Anderson’s continuous ownership rule or the “fraud exception.”
The full opinion is available here.