Delaware Chancery Court Holds That a Stockholder Inadequately Represents a Corporation in Derivative Litigation When He or She Files a Caremark Claim Without First Making a Section 220 Books and Records Demand

by Sheppard Mullin Richter & Hampton LLP
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In South v. Baker, C.A. No. 7294-VCL, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012), the Delaware Court of Chancery adopted a rebuttable presumption of inadequate representation when a stockholder asserts a “Caremark claim” without first investigating the claim using Section 220 of the Delaware General Corporation Law (“Section 220”), a statute allowing under certain conditions stockholder inspection of the corporation’s books and records. Because the dismissal of a stockholder’s derivative action due to inadequate representation has no preclusive effect on the litigation efforts of other stockholders, the court in South adopted and applied the presumption to ensure that its order dismissing with prejudice plaintiffs’ inadequately pled complaint would not bar other stockholders of the corporation (who had properly opted to use Section 220 rather than sue in the first instance) from later pursuing the same claim on behalf of the corporation.

Plaintiffs purportedly were stockholders of Hecla Mining Company (“Hecla”). Hecla is a Delaware corporation headquartered in Idaho that discovers metals, including silver. In 2011, Hecla’s Idaho mine suffered three mishaps, resulting in death and injury to mine workers. In January 2012, Hecla announced a U.S. agency’s closure of the mine pending removal of dangerous conditions, and adjusted downward the company’s silver production estimates. Later that same month, the agency announced that it had issued 59 citations and 15 orders against Hecla relating to unsafe mine conditions.

On February 1, 2012, Hecla investors filed the first of two federal securities class actions against Hecla, seeking damages. Between February 23 and 29, 2012, Hecla stockholders brought three derivative actions in Idaho against Hecla’s directors, each asserting a “Caremark claim” concerning the safety problems at the Idaho mine. In a “Caremark claim” — which gets its name from In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) — stockholders seek to hold directors liable to the corporation for injury the corporation suffers when the directors knowingly cause or consciously permit the corporation to violate positive law, or utterly fail to take steps to ensure the corporation’s compliance with positive law.

On March 1, 2012, the Souths filed a derivative action in Delaware asserting the same Caremark claim.  Three more identical derivative actions in Idaho followed shortly thereafter.  All of the plaintiffs ignored the Delaware Supreme Court’s admonitions to use Section 220 to investigate the basis for a Caremark claim before asserting one.  See, e.g., Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 845 A.2d 1040, 1056 (Del. 2004).  Notably, however, two Hecla stockholders had not sued and were at the time of the court’s opinion pursuing Section 220 demands.

Defendants moved to dismiss the Delaware action for failure to adequately plead “demand futility,” i.e., particularized facts creating doubt that Hecla’s board would have properly exercised its independent and disinterested business judgment in responding to a litigation demand. As the court explained, a sufficient nexus must exist between the corporate trauma (here, the mine accidents and resulting securities litigation) and the board of directors that gives rise to a risk of personal director liability, without which there is no basis to doubt the board’s ability to evaluate the litigation demand. The Chancery Court held that the complaint failed to plead facts connecting the three mine accidents to Hecla’s board, such as what the directors were told, what the board’s response was, or that the incidents were connected. The court noted that a Section 220 request might have supplied the facts needed to show demand futility.

In dismissing the complaint with prejudice, the court voiced concern that the dismissal might preclude those Hecla stockholders who served Section 220 demands and who might eventually seek to assert the same claim on behalf of Hecla. Because a dismissal due to a stockholder plaintiff’s failure to adequately represent the corporation has no preclusive effect, the court delineated and adopted a rebuttable presumption that when a stockholder rushes to assert a Caremark claim without first resorting to Section 220 to show a connection between the corporate trauma and director action or inaction, the stockholder inadequately represents the corporation. Such a presumption had only been suggested in prior Chancery Court opinions.

The court explained that, unlike derivative claims directly challenging specific board decisions, with Caremark claims, a connection to the board cannot be reasonably inferred from the occurrence of the corporate trauma itself, so an investigation is usually necessary. There is also usually no need to immediately file a Caremark claim as related regulatory proceedings and regulatory actions rarely will be resolved. At that moment, a Caremark claim does not serve the corporation’s interests: “A plaintiff who hurries to file a Caremark claim after the announcement of a corporate trauma behaves contrary to the interests of the corporation but consistent with the desires of the filing law firm to gain control of (or a role in) the litigation.”

In South, the court applied the presumption and found the prerequisites satisfied. It found no grounds for rebuttal. As the court put it, there was no “entity-beneficial reason for filing” at the time of filing. Indeed, plaintiffs’ counsel conceded that he filed hastily because of concern that other stockholder plaintiffs who had moved quickly (as they had also not made and awaited the results of Section 220 demands), might gain control of the litigation. The court concluded that plaintiffs inadequately represented Hecla. The court’s dismissal will not preclude the litigation efforts of other Hecla stockholders but will only bar the named plaintiffs.

South signals that failure to conduct a pre-suit Section 220 investigation will likely lead to a dismissal with prejudice of Caremark claims, albeit without preclusive effect on other stockholders. Delaware corporations should continue to expect to see an increase in Section 220 demands, as stockholders jockey to be the first to obtain access to the corporation’s books and records before filing suit. When a corporation succeeds in dismissing a Caremark claim not preceded by a Section 220 demand, the dismissal will be a narrow victory against that stockholder alone.

For further information, please contact John Stigi at (310) 228-3717 or John Landry at (213) 617-5561.

 

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