Chancery Recommends Rule to Determine Preclusive Effect of Judgments in Prior Derivative Actions

by Morris James LLP
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Delaware Business Court Insider - August 9, 2017

The predominant approach in most jurisdictions to determine whether the dismissal of a derivative action based on the failure to adequately plead demand futility bars re-litigation of this issue in a subsequent derivative action brought by a different stockholder plaintiff is to apply the traditional legal test for issue preclusion. Generally in these jurisdictions, issue preclusion bars re-litigation of demand futility if: the demand-futility issue is the same; the issue is actually litigated and necessary to a final judgment; it involves the same parties in the prior derivative action or in privity with those parties; and there is adequate representation of counsel in the prior derivative action.

Following the predominant approach for issue preclusion, the Delaware Court of Chancery dismissed a derivative action in In re Wal-Mart Stores, Delaware Derivative Litigation, C.A. No. 7455-CB (Del. Ch. May 13, 2016), based on an Arkansas federal district court dismissal of a prior derivative action, challenging the same Wal-Mart bribery scheme, on grounds of failure to adequately plead demand futility. In finding that the requirement of "privity" for issue preclusion was met in two derivative actions involving different stockholder plaintiffs, the court noted that the vast majority of other jurisdictions had found privity between different stockholder plaintiffs who file separate derivative actions because the corporation is the real party in interest, and both plaintiffs are bringing suit on behalf of the corporation, making them essentially interchangeable. Since the constitutional principles of "due process" are embedded in the restatement's legal test to determine "adequate representation of counsel," the court applied the restatement test to find that the representation of counsel in the prior derivative action was not "grossly deficient." Accordingly, the court concluded that the Arkansas federal district court dismissal of the prior derivative action based on demand futility precluded re-litigation of this issue in the subsequent Wal-Mart derivative action.

The Delaware Supreme Court reversed the Court of Chancery's dismissal of the subsequent Wal-Mart derivative action. On remand, the Delaware Supreme Court directed the Court of Chancery to address the question when "dismissal by the federal court in Arkansas of a stockholder plaintiff's derivative action for failure to plead demand futility is held by the Delaware Court of Chancery to preclude subsequent stockholders from pursuing derivative litigation, have the subsequent stockholders' due process rights been violated? See Smith v. Bayer , 564 U.S. 299 (2011)." The Court of Chancery framed the issue on remand as whether the predominant approach to issue preclusion in connection with two derivative actions involving different stockholder plaintiffs violates due process.

In Smith v. Bayer, which the Delaware Supreme Court cited in its question to the Court of Chancery, the U.S. Supreme Court adopted a bright-line rule for determining the preclusive effect of a judgment in a prior class action on a subsequent class action. Distinguishing between pre- and post-class certification, the U.S. Supreme Court found that a judgment before class certification only binds the putative class representative in the prior uncertified class action.

Relying on the logic of the U.S. Supreme Court's decision in Smith v. Bayer in the class-action context, the Court of Chancery had previously found, in dictum, in In re EZCORP, Consulting Agreement Derivative Litigation, that a judgment in a prior derivative action cannot bind "the corporation or other stockholders in a derivative action until the action has survived a Rule 23.1 motion to dismiss, or the board of directors has given the plaintiff authority to proceed by declining to oppose the suit," 130 A.3d 934, 948 (Del. Ch. 2016) (Laster, V.C.). By analogy to the U.S. Supreme Court's decision in Smith v. Bayer, which distinguished between pre- and post-class certification to determine the preclusive effect of a judgment in a prior class action, EZCORP proposed adoption of a bright-line rule that distinguished between pre- and post-demand futility phases of derivative litigation to determine the preclusive effect of a judgment in a prior derivative action. The EZCORPcourt explained that before a stockholder plaintiff in a derivative action acquires authority to litigate on behalf of a corporation, either by satisfying demand futility under Rule 23.1, or obtaining approval from the corporation to proceed on its behalf, the stockholder plaintiff is in a similar position as the putative class representative before the class is certified in a class action. Accordingly, the EZCORP court concluded that "under the logic of Bayer, the due process clause forecloses a judgment in a derivative action that is entered before the stockholder plaintiff acquires authority to litigate on behalf of the corporation from binding [other stockholders] other than the named stockholder plaintiff."

In its recent decision in In re Wal-Mart Stores, Delaware Derivative Litigation, C.A. No. 7455-CB (Del. Ch. July 25), the Court of Chancery recommended that the Delaware Supreme Court adopt the bright-line rule proposed in EZCORP that until the stockholder plaintiff in the prior derivative action acquires authority to litigate on behalf of the corporation, either by satisfying demand futility under Rule 23.1, or obtaining approval from the corporation to proceed on its behalf, a judgment in the prior stockholder derivative action does not bind or preclude a subsequent derivative action brought by a different stockholder plaintiff. Thus, under the proposed rule, dismissal of a derivative action based on the failure to adequately plead demand futility would not bar or preclude re-litigation of this issue in a subsequent derivative action brought by a different stockholder plaintiff.

The Court of Chancery's recommendation was based on the similarities between class and derivative actions, the realities of derivative litigation, and public policy. First, similar to the due process concerns designed to protect the interests of class members in a class action, the court reasoned that a derivative action is also a representative action designed to ensure due process to the derivative class of other stockholders, whose interests to enforce the rights of the corporation are also at stake in the derivative action. While the corporation is the real party in interest in both the prior and subsequent derivative actions, when a stockholder is denied authority to sue on behalf of the corporation, the derivative action has failed as a representative action, and no more qualifies for preclusion than a putative class action that fails to meet the requirements for class certification. Second, the court noted the practical concerns in the assessment of the requirement for adequate representation of counsel in the prior derivative action, which is essential to ensure due process under the predominate approach for issue preclusion. In multiforum derivative litigation, defendants often have little incentive to challenge the adequacy of the representation of counsel in the hope of obtaining dismissal on grounds of demand futility to potentially bar re-litigation of this issue in a subsequent derivative action by a different stockholder plaintiff, who may have obtained the corporation's books and records to file a more-factually developed complaint that might survive demand futility. Thus, the assessment of the adequacy of the representation of counsel in the prior derivative action is often not determined until the court in the subsequent derivative action applies the legal test for issue preclusion. This back-end form of adequacy of counsel review, however, negates the ability of courts to compare the qualities of competing representative stockholder counsel to choose the best counsel to represent the interests of the corporation and its stockholders. Finally, while recognizing the competing policy rooted in judicial efficiency to avoid duplicative litigation concerning demand futility, the court emphasized that the proposed rule would "go a long way to addressing the 'fast-filer' problem and ensuring better protection of due process rights for stockholder plaintiffs." The court pointed out that principles of stare decisis and comity are likely sufficient to curtail truly duplicative derivative litigation.

Practice Point

While the Delaware Supreme Court has yet to weigh in on the Court of Chancery's recommendation, the proposed rule makes eminently good sense. In application, the proposed rule contains a clear line of demarcation to determine the preclusive effect of a judgment in a prior derivative action. As a matter of public policy, the proposed rule will discourage the race to file phenomenon, and instead, encourage well-grounded complaints in stockholder derivative actions based on a factual record developed by first obtaining a corporation's books and records under Section 220 of the Delaware General Corporation Law. 

Delaware Business Court Insider | August 9, 2017 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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