Second Circuit Affirms Dismissal Of Shareholder Suit, Finding Subject Matter Jurisdiction Was Properly Exercised, Equity Dilution Claim Was Derivative, And Demand Futility Was Inadequately Pleaded

by Shearman & Sterling LLP
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On April 26, 2017, the United States Court of Appeals for the Second Circuit affirmed the dismissal of a lawsuit brought by a shareholder of Star Bulk Carriers Corp. (“Star Bulk”) against its directors and entities affiliated with the director defendants.  F5 Capital v. Pappas, No. 16-530 (2d Cir. April 26, 2017).  Challenging various transactions in which Star Bulk had engaged, plaintiff asserted derivative claims for breaches of fiduciary duty and waste, as well as a purported direct class-action claim for wrongful equity dilution.  Affirming the dismissal of all claims, the Second Circuit held that (1) the equity dilution claim was not within the “limited circumstances involving controlling stockholders” to enable it to be considered a direct (rather than derivative) claim; (2) the district court nevertheless had and properly retained subject matter jurisdiction; and (3) plaintiff failed to plead demand futility, as required under Federal Rule of Civil Procedure 23.1 to maintain shareholder derivative claims. 

Plaintiff, a Star Bulk shareholder, alleged generally that three defendant entities, which were also Star Bulk shareholders, orchestrated various transactions to the detriment of Star Bulk’s other shareholders.  In advance of the transactions, these three defendant groups held approximately 3.3% (“Group I”), 19.6% (“Group II”), and 21% (“Group III”) of Star Bulk shares (amounting in total to 43.9%).  The complaint focused principally on a transaction in which Star Bulk acquired Oceanbulk Carriers LLC (“Oceanbulk”), allegedly allowing defendants “to consolidate their control.”  After this merger, the first two groups increased their holdings to 12.6% and 61.3%, respectively, but Group III had its interest decrease to 7.4%.  Notably, 95.6% of all Star Bulk shareholders voted in favor of the deal.   

Plaintiff initially brought the case in state court in New York, asserting derivative claims for breaches of fiduciary duty, aiding and abetting, and waste, as well as a purported direct class-action claim for equity dilution.  The defendants removed to federal district court asserting jurisdiction over the direct, class-action dilution claim under the Class Action Fairness Act (“CAFA”), 28 U.S.C. § 1332(d), and supplemental jurisdiction over the non-class, state law derivative claims, 28 U.S.C. § 1367(a).  Plaintiff did not contest removal.

Regarding the substance of the claims, the Court noted that the parties agreed that Delaware law applied because Star Bulk is incorporated in the Marshall Islands, which adopted Delaware corporate law. 

As to the equity dilution claim, the Court explained that Delaware considers such claims derivative except in “limited circumstances” involving an increase in the percentage of shares owned by the “controlling stockholder” and a corresponding decrease in the share percentage owned by the other shareholders that amounts to “an improper transfer . . . of economic value and voting power.”  Here, the Court found that plaintiff had failed to allege “sufficient facts” to demonstrate a plausible claim that “the three groups of defendants constituted a single control group.”  Specifically, the Court explained that “[i]t is implausible . . . to allege that [Group III] committed with [the other two defendant groups] to expand their ownership stake while shrinking its own.”  Further, the Court found that even if the shares held by the three defendant groups could be aggregated, “their collective interest [of 43.9%] is insufficient to satisfy the definition of a controlling stockholder” because 43.9% is “plainly less than 50%, and [plaintiff] has not plausibly alleged that the group collectively exercise[d] control over the business and affairs of the corporation.”  The Court also highlighted that the fact that 95.6% of all Star Bulk shareholders voted in favor of the Oceanbulk merger “renders still more implausible [plaintiff’s] claim that [the three defendant groups] colluded to take over the corporation to the other shareholders’ detriment.”  

Although neither side raised the issue, the Court next addressed whether the federal district court had and retained subject matter jurisdiction over the claims.  First, the Court considered the implications of its decision that the equity dilution claim was a derivative claim and not a direct class-action claim.  At the time of removal, the equity dilution class-action claim satisfied the jurisdictional requirements under CAFA, including “minimal diversity” because plaintiff was a foreign corporation and at least one defendant was a United States citizen.  The Court held that “the later failure of the class claim”—which it found to be derivative—“did not divest the district court of subject matter jurisdiction because CAFA anchored jurisdiction at the time of removal.”

Second, the Court held that—“on the facts of this case”—the absence of “complete diversity” (because plaintiff was a foreign corporation and there were foreign defendants) did not “preclude[] the district court from exercising supplemental jurisdiction” over the claims that had initially been brought as derivative non-class claims.  The Court explained:  “Given that CAFA is the jurisdictional anchor for the complaint and that the evident purpose of that statute was to expand federal jurisdiction over suits that meet its requirements, it would be inconsistent with that purpose to interpret [28 U.S.C.] § 1367(b) [a provision limiting supplemental jurisdiction] to keep the pendent claims out of federal court while allowing the class claims to proceed, where the anchor of jurisdiction plainly does not contemplate such a result.” The Court added that “[t]he fact that this is a removal case also favors exercising supplemental jurisdiction here.” 

Finally, the Court held that all of the claims—now found to be derivative—must, but did not, satisfy the requirement under Rule 23.1 to plead that a demand on the board to sue was excused.  Applying Delaware law, the Court determined that “at least a majority of the board [five of nine members] was disinterested.”  Specifically, the Court found that, as to one director, allegations that he served on other boards with an interested director did not “raise a reasonable doubt concerning” his independence.  As to three other directors who (after the Oceanbulk transaction) had been appointed by and were employees of the Group II shareholder, plaintiff had “not pled any particularized facts concerning [their] conduct in their positions or the nature of their obligations to [the Group II shareholder] that raise a reasonable doubt concerning their independence.”  As to a fifth director, plaintiff alleged only that he was Star Bulk’s CEO before the Oceanbulk merger and received shares as a change-of-control payment and became non-executive chairman in connection with the transaction.  The Court concluded that “[a]bsent a suggestion that the compensation was excessive, the receipt of such payment does not disqualify [him] from passing on the pre-suit demand.”  The Court also held that the complaint failed to plead facts showing the challenged transactions were undertaken in “bad faith” or that the directors “failed to inform themselves” in advance.  Therefore, the Court affirmed the dismissal.    

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