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California State Teachers' Retirement System v. Alvarez: Delaware Supreme Court Finds Dismissal of Derivative Action for Failure to Plead Demand Futility Ordinarily Has Preclusive Effect on Other Derivative Plaintiffs

March 8, 2018

In California State Teachers’ Retirement System v. Alvarez, --- A.3d ---, 2018 WL 547768 (Del. Jan. 25, 2018), the Delaware Supreme Court declined to adopt a proposed rule from the Court of Chancery that, as a matter of due process, a judgment in a derivative action cannot bind a corporation or other stockholders until the suit has survived a motion to dismiss for failure to plead demand futility. In doing so, the Supreme Court confirmed that, generally, the dismissal of a shareholder derivative action for failure to plead demand futility precludes other derivative actions brought in other jurisdictions as long as the plaintiff in the dismissed case adequately represented the corporation’s interests.

In April 2012, The New York Times reported on an alleged bribery scheme and subsequent cover-up by executives of a Wal-Mart subsidiary. Derivative lawsuits asserting claims for breach of fiduciary duty against Wal-Mart’s officers and directors were filed in Arkansas federal court and in the Delaware Court of Chancery. The Delaware plaintiffs made a books and records demand pursuant to Section 220 of the Delaware General Corporation Law, while the plaintiffs in the Arkansas litigation did not make a similar demand, relying solely on publicly available information, including internal Wal-Mart corporate memos referenced in a news article.

While litigation relating to the Delaware plaintiffs’ Section 220 demand was pending, Wal-Mart moved to dismiss the Arkansas action under Federal Rule of Civil Procedure 23.1, arguing that the Arkansas plaintiffs had failed to plead sufficiently that demand on Wal-Mart’s board of directors would have been futile. The Arkansas court granted the motion to dismiss, and Wal-Mart moved to dismiss in Delaware on the grounds that the decision by the Arkansas court had a preclusive effect on the issue of demand futility. The Delaware Court of Chancery agreed, applying Arkansas preclusion principles and dismissing the Delaware action.

Following the Court of Chancery’s original decision, the Delaware plaintiffs appealed to the Delaware Supreme Court.  The Supreme Court issued an order in January 2017 in which it did not disagree with the Court of Chancery’s dismissal, but expressed concern over the due process implications.  The Supreme Court remanded the action to the Court of Chancery to determine whether “the subsequent stockholders’ Due Process rights [had] been violated” by the dismissal of the Arkansas action on demand futility grounds.  See Cal. State Teachers’ Ret. Sys. v. Alvarez, 175 A.3d 86 (Del. Jan. 18, 2017) (TABLE).

On remand, the Court of Chancery recommended that the Supreme Court adopt a rule that derivative litigation does not have a preclusive effect against stockholders in another derivative action “until the [first] 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.” See In re Wal-Mart Stores, Inc. Del. Deriv. Litig., 167 A.3d 513 (Del. Ch. 2017).

The Supreme Court declined to adopt the Court of Chancery’s recommendation, and instead affirmed the Court of Chancery’s original dismissal of the Delaware action on preclusion grounds. The Supreme Court observed that three federal Courts of Appeals had arrived at the same conclusion—a subsequent derivative plaintiff’s due process rights were protected, and dismissal based on issue preclusion was appropriate where the plaintiff’s “interests were aligned with and were adequately represented by the prior plaintiffs.”

Applying that test, the Supreme Court found that, under the Arkansas privity test—which is satisfied “when two parties are so identified with one another that they represent the same legal right”—the Arkansas and the Delaware plaintiffs stood in privity. The Supreme Court reasoned that even where there are multiple pending derivative actions, the derivative plaintiffs “seek to control the corporation’s cause of action” and therefore stand in privity to one another. The Supreme Court rejected the plaintiffs’ argument that the dual-phase nature of a derivative action, as first a suit seeking authority to pursue the corporation’s claim and then a suit to recover on behalf of the corporation, transformed the first step of a derivative action into an individual claim by the shareholder, which (plaintiffs argued) caused a stockholder-plaintiff who fails to reach the second phase not to be in privity with other stockholders seeking to assert the same claim.

Turning to the due process analysis, the Supreme Court applied the test outlined in Restatement (Second) of Judgments, under which a prior representation would be considered inadequate only where (1) the prior litigation was conducted in a “grossly deficient” manner, or (2) the first-filed plaintiffs had a conflict of interest that caused them to pursue the litigation at the expense of later-filed plaintiffs. The Supreme Court found that neither prong of that test was present. First, while the Supreme Court recognized that the Arkansas plaintiffs may have made a “tactical error” by not pursuing a books and records demand prior to filing a derivative action, such a decision was considered and one upon which “[r]easonable litigants can differ” in the context of this litigation. Second, the Delaware plaintiffs made no showing that the Arkansas plaintiffs’ interests were adverse to those of Wal-Mart, and therefore the Supreme Court found no conflict of interest that would render the Arkansas representation inadequate.