Louisiana Municipal Police Employees’ Ret. Sys. v. Pyott: Court of Chancery Holds that Dismissal on Demand Futility Grounds Is Not Entitled to Preclusive Effect in an Action Filed by a Different Stockholder Plaintiff

September 5, 2012

Publication| Corporate Transactions| Corporate & Chancery Litigation

In Louisiana Municipal Police Employees’ Ret. Sys. v. Pyott, 46 A.3d 313 (Del. Ch. 2012), the Court of Chancery held that a federal court’s decision to dismiss derivative litigation for failure to plead demand futility adequately under Rule 23.1 did not preclude relitigation of that same issue in another case involving a different stockholder plaintiff. The defendants have appealed the Court’s ruling, and that appeal remains pending.

On September 1, 2010, Allergan, Inc.—the manufacturer of the drug Botox—announced that it had entered into a settlement with the United States Department of Justice. The settlement arose out of allegations that Allergan had misbranded Botox and illegally marketed the drug for “off-label” uses. Allergan pled guilty to criminal misdemeanor misbranding, paid a total of $600 million in civil and criminal fines, and entered into a five-year Corporate Integrity Agreement with the Department of Health and Human Services, Office of Inspector General.

Within 48 hours of the announcement of the settlement, Allergan stockholders began to file derivative actions against Allergan’s board of directors for their alleged complicity in the misbranding, and by September 24, 2010, at least four separate cases had been filed in the Delaware Court of Chancery and the United States District Court for the Central District of California.

In addition, on November 3, 2010, U.F.C.W. Local 1776 (“UFCW”), an Allergan stockholder, sent Allergan a books and records demand pursuant to 8 Del. C. § 220. After receiving documents, UFCW joined in the existing Delaware Court of Chancery action, and the Delaware plaintiffs filed an amended complaint.  Allergan shared the books and records it produced to UFCW with the plaintiffs in the California action, who also filed an amended complaint.

The defendants moved to dismiss in both Delaware and California. The California court reached a decision first, holding in January 2012 that the California plaintiffs had failed to plead demand futility adequately and that their amended complaint would be dismissed with prejudice pursuant to Rule 23.1.

In the Delaware action, the defendants argued that the doctrine of collateral estoppel precluded relitigation of the demand futility issue, in addition to their substantive arguments that the complaint was inadequate under Rules 23.1 and 12(b)(6). In response to the collateral estoppel argument, the Court of Chancery noted a “growing body of precedent” holding that a Rule 23.1 dismissal has a preclusive effect on other derivative complaints, based on the theory that all stockholder plaintiffs are in privity with each other because they all are suing in the name of the corporation.

The Court declined to follow that authority, holding that the Delaware Supreme Court has made clear that a stockholder whose litigation efforts are opposed by the nominal defendant corporation does not have authority to sue on the corporation’s behalf until either (i) there is a finding of demand excusal, or (ii) a court holds that the corporation wrongly refused the stockholder’s demand to sue. Because a stockholder who loses a Rule 23.1 motion necessarily fails to win the right to sue on the corporation’s behalf, the basis of previous court holdings that collateral estoppel prevented relitigation of demand futility allegations—that successive stockholders were in “privity” with each other because they were all suing in the corporation’s name—is inconsistent with Delaware law. The Court therefore held that a Rule 23.1 dismissal of one stockholder’s derivative complaint would not preclude a different stockholder from relitigating that issue in a separate case.

Going further, the Court held that an “independent basis” for its refusal to apply collateral estoppel to the case at hand applied: the plaintiffs in the California action did not adequately represent Allergan. The Court addressed at length what it referred to as the “fast-filing problem” and held that in cases such as the one at issue where swift action was not required in order to prevent irreparable harm, a plaintiff who files a derivative action shortly after announcement of a corporate loss without first conducting a meaningful investigation has not provided adequate representation to the corporation it is seeking to represent.

Having determined that the California court’s judgment did not collaterally estop the Delaware plaintiffs from proceeding with their demand futility arguments, the Court addressed the substance of the claims. The Court of Chancery held that the complaint at issue contained adequate factual allegations from which it could reasonably be inferred that the Allergan directors faced a substantial risk of liability if the litigation were pursued, and demand would therefore have been futile. Not surprisingly, given its holding that the complaint survived the more rigorous scrutiny required by Rule 23.1, the Court also denied the defendants’ motion to dismiss for failure to state a claim upon which relief can be granted.

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