In their article, Abandoned and Split, But Never Reversed: Borak and Federal Derivative Litigation, Professors Mohsen Manesh and Joseph Grundfest argue that Lee had the right of it and Seafarers got it wrong. Motivated by concern about abusive litigation, they argue, first, that derivative Section 14(a) claims are duplicative of other rights of action, and that therefore, under Delaware corporate law, bylaws waiving such claims do not operate inequitably. Second, they argue that derivative Section 14(a) claims should not be recognized at all, in part because of ambiguities in the original Supreme Court case to recognize them, J.I. Case Co. v. Borak, but also because of their internal illogic and subsequent Supreme Court precedent.
I agree with Professors Manesh and Grundfest that there is abuse in the system (though there seem to be plenty of procedural tools for addressing those problems). But I also think that, so long as the direct/derivative distinction is defined by state law, there are critical roles for derivative Section 14(a) actions to play in protecting investors and securities markets more generally, and that any elimination of the right should emanate from Congress, rather than the courts or—worse—at corporate defendants’ option via the unilateral adoption of a bylaw. That said, if we relax the direct/derivative distinction for federal claims, many of Manesh and Grundfest’s objections would be resolved, and investors would remain protected.
II. Borak Says What It Says
In 1956, Carl Borak, a shareholder of the J.I. Case Company, filed a lawsuit alleging that the company had effected a stock-for-stock acquisition of the American Tractor Corporation by means of a false and misleading proxy statement, in derogation of his preemptive rights. As a remedy, he sought a declaration that the proxies and the merger were void and damages for himself and similarly situated stockholders. The defendants contended that the lawsuit was derivative in nature and that Section 14 neither extended to derivative suits nor permitted retrospective relief. In J.I. Case Company v. Borak, the Supreme Court held that defendants’ argument that the lawsuit was derivative in nature was irrelevant, as “a right of action exists as to both derivative and direct causes” under Section 14(a) in order to “prevent management or others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation.” As the Court put it:
The injury which a stockholder suffers from corporate action pursuant to a deceptive proxy solicitation ordinarily flows from the damage done to the corporation, rather than from the damage inflicted directly upon the stockholder. The damage suffered results not from the deceit practiced on him alone but rather from the deceit practiced on the stockholders as a group. To hold that derivative actions are not within the sweep of the section would therefore be tantamount to a denial of private relief.
The most straightforward reading of Borak, then, is not only that Section 14(a) provides a derivative right of action—a holding necessary in order to reject the defendants’ argument that it did not—but that its usual application would be in the derivative context, as most shareholder votes result in derivative, rather than direct, harms. In Borak itself, the district court characterized the claim as derivative, an issue that the Supreme Court did not need to consider precisely because it believed the direct/derivative distinction to be irrelevant to whether Borak’s claim could proceed. Even the question presented on certiorari—whether the Exchange Act “authorizes a federal cause of action for rescission or damages to a corporate stockholder with respect to a consummated merger which was authorized pursuant to the use of a proxy statement alleged to contain false and misleading statements violative of § 14(a) of the Act”—implies the propriety of derivative causes of action, because many claims involving defective proxy statements with respect to “consummated mergers” will be derivative ones, at least under state law.
Granted, Borak represented the end of an era with respect to the free implication of private rights of action. Beginning in 1975 with Cort v. Ash, and continuing for many years thereafter, the Supreme Court developed a new approach to determining when individual citizens may bring lawsuits to enforce federal statutes. Yet the Court never purported to overrule Borak’s holding, even as Borak’s interpretive methods fell into disrepute; to the contrary, Cort v. Ash repeatedly cited and invoked Borak, distinguishing rather than rejecting it. Sixteen years after that, when the Supreme Court was again confronted with a private Section 14(a) claim in Virginia Bankshares, Inc. v. Sandberg, the Court was explicit that nothing in the case required it to “question the holding” of Borak. Though the Court declined to extend the right recognized in Borak, and refused to allow claims to proceed where the shareholder vote was not necessary to accomplish the challenged transaction—in other words, Virginia Bankshares denied standing to shareholders when management did not “obtain[] authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation”—nothing in the case purported to limit the right that had previously been recognized in Borak itself, that is, the right to sue when management did obtain such authorization by means of a false proxy.
The vitality of Borak was subsequently reaffirmed by the passage of the Private Securities Litigation Reform Act (PSLRA) in 1995. That Act placed a number of new procedural guardrails on private securities actions, including actions brought under Exchange Act Sections 10(b) and 14(a). Subsequently, when the Supreme Court acknowledged in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. that it had “moved away” from an expansive approach to implying rights of action (citing Borak), it simultaneously concluded that, with the PSLRA’s passage, Congress had “ratified” the implied right of action under Section 10(b) as it existed at that time. The logical implication is that the implied right of action under Section 14(a), as it existed in 1995, was preserved as well.
Manesh and Grundfest nonetheless contend that Section 14(a) provides only a direct, rather than derivative, right of action, in part because Borak’s rationale—that denying derivative standing would be “tantamount to a denial of private relief”—is not true, so long as other rights of action remain available. It is to that claim I now turn.
III. Derivative Section 14(a) Claims Remain Important—With an Asterisk
Manesh and Grundfest contend that derivative Section 14(a) claims are duplicative of other causes of action, namely, state law derivative claims for breach of fiduciary duty and federal “direct or class” actions. For that reason, they argue that not only is an implied right unnecessary, but also that a bylaw that purports to waive derivative Section 14(a) claims is not “inequitable” under state law. Their use of the phrase “direct or class” is curious, because class actions are direct actions; they simply use the procedural device of class certification to combine the claims of multiple plaintiffs. That said, Manesh and Grundfest cite In re Boeing Co. Aircraft Securities Litigation as an example of a “class” claim that can substitute for a derivative Section 14(a) claim, although the Boeing plaintiffs brought claims under Section 10(b) of the Exchange Act, but not Section 14(a). I therefore take their argument to be that direct Section 14(a) actions, direct Section 10(b) actions, and state law derivative actions, together function as a substitute for derivative claims brought under Section 14(a).
A. Section 10(b) Claims
There are numerous reasons why a direct claim under Section 10(b) is not a substitute for a derivative claim under Section 14(a). Even leaving aside the obvious fact that direct claims will provide remedies to the injured shareholders and not the corporation itself, Section 10(b) requires a showing of scienter; Section 14(a) sounds in negligence. Indeed, in its ruling on the motion to dismiss in Boeing—the very case Manesh and Grundfest use as an example that claims under Section 10(b) serve as a substitute for claims under Section 14(a)—the district court dismissed a number of allegations on the grounds that, even if the defendants had made false statements, they had not done so intentionally.
The differences do not stop there. Section 10(b) concerns fraud “in connection with the purchase or sale of any security;” therefore, investors who do not buy or sell in response to the fraudulent statement, but merely hold their shares, have no claim. Section 14(a) contains no such limitation and, in its derivative form, can Section 10(b) be maintained only by a shareholder who purchased before the misconduct and held continuously throughout the litigation. Section 10(b) requires that plaintiffs plead and prove reliance to establish causation, a hurdle that has become increasingly difficult to surmount in light of new evidentiary requirements; under Section 14(a), causation is inferred from materiality. Though the two may overlap in some cases, that does not make them substitutes; indeed, the Supreme Court held as much in Herman & MacLean v. Huddleston, where it recognized that different provisions of the securities laws may provide distinct causes of action arising out of the same behavior.
B. State Fiduciary Claims
State breach-of-fiduciary-duty claims are likewise no substitute for claims under Section 14(a) because, as with claims under Section 10(b), they do not impose damages liability for negligence. Though corporate managers are subject to a fiduciary duty of care (with a lack of care defined in Delaware as “gross negligence” akin to “recklessness”)—every state permits its corporations to exculpate directors for monetary damages associated with breaches of the duty of care, and many states permit exculpation for officers as well. Therefore, unless an injunctive remedy is available, in most scenarios, plaintiffs alleging a breach of fiduciary duty under state law will need to plead that corporate managers labored under an uncleansed conflict of interest or that they consciously abandoned their fiduciary obligations, (and some states may require even more stringent showings). The possibility that states would adopt such heightened liability standards, which go well beyond the standard imposed by Section 14(a), was the exact concern that motivated the decision in Borak in the first place: The Court reasoned that Section 14(a)’s remedies must be independent of state corporation law, because “the whole purpose of the section might be frustrated” if vindication depended on the idiosyncrasies of a particular state.
Significantly, Cort v. Ash highlighted this very aspect of Borak in the course of distinguishing it. Though in Cort, the Court concluded that state-created remedies might often function as substitutes for federal ones, making an implied right of action unnecessary for many federal statutes, the Court simultaneously recognized that Borak and Section 14(a) are different. “In Borak,” the Cort Court explained, “the statute involved was clearly an intrusion of federal law into the internal affairs of corporations; to the extent that state law differed or impeded suit, the congressional intent could be compromised in state-created causes of action.” Thus, Manesh and Grundfest are simply wrong to claim that the availability of state causes of action undermines Borak’s rationale for implying a derivative action: Borak considered that very possibility and rejected it.
Even beyond the lack of damages liability for negligence-based claims, there is no guarantee that a state’s approach to evaluating the truthfulness and completeness of a proxy statement will mirror the federal approach. As described in the next subsection, in many cases, state law causes of action for breach of fiduciary duty do not focus on the violation of shareholders’ voting rights so much as directors’ inequitable conduct in managing the corporate entity, rendering such actions a poor vehicle for advancing the purposes that motivated Section 14(a). And even when state fiduciary cases do focus on shareholders’ informational entitlements, states may adopt different standards for evaluating the adequacy of such disclosures. Even in Delaware, which has formally adopted the federal definition of materiality, individual decisions may sub rosa take an approach to materiality that is at odds with how federal courts view matters.
The broader point is that federal concerns are different than state concerns. There is a federal interest in ensuring uniform standards regarding the completeness and accuracy of proxy disclosures that do not vary based on bespoke state interpretations of the duty of candor. Federal securities regulation, ultimately, is intended to ensure efficient capital allocation throughout the economy; false disclosures (and the transactions they enable) have marketwide distorting effects, and that is a level of regulation that is beyond any individual state’s—even Delaware’s—sphere of authority.
C. Direct Section 14(a) Claims
Manesh and Grundfest’s main claim—and the rationale underlying the Ninth Circuit’s decision in Lee ex rel. Gap, Inc. v. Fisher—is that direct Section 14(a) claims not only substitute for derivative ones, but also stand on firmer doctrinal footing. To address that argument, I must return to first principles and examine the distinction between direct and derivative actions.
A derivative action is a tool of equity that permits shareholders to force the corporation to file a lawsuit on its own behalf, in the event that its existing directors wrongfully refuse to take action to protect the corporation’s legal interests. By contrast, a direct action is one that investors bring to vindicate duties owed to them as stockholders. That dividing line is an unstable one, for the obvious reason that the corporation itself is an avatar for shareholder wealth. Especially in recent years, Delaware courts have become especially blunt in their insistence that directors must “strive to maximize value for the benefit of” shareholders, in “every scenario,” rendering the distinction between shareholder harm and corporate harm somewhat artificial (a fact evident to any professor who has attempted to teach the subject to an introductory business law class).
To take one common scenario, suppose a shareholder alleges that the company undertook a value-reducing transaction just before being acquired, thus diminishing the consideration paid to target shareholders. Traditionally, a challenge to the consideration received in a merger is a direct claim; a challenge to a reduction in corporate value is a derivative one. Yet, on the cusp of an acquisition, the two collide. Delaware has purported to square that circle by characterizing value-reducing transactions as giving rise to direct claims if they were related to the acquisition and to derivative claims in other circumstances. Similarly, though injuries to voting rights are usually treated as direct claims, when plaintiffs claim that an issuance of new shares diluted their voting power, the claim is derivative. For a long time, Delaware held that the issuance of new shares to a controlling shareholder, at a price below their true value, caused both direct and derivative injuries, but recently, it reversed course and held that such injuries are solely derivative. Decisions from the Delaware Court of Chancery have articulated conflicting views over whether a board’s failure to accept an acquisition offer constitutes a direct harm or a derivative one. It is perhaps accurate, then, to say that the distinction between a “direct” action and a “derivative” one is less an objective determination than a set of policy choices regarding when a corporate board, rather than shareholders, should have control over litigation, and whether remedies should flow to the company or to shareholders individually. This is most clearly reflected in states’ differing approaches for categorizing claims as direct or derivative.
Under current Delaware standards, a shareholder’s allegation that her voting rights were violated via the issuance of a false proxy states a direct claim. At the same time, where the only economic injury falls on the corporate entity—the exact scenario that the Borak Court singled out as necessitating derivative relief—there is no direct remedy. In practical effect, Delaware law does not permit direct damages claims for violations of voting rights in most scenarios in which the shareholder holds stock in a continuing entity. Instead, the only claims Delaware affords such shareholders are derivative ones that focus less on the intrusion on shareholders’ voting rights than on the directors’ potential breach of fiduciary duty to the entity by procuring shareholder approval of corporate action by means of a misleading proxy.
Manesh and Grundfest contend that the direct/derivative distinction, for Section 14(a) purposes, depends on state (Delaware) law, which is also the position that the Ninth and Eleventh Circuits have taken. That argument relies on Burks v. Lasker and Kamen v. Kemper Financial Services, Inc., two derivative cases brought under the Investment Company Act (ICA). In both cases, the Supreme Court held that, as congressional regulation of corporations operates against a backdrop of state corporate law, “interstices” in “federal remedial schemes” should be filled by incorporating state law as the federal rule of decision, rather than by inventing a whole new federal corporation common law out of whole cloth. Under this principle, then, if Section 14(a) follows the state law direct/derivative distinction—meaning, if corporate harms resulting from a false proxy statement cannot be remedied via direct actions and can be remedied only via derivative ones—then derivative Section 14(a) claims play a critical gap-filling role: they permit shareholders to sue when corporate managers “obtain[] authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation” to the detriment of the entity, in scenarios where state law would exculpate corporate managers for negligence and would otherwise impose liability standards that fundamentally define the wrong itself differently from federal law.
But there is another possibility: State law should not, in fact, control the determination whether a Section 14(a) claim is direct or derivative. Both Kamen and Burks contain the important reservation that state law should not be incorporated into the federal scheme where doing so would “frustrate specific objectives of the federal programs,” or where “the scheme in question evidences a distinct need for nationwide legal standards,” and, as above, the direct/derivative distinction itself is a policy choice regarding who should have control over the litigation, and where remedies should flow. That distinction is precisely the territory that Borak carved out as more appropriate for federal, rather than state, rules of decision. The Borak Court repeatedly emphasized that federal courts have a duty “to provide such remedies as are necessary to make effective the congressional purpose,” that “federal courts have the power to grant all necessary remedial relief,” and that state law should not be permitted to stand as an obstacle to the remedies a federal court might impose. One reading of the case, then, is that the Borak Court was less concerned with the abstract distinction between direct and derivative actions than with affirming federal courts’ flexibility to remedy any misuses of the corporate proxy, regardless of how the action is styled by the plaintiff. Notably, in 1964, when Borak was decided, the distinction between direct actions and derivative ones had even less coherence than it does today. The Delaware Supreme Court would not decide Tooley v. Donaldson, Lufkin & Jenrette, Inc., which purported to rationalize its law on the subject, for another forty years, and, of course, the corporation in Borak was organized under Wisconsin law. The proper reading of Borak may simply be that, in the Section 14(a) context, the direct/derivative distinction is merely a way of characterizing the nature of the award that the court deems adequate under the circumstances. Indeed, historically, the derivative form of action itself was viewed as the “remedy” for inequitable conduct by a corporate board.
Perhaps for that reason, federal courts have often been quite vague about how the line between direct and derivative actions should be drawn for Section 14(a) purposes. Many courts simply accept plaintiffs’ characterizations of their own actions; others treat actions seeking individualized (stock price drop) remedies as direct, and corporate remedies as derivative, which may very well approximate what the Borak Court intended all along.
A rule that makes this idea explicit—permitting shareholders to bring Section 14(a) claims directly (i.e., in their individual capacities) but also permitting them to seek relief to remedy corporate harms—would not only be consistent with Borak’s rhetoric, but also would solve what Manesh and Grundfest view as a doctrinal absurdity at the heart of derivative Section 14(a) actions: that the existence of derivative actions implies that corporations could bring their own Section 14(a) claims. Manesh and Grundfest argue, which argument was accepted by the Ninth Circuit, that the very notion of a corporation pursuing a Section 14(a) claim regarding a vote of its shareholders is inconsistent with the concern for the stockholder franchise as expressed in cases like Borak and Virginia Bankshares.
I do not agree that there is anything incongruous about corporate entities protecting themselves from the harmful effects of a tainted shareholder vote. That said, derivative actions also come with some version of a demand requirement, which allows the corporation’s directors—usually the very actors accused of wrongdoing—to take first crack at considering whether an action should be brought in the corporation’s name in the first place. Borak never addressed demand requirements and the issue was not discussed by the court below. Today, federal courts usually look to state law when considering whether the demand requirement is met, and that practice, perhaps even more than line-drawing between direct and derivative actions, is likely to allow manager-protective state law rules—which result from charter competition—to interfere with the enforcement of federal rights.
To be sure, in both Kamen and Burks, the Supreme Court imported state law rules about managerial control over derivative litigation into federal derivative ICA actions, explicitly concluding that demand and similar requirements were not necessarily an obstacle to the accomplishment of federal objectives (though they would be evaluated for their application in particular cases). But, at the same time, the Supreme Court recognized that the ICA imposes its own rules for director independence, and provides remedies that allow shareholders to seek recoveries for injured funds while bypassing boards entirely, all of which ensures that federal law provides a crucial corporate governance floor that operates alongside any state law rules about board control over corporate claims. Section 14(a), by contrast, was not designed around a similar safety net. The real incongruity inherent in derivative Section 14(a) claims, then, is that state law demand requirements might stymie enforcement of federal law. That problem is solved if Section 14(a) claims are treated as direct, but with a multiplicity of options for the actual remedy.
There is, in fact, precedent for precisely this kind of arrangement under the federal securities laws. Section 36(b) of the ICA permits mutual fund shareholders to bring a claim for excessive fees, with the overpayment returned to the fund itself, rather than to shareholders individually. In Daily Income Fund, Inc. v. Fox, the Supreme Court held that Section 36(b) claims are not derivative in the traditional sense, because they cannot be advanced by the issuer in its own name. Daily Income Fund demonstrates that it is entirely possible to permit a private plaintiff to seek recoveries on a corporation’s behalf, while denying the corporation its own right of action.
In sum, while derivative Section 14(a) claims remain necessary to protect investors so long as state law direct/derivative distinctions are incorporated into federal law, an alternative possibility that squares more with the language of Borak permits plaintiffs advancing direct Section 14(a) claims to seek any remedy necessary to make themselves—or the company—whole. In that scenario, there would be no need for derivative Section 14(a) claims, and many of Manesh and Grundfest’s objections would be satisfied.
IV. Conclusion
The premise that justifies forum selection bylaws is that corporate constitutive documents constitute “contracts” to which shareholders voluntarily agree. I have elsewhere argued that constitutive documents are not contracts, but that blindly treating them as such will increasingly concentrate regulatory—and veto—power in the state of incorporation. If federal courts respect bylaws that deny plaintiffs any forum in which to bring effective Section 14(a) claims, then states (locked in a newly invigorated battle for corporate charters) will be put in the impossible position of deciding whether to allow their organizational law to be used to effect a waiver of federal rights. The mere notion turns the Supremacy Clause on its head, and represents an unhealthy reliance on corporate law—and heroic assumptions of market efficiency—to substitute for the hard work of designing appropriate regulatory safeguards to deter corporate misconduct.
There are real abuses in the system, but, given the frequency with which meritless securities cases are dismissed, it is hard to believe there is anything like a crisis that would require such a drastic solution. If a fix is to be had, let it come from Congress.
