October 10, 2017

Delaware Supreme Court to Address Whether Federal Due Process Protects Repetitive Derivative Suits

Caroline Zalka and Robert S. Ruff – October 10, 2017

When a court has dismissed a stockholder derivative suit for failure to plead demand futility, what is the preclusive effect on a later suit that brings the same claims? The vast majority of courts that have addressed the question have held that, because the corporation is the real party in interest in a derivative suit, the parties in both suits are the same or the stockholder plaintiffs are at least in privity with one another. Thus, preclusion is appropriate assuming the other elements are present.

But a recent decision from the Delaware Court of Chancery in the long-running Wal-Mart case (No. 7455-CB, filed in 2012) has introduced uncertainty. The decision recommends that the Delaware Supreme Court adopt a rule based on dicta from an earlier Court of Chancery decision, In re EZCORP Inc. Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016). On due process grounds, the “EZCORP rule” would give no preclusive effect to a derivative suit judgment unless the board had declined to oppose the suit or the suit had survived a motion to dismiss by pleading that demand on the board was excused as futile or wrongfully refused (a Rule 23.1 motion in both Delaware and federal court). The rule is questionable as a matter of both law and public policy.

The Wal-Mart Case
The Court of Chancery grounded the rule in due process concerns arising out of the potential preclusion of the Wal-Mart plaintiffs’ suit due to an Arkansas federal court’s dismissal of similar claims brought by different stockholders. Delaware and Arkansas plaintiffs filed multiple complaints shortly after an April 2012 newspaper article publicized an alleged bribery scheme involving Wal-Mart’s Mexico subsidiary.

The Arkansas cases were consolidated in federal court. In March 2015, the Arkansas federal court granted the defendants’ motion to dismiss under Rule 23.1 because the plaintiffs had failed to plead demand futility. The Eighth Circuit affirmed.

Meanwhile, one of the Delaware plaintiffs pursued a demand for Wal-Mart’s books and records, a strategy long encouraged by Delaware courts. The books and records action finally concluded in May 2015. Around the same time, and about a month after the dismissal of the Arkansas case, the Delaware plaintiffs filed a consolidated amended complaint.

The defendants moved to dismiss, arguing that, under Arkansas law, the Arkansas judgment precluded the Delaware plaintiffs from pleading demand futility. Arkansas law governed under the U.S. Supreme Court’s decision in Semtek International Inc. v. Lockheed Martin Corp., 531 U.S. 497 (2001), which held that a judgment by a federal court exercising diversity jurisdiction has the preclusive effect it would be given by the courts of the state in which the federal court sits.

The Court of Chancery agreed, finding that Arkansas courts would likely follow the “vast majority of other jurisdictions” and hold that the Delaware action involves the same parties as the Arkansas action (or involves parties in privity with the Arkansas parties) because “the corporation is the real party in interest in both the first derivative action and the subsequent suit.” The court dismissed the case on preclusion grounds, and the plaintiffs appealed.

Wal-Mart Appeal and Remand
On appeal, the Delaware Supreme Court questioned whether the Court of Chancery had shortchanged the plaintiffs’ due process argument by treating due process as coextensive with Arkansas preclusion law. The Delaware Supreme Court noted the “general” rule that due process prohibits judgments from binding nonparties, with limited exceptions. In the court’s view, “the most analogous of these exceptions involves class actions,” and the court cited the U.S. Supreme Court’s holding in Smith v. Bayer Corp., 564 U.S. 299 (2011), that “[n]either a proposed class action nor a rejected class action may bind nonparties”; only a class certified under Rule 23 has that effect. The Delaware Supreme Court also noted that, in EZCORP, the Court of Chancery had extended the reasoning of Bayer to conclude that

just as the Due Process Clause prevents a judgment binding absent class members before a class has been certified, the Due Process Clause likewise prevents a judgment from binding 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.

The Delaware Supreme Court then remanded the case, directing the Court of Chancery to issue a supplemental opinion addressing Bayer, EZCORP, and whether precluding the Delaware plaintiffs’ suit based on the Arkansas judgment would violate the Delaware plaintiffs’ due process rights.

On remand, the Court of Chancery issued an opinion reconsidering its earlier decision and recommending that the Delaware Supreme Court adopt the EZCORP rule, which would give no preclusive effect to the Arkansas judgment. The court based its recommendation on three points: “(1) the similarities between class actions and derivative actions, (2) some of the realities of derivative litigation, and (3) public policy considerations.”

On the first point, the court observed that derivative actions, like class actions, are representative in nature and that, as EZCORP concluded, a derivative action dismissed for failure to plead demand futility “is no more a representative action than the proposed class action in Bayer that was denied certification.” The court further explained that, while the corporation is the “real party in interest,” that “does not answer who has the authority to represent the corporation.” In the court’s view, satisfying the EZCORP rule creates that authority. The court also discussed the similarities between Rules 23 and 23.1.

On the second point, the court stated that “[t]he need for a more rigorous preclusion rule in the derivative action context is heightened by the disparity between class and derivative actions in terms of how adequacy of representation is assessed in practice.” The court pointed out that a derivative plaintiff’s adequacy is not typically challenged until a preclusion motion in later litigation, where the hard-to-meet “grossly deficient” standard applies. In class actions, by contrast, the plaintiff must show adequacy at the class-certification stage.

Finally, on the third point, the court noted that the EZCORP rule would protect the due process rights of stockholders from plaintiffs who rush to court without conducting a thorough investigation. The court was not concerned that the EZCORP rule would permit repetitive litigation because, in the court’s experience, stockholders rarely attempt to relitigate failed claims and the principles of stare decisis and comity could handle the rare cases.

For these reasons, the Court of Chancery recommended that the Delaware Supreme Court adopt the EZCORP rule. Oral argument on appeal is set for November 1, 2017.

The Delaware Supreme Court’s upcoming Wal-Mart decision will affect the behavior of derivative litigants around the country. But there is “no roving ‘public policy exception’ to the full faith and credit due judgments.” Baker by Thomas v. Gen. Motors Corp., 522 U.S. 222 (1998). So the issue before the court is whether the law supports the EZCORP rule, not whether the rule promotes good behavior.

There are reasons to doubt the legal soundness of the EZCORP rule. The most important reason is that the rule arguably conflicts with Semtek’s holding that federal court judgments are entitled to the preclusive effect they would be given by courts of the state in which the federal court sits. By importing demand futility concepts into the preclusion analysis, the EZCORP rule would permit Delaware courts to reject on “due process” grounds the finality of other courts’ judgments based on Delaware’s interpretation of privity. This would undercut at least the spirit of Semtek and the Delaware Supreme Court’s own holding in Pyott v. Louisiana Municipal Police Employees’ Retirement System, 74 A.3d 612 (Del. 2013). The Pyott court held that Delaware’s “undisputed interest” in “governing the internal affairs of its corporations must yield to the stronger national interests that all state and federal courts have in respecting each other’s judgments.” Pyott rejected the Court of Chancery’s reliance on Delaware demand futility law in the preclusion context as a “mistaken premise.” The EZCORP rule appears to make a similar mistake.

Relatedly, adopting the EZCORP rule would imply that the substantial number of courts that have allowed preclusion missed violations of federal due process. This would include courts that have explicitly addressed due process in the derivative action preclusion context and treated it, as the Court of Chancery did in the first Wal-Mart opinion, as embedded in the issues of privity and adequate representation. It is not clear how those aspects of preclusion law fail to address the due process concern that animates the EZCORP rule, the binding of nonparties.

In addition, the foundation of the EZCORP rule—extending Bayer’s concerns about binding absent class members to derivative actions—is shaky. While the analogy is tempting given the representative nature of both class and derivative suits and the structural similarities of Rules 23 and 23.1, class and derivative actions diverge in key respects. For instance, absent class members are truly nonparties until the court certifies a class. If the court doesn’t, the named plaintiff still has claims he or she can pursue in an individual capacity. But in a derivative action, the corporation is a party at all times. The corporation is named and served, the claims belong to the corporation and only to it, and the corporation is the party in interest. It can hardly be said that the corporation is “absent” or a “nonparty” in the same way that proposed class members are. Thus, preclusion of the corporation’s claims in repetitive derivative litigation does not squarely present the concerns addressed in Bayer.

Also, while some similarities between Rules 23 and 23.1 support the EZCORP rule, some key differences do not. Rule 23 lists the prerequisites for a class action, requires findings by the court on those prerequisites, and dictates the procedure for certifying a class if it meets those prerequisites. By contrast, Rule 23.1 mostly establishes an additional pleading requirement for derivative claims and allows dismissal where defendants can show a pleading deficiency or, less commonly, inadequacy. It does not empower a court to “certify” a plaintiff to prosecute the corporation’s claims. Treating Rule 23.1 as though it serves the same function as Rule 23 could complicate derivative standing in other contexts (for instance, when a merger breaks a plaintiff’s continuous ownership or when a previously conflicted or acquiescent board seeks to take over the claims later in the case due to new membership or the formation of an independent committee).

Even as a matter of public policy, the EZCORP rule is problematic. It would facilitate repetitive derivative suits, which may be rare in the Court of Chancery but are more common in other jurisdictions. Also, once preclusion is completely off the table and the only additional hurdles facing repetitive suits are the fluid principles of comity and stare decisis, Delaware too may see more copycat complaints. And while the EZCORP rule would prevent dismissals of hastily filed complaints from precluding diligently investigated, valid claims, intervention in the first action by the diligent plaintiffs could solve the same problem without promoting repetitive lawsuits. Presumably, courts outside Delaware would fairly consider a motion to intervene before issuing a decision that could preclude legitimate claims. But the EZCORP rule would gut that solution: Stockholders would have little incentive to intervene absent the threat of preclusion.

For these reasons, it is questionable whether the concerns addressed by the EZCORP rule support denying the preclusive effect owed to Rule 23.1 dismissals.

Caroline Zalka and Robert S. Ruff – October 10, 2017