July 23, 2018 Articles

Limits on Delaware’s Tooley Standard—A Brief Survey

An understanding of how recent decisions have cabined this analysis to specific scenarios can help guide both pleading and defense strategies.

By Jason C. Cyrulnik and Marc Ayala

Practitioners experienced in the oft-litigated issue of whether a stockholder plaintiff’s claims are derivative or direct are no doubt familiar with the standard set out by the Delaware Supreme Court in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004). In more recent decisions, however, that court has recognized meaningful limits on the applicability of the Tooley standard. This article surveys those limits, an understanding of which can help guide both pleading and defense strategies.

In Tooley, minority stockholders challenged a controlling stockholder’s agreement—on behalf of the controlled corporation—to extend a merger deadline, claiming that the controller’s agreement constituted a breach of fiduciary duties. Id. at 1033–34. The Court of Chancery dismissed the action with prejudice, finding that “plaintiffs’ injury was not a special injury, and th[e] action [w]as, thus, a derivative action. . . .” Id. at 1034. (The “special injury test” identified direct actions as ones in which the stockholder plaintiff’s injury was “not suffered by all stockholders generally” or “involves a contractual right of the stockholders.” In re First Interstate Bancorp, 729 A.2d 851 (Del. Ch. 1998).) The Court of Chancery further reasoned that the plaintiffs had lost standing to prosecute such derivative claims once the plaintiffs tendered their shares as part of the then-completed merger. Tooley, 845 A.2d at 1034–35. On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of the action but ordered that the order of dismissal be amended to provide that the dismissal was without prejudice. Id. at 1039–40.

The grounds for affirmance, however, were very different from those relied on by the Delaware Chancery Court. In particular, the Delaware Supreme Court held that the Chancery Court should not have relied on the “special injury” test to determine whether the minority stockholders’ claims were derivative or direct. Id. at 1035–36. The supreme court disapproved of the concept of “special injury” and explained that the proper analysis to distinguish between direct and derivative claims is “based solely on the following questions: Who suffered the alleged harm—the corporation or the suing stockholder individually—and who would receive the benefit of the recovery or other remedy?” Id. Later in that decision, the court also explained in an oft-cited passage that

a court should look to the nature of the wrong and to whom the relief should go. The stockholder’s claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.

Id. at 1039.

In 2015, however, the Delaware Supreme Court made clear that the standards it had set out in Tooley apply only to a certain class of claims. Specifically, in NAF Holdings, LLC v. Li & Fung (Trading) Ltd., 118 A.3d 175 (Del. 2015), the plaintiff entity brought a breach of contract claim against a counterparty to a contract, Li & Fung. NAF Holdings alleged that Li & Fung had breached the parties’ contract, thereby harming NAF Holdings’ subsidiaries, and thereby indirectly harming NAF Holdings as well, as a stockholder of the NAF subsidiaries. Id. at 177–78. Li & Fung moved to dismiss NAF Holdings’ claim, arguing that NAF Holdings could not assert a direct claim against Li & Fung because, under Tooley, “NAF [Holdings] only sought compensation for the harm suffered by the NAF Subsidiaries” and “because NAF [Holdings] did not suffer a direct injury independent of the harm suffered by its subsidiaries.” Id. at 178. Presented with that argument, the Court of Appeals for the Second Circuit certified the following question to the Delaware Supreme Court:

Where the plaintiff has secured a contractual commitment of its contracting counterparty, the defendant, to render a benefit to a third party, and the counterparty breaches that commitment, may the promisee-plaintiff bring a direct suit against the promisor for damages suffered by the plaintiff resulting from the promisor’s breach, notwithstanding that (i) the third-party beneficiary of the contract is a corporation in which the plaintiff-promisee owns stock; and (ii) the plaintiff-promisee’s loss derives indirectly from the loss suffered by the third-party beneficiary corporation; or must the court grant the motion of the promisor-defendant to dismiss the suit on the theory that the plaintiff may enforce the contract only through a derivative action brought in the name of the third-party beneficiary corporation?

Id. at 176.

The Delaware Supreme Court’s answer to that question, in short, was yes, a promisee plaintiff may bring such a direct suit, but its decision clarified and outlined the limitations of Tooley in important ways. The court explained that Tooley and the related “body of case law was intended to deal” with “determining the line between direct actions for breach of fiduciary duty suits by stockholders and derivative actions for breach of fiduciary duty suits subject to the demand excusal rules set forth in §327 of the Delaware General Corporation Law, Court of Chancery Rule 23.1, and related case law.” Id. at 179. It reasoned as follows:

In concluding that NAF could proceed only by a derivative suit, the District Court focused on this Court’s statement in Tooley that a stockholder-plaintiff is required to show that it “can prevail without showing an injury to the corporation” to bring a direct claim. Li & Fung read this language as intended to be a general statement requiring all claims, whether based on a tort, contract, or statutory cause of action (e.g., antitrust), to be brought derivatively whenever the corporation of which the plaintiff is a stockholder suffered the alleged harm. If that was true, NAF’s suit for compensation for the diminution in value of its stock in the NAF Subsidiaries could not be brought as a direct action. But in that situation, a more important initial question has to be answered: does the plaintiff seek to bring a claim belonging to her personally or one belonging to the corporation itself? Thus, it is of course true that NAF cannot bring direct contractual claims belonging only to its subsidiaries without first proving demand futility. But that does not mean that NAF must proceed derivatively as to contract claims NAF itself possesses. Reading Tooley to convert direct claims belonging to a plaintiff into something belonging to another party would, we confess, be alien to our understanding of what was at stake in that case, or in the cases after Tooley that relied on it.

Id. at 180.

Almost one year after the Delaware Supreme Court clarified the applicability of Tooley, the Court of Appeals for the Second Circuit faced similar arguments to those presented in NAF Holdings and again certified a question to the Delaware Supreme Court. This time, stockholders of Citigroup sued Citigroup and several of its officers and directors, alleging that the defendants had failed to disclose accurate information about Citigroup’s financial condition, which caused the plaintiff stockholders to hold rather than sell their Citigroup stock to the plaintiffs’ detriment. Citigroup v. AHW Inv. P’ship, 140 A.3d 1125, 1128–29 (Del. 2016). Based on those allegations, the plaintiffs asserted claims for negligent misrepresentation and common-law fraud. Id. The Second Circuit certified the following question to the Delaware Supreme Court:

Are the claims of a plaintiff against a corporate defendant alleging damages based on the plaintiff’s continuing to hold the corporation’s stock in reliance on the defendant’s misstatements as the stock diminished in value properly brought as direct or derivative claims?

Id. at 1126.

Again the Delaware Supreme Court rejected the relevance of Tooley and held that the plaintiffs had properly brought their claims directly because those claims belonged to the plaintiffs. Id. at 1138. In doing so, the Citigroup court reaffirmed and elaborated on its decision in NAF Holdings:

[D]etermining whether a claim is direct or derivative depends on the nature of the claim itself. In NAF Holdings, LLC v. Li & Fung (Trading) Limited, a case in the commercial contract context, we explained that “[t]he case law under Tooley . . . and its progeny deal with the distinct question of when a cause of action for breach of fiduciary duty or to enforce rights belonging to the corporation itself must be asserted derivatively.” . . . After explaining that Tooley was designed for determining whether fiduciary duty claims are direct or derivative, we rejected the defendant’s assertion that Tooley was “intended to be a general statement requiring all claims, whether based on a tort, contract, or statutory cause of action . . . to be brought derivatively whenever the corporation of which the plaintiff is a stockholder suffered the alleged harm.” We take this opportunity to reaffirm our explanation in NAF Holdings of Tooley’s limited scope.

Just as a Tooley analysis was not needed to determine whether the commercial-contract claim in NAF Holdings was direct or derivative, it does not apply here. . . . [A]s we explained in NAF Holdings, when a plaintiff asserts a claim based on the plaintiff’s own right, such as a claim for breach of a commercial contract, Tooley does not apply.

Id. at 1138–39.

Later that same year, in El Paso Pipeline GP Co. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016), the Delaware Supreme Court again addressed the circumstances under which the Tooley test was applicable. There, a limited partner sued a limited partnership’s general partner for violating a provision of their partnership agreement prohibiting the general partner from causing the limited partnership to enter into a transaction affected by a conflict of interest. The defendant asserted that the plaintiff lacked standing to assert his claim because (1) his claim was derivative and (2) an intervening merger had divested the plaintiff of his ability to pursue a derivative claim on behalf of the partnership. The court was thus presented with the issue of whether the alleged breach of the partnership agreement amounted to a direct or derivative claim. Id. at 1253–54, 1257–59.

This time, the court found that the plaintiff’s claim was derivative and not direct, further clarifying the implications of its recent decisions in NAF Holdings and Citigroup:

As we explained [in NAF Holdings], when a plaintiff asserts a claim based upon the plaintiff’s own right, such as a claim for breach of a commercial contract, Tooley does not apply. NAF Holdings does not support the proposition that any claim sounding in contract is direct by default, irrespective of Tooley. Nor does it mean that [the plaintiff’s] status as a limited partner and party to the [partnership agreement] enable him to litigate directly every claim arising from the [partnership agreement].

Id. at 1259 (emphasis in original).

The court then found—citing Citigroup—that “because [the plaintiff’s claim] sounds in breach of a contractual duty owed to the Partnership,” Tooley applies “to determine whether the claim ‘to enforce the Partnership’s own rights must be asserted derivatively’ or is dual in nature such that it can proceed directly.” Id. at 1260 (emphasis added). On that basis, the court then applied the Tooley test and found that the plaintiff’s claim, in that case, was derivative. Id. at 1260–65.

Together, these decisions have cabined the Tooley analysis to specific scenarios. Indeed, the Tooley analysis does not apply at all where a stockholder plaintiff asserts a breach of a duty owed to the stockholder, as in Citigroup. This holds true in the parent-subsidiary context, provided that the parent plaintiff asserts a breach of a duty owed to the parent, as in NAF Holdings. Instead, the only context in which the Tooley test is applicable is where claims allege the breach of a duty that was owed to the entity, as in Tooley (where a director owed fiduciary duties to the entity) and El Paso Pipeline (where the claims alleged that the defendant breached a provision of the partnership agreement that established a contractual duty owed to the entity). That includes, for example, classic derivative claim scenarios, such as stockholder claims against corporate fiduciaries for allegedly causing the corporation to dispose of corporate assets at an unfair price.

These limitations on Tooley are significant. Without them, defendants could attempt to misuse Tooley to support arguments that unreasonably deprive plaintiffs of claims that fundamentally belong to them. The Delaware Supreme Court clarified that Tooley was not intended to do that—that is, Tooley does not take fundamentally direct claims and transform them into claims exclusively owned by the entity, as some litigants (and courts) had argued in the years following that decision. Instead, Tooley confronts the specific (albeit common) circumstance of stockholders seeking to assert direct claims based on breaches of duties owed to a corporation.

Consider the following scenario, for example: Stockholder is induced to invest in HoldCo based on a fraudulent misrepresentation to Stockholder by a HoldCo director that OpCo (HoldCo’s subsidiary) owns patent-protected technology. It turns out that OpCo’s technology is in the public domain; competitors begin to implement it; OpCo’s sales plummet; the value of HoldCo’s interest in OpCo plummets; and, accordingly, the value of Stockholder’s interest in HoldCo plummets.

If a court were to bypass the threshold analysis that the Delaware Supreme Court described in NAF Holdings and Citigroup, and instead erroneously apply Tooley in the first instance, it could deprive Stockholder of her common-law fraud claim against the HoldCo director and conclude that OpCo owns the claim. That is because, under Tooley, Stockholder may not be able to show that her injury truly was “independent of any alleged injury to [OpCo]” or that she could prevail “without showing an injury to [OpCo],” and that could potentially lead to the erroneous conclusion that the claim is a double-derivative claim belonging to OpCo. See Tooley, 845 A.2d at 1039.

That would be an absurd result. In short, it would mean that OpCo would possess a fraud claim even though no misrepresentation was made to it and even though it did not rely on any such misrepresentation—both elements of a legal cause of action for fraud. At the same time, Stockholder—who did rely on a material misrepresentation made to her—would be divested of a claim that clearly she should be permitted to assert.

Applied properly, NAF Holdings and Citigroup prevent that outcome. As discussed above, they require that—before Tooley even can be considered—the first question that a court must ask is, to whom does the claim belong? In the above scenario, the answer is simple: The fraud claim belongs to Stockholder, just as the contract claim belonged to the parent in NAF Holdings and the holder claims belonged to the stockholders in Citigroup. Stockholder—under a proper analysis—would thus be empowered to assert her fraud claim, notwithstanding Tooley.

Practitioners would thus be well advised to familiarize themselves with and internalize the limitations of Tooley. From a defense perspective, knowing those limits can prevent one from taking positions that, taken to their logical conclusions, would yield absurd results and from relying too heavily on a Rule 23.1 defense. From a plaintiff’s perspective, knowing those limits can inform pleading strategies and motion practice.

 

Jason C. Cyrulnik is a partner and Marc Ayala is an associate with Boies Schiller Flexner in Armonk, New York.