January 16, 2020 Practice Points

Derivative Suits 101: Tips for Successful Settlements

The unique procedural posture of shareholder derivative suits requires court approval of settlements under Rule 23.1 of the Federal Rules of Civil Procedure. Settling parties must be diligent in satisfying the settlement prerequisites to ensure the settlement is approved by the court.

By D. Scott Carlton

A shareholder derivative suit seeks relief for the corporation; it does not seek direct relief for the individual shareholders. Since the shareholder is suing on behalf of the corporation, the shareholder is a fiduciary and cannot seek a personal benefit. As such, a shareholder is not free to settle or dismiss a shareholder derivative suit without court oversight. Under Rule 23.1 of the Federal Rules of Civil Procedure, for instance, a shareholder derivative suit cannot be voluntarily dismissed or settled without court approval. Many states, such as Delaware, New York, California, and Nevada, have similar rules or requirements governing the settlement of shareholder derivative suits.

“Settlements of derivative actions are particularly favored because the cases are ‘notoriously difficult and unpredictable.’” Maher v. Zapata Corp., 714 F.2d 436, 455 (5th Cir. 1983). Courts balance the policy interest in favor of settlement against the need to protect the company and its shareholders. Courts therefore must make a determination that settlements are fair, reasonable and adequate in light of the claims being settled. The settling parties therefore should be prepared to overcome the following hurdles when seeking final approval of the derivative suit. The relevant legal principles differ slightly depending on the jurisdiction, but these principles generally apply:

Notice to Shareholders

Shareholders are entitled to “the best notice practicable” of a proposed settlement or dismissal so that they have the opportunity to be heard. Donoghue v. CSX Corp., No. CIV.A.08CIVIL9252(MG), 2009 WL 750232, at *1 (S.D.N.Y. Mar. 9, 2009). The settling parties typically seek court approval of the form and content of the notice to shareholders. The notice must disclose the nature of the action; the factual evidence; the parties’ positions; the terms of the proposed settlement, including any monetary recovery and the attorney fees; the time and manner in which objections must be made; and the date for the hearing.

Court Considerations

Courts have broad discretion in deciding whether to approve a settlement. Courts consider a variety of factors, including “(1) the probable validity of the claims, (2) the apparent difficulties in enforcing the claims through the courts, (3) the collectibility of any judgment recovered, (4) the delay, expense and trouble of litigation, (5) the amount of the compromise as compared with the amount and collectibility of a judgment, and (6) the views of the parties involved, pro and con.” Polk v. Good, 507 A.2d 531, 536 (Del. 1986). The motion seeking court approval of the settlement should address each factor relevant to the matter.

Burden of Proof

The burden of proving a settlement’s fairness and adequacy falls on the settling parties. The settling parties should present sufficient information to the court to satisfy their burden. Once the settling parties meet their burden of proof, the burden then shifts to any objectors who must show that the plaintiff did not acted in bad faith in entering into the settlement and/or during the settlement negotiations with defendants. See Ryan v. Gifford, No. CIV. A. 2213-CC, 2009 WL 18143, at *5 (Del. Ch. Jan. 2, 2009).

Attorney Fees for Plaintiffs’ Counsel

Plaintiffs’ counsel who successfully litigate a derivative action may be entitled to an award of attorneys’ fees and expenses. See Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970). To obtain attorneys’ fees, the settlement of the derivative action need not confer a pecuniary benefit on the corporation. Attorneys’ fees may be awarded based solely on changes in corporate governance or other non-monetary relief. The factors a court considering an award of attorneys’ fees will focus on include: (1) the benefit achieved; (2) the efforts and number of hours spent by the attorneys in legal activities; (3) the contingent nature of success; (4) the difficulty of the litigation and skill required to handle it; (5) the customary fee charged; and (6) the standing, ability and reputation of counsel involved. See Sugarland Indus., Inc. v. Thomas, 420 A.2d 142, 149-50 (Del. 1980).

No Notice Required Under the Class Action Fairness Act of 2005 (CAFA)

Unlike a typical class actions, defendants settling a shareholder derivative action to do not have to comply with the notice requirements of CAFA.

D. Scott Carlton is of counsel with Paul Hastings in Los Angeles, California.

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