The Hidden Benefits of Pro Bono

As a general principle, the direct-derivative distinction is a major barrier to investors seeking to recover individual losses caused by corporate mismanagement. Shareholders do not have standing to sue directly on claims that are derivative of the corporation’s rights unless special circumstances apply. To have standing to sue directly, shareholders must establish that their claims are direct and particularized, not secondary to that of the corporation. Before the decision in Citigroup, whether a claim was direct depended on whether the shareholder suffered an injury independent from the harm to the company and whether the shareholder would receive the recovery directly if he or she prevailed. Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031, 1035 (Del. 2004). The Citigroup case, however, forced Delaware’s Supreme Court to revisit the scope of its decision in Tooley, which has been widely regarded for years as the leading case on the direct-derivative distinction.  

Citigroup Differs from the Classic Derivative Case
The classic derivative case arises when shareholders sue a company and its directors alleging the board breached a fiduciary duty by delaying a merger or entering into a transaction that ultimately harms the value of the company. These “corporate mismanagement” claims are normally derivative under Tooley because the shareholders cannot show an injury that was independent from the harm suffered by the corporation. Where this is the case, shareholder grievances are subject to the statutory demand excusal process and therefore must first be submitted for the board’s consideration and determination. Only rarely do courts allow shareholders to proceed with a derivative suit after the board decides not to pursue their demand. 

Citigroup differs from the classic derivative case because the plaintiffs claim that Citigroup and several Citigroup executives made material misrepresentations during the heart of the financial crisis that caused the shareholders to delay selling stock while the price of Citigroup’s shares continued to plummet. The plaintiffs argued that their claims are direct because they are the ones, not Citigroup, who relied on the company’s misrepresentations about its investments in toxic assets resulting in their forbearance from selling the securities. Citigroup argued, on the other hand, that the claims are derivative under Tooley because the damages alleged are based on the decrease in the company’s stock price between 2007 and 2009, which was a harm suffered by Citigroup as a whole and every shareholder based on their pro rata ownership stake in the company.

Several States Already Recognize Direct Holder Claims
Courts from several other states permit shareholders to bring direct holder claims if they have been induced to delay or cancel their plan to sell stock due to misrepresentations by a company or its directors. They generally require a showing of concrete reliance by the shareholder on the alleged deceptive communications. For example, the California Supreme Court held that claimants who actually relied on alleged misrepresentations published in official financial reports could sue directly. Small v. Fritz Cos., 30 Cal. 4th 167, 185 (Cal. 2003) (“Plaintiff here did not attempt to bring a derivative action, however. His complaint does not allege injury to the corporation or a wrong common to the entire body of stockholders, but only to those stockholders who actually relied on defendants’ misrepresentations. Thus, the complaint must stand or fall on the allegations of personal reliance.”). The Georgia Supreme Court, relying in part on the California Supreme Court’s rationale in Small, also recognized that shareholders who allege concrete reliance can bring direct holder claims under common-law fraud and misrepresentation theories. Holmes v. Grubman, 691 S.E.2d 196, 200 (Ga. 2010) (“ We see no reason why our authorization of common-law fraud claims based on forbearance in the sale of publicly traded securities, along with the limitations articulated above, should not extend to Appellants’ other common-law tort claims”). The courts of several other states (including Massachusetts, New Jersey, Texas, and New York) have all recognized direct holder claims in cases where the shareholder actually perceived the corporate communication and specifically relied on it, resulting in forbearance in the sale of securities.  

Meanwhile other jurisdictions continue to hew closely to the proposition that shareholders plead derivative claims when they allege an injury solely quantified by the pro rata loss in value of corporate assets because their personal losses are secondary to the direct injury to the company. See, e.g., Ex parte Regions Fin. Corp., 67 So. 3d 45, 54 (Ala. 2010) (holding that claims are direct where shareholders cannot prove claims without showing injury to the corporation and citing Tooley). These hard-line decisions are motivated by a range of concerns, including that shareholders will fabricate claims to extort settlements after making bad investments and the difficulty of proving causation by anything other than oral testimony. They also argue that the board of directors should be the sole manager of the company’s litigation rights whenever the harm is measured by a drop in stock prices and that these claims must be derivative to avoid duplicative litigation and double recoveries. In addition, federal securities laws have been interpreted to support the conventional view that holder claims are derivative. Based on long-standing precedent, the courts have interpreted the Securities and Exchange Commission’s anti-fraud regulations, see 17 C.F.R. § 240.10b-5, as aimed solely at misrepresentations that induce a party to either purchase or sell a security, as opposed to holding one. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975) (holding Rule 10b-5 does not provide standing for holder claims). However, this interpretation of federal securities laws, many have observed, was not intended to supersede causes of action under state law. Id. at 739 n.9.

Delaware Law Historically Favored Citigroup
For the most part, Delaware courts prior to Citigroup held that a claim is derivative under Tooley if the shareholder’s damages are measured solely by the decline in stock prices. See, e.g., Feldman v. Cutaia, 951 A.2d 727, 733 (Del. 2008) (“Where all of a corporation’s stockholders are harmed and would recover pro rata in proportion with their ownership of the corporation’s stock solely because they are stockholders, then the claim is derivative in nature.”). Yet, one recent Delaware Supreme Court decision narrowed the scope of Tooley and signaled a shift away from the position that Tooley automatically classifies claims as derivative whenever damages are measured by stock depreciation. See NAF Holdings, LLC v. Li & Fung (Trading) Ltd., 118 A.3d 175, 180 (Del. 2015). In NAF Holdings, a parent entity of two subsidiaries sued a company based in Hong Kong for losses suffered in reliance on the Hong Kong company’s misrepresentations. The damages sought by the parent were measured by the diminution in value to the shares it held in the two wholly owned subsidiaries. The defendant argued on summary judgment that the parent lacked standing to sue under Tooley. But the Delaware Supreme Court held that the claims were direct. “Tooley and its progeny,” the court explained, “do not, and were never intended to, subject commercial contract actions to a derivative suit requirement. That body of case law was intended to deal with a different subject: determining the line between direct actions for breach of fiduciary duty suits by stockholders and derivative actions for breach of fiduciary suits[.]” Id. at 182. 

Armed with the decision in NAF Holdings, the Citigroup plaintiffs argued that Tooley’s logic breaks down in cases like Citigroup, in which the source of harm is material misrepresentations by the company and its executives that induce a shareholder to take or forbear action, as opposed to mismanagement issues insulated by the business judgment rule. Under these circumstances, the plaintiffs argued that only Citigroup’s shareholders could bring the claims at issue because it was they and they alone who relied on Citigroup’s representations about the financial well-being of the company while the stock price was in freefall. They argued that it would defy logic to conclude that the shareholders’ claims were indirect under Tooley, because that would mean only Citigroup could bring the claims against itself for misrepresentations that Citigroup made to the public and that Citigroup never relied on (or suffered damages for) in the first place. In the certification order, the Second Circuit similarly observed that it “would be a strange outcome indeed for Citigroup to pay itself for losses sustained by certain shareholders arising from alleged misrepresentations made to those shareholders by the Company and its officers.” Citigroup, 806 F.3d at 700.  

The Delaware Supreme Court Held That the Plaintiffs in Citigroup Pled Direct Claims
In Citigroup, the Delaware Supreme Court held that the plaintiffs’ holder claims were direct, but it stopped short of expressly recognizing direct holder claims under Delaware law. The reason the court did not go as far as it could have was because it found that the laws of states other than Delaware governed the shareholder claims at issue.  

The court’s official ruling was that the holder claims against Citigroup were direct because under the state laws governing those claims, either Florida or New York, the claims belonged personally to the shareholders, not the corporation. Citigroup, 2016 Del. LEXIS 310, at *2. At the same time, however, the court further clarified the limited scope of its decision in Tooley. As in NAF Holdings, the court explained that Tooley was designed for only the narrow purpose of determining whether fiduciary duty claims (such as corporate mismanagement claims) brought by shareholders are direct or derivative, and the court rejected the assertion that all claims are derivative when the corporation suffers the harm directly. To the contrary, the court held that “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 *40. Thus, the holder claims in Citigroup would be direct “because they belong to the holders and are ones that only the holders can assert, not claims that could plausibly belong to the issuer corporation, Citigroup.” Id. at *35. 

The court’s decision in Citigroup is significant because it made clear that the two-part test from Tooley is inapplicable to the question of whether a shareholder has standing to sue a company directly when the company misrepresents material information that induces the shareholder to hold stock instead of selling it. Id. Instead, the court explained, the right inquiry is whether “the plaintiff seeks to bring a claim [based on a right] belonging to her personally or one belonging to the corporation itself,” which is a question that is answered without Tooley. Id. at *2. Moreover, despite stopping just shy of officially recognizing holder claims in Delaware, the court specifically noted that several federal courts have already interpreted Delaware law to provide for such a result. Id. at *42 n.75 (citing cases that held holder claims are direct under Delaware law).

Conclusion
In Citigroup, the Delaware Supreme Court took a step toward recognizing direct holder claims under Delaware corporations law. In light of Delaware’s prevailing influence over the corporate and securities laws of other states, the importance of this case should not be underestimated. The decision in Citigroup follows the trend of courts nationally recognizing that holder claims based on corporate misrepresentations are direct. For such a claim to be viable, most courts require that the complaint allege concrete facts showing that the alleged misrepresentations were actually perceived and relied on by the shareholder. Whether the plaintiffs in Citigroup satisfy this requirement remains to be seen. It is important to remember that the debate over whether holder claims are direct or derivative centers on the party’s standing to bring the claim and whether it can survive an early dispositive motion on the pleadings. Even in states that permit shareholders to bring holder claims against a company directly, the burden of proof for these claims is significant. Not only will the plaintiff be required to prove scienter if the claims are predicated on fraud, but to actually prevail, the plaintiff must identify the misrepresentations by the company and show concrete reliance by the shareholder and evidence of actual loss, which requires expert testimony about market conditions, including the downward pressure to a company’s stock price caused by a hypothetical sale of the putative holder’s securities. In other words, actually winning a holder case is not as simple as showing the price at the time the shareholders could have or wanted to sell.

Keywords: commercial and business, litigation, business, Citigroup, commercial, direct-derivative, financial crisis, forbearance, holder claims, litigation, Tooley, shareholder claims