Direct or derivative: does it matter after Gentile v. Rossette?

• Author: Olson, Zachary D.

1. INTRODUCTION II. BACKGROUND A. Direct Versus Derivative Claims 1. Fundamental Characteristics of Derivative and Direct Claims B. Pre-Gentile Delaware Direct/Derivative Jurisprudence: Rise and Fall of the "Special Injury" 1. Lipton v. News International 2. Kramer v. Western Pacific Industries, Inc. 3. In re Tri-Star 4. Grimes v. Donald 5. Parnes v. Bally Entertainment Corp. 6. A New Direction: Agostino and Tooley a. Agostino v. Hicks b. Tooley v. Donaldson, Lufkin, & Jenrette, Inc. C. The Gentile Decision 1. Gentile v. Rossette: Factual Background 2. Gentile I: Court of Chancery Decision a. The Debt Conversion Claim: Derivative or Direct? 3. Gentile II: Delaware Supreme Court Decision a. The Debt Conversion Claim: Derivative or Direct? i. Change from Majority to Minority Shareholder Status ii. Materiality Does Not Determine Whether a Claim is Derivative, Direct, or Both iii. Gentile II: The Result Fits within the Tooley Framework III. ANALYSIS A. Who Suffered the Injury? 1. Requirement of a Shift from Minority to Majority Shareholder Status 2. Requirement of a "Material" Reduction in Voting Power B. Who Would Benefit from Recovery or Other Remedy? IV. RECOMMENDATION V. CONCLUSION What's in a name? That which we call a rose By any other name would smell as sweet. (1)

1. INTRODUCTION

   The distinction between direct and derivative claims has been the source of considerable litigation in the Delaware courts through the years. (2) Whether a claimant has standing to sue directly or derivatively is not always clear. Accordingly, the courts have developed various tests designed to resolve the question. (3) The most recent articulation by the Delaware Supreme Court of the test to determine whether a claim is direct or derivative is found in the 2004 case of Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (4) The Delaware courts seem content with this test, having applied it over 30 times. (5) The Tooley test provides that the determination of whether a claim is direct or derivative "must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?" (6) One recent case, however, indirectly drags a skeleton out of the Delaware case law closet. That skeleton is the concept of "special injury." (7)

   Gentile v. Rossette, (8) which concerned a stock-dilution claim, arose after Tooley. (9) The Delaware Supreme Court held that the stock dilution claim was direct, (10) although dilution claims are typically derivative claims. (11) The effect of holding that the dilution claim was direct was that the shareholder plaintiffs could bring the claim on their own behalf, rather than on behalf of the corporation. In reaching this decision, the Gentile court followed a 1993 Delaware Supreme Court case, (12) In re Tri-Star Pictures, Inc. Litigation. (13) Tri-Star relied heavily on the special injury analysis (14) to determine the nature of a claim. (15) The application of the Tri-Star analysis in the Gentile supreme court decision is unexpected because the Tooley court explicitly discarded the Tri-Star special injury test in 2004. (16)

   This Note first reviews the differences between direct and derivative claims. Part II.B recounts the history of the different tests courts have used to determine whether a claim is direct or derivative. Specifically, Part II.B.6 analyzes the current test, the Tooley test, Delaware courts are using in corporate law cases. Part II.C presents the focal case of this Note, Gentile v. Rossette. Part II.C.1 recounts the factual background of Gentile. Part II.C.2 examines the analysis of Gentile by the Delaware Court of Chancery (Gentile I), (17) followed by the analysis of Gentile by the Delaware Supreme Court (Gentile II) (18) in Part II.C.3, overturning the court of chancery decision. Part III analyzes the Gentile II decision. This Part scrutinizes the analysis of Gentile II and examines different possibilities for analyzing future claims similar to those brought in the Gentile case. In Part IV, this Note explores possible solutions for the direct/derivative problems presented by the Gentile II decision. This Note then recommends that the direct/derivative distinction is outdated, no longer serves a purpose, and that Delaware should eliminate it. However, the most important requirements of the derivative claim, the contemporaneous ownership requirement (19) and the heightened pleading requirements, (20) remain as obstacles to eliminating the distinction. This Note also addresses possible alternatives to the current derivative requirements.

2. BACKGROUND

   1. Direct Versus Derivative Claims

      Distinguishing between direct and derivative claims has been a challenging task for the Delaware courts. (21) Since the chancery court in Elster v. American Airlines, Inc. (22) first used the term "special injury," (23) the Delaware courts have used different tests to try to distinguish between direct and derivative claims, and the distinctions were not always clear. (24) Even similar fact patterns have produced differing results, often slicing the distinction quite thin. (25)

      1. Fundamental Characteristics of Derivative and Direct Claims

      In determining whether a claim is direct or derivative, the initial inquiry is the following: To whom does the claim belong? (26) A derivative claim is a claim belonging to the corporation, which an individual or group of individuals brings on behalf of the corporation. (27) Contrast this with a direct claim, which is a claim belonging to an individual (or class of individuals) that is appropriately brought by that individual (or class) on his or her (or their) own behalf. (28) The recovery in a derivative suit "must go to the corporation," and the recovery in a direct suit "flows directly to the stockholders, not to the corporation." (29)

      Consider a typical example for each type of claim, which together provide bookends for the "vast sea of varying shades of gray" between the archetypal examples. (30) A typical example of a derivative claim is one brought by a shareholder on behalf of the corporation against the corporation's board of directors for waste of the corporation's assets. (31) If a corporation sells assets for insufficient consideration, shareholder plaintiffs could bring a claim for waste on behalf of the corporation. The sale harms the corporation because it parts with valuable assets and receives nothing in return. Consequently, a party making a claim seeks redress for the company's loss rather than an individual's loss. Any loss an individual suffers in this situation would be indirect. (32) Thus, the company, not the individual, recovers on the suit.

      On the other hand, an example of a direct claim is one brought by an individual shareholder against a corporation's board of directors for a breach of duty to disclose. (33) For example, if the shareholders receive incomplete information before voting for a merger, the nondisclosure would directly injure the shareholders deprived of an opportunity to vote their shares meaningfully. The incomplete information does not injure the company in any way that a remedy can redress; therefore, the only redress available is for the individual stockholders.

      The determination of whether a claim is direct or derivative is fact sensitive, which makes laying out a bright-line test difficult. (34) As will be shown, the tests, terminology, and distinctions for derivative and direct claims ebb and flow, but in each of them, the courts consider the same underlying issues, such as the nature of the injury and the person or entity that suffered the injury. (35) Gentile v. Rossette is a recent application of the Tooley test, the current direct/derivative test in Delaware. Gentile provides an example of the ever-evolving direct/derivative distinction.

   2. Pre-Gentile Delaware Direct/Derivative Jurisprudence: Rise and Fall of the "Special Injury"

      Courts and commentators have explained the history of the direct/derivative analysis several times. (36) However, an abbreviated version is appropriate for the analysis that follows in Part III of this Note. This recitation is by no means an exhaustive documentation of the distinctions.

      1. Lipton v. News International

         The Delaware Supreme Court first analyzed the direct/derivative distinction as a substantive matter (37) in Lipton v. News International. (38) The transaction at issue was the stipulated dismissal of claims between defendant News International (News) and Warner Communications, Inc. (Warner). (39) Two Warner shareholders brought a claim as intervenors alleging that the claims dismissed between News and Warner (the News claims) were derivative in nature and the dismissal precluded other shareholders from potentially bringing the claims derivatively on behalf of the corporation. (40)

         The Lipton court relied on two previous Delaware Court of Chancery cases for its direct/derivative analysis: (41) Elster v. American Airlines, Inc., (42) and Moran v. Household International, Inc. (43) The Lipton court focused on reconciling the analyses of the aforementioned cases in determining whether a claim is direct or derivative. (44) The Lipton court stated that "[t]o determine whether a complaint states a derivative or an individual [direct] cause of action, [the court] must look to the nature of the wrongs alleged in the body of the complaint...." (45)

         Elster and Moran approached the issue of what constituted an individual cause of action in two different ways. (46) First, the Elster court used the term "special injury" (47) to describe the type of injury that was direct in nature. (48) The Elster court identified two types of special injuries: "[(1) a] wrong inflicted upon [a claimant] alone or [(2)] a wrong affecting any particular right which he is asserting." (49) The Elster court also identified a third type...