Shareholder Litigation

• Pages: 255-301
• Author: Stephen M. Bainbridge

255

Chapter 8

SHAREHOLDER LITIGATION

§ 8.1 Introduction

In the preceding chapters, we reviewed the fiduciary duties

corporate law imposes on corporate management and the board of

directors that supervises those managers. In this chapter, we take up

the mechanism by which those duties are enforced.

In general, fiduciary duties of officers and directors are owed to

the corporation as an entity, rather than to individual shareholders.

Accordingly, this chapter focuses on the mechanism by which those

duties typically are enforced—the derivative suit.

1

The law governing derivative litigation has many complexities,

most of which result from the collision of two basic principles. On the

one hand, the derivative cause of action belongs to the corporation.

The board of directors is charged with running the corporation and

therefore ought to control corporate litigation. On the other hand,

when it is the directors or their associates who are on trial, we may

not trust them to make unbiased decisions. Consequently, like the

substantive content of fiduciary duties, the law governing derivative

litigation must balance the competing policies of deference to the

board’s decision-making authority and the need to hold erring

directors accountable.

§ 8.2 Direct Versus Derivative Litigation

“Direct” shareholder suits arise out of causes of action belonging

to the shareholders in their individual capacity. It is typically

premised on an injury directly affecting the shareholders and must

be brought by the shareholders in their own name. In contrast, a

“derivative” suit is one brought by the shareholder on behalf of the

corporation. The cause of action belongs to the corporation as an

entity and arises out of an injury done to the corporation as an entity.

The shareholder is merely acting as the firm’s representative.

Distinguishing direct and derivative suits is easier said than

done. The ALI PRINCIPLES posit two basic tests: (1) Who suffered the

most immediate and direct injury? Note that it is not enough for a

shareholder to allege that the challenged conduct resulted in a drop

in the corporation’s stock m arket price. (2) To whom did the

1

In theory, of course, a derivative suit may be brought by any shareholder

who meets the specified procedural requirements to redress any injury done the

corporation by any party. As noted, however, its most important function is providing

a mechanism by which breaches of fiduciary duty are remedied.

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SHAREHOLDER LITIGATION

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defendant’s duty run?

2

In Grimes v. Donald, the Delaware Supreme

Court favorably cited the ALI standards, but also added yet another

test based on the nature of the relief being sought. In Grimes,

plaintiff alleged that the board of directors had improperly abdicated

its authority to the chief executive officer. Plaintiff’s only requested

relief was “a declaration of the invalidity” of the employment

agreements by which the board delegated power to the officer.

Accordingly, the court held, those claims could proceed directly

because no monetary recovery would accrue to the corporation as a

result of the suit.

3

The commentary to the ALI PRINCIPLES confirms

that “courts have been more prepared to permit the plaintiff to

characterize the action as direct when the plaintiff is seeking only

injunctive or prospective relief.”

4

Specific suits that have been characterized as derivative in

nature include claims involving corporate rights arising out of tort or

contract, monetary damages based on corporate mismanagement,

executive compensation, waste of corporate assets, and the adequacy

of consideration for issuance of corporate stock. Suits that may be

brought directly include claims involving oppression of minority

shareholders, a proposed reorganization favoring one class of shares

over another, compelling declaration of a dividend, inspection of

corporate books and records, shareholder voting rights, preemptive

rights, and injunctive relief where the board of directors improperly

abdicated its authority to corporate officers. Examples of conduct

simultaneously giving rise both to derivative and direct causes of

action include sale of corporate offices and violations of the federal

proxy rules. In close cases, as already suggested, courts are often

willing to accept a plaintiff’s characterization of the suit as direct, at

least where plaintiff is seeking only injunctive or prospective relief.

5

Note that in diversity actions brought in federal court, state law

controls whether a suit is direct or derivative.

6

2

ALI PRINCIPLES § 7.01. When the defendants are corporate directors or

officers, it is particularly important identify the party to whom the defendants owed

the relevant duty, because they owe duties to both the corporation as an entity and the

shareholders as individuals. Because of this dual loyalty, a particular course of conduct

sometimes will violate two or more duties owed by the same defendant—one to the

corporation and a different one owed to the shareholders as individuals. Insider

trading, for example, can violate both a duty owed to the corporation as an entity and

a separate duty owed to the shareholder who is selling the securities. In such a case,

the shareholders may bring a direct action to redress their own injuries, while also

bringing a derivative actio n to redress the injury to the corporation. ALI PRINCIPLES

§ 7.01(c).

3

Grimes v. Donald, 673 A.2d 1207, 1213 (Del.1996).

4

ALI PRINCIPLES § 7.01 cmt. d.

5

ALI PRINCIPLES § 7.01 cmt. d.

6

Sax v. World Wide Press, Inc., 809 F.2d 610, 613 (9th Cir.1987).

§ 8.2

DIRECT VERSUS DERIVATIVE LITIGATION

257

The Delaware Supreme Court revisited this issue in Tooley v.

Donaldson, Lufkin & Jenrette, Inc.

7

The Tooley opinion recognized

that many prior decisions used the so-called “special injury” test to

determine whether a suit was direct or derivative. A special injury

was defined as a wrong that “is separate and distinct from that

suffered by other shareholders, . . . or a wrong involving a contractual

right of a shareholder, such as the right to vote, or to assert majority

control, which exists independently of any right of the corporation.”

8

In Tooley, the Delaware Supreme Court rejected the special injury

test, in favor of the following two-pronged standard: (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. This

is a potentially easier standard to apply than the ALI version, since

it eliminates the need to determine the party to whom the defendant

owed duties.

It is sometimes said that a claim for breach of fiduciary duty can

only be brought as a derivative suit. Indeed, it is claimed that there

are a “legion” of cases holding “that a shareholder may not sue

directly for breaches of duties by officers and directors of a company

because those injuries are actually suffered by the corporation.”

9

It’s

not clear when or where this belief took hold, but the weight of

authority is to the contrary.

As the Delaware Supreme Court has explained:

Tooley and its progeny . . . 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 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.

10

7

845 A.2d 1031 (Del.Sup.2004).

8

Moran v. Household Int’l, Inc., 490 A.2d 1059, 1070 (Del.Ch.1985) , aff’d 500

A.2d 1346 (Del.1985).

9

7547 Corp. v. Parker & Parsley Dev. Partners, L.P., 38 F.3d 211, 221 (5th

Cir. 1994).

10

NAF Holdings, LLC v. Li & F ung (Trading) Ltd., 118 A.3d 175, 179 (Del.

2015). The “different subject” to which the court referred in NAF Holdings was a claim

arising out of a commercial contract under whic h the suing shareholder had personal

rights. The NAF Holdings court held that, under those circumstances, the “the Tooley

analysis was not needed to determine whether the commercial-contract claim was

direct or derivative. As we explained there, 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.” El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248, 1259

(Del. 2016). In El Paso, however, the Court further clarified that “NAF Holdings does

not support the proposition that any claim sounding in contr act is direct by default,

irrespective of Tooley.” Accordingly, it held that where a “sounds in breach of a