Standing in Shareholder Derivative Litigation
Editor's Note: This column was originally published in The New York Law Journal on Oct. 10.
Under Delaware's continuous ownership rule, once a shareholder derivative plaintiff ceases for any reason to be a stockholder in the corporation on whose behalf the suit was brought, it no longer has a financial interest in any recovery pursued for the benefit of the corporation and therefore lacks standing to seek relief on behalf of the corporation. Where the corporation on whose behalf a derivative action is pending is acquired in a merger that deprives the derivative plaintiff of its shares, the derivative claim is transferred to and becomes an asset of the acquiring corporation. The original plaintiff loses standing under the continuous ownership rule because it does not own shares in the surviving entity. In Arkansas Teacher Ret. System v. Countrywide Fin.,1 the Delaware Supreme Court sitting en banc last month reexamined the conceptual roots and practical effects of the continuous ownership rule in shareholder derivative litigation.
Answering a certified question from the U.S. Court of Appeals for the Ninth Circuit, the court reaffirmed that the "fraud exception" to the continuous ownership rule applies only in the narrow circumstance where the shareholder plaintiff alleges that the merger was executed "merely" to extinguish derivative standing and lacked any legitimate business purpose, an exceedingly difficult standard to meet.
In a shareholder derivative action, the plaintiff is suing to enforce a purported right or remedy belonging to a corporation in which plaintiff is a shareholder. In the corporate context, questions of standing must be considered in light of the fundamental corporate governance principle that under 8 Del. C. §141(a), the board of directors has the ultimate responsibility for managing the business and affairs of the company on behalf of its stockholders. Because a derivative action impinges on the managerial freedom of directors, a stockholder plaintiff can assert a claim derivatively only if the plaintiff satisfies criteria established by Rule 23.1, common law and statute for derivative actions, including the contemporaneous and continuous ownership requirements. Together, these requirements demand that the plaintiff be a stockholder of the corporation at all relevant times.
By statute, Delaware law imposes a "contemporaneous ownership" requirement, which provides that a derivative plaintiff does not have standing to bring a derivative suit unless it was a shareholder or member at the time of the transaction of which the plaintiff complains.2 Rule 23.1 of the Court of Chancery's Rule and its federal counterpart are to the same effect. The purpose of the contemporaneous ownership requirement is to prevent potential plaintiffs from purchasing a lawsuit through the acquisition of shares of stock in a corporation after an alleged wrong has occurred. It is beneficial ownership, rather than record ownership, that must be established for a derivative plaintiff to have standing. Courts have interpreted this rule to mean that, "[w]hen a series of wrongful transactions is alleged and some of them transpired before plaintiff became a shareholder but others took place subsequent to that date, the shareholder's action may be maintained only on the basis of the later events."3
Separately, Delaware's "continuous ownership" rule is a common law requirement that a plaintiff in a derivative action "not only be a stockholder at the time of the alleged wrong and at the time of commencement of suit but that he must also maintain shareholder status throughout the litigation."4 When a derivative plaintiff ceases to be a stockholder in the corporation on whose behalf a suit was brought, whether by reason of a merger or any other reason, it no longer has a financial interest in any recovery pursued for the benefit of the corporation.
The rule that a plaintiff who ceases to be a shareholder loses standing to continue a derivative suit gives effect to Delaware Code §259(a), which provides that "all property…and every other interest" of a corporation that is acquired or merged into another corporation belong to the surviving corporation.5 For derivative claims that arose before a merger, shareholders typically lose standing to pursue those claims following a merger because of the "continuous ownership" rule.
Delaware law recognizes only two exceptions to loss of derivative standing after a corporate merger: (1) the "mere reorganization" exception, under which the merger is essentially a reorganization of a single corporation that does not affect the plaintiff's relative ownership in the post-merger entity, and (2) the "fraud" exception, which requires a showing that the reason for entering into the merger was to divest the plaintiff of derivative standing.
The path to Delaware in Arkansas Teacher began with a shareholder derivative action brought in California federal court on behalf of the former Countrywide Financial Corporation, asserting state and federal derivative claims for breach of fiduciary duty and securities law violations against former Countrywide officers and directors. While the suit was pending, Countrywide merged with and into a wholly owned subsidiary of Bank of America Corporation (BofA) in a stock-for-stock transaction that divested the plaintiffs of their Countrywide shares. All outstanding Countrywide shares were exchanged for BofA shares, and all Countrywide shareholders at the time of the merger became shareholders of BofA.
Nominal defendant Countrywide then moved for judgment on the pleadings, arguing that the merger extinguished the plaintiffs' standing to pursue derivative claims on Countrywide's behalf. The district court agreed, determining in 2008 that the plaintiffs could not satisfy the "continuous ownership" requirement for shareholder derivative standing under both Federal Rule of Civil Procedure 23.1 and Delaware substantive law.
After Countrywide and BofA announced their merger, the plaintiffs amended their federal complaint to add direct merger-related class action claims on behalf of former Countrywide shareholders. The district court stayed the plaintiffs' direct claims in favor of similar claims asserted on behalf of the same putative class already pending in the Delaware Court of Chancery. Upon announcement of a proposed settlement of the merger-related direct claims in Delaware, the district court directed the federal plaintiffs to address to the Delaware Court of Chancery any objections concerning the release of their federal merger-related direct claims. The federal plaintiffs objected in Delaware to approval of the settlement, arguing that it would improperly release their direct claims. The Court of Chancery approved the settlement releasing all direct, class action claims related to the merger, allowing the merger to proceed.
In Arkansas Teacher Ret. Sys. v. Caiafa (Arkansas Teacher I),6 the Delaware Supreme Court in 2010 affirmed the class action settlement approval. After affirming the approval of the settlement of the Countrywide shareholders' direct merger-related claims, and specifically noting that the merger would result in loss of standing as to the derivative claims plaintiffs sought to assert, the Delaware Supreme Court, in dicta, commented on certain allegations underlying plaintiffs' objection to the settlement agreement. In the court's view, those allegations appeared to describe a theory of a "single, inseparable fraud" in connection with the merger—i.e., conduct that may have "severely depressed the company's value at the time of [the merger], and arguably necessitated a fire sale merger"—that might have survived the merger had it been pleaded as a direct fraud claim against the Countrywide directors. Had this claim been asserted, the court noted in Arkansas Teacher I, "the injured parties would be the shareholders," not the corporation, and the shareholders "would have post-merger standing to recover damages instead of the corporation."
Fastening onto this dicta, the plaintiffs sought reconsideration of the federal court dismissal of their derivative suit, arguing that the Delaware Supreme Court's decision in Arkansas Teacher materially changed Delaware law. Plaintiffs did not argue that the sole purpose of the merger was to eliminate derivative liability; in fact the Court of Chancery found that "avoiding derivative liability was neither the only nor the principal reason for supporting the transaction." Rather, plaintiffs argued that Arkansas Teacher I expanded the fraud exception to the continuous ownership rule to apply not only where the sole purpose of a merger was to deprive shareholders of standing to maintain a derivative action, but also where the directors' fraudulent conduct and breach of fiduciary duty before the merger impaired the corporation's financial condition so badly that a merger became a practical necessity.