Direct V. Derivative Lawsuits 81a5j

Class 11 (2-27-13) Derivative Lawsuits • General • Check out Economics of Settlement slide • Winning is costly (there is a large inducement to settle) • To what extent should we allow shareholders to bring litigation? • There is a worry that a small subset of shareholders will take hold of litigation for the purpose of collecting lots of money from forcing settlements • Doctrinal Justifications • (1) Doctrine designed to reduce frivolous lawsuits • Plaintiffs’ firms that sue for the sake of justifying paying attorneys’ fees • (2) Corporation is a separate entity so it must be treated separately • Motion to Dismiss Phase – Methods for Corporations to kill lawsuits early • (a) Win on BJR • (b) Derivative Suit v. Direct (shareholder controls) lawsuit • Default – BoD controls derivative lawsuits • Definition of Derivative Lawsuits • Corporation is the Plaintiff • Complaining Minority Shareholder must bring a suit in equity to compel the corporation to bring a lawsuit against directors & officers • Step 1 – Force corporation to file lawsuit (SH v. Corp.) • Step 2 – Determine who controls the lawsuit (Corp. v. BoD • Conceptually – in a derivative lawsuit, the corporation specifically is harmed • Direct v. Derivative – (step 2) • Defendant will be the side that argues for it to be a derivative lawsuit (goal is to get the suit kicked out early in the process) • (1) Who is harmed? • (2) Who gets remedy? • (3) Is P seeking injunction (usually direct) or damages? • Eisenberg v. Flying Tiger Line, Inc. (2d Cir. 1971) • Background Transactions • Flying Tiger creates subsidiary Flying Tiger Corp. which creates subsidiary Flying Tiger Line (Flying Tiger is being merged into Flying Tiger Line) • Shareholders used to have a direct vote over the operating business; now shareholders have a vote over a holding company which has the direct vote • SH argues they have become one step removed from the decision about their company • Loss of voting rights makes this a direct lawsuit • SH must allege something more than a loss of money for a direct lawsuit • Direct v. Derivative Test • Why do not all derivative suits get controlled by shareholders? • If every suit was direct, subsets of the shareholders might bring strike suits to benefit themselves (side contracts, etc.) • Professional plaintiffs’ attorneys may force suits to gain high payout settlements • Gordon v. Elliman Test (NY) • Early test that looked at dividends • Derivative Lawsuit is any suit involving: “Performance of corporate acts which good faith requires the directors to take in order to perform a duty which they owe to the corporation” • This is too broad a standard (rejected in Eisenberg above) • Modern View • (1) New York Test – Do shareholders bear a specific harm (harm beyond the mere fact that the corporation is harmed)? • Looking for something other than reduction of value of the corporation

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• A harm other than a drop in the stock price • Ex: interference w/right to vote, redemption rights, etc. • (2) DE Test (Tooley v. Donaldson) – Who would receive the remedy? • Includes the above test & adds an evaluation of who receives the remedy • (3) Type of relief • Injunctive relief is typically direct (because injunctive relief would likely not be sought in strike suits) • Hypo (Slides 9-13) • #1 – ABC Corp & Jones contract breach scenario • Harm to the corporation; classic derivative lawsuit • #2 – ABC Treasurer embezzles and runs away • Harm to the corporation; classic derivative lawsuit • #3 – Tina run over by Cab & wants to pierce corporate veil • Tina is not a shareholder; not derivative, not direct • #4 – Dan Director indicted on anti-trust and sues for legal coverage under indemnification statute • Not suing in his capacity as SH; neither derivative or direct • #5 – XYZ voting rights suit • Harm to individual SH; direct lawsuit • #6 – Merrill Lynch/BOA Merger • BOA SH not happy about the merger and argue that their stock was diluted $15 billion in exchange for assets worth $2 billion • COURT: Direct or Derivative; case ultimately settled • Typically Direct • Interfering w/voting rights • Enforcing stock redemption rights • Compel dividends • Typically Derivative • Uninformed decision-making • Conflict of interest • Excessive exec pay • Waste • Other business judgments Role of Demand Requirement • Del. R 23.1 • Complaint shall also allege w/particularity the efforts… made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and reasons for failure to obtain the action or not making the effort • The Demand • Typically a letter from SH to BoD • Requests BoD bring suit • Sufficiently specific • Demand/Excused Doctrine (Demand Futility) • Grimes v. Donald (Del. 1996) • Grimes sues over a really high comp package w/questionable • Abdication Claim • The constructive termination clause in Donald’s contract places a chilling effect on the Board • Although abdication claim seems that it would be derivative (working thru drop in corporate value as a harm claim), the plaintiff is seeking injunctive relief – indicating this is likely a direct lawsuit, because injunctive relief would likely not be sought by a BoD against itself • Due Care, Waste, Excessive Comp.

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Demand Futility (DE) • “One ground for alleging with particularity that demand would be futile is that a ‘reasonable doubt’ exists that the board is capable of making an independent decision to assert the claim if demand were made” • (1) Majority of board has a material financial or familial interest, or • (2) Majority of the board is incapable of acting independently…[due to] dominion or control, or • (3) Not the product of a valid exercise of business judgment • Bifurcated process (Slide 24 & 27 Image) • Either must give decision to corporation or meet reasonable doubt standard of the above • This is a choice made by the SH: “if demand is made, the SH has spent one – but only one – arrow in the quiver.” • SH can then argue that demand was wrongfully refused • Demand Excused Route (Slide 29) • Board never gets a chance to take action • Demand Refused Route • Board gets to weigh in on demand letter • Often, Board will delegate all authority to the disinterested board via a special committee to make a decision to invoke BJR • Marx v. Akers (N.Y. 1996) • Background • Suit of excessive exec comp (demand required) (3/18) • Suit of excessive comp of outside directors (demand excused) (15/18) • In NY, complain must “allege with particularity” that • (1) A majority of the directors are interested • (2) Directors failed to inform themselves to a reasonable degree necessary to make a decision • (3) Challenged transaction could not have been sound business judgment • What happens when there is a board member w/no conflict in the challenged transaction? • What if CO or controlling SH has a conflict? What if board member has been on the board for a very long time? What if board member makes a lot of money on board? What if board member has friendships with potential defendant? • Aronson v. Lewis (Del. 1984) – Chief wrongdoer owned 47% and elected every board member • COURT: this did not render the board per se incapable of exercising independent judgment • P must demonstrate that directors beholden to controlling SH • Doctrine today: mostly a direct financial connection (mere friendships is insufficient to eliminate independence Who should control derivative litigation after the demand stage? • General: Can the board decide to terminate the lawsuit? • If SH gets around Demand Excused, then the Corporation can form a special litigation committee to dismiss suit • Auerbach v. Bennet (N.Y. 1979) • Allegations that the branches of the company internationally issued bribes to public officials in various countries • SLC formed w/3 directors who ed board after alleged bribes took place • SLC retains attorneys & auditors, interviews people, writes report, etc. & then concludes the suit should be dropped • “Disposition on the merits turns on the proper application of the business judgment doctrine… Our inquiry…has a two-tiered aspect”

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First Tier: Illegal payments • Second Tier: Committee rec to terminate the litigation (tier court looks at: it’s ok so long as they are independent, acting in good faith with good process) • ** Example of the traditional view of independence – strictly financial ** • “Tootsie Pop Defense” – second tier insulates first tier from judicial scrutiny (special litigation cmte formed by new board following good process) • Choi – NY Rule results in making derivative lawsuit almost worthless Zapata Corp. v. Maldonado (Del. 1981) • Similar to Auerbach • Independent Investigation Committee consisting of 2 new outside directors • COURT: Seeks a balancing point btwn SH & BoD • Zapata 2-Step Inquiry • (1) Independence, good faith, reasonable investigation (Auerbach) • Corporation bears the burden • (2) Court applies its own “independent business judgment” as to whether the case is to be dismissed • Does corporation have compelling interest in dismissing suit • Matters of public policy * Footnote 13 in Grimes * • Use of a cmte of the board formed to respond to a demand or to advise the board on its duty in responding to a demand is not the same as the SLC process contemplated by Zapata