Class-Action Reforms Spur Derivative Claims
By Michael A. Collora and David M. Osborne
Send Email to: mcollora@dwyercollora.com
National Law Journal, February, 15, 1999
CONGRESS HAS FIRED the latest salvo in a decade-long campaign to curb abusive securities class-action litigation, amending the federal securities laws to allow defendants to push a host of state class actions into federal court. This move, enacted last October, combined with the 1995 enactment of stricter procedural requirements for federal class actions and recent decisions by the U.S. Supreme Court raising the bar for investors seeking to recover losses from the purchase or sale of securities, has forced a renewed interest in an old-fashioned remedy for management fraud--the stockholder derivative suit. The growing practice of litigating securities fraud through derivative claims--a use for which the derivative action was never intended--threatens to undermine the goals of the securities class-action reform movement.
The 1990s have been marked by a series of judicial and legislative efforts to curb securities class actions. These began with decisions by the Supreme Court to shorten the statute of limitations period for federal securities-fraud class actions1 and to eliminate aider and abettor liability.2
In 1995, Congress joined the fray, enacting the Private Securities Litigation Reform Act (the Reform Act)3 to end what it called the "routine filing of lawsuits against issuers of securities and others whenever there is a significant negative change in the value of the issuer's stock" and to end "the abuse of the discovery process to impose costs so burdensome that it is often economical for the victimized party to settle."4 The Reform Act addressed these practices by establishing stricter pleading requirements, mandating a stay on discovery pending a motion to dismiss and creating a "safe harbor" for forward-looking statements.
Empirical evidence shows that the Reform Act has led to forum shopping. Increasingly, plaintiffs are taking class-action securities-fraud claims to state court, where the Reform Act does not apply.5 For instance, a plaintiff may file a parallel state proceeding for the purpose of bypassing the federal discovery stay. This, in turn, may enable the plaintiff to amend a federal complaint sufficiently to survive a motion to dismiss. Alternatively, a plaintiff may choose to ignore a federal forum entirely and litigate the matter in state court under a blue sky law.
In response, Congress recently enacted the Securities Litigation Uniform Standards Act of 1998 (the Standards Act), which establishes what Congress calls "national standards" for securities class actions.6 The act, which was signed by President Clinton on Nov. 3, 1998, enables defendants to remove a wide range of state securities-fraud class actions to federal court, where the proceedings will be governed by the Reform Act.
The Standards Act applies to single lawsuits in which damages are sought on behalf of more than 50 prospective class members or which are brought by one or more named parties seeking damages on a representative basis, as well as to any group of consolidated lawsuits in which damages are sought on behalf of more than 50 people.7 Derivative actions and class actions brought under the statutory or common laws of the state in which the issuer is incorporated are expressly excluded from the Standards Act.8
An Alternative Remedy
Faced with this crackdown on securities class actions at both the federal and state levels, shareholders are taking a fresh look at an old remedy--the shareholder derivative suit.
While shareholder derivative suits have undergone considerable growth and refinement since they were first recognized by the Supreme Court almost a century and a half ago,9 they have always served as a mechanism for protecting corporate interests against the misdeeds of corporate management by enabling a shareholder to sue on behalf of the corporation when the board of directors fails to take action on its own. The essential characteristic of a derivative wrong is that it "injures the shareholders indirectly and dependently through direct injury to the corporation."10
Traditional derivative claims most often arise when corporate managers steal or squander corporate funds or misappropriate corporate opportunities. Examples of misconduct that have been the subject of recent derivative litigation include using corporate funds for personal gain;11 approving excessive compensation packages for officers;12 awarding directors options to purchase millions of shares in their company at an exercise price below the shares' fair market value;13 and paying more than fair market value for a corporate acquisition.14
In situations such as these, the corporation suffers a direct financial loss, while the corporation's stockholders indirectly share that loss, presumably reflected in the diminished value of their stock. When the corporation recovers its loss through a lawsuit, stockholders also benefit, presumably in the appreciation of their stock.
Increasingly, however, derivative suits are being used to pursue another kind of misconduct that does not fit this scheme of direct loss to the corporation and indirect loss to the shareholders--the investor fraud claim. Consider the following recent suits:
In Delaware, a shareholder brought a derivative action alleging that the directors of York Research Corp. made false public statements regarding the company's revenue growth and future business prospects, and then sold off their shares at inflated prices.15
A derivative claim filed in Pennsylvania alleged that First Eastern Bank and its officers materially misrepresented the bank's financial condition, causing its stock price to be artificially inflated and harming the bank's investors.16
Two derivative lawsuits were brought in California, alleging that Oracle Systems Corp.'s directors breached their fiduciary duties to the company by improperly recognizing contingent receivables as revenue, to inflate Oracle's stock price, and then engaging in insider trading.17
In these and other garden-variety securities fraud cases, it is the investing public, not the corporation, that is victimized by the deceptive conduct. Under the conventional definition of a derivative wrong, then, one would expect the shareholders to have been barred from bringing a derivative action because the fraud caused neither direct injury to the corporation nor indirect injury to the shareholders (except those shareholders who themselves traded in stock while the misconduct was taking place).
Rather, only the defrauded investors themselves should have had a cause of action against the wrongdoers. Suits of this kind, however, are rarely challenged for failing to state a derivative claim. When courts do dismiss them, it is usually for failure to make proper pre-suit demand on the board of directors in accordance with Federal Rule of Civil Procedure 23.1 or an analogous state rule.18
There are some situations in which a corporation suffers direct harm as a result of investor fraud, warranting a derivative action.19 For example, the Supreme Court has held that a corporation that participates in a securities transaction may have a claim under § 10(b) of the Securities Exchange Act of 1934 or Rule 10b-5 of the Securities and Exchange Commission.20
However, if the corporation is not a market participant, it is unlikely to suffer any economic harm when its directors or officers take steps to artificially inflate the price of the corporation's stock or engage in insider trading.
Damageless Suits
The groundwork for this expanded use of derivative securities litigation was laid more than a half-century ago, when the Delaware Court of Chancery held that a shareholder could bring a derivative suit against a confidential secretary who traded on inside information, even though the company was not harmed by the secretary's trades.21 The court concluded that the secretary was liable to the corporation for any profits he realized from his trades because "[p]ublic policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss."22
Twenty years later, the New York Court of Appeals (the state's highest court) adopted the Delaware approach, upholding a derivative claim against a director and officer who allegedly traded on inside information, despite the fact that the company was not injured.23 The court noted that the need to prove damages "has never been considered to be an essential requirement for a cause of action founded on a breach of fiduciary duty."24 Although the handful of courts that have considered this question are split, the notion that a breach-of-fiduciary-duty claim can be based on abstract damages such as reputational harm or misappropriation of confidential information appears to be gaining strength.25
Derivative plaintiffs also have succeeded in alleging injury that is tangible but only collateral to the misconduct. For instance, when a corporate manager defrauds investors, the corporation often finds itself a defendant in a class action or the target of an investigation by the SEC. As a result, the corporation is forced to incur substantial legal fees to defend itself, and it also may have to pay a settlement, judgment or civil penalty to resolve the class action or investigation. This was the case in a recent suit brought in the Delaware Court of Chancery, in which a shareholder alleged that the corporation was harmed by the misdeeds of its directors because the corporation was forced to pay out $500,000 to settle several related federal securities-fraud class actions.26
An imaginative shareholder can identify some intangible or collateral harm to a corporation in almost any situation in which investors have been defrauded. The result: Injury to the corporation is no longer the distinguishing characteristic of a derivative wrong, making it possible to litigate almost any investor fraud claim derivatively.
An Imperfect Substitute
A derivative suit does not guarantee that a shareholder will be able to entirely circumvent the procedural changes of the Reform Act. For instance, at least one court has rejected the argument that the act's discovery stay does not apply to a derivative action alleging a violation of the Securities Exchange Act, finding no distinction between derivative actions and class actions in the Reform Act.27 Even when a derivative action is brought in a state forum, some courts will honor any discovery stay in a related federal action.28 In fact, the Standards Act itself authorizes a federal court to stay a state court discovery proceeding that might interfere with a stay mandated under the Reform Act.29
Moreover, the derivative action entails some unique procedural hurdles of its own. Under the contemporaneous-ownership rule, plaintiffs must prove stock ownership both at the time of the misconduct and during the pendency of the litigation.30 Before initiating a derivative action, shareholders must make demand on the board of directors or be excused from doing so by the court.31
Even when demand is excused, many jurisdictions permit the board to reassert control over the suit by establishing a special litigation committee empowered to decide whether the derivative action should be terminated.32 In many jurisdictions, the plaintiff may have to post security for litigation expenses.33 Finally, because derivative actions are equitable in nature, there is no automatic right to a jury trial. For instance, in Delaware--a major point of origin for derivative litigation--courts do not appear to recognize any right to a jury trial.34
These procedural barriers are not insuperable, however. Although a plaintiff typically has to make demand on the board, many jurisdictions recognize the principle of demand futility, allowing plaintiffs to have the matter reviewed by a court. In Delaware, for instance, a plaintiff may be excused from making demand either by showing that the directors are interested or incapable of exercising independent business judgment or by pleading particularized facts creating a reasonable doubt as to the soundness of the challenged business.35
With regard to security-for-expense statutes, only around one-third of the states have enacted them, and even these requirements can be avoided if the claim can be fashioned into a violation of federal securities law.36 Finally, the inability to claim a jury trial is usually an insignificant factor to a shareholder-plaintiff, as the goal of a derivative action generally is to extract a settlement, not to win a jury verdict.37
Further, a derivative investor fraud claim holds some special advantages of its own. A derivative action may be the only way many shareholders will ever benefit from securities fraud litigation because a derivative claim enables those shareholders who did not trade in the corporation's stock--and therefore cannot qualify for class membership--to reap some compensation, however slight, in the form of stock appreciation.
The shareholders who serve as the named plaintiffs in a derivative action may receive some share of whatever recovery results from the litigation, and thus may have an incentive above and beyond the possibility of a general rise in the value of their stock. Because the federal securities laws no longer recognize aider and abettor liability,38 a derivative action may enable a plaintiff to sue parties who are beyond the reach of a direct action.39 Finally, under an unjust enrichment or constructive trust theory, a derivative plaintiff may be able to reclaim for the corporation whatever profits accrued to the wrongdoers as a result of their misconduct40--which means that the financial stakes of a derivative suit for a defendant can be quite high.
The derivative action has grown far beyond its traditional role as a protector of corporate assets and shareholder stock. In many jurisdictions, freed of the need to prove harm to the corporation, shareholders have transformed the derivative action into a new way to litigate investor fraud claims. As Congress and the courts increasingly place limits on securities class actions, derivative suits are available to fill the void, undermining the objectives of securities litigation reform. Effective securities litigation reform may not be achieved until derivative plaintiffs are required to show direct harm to the economic interests of the corporation on whose behalf they purport to act.
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Footnotes:
1 See Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 363-64 (1991).
2 See Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A., 511 U.S. 164, 177 (1994).
3 Pub. L. No. 104-67 (Private Securities Litigation Reform Act of 1995).
4 H.R. Conf. Rep. No. 369, 104th Cong., 1st Sess. (1995), 141 Cong. Rec. H13692 at H13699 (1995).
5 Joseph A. Grundfest and Michael A. Perino, "Securities Litigation Reform: The First Year's Experience," Stanford Law School, Release 97.1 (Feb. 27, 1997); see also U.S. Securities and Exchange Commission, Office of the General Counsel, "Report to the President and the Congress on the First Year of Practice Under the Private Securities Litigation Reform Act of 1995" (April 1997).
6 See Pub. L. No. 105-353, § 2 (Securities Litigation Uniform Standards Act of 1998), codified at 15 U.S.C. 77p, 77v(a), 78bb, and 78u-4(b)(3).
7 See id. § 101.
8 See id. § 101. In a major development last month, the California Supreme Court held that California's blue sky law protected out-of-state purchasers and sellers of securities. See Diamond Multimedia Systems Inc. v. Superior Court, 80 Cal. Rptr. 2d 828 (Cal. 1999). Because the Standards Act does not apply to class actions brought under state law, many more shareholders may be able to circumvent the Reform Act as a result of this decision. The long-term impact of Diamond Multimedia on the success of securities litigation reform remains to be seen.
9 Dodge v. Woolsey, 59 U.S. 331, 341 (1855).
10 Avacus Partners L.P. v. Brian, 1990 Del. Ch. Lexis 178, at *21-*22 (Del. Ch. 1990).
11 Smith v. Smitty McGee's Inc., 1998 Del. Ch. Lexis 87, at *4 (Del. Ch. 1998).
12 Carlton Investments v. TLC Beatrice International Holdings Inc., 1997 Del. Ch. Lexis 86, at *3 (Del. Ch. 1997).
13 Noerr v. Greenwood, 1997 Del. Ch. Lexis 121, at *3-*4 (Del. Ch. 1997).
14 Edge Partners L.P. v. Dockser, 944 F. Supp. 438, 442 (D. Md. 1996).
15 Friedman v. Beningson, 1995 Del. Ch. Lexis 154, at *4-*8 (Del. Ch. 1995), appeal denied, 676 A.2d 900 (Del. 1996).
16 First Eastern Corp. v. Mainwaring, 21 F.3d 465, 466 (D.C. 1994).
17 In re Oracle Sec. Litig., 829 F. Supp. 1176, 1177-78 (N.D. Cal. 1993).
18 See, e.g., Seminaris v. Landa, 662 A.2d 1350 (Del. Ch. 1995).
19 In some limited situations, a derivative action may be authorized by statute even though the corporation has suffered no direct injury. For instance, the Securities Exchange Act of 1934 expressly allows an issuer of securities to recover the short-swing profits of inside traders, either directly or derivatively. See, e.g., Securities Exchange Act of 1934, § 16(b).
20 Superintendent of Ins. of N.Y. v. Bankers Life & Cas. Co., 404 U.S. 6, 12-13 (1971); see also Estate of Soler v. Rodriguez, 63 F.3d 45, 55 (1st Cir. 1995).
21 Brophy v. Cities Service Co., 70 A.2d 5, 8 (Del. Ch. 1949).
22 Id.
23 Diamond v. Oreomuno, 248 N.E.2d 910, 914-16 (N.Y. 1969).
24 Id. at 912.
25 The holdings of Brophy and Diamond have been adopted by courts in Connecticut, New Jersey and Nevada. See In re Coleca Sec. Litig., 591 F. Supp 1488, 1495 (S.D.N.Y. 1984); Ferris v. Ploycast Technology Corp., 429 A.2d 850, 853 (Conn. 1980); In re ORFA Sec. Litig., 654 F. Supp. 1449, 1455 (D.N.J. 1987); In re Jackpot Enterprises Sec. Litig., 1991 U.S. Dist. Lexis 16287, at *6 (D. Nev.1991). The approach was rejected in Freeman v. Decio, 584 F.2d 186, 196 (7th Cir. 1978), and in Schein v. Chasen, 478 F.2d 817 (2d Cir. 1973) (applying Florida law), vacated and remanded sub nom., Lehman Bros. v. Schein, 416 U.S. 386 (1974), on certification to the Fla. Sup. Ct., 313 So.2d 739 (Fla. 1975), aff'g district court after disposition of certified question, 519 F.2d 453 (2d Cir. 1975).
26 Friedman, 1995 Del. Ch. Lexis 154, at *5.
27 In re Trump Hotel Shareholder Derivative Litig., 1997 U.S. Dist. Lexis 11353, at *3-*4 (S.D.N.Y. 1997).
28 See Milano v. Auhll, No. SB 213 476 (Cal. Super. Ct., Santa Barbara Co., Oct. 2, 1996); Sperber v. Bixby, No. 699812 (Cal. Super. Ct., San Diego Co., Oct. 25, 1996).
29 See Pub. L. No. 105-353, § 101.
30 See, e.g., Fed.R.Civ.P. 23.1 (requiring derivative plaintiff to have stock ownership in company at time of misconduct); see also Wefel v. Kramarsky, 61 F.R.D. 674, 679 (S.D.N.Y. 1974).
31 See, e.g., Fed.R.Civ.P. 23.1.
32 See, e.g., Auerbach v. Bennett, 393 N.E.2d 994, 999-1000 (N.Y. 1979); Zapata Corp. v. Maldonado, 430 A.2d 779, 781 (Del. 1981).
33 See, e.g., N.Y. Bus. Corp. L. § 626(e).
34 See, e.g., Levien v. Sinclair Oil Corp., 314 A.2d 216, 221 (Del. Ch. 1973), aff'd, Sinclair Oil Corp. v. Levien, 332 A.2d 139 (Del. 1975). In federal court, when the underlying claim is legal rather than equitable, the Seventh Amendment right to a jury trial attaches. See Ross v. Bernhard, 396 U.S. 531, 538 (1970).
35 Levine v. Smith, 591 A.2d 194, 205-206 (Del. 1991).
36 See McClure v. Borne Chem. Co. Inc., 292 F.2d 824, 835 (3d Cir. 1961), cert. denied, 368 U.S. 939 (1961).
37 Several studies have shown that, in the vast majority of cases, securities class actions and derivative actions are resolved through settlement rather than adjudication. See, e.g., Janet Cooper Alexander, "Do the Merits Matter? A Study of Settlements in Securities Class Actions," 43 Stan. L. Rev. 497, 525-26 (1991); John E. Kennedy, "Securities Class Actions and Derivative Actions in the United States District Court for the Northern District of Texas: An Empirical Study," 4 Hous. L. Rev. 769, 811 (1977); Roberta Romano, "The Shareholder Suit: Litigation Without Foundation?," 7 J. L. Econ. & Org. 55, 84-85 (1991).
38 See Central Bank, 511 U.S. at 191.
39 See, e.g., Smith, 1998 Del. Ch. Lexis 87, at *5.
40 See, e.g., Diamond, 248 N.E.2d at 912.