Inviting a Second Bite at the Apple: Delaware Chancery Court Suggests New Approach to Evaluating Preclusive Effect of Prior Unsuccessful Derivative Litigation

In response to the Delaware Supreme Court’s question in connection with remand, the Delaware Chancery Court has suggested reevaluation of its prior willingness to dismiss subsequent derivative litigation where an earlier derivative action has been dismissed due to demand futility.  In re Wal-Mart Stores, Inc. Delaware Derivative Litigation, C.A. No. 7455-CB (consol.), supp. op. (Del. Ch. July 25, 2017).  Where the court previously would dismiss subsequent efforts to re-litigate demand failure, the new approach suggested by the Chancery Court provides that an earlier action should not be given preclusive effect if it failed to survive a motion to dismiss pursuant to Delaware Chancery Court Rule 23.1, the Delaware analog to Federal Rule of Civil Procedure 23.1.

The case arose out of a series of derivative actions filed both in Arkansas and Delaware against a large corporation.  Multiple actions were consolidated in federal district court in Arkansas, and those actions were ultimately dismissed due to failure to allege demand futility.  The actions filed in Delaware were likewise consolidated but proceeded more slowly, due in part to the fact that plaintiffs initially filed a books and records demand that had led to a Section 220 Delaware General Corporation Law proceeding alleging deficiencies in the defendant corporation’s production.  By the time that action was resolved and a consolidated derivative complaint was filed in Delaware, the Arkansas action had been dismissed.  The defendants accordingly moved to dismiss the Delaware action based on collateral estoppel with respect to demand futility.  The Chancery Court granted that motion.

On appeal, the Delaware Supreme Court ultimately issued a remand order, which asked the Chancery Court to address the following question:

In a situation where dismissal by the federal court in Arkansas of a stockholder plaintiff’s derivative action for failure to plead demand futility is held by the Delaware Court of Chancery to preclude subsequent stockholders from pursuing derivative litigation, have the subsequent stockholders’ Due Process rights been violated? See Smith v. Bayer Corp., 564 U.S. 299 (2011).

On remand, the Chancery Court began its analysis by noting that its prior decision was based in part on consideration of the Due Process issue, noting that case law nationally generally supported the notion that Due Process rights of the subsequent shareholders were deemed sufficiently protected, despite their status as non-parties to the first litigation, because courts were willing to conclude that the competing shareholders were in privity, at least where the initial shareholder’s counsel provided adequate representation.  However, the Chancery Court noted the peculiarities of derivative litigation in this context, in that Delaware courts have repeatedly admonished shareholders to “use the tools at hand,” i.e., to obtain corporate books and records under Section 220, before bringing a derivative action, which is in considerable tension with plaintiff counsel’s financial incentive to be the first to file an action in a “race to the courthouse.”  As a result, the Chancery Court noted that the first filed actions were more prone to dismissal for demand failure, as they were less likely to have the benefit of “adequate due diligence.”  Thus, the subsequent shareholder would lose out on collateral estoppel grounds, despite a better prepared complaint, arguably giving rise to the Due Process concerns noted by the Delaware Supreme Court.

In response to this tension, the Chancery Court advocated adopting an approach suggested in dicta last year in In re EZCORP Inc. Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016).  That is, preclusive effect should only be given to prior derivative actions that have survived motions to dismiss pursuant to Rule 23.1.  While acknowledging that this result could lead to “seriatim lawsuits litigating demand futility,” the Chancery Court noted that such subsequent lawsuits would typically be based on “a more refined complaint with more particularized allegations or more tailored legal theories after doing additional homework, such as obtaining corporate books and records through a Section 220 proceeding.”   According to the court, this approach “should go a long way in addressing the ‘fast-filer’ problem and ensur[e] better protection of due process rights” for shareholder plaintiffs.

*          *          *

Corporate Coverage Analysis:  Should the Chancery Court’s approach ultimately be adopted by the Delaware Supreme Court, D&O insurers should expect a significant uptick in derivative actions and related defense costs, as a significant hurdle to subsequent derivative actions where an earlier action has failed due to demand futility will have been removed.  Quick-filing plaintiffs’ counsel without doubt will continue to race to the court house, but the decision also incentivizes a more considered action, grounded in a Section 220 books and records demand, to be filed as well, leading to litigation on multiple fronts and the “seriatim litigation” the Chancery Court predicted.  While the Due Process issues here are complex and the Delaware Supreme Court’s resolution of the issue remains to be seen, this is a potentially troubling development in terms of exposure faced by insurers.