No Second Bite for Derivative Plaintiffs: Delaware Supreme Court Rebuffs Invitation to Undermine Preclusive Effect of Prior Unsuccessful Derivative Action

The Delaware Supreme Court, once again addressing questions of issue preclusion in the context of shareholder derivative litigation, has rejected suggestions by the Chancery Court that giving preclusive effect to initial, unsuccessful efforts to litigate demand futility violates the Due Process rights of shareholders attempting to bring a subsequent action elsewhere. California State Teachers' Retirement System, et al. v. Aida M. Alvarez, et al. and Wal-Mart Stores, Inc., No. 295, 2016 (Del. Jan. 25, 2018).  According to the Court, such issue preclusion does not necessarily violate Due Process rights, at least where the various plaintiffs have a common interest and legal representation is adequate in the initial action.

This matter 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.

In the initial appeal of the Delaware Action, the Delaware Supreme Court issued a remand order asking the Chancery Court to address whether the determination that the Arkansas court’s initial ruling precluded subsequent efforts to pursue derivative litigation in Delaware violated the subsequent stockholders’ Due Process rights.  In response, the Chancery Court determined that preclusive effect should only be given to prior derivative actions that have survived motions to dismiss pursuant to Rule 23.1(the Delaware analog to Federal Rule of Civil Procedure 23.1).  In reaching its conclusion, the Chancery Court emphasized 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, where subsequent shareholders lost out due to issue preclusion, Due Process rights were implicated.

On appeal once again, the Delaware Supreme Court was not persuaded.  First, it noted that, because the Arkansas decision was rendered by a United States District Court, federal law governed the Due Process analysis.  The Court then observed that three federal circuit courts have previously determined that Due Process rights of subsequent plaintiffs are protected where their interests were aligned with the prior plaintiffs and where those prior plaintiffs had adequate representation.

With respect to whether the two groups of plaintiffs shared common interests, the Court explained that both groups of plaintiffs were in privity, as each group was seeking to assert the same set of rights, i.e., those of the corporation, and not their own individual rights as shareholders.  Thus, plaintiffs in separate derivative actions nonetheless share a commonality of interest sufficient to avoid offense to notions of Due Process.

The court then focused on the adequacy of representation, stating that federal law generally deemed representation “adequate” where (1) the interests of the party and non-party are aligned, (2) the initial party understood that it was acting in a representative capacity or otherwise took care to protect the interests of the non-party, and, at least in some instances, (3) notice is provided to the non-party.  It also indicated that an analysis of quality of the representation and confirmation of a lack of any conflicts was also appropriate to the adequacy evaluation.

With respect to the first of the federal requirements, the Court stated that its privity analysis confirmed the relevant alignment of interests.  Regarding representative capacity, it concluded that the record demonstrated both groups of plaintiffs were aware of the competing actions and the likelihood of one action being held preclusive as to the other.  As for notice, the Court concluded that federal courts dispensed with this requirement with respect to derivative actions.

Turning to adequacy, the Court addressed the fact that the Arkansas plaintiffs had not made a books and records demand before filing their complaint.  It observed that Arkansas counsel had access to certain relevant corporate documents that were in the public domain via a newspaper article and that counsel had made the determination that these documents were sufficient to make the case.  In other words, while counsel considered the option, it ultimately did not think a Section 220 demand was necessary.  Just because that determination ultimately proved to be wrong, the Court stated, was not sufficient to deem counsel inadequate, though the Court stressed that determination was based on the specific facts at hand.  As for potential conflicts, the Court found no evidence that the initial plaintiffs advanced their interests at the expense of the later plaintiffs.

Accordingly, having found that the two groups of plaintiffs’ interests were aligned and that the initial plaintiffs were adequately represented, the Court held that there was no Due Process violation in according preclusive effect to the initial ruling.

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Corporate Coverage Analysis:  As noted when this case was first reported, any move by Delaware courts to deny preclusive effect to prior rulings in this context could have had a negative effect on D&O insurers by way of a further proliferation in derivative actions and related defense costs.  The Delaware Supreme Court’s emphasis on favorable federal law and rejection of the Chancery Court’s suggestions regarding a new approach is a welcomed outcome for D&O carriers and their insureds.