Derivative Or Direct?

A sometimes confusing area of corporate litigation concerns whether a claim asserted by a stockholder in a lawsuit against a corporation's officers and directors is a “derivative” claim brought on behalf of the corporation, or a “direct” claim brought by the stockholder on his or her own behalf rather than the corporation's. The distinction is important, as the proper characterization of a stockholder claim can have a significant impact on the parties and how the lawsuit proceeds, in some instances determining whether it proceeds at all. In a new opinion, Tooley v. Donaldson, Lufkin & Jenrette, Inc., No. 18414 (Del. S. Ct. April 2, 2004), the Delaware Supreme Court has cleared up some of the confusion, holding that a claim is derivative whenever the corporation has suffered the alleged harm and will be the beneficiary of the relief granted by the court.

Derivative v. Direct Claims

It is axiomatic that a corporation's board of directors has the right and the obligation to manage and direct the corporation's affairs, including litigation against those who have wronged the corporation. At times, however, a board may be unwilling or unable to pursue a lawsuit on the corporation's behalf. This is particularly true where the subject of the putative lawsuit concerns the conduct of the directors themselves. Hence, courts of equity created the stockholder's derivative lawsuit, which allows a stockholder to pursue claims on behalf of the corporation that the board does not pursue. It has been characterized as an “ingenious device” for holding corporate fiduciaries accountable for their activities. R. Clark, Corporate Law 639-40 (1986).

To balance the directors' prerogative to manage the corporation with the realization that stockholder policing of board decisions is sometimes necessary and appropriate, Delaware (like other jurisdictions) has procedural prerequisites to a stockholder's prosecution of a derivative lawsuit. Delaware Court of Chancery Rule 23.1 provides that in order to prosecute a derivative lawsuit, a stockholder must either 1) demand that the board of directors pursue the lawsuit before filing it, or 2) show that such a demand would have been futile. In addition, the stockholder must have owned his or her stock at the time of the conduct or transaction at issue, and remain a stockholder throughout the litigation. If these conditions are not met, the stockholder lacks standing to prosecute the lawsuit, in which case it must be dismissed.

In contrast, stockholder lawsuits involving direct claims implicate the stockholder's individual rights, not the corporation's. In theory, direct actions should be easy to identify. Examples given by the Delaware Supreme Court in Tooley include lawsuits involving a stockholder's preemptive rights with respect to some action, or involving rights to control the corporation. Because direct claims do not involve the corporation's rights or impinge on the directors' rights to manage the corporation, they are not subject to the procedural requirements for derivative lawsuits.

Because derivative lawsuits involve the corporation's claims for harm suffered by the corporation, it can reasonably be said that all stockholders suffer the same injury, ie, the corporation's injury, which affects all stockholders alike. Direct claims usually involve harm to one or a few stockholders that is not necessarily shared by all stockholders. This is not always the case, however, and Tooley shows the error that can result when a court focuses on the distribution of harm among stockholders rather that on the nature of the harm and the recipient of the relief.

The Chancery Court's Decision

The lawsuit in Tooley arose out of Credit Suisse Group's acquisition of Donaldson, Lufkin & Jenrette, Inc. (DLJ) in the Fall of 2000. Credit Suisse and AXA Financial, Inc., which owned 71% of DLJ's stock, entered into an agreement for Credit Suisse to acquire all of DLJ's stock in a two-step process. The first step was a cash tender offer in which Credit Suisse was to acquire all of the DLJ stock held by the public for $90 per share. Credit Suisse would then purchase all of AXA's stock in the second step for a combination of cash and stock worth $90 per share, followed by a merger of DLJ into a Credit Suisse subsidiary.

The tender offer for the public shares was to expire 20 days after its commencement, but allowed the parties to extend the tender offer if certain conditions, (eg, regulatory approvals, payment obligations, etc.) were not met. DLJ and Credit Suisse could also extend the tender offer by agreeing to postpone Credit Suisse's acceptance of the DLJ stock tendered by the public stockholders. Credit Suisse extended the offer twice, the first time because certain conditions had not been met, the second time by an agreement with DLJ that delayed the closing by 22 days.

Two public stockholders, Tooley and Lewis, subsequently filed a class action lawsuit against DLJ's board alleging that the 22-day delay was not authorized and claiming damages equal to the time-value of the money they did not receive during the period of the delay. The Court of Chancery held that the stockholders' lawsuit was a derivative one brought on behalf of the corporation (and not a direct claim of the stockholders) because the delay affected all DLJ stockholders equally and thus all stockholders had incurred the same injury. The court rejected the plaintiffs' argument that they had incurred a “special injury” separate and distinct from any injury suffered by AXA, because AXA, unlike the plaintiffs, did not tender its shares in the first step of the merger. The court reasoned that AXA suffered the same type of injury because the 22-day postponement also delayed the second step of the merger. Accordingly, the Chancery Court dismissed the case because the plaintiff had sold their stock in the first step of the merger and, as former stockholders, lacked standing to prosecute a claim on behalf of the corporation.

The Supreme Court's Decision

The Delaware Supreme Court reversed the lower court's determination that the lawsuit was a derivative one. The principal problem with the Chancery Court's analysis, according to the Supreme Court, was its focus on whether the alleged injury ' the loss of the use-value of the $90-per-share consideration for 22 days ' was a “special injury” incurred only by the plaintiff public stockholders, or was an injury that was shared by all of DLJ's stockholders. The Supreme Court surveyed the prior cases and found some support for the Chancery Court's analysis, but concluded that “special injury” was an “amorphous and confusing concept” that unnecessarily complicated the analysis of whether a claim was derivative or direct. It found equally confusing the notion, occasionally found in the cases, of whether the alleged injury is shared by all stockholders or only a few. The proper analysis, the Supreme Court held, must be based on two questions: “Who suffered the alleged harm ' the corporation or the suing stockholder individually ' and who would receive the benefit of the recovery or other remedy?” The Court reviewed several prior cases using the “special injury” concept into the analysis and found that they could have been more easily resolved by focusing solely on these two factors, without regard to whether the plaintiff suffered a special injury.

Applying the standard to the plaintiffs' complaint, the Supreme Court concluded that their claim was not a derivative one because the complaint alleged no claim involving an injury to the corporate entity. Unstated by the Court, but equally obvious, was that the relief requested ' the time value of the $90 tender-offer price ' would go only to the stockholders and not the corporation. The Supreme Court nonetheless affirmed the dismissal of the case, but without prejudice, because even considered as a direct claim, the complaint failed state any claim at all. According to the court, the public stockholders did not obtain any enforceable rights, including rights relating to the extensions of the closing about which the plaintiffs complained, until the terms of the merger had been fulfilled.

Conclusion

One of the initial factors that counsel should consider in any evaluating any lawsuit filed by stockholders against a Delaware corporation is whether the lawsuit asserts derivative claims on behalf of the corporation and, if so, whether the plaintiff has complied with the rigorous demand requirements of Court of Chancery Rule 23.1. In eliminating some of the confusing language and concepts that past cases have employed, the Delaware Supreme Court's two-pronged inquiry ' who suffered the harm and who will benefit from the relief granted ' should make such determinations easier and, possibly eliminate some of the costly motions practice that can arise from this threshold issue.

A sometimes confusing area of corporate litigation concerns whether a claim asserted by a stockholder in a lawsuit against a corporation's officers and directors is a “derivative” claim brought on behalf of the corporation, or a “direct” claim brought by the stockholder on his or her own behalf rather than the corporation's. The distinction is important, as the proper characterization of a stockholder claim can have a significant impact on the parties and how the lawsuit proceeds, in some instances determining whether it proceeds at all. In a new opinion, Tooley v. Donaldson, Lufkin & Jenrette, Inc., No. 18414 (Del. S. Ct. April 2, 2004), the Delaware Supreme Court has cleared up some of the confusion, holding that a claim is derivative whenever the corporation has suffered the alleged harm and will be the beneficiary of the relief granted by the court.

Derivative v. Direct Claims

It is axiomatic that a corporation's board of directors has the right and the obligation to manage and direct the corporation's affairs, including litigation against those who have wronged the corporation. At times, however, a board may be unwilling or unable to pursue a lawsuit on the corporation's behalf. This is particularly true where the subject of the putative lawsuit concerns the conduct of the directors themselves. Hence, courts of equity created the stockholder's derivative lawsuit, which allows a stockholder to pursue claims on behalf of the corporation that the board does not pursue. It has been characterized as an “ingenious device” for holding corporate fiduciaries accountable for their activities. R. Clark, Corporate Law 639-40 (1986).

To balance the directors' prerogative to manage the corporation with the realization that stockholder policing of board decisions is sometimes necessary and appropriate, Delaware (like other jurisdictions) has procedural prerequisites to a stockholder's prosecution of a derivative lawsuit. Delaware Court of Chancery Rule 23.1 provides that in order to prosecute a derivative lawsuit, a stockholder must either 1) demand that the board of directors pursue the lawsuit before filing it, or 2) show that such a demand would have been futile. In addition, the stockholder must have owned his or her stock at the time of the conduct or transaction at issue, and remain a stockholder throughout the litigation. If these conditions are not met, the stockholder lacks standing to prosecute the lawsuit, in which case it must be dismissed.

In contrast, stockholder lawsuits involving direct claims implicate the stockholder's individual rights, not the corporation's. In theory, direct actions should be easy to identify. Examples given by the Delaware Supreme Court in Tooley include lawsuits involving a stockholder's preemptive rights with respect to some action, or involving rights to control the corporation. Because direct claims do not involve the corporation's rights or impinge on the directors' rights to manage the corporation, they are not subject to the procedural requirements for derivative lawsuits.

Because derivative lawsuits involve the corporation's claims for harm suffered by the corporation, it can reasonably be said that all stockholders suffer the same injury, ie, the corporation's injury, which affects all stockholders alike. Direct claims usually involve harm to one or a few stockholders that is not necessarily shared by all stockholders. This is not always the case, however, and Tooley shows the error that can result when a court focuses on the distribution of harm among stockholders rather that on the nature of the harm and the recipient of the relief.

The Chancery Court's Decision

The lawsuit in Tooley arose out of Credit Suisse Group's acquisition of Donaldson, Lufkin & Jenrette, Inc. (DLJ) in the Fall of 2000. Credit Suisse and AXA Financial, Inc., which owned 71% of DLJ's stock, entered into an agreement for Credit Suisse to acquire all of DLJ's stock in a two-step process. The first step was a cash tender offer in which Credit Suisse was to acquire all of the DLJ stock held by the public for $90 per share. Credit Suisse would then purchase all of AXA's stock in the second step for a combination of cash and stock worth $90 per share, followed by a merger of DLJ into a Credit Suisse subsidiary.

The tender offer for the public shares was to expire 20 days after its commencement, but allowed the parties to extend the tender offer if certain conditions, (eg, regulatory approvals, payment obligations, etc.) were not met. DLJ and Credit Suisse could also extend the tender offer by agreeing to postpone Credit Suisse's acceptance of the DLJ stock tendered by the public stockholders. Credit Suisse extended the offer twice, the first time because certain conditions had not been met, the second time by an agreement with DLJ that delayed the closing by 22 days.

Two public stockholders, Tooley and Lewis, subsequently filed a class action lawsuit against DLJ's board alleging that the 22-day delay was not authorized and claiming damages equal to the time-value of the money they did not receive during the period of the delay. The Court of Chancery held that the stockholders' lawsuit was a derivative one brought on behalf of the corporation (and not a direct claim of the stockholders) because the delay affected all DLJ stockholders equally and thus all stockholders had incurred the same injury. The court rejected the plaintiffs' argument that they had incurred a “special injury” separate and distinct from any injury suffered by AXA, because AXA, unlike the plaintiffs, did not tender its shares in the first step of the merger. The court reasoned that AXA suffered the same type of injury because the 22-day postponement also delayed the second step of the merger. Accordingly, the Chancery Court dismissed the case because the plaintiff had sold their stock in the first step of the merger and, as former stockholders, lacked standing to prosecute a claim on behalf of the corporation.

The Supreme Court's Decision

The Delaware Supreme Court reversed the lower court's determination that the lawsuit was a derivative one. The principal problem with the Chancery Court's analysis, according to the Supreme Court, was its focus on whether the alleged injury ' the loss of the use-value of the $90-per-share consideration for 22 days ' was a “special injury” incurred only by the plaintiff public stockholders, or was an injury that was shared by all of DLJ's stockholders. The Supreme Court surveyed the prior cases and found some support for the Chancery Court's analysis, but concluded that “special injury” was an “amorphous and confusing concept” that unnecessarily complicated the analysis of whether a claim was derivative or direct. It found equally confusing the notion, occasionally found in the cases, of whether the alleged injury is shared by all stockholders or only a few. The proper analysis, the Supreme Court held, must be based on two questions: “Who suffered the alleged harm ' the corporation or the suing stockholder individually ' and who would receive the benefit of the recovery or other remedy?” The Court reviewed several prior cases using the “special injury” concept into the analysis and found that they could have been more easily resolved by focusing solely on these two factors, without regard to whether the plaintiff suffered a special injury.

Applying the standard to the plaintiffs' complaint, the Supreme Court concluded that their claim was not a derivative one because the complaint alleged no claim involving an injury to the corporate entity. Unstated by the Court, but equally obvious, was that the relief requested ' the time value of the $90 tender-offer price ' would go only to the stockholders and not the corporation. The Supreme Court nonetheless affirmed the dismissal of the case, but without prejudice, because even considered as a direct claim, the complaint failed state any claim at all. According to the court, the public stockholders did not obtain any enforceable rights, including rights relating to the extensions of the closing about which the plaintiffs complained, until the terms of the merger had been fulfilled.

Conclusion

One of the initial factors that counsel should consider in any evaluating any lawsuit filed by stockholders against a Delaware corporation is whether the lawsuit asserts derivative claims on behalf of the corporation and, if so, whether the plaintiff has complied with the rigorous demand requirements of Court of Chancery Rule 23.1. In eliminating some of the confusing language and concepts that past cases have employed, the Delaware Supreme Court's two-pronged inquiry ' who suffered the harm and who will benefit from the relief granted ' should make such determinations easier and, possibly eliminate some of the costly motions practice that can arise from this threshold issue.