By Jay McMillan
In California State Teachers’ Retirement System v. Alvarez, 2018 Del. LEXIS 41 (Del. Jan. 25, 2018), the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of a derivative suit against the board of directors of Wal-Mart Stores, Inc., finding that the claims were precluded because a similar suit in an Arkansas federal court had been dismissed for the stockholder plaintiffs’ failure to make a demand for action on the board, or to plead that such a demand would be futile. The Court found that the Arkansas plaintiffs’ representation of the corporation’s stockholders was not “grossly deficient” despite their failure to make a demand for inspection of corporate books and records under Section 220 of the Delaware General Corporation Law. The Court also rejected Chancellor Andre G. Bouchard’s recommendation that it adopt a more plaintiff-friendly standard.
The Delaware and Arkansas suits both asserted claims for breach of fiduciary duty against Wal-Mart’s directors for failure to adequately oversee the company’s Mexican unit, Wal-Mart de Mexico (WalMex), whose executives allegedly engaged in a bribery scheme and cover-up. Following an April 2012 report in the New York Times, eight derivative complaints were filed in the United States District Court for the Western District of Arkansas, and seven more were filed in the Delaware Court of Chancery. The Arkansas court initially stayed its proceedings pending the Delaware action. At the urging of then-Chancellor Leo Strine, the Delaware plaintiffs sought Wal-Mart’s books and records under Section 220. However, the “unusually contentious” Section 220 action dragged on for three years.
Meanwhile, in 2013, the Arkansas court’s stay was lifted and, on March 31, 2015, the Arkansas court granted the director defendants’ motion to dismiss with prejudice for the plaintiffs’ failure to make demand or plead demand futility as required by Rule 23.1 of the Federal Rules of Civil Procedure. One month later, on May 1, 2015, the Delaware plaintiffs amended their complaint based on what they had learned from Wal-Mart’s books and records. The director defendants moved to dismiss the amended complaint based on res judicata, or issue preclusion, arguing that the Delaware plaintiffs were precluded by the Arkansas dismissal from pleading that demand was excused as futile.
Chancellor Bouchard granted the motion to dismiss based on res judicata. The stockholder plaintiffs appealed to the Delaware Supreme Court, arguing, among other things, that they were denied their federal right of due process. The Delaware Supreme Court affirmed the dismissal, finding that the issues were the same in both actions and that the plaintiffs in the two actions were “in privity,” or had identical interests, because, under applicable Arkansas law and federal law, the real party in interest in both cases was the corporation.
Chancellor Bouchard’s recommendation that the Delaware Supreme Court should establish a more plaintiff-friendly standard was rejected. In a supplemental opinion issued on remand, Chancellor Bouchard suggested that res judicata should not apply where an action in another jurisdiction was dismissed for failure to make demand. The Chancellor recommended that the Delaware Supreme Court adopt a rule proposed by Vice Chancellor J. Travis Laster in In re EZCORP Inc. Consulting Agreement Derivative Litigation, 130 A.3d 934 (Del. Ch. 2016), which would allow other representative plaintiffs to assert derivative claims after an action was dismissed under Rule 23.1. The Chancellor suggested that such a rule would “better safeguard the due process rights of stockholder plaintiffs and should go a long way to addressing fast-filer problems currently inherent in multi-forum derivative litigation.”
The Delaware Supreme Court disagreed, finding that all three federal circuit courts of appeal that addressed the issue held that stockholder plaintiffs’ due process rights were protected “when their interests were aligned with and were adequately represented by the prior plaintiffs,” and that “most other cases” granted preclusive effect to prior Rule 23.1 dismissals.
The Delaware Supreme Court found that the Arkansas plaintiffs and the Delaware plaintiffs had an identity of interests, that they were both aware that a judgment in one case could have a preclusive effect on the other case, and that the Arkansas stockholder plaintiffs adequately represented the Delaware stockholder plaintiffs. As to adequacy of representation, the Delaware Supreme Court found that “(i) the quality of their representation was not grossly deficient, and (ii) their economic interests were not antagonistic to other stockholders.” The Court found that the Arkansas plaintiffs decided not to make a Section 220 demand – as urged by then-Chancellor Strine – because they thought that documents in the public domain cited in the New York Times article were sufficient to plead demand futility. Although that turned out to be a “tactical error,” the decision not to make a Section 220 demand “in this instance does not rise to the level of constitutional inadequacy.” (Emphasis in original).
The Delaware Supreme Court thus left open the possibility that failure to make a Section 220 demand could in another instance make a plaintiff an inadequate representative, which would allow a subsequent plaintiff to proceed without preclusion. The Court agreed, however, with the Court of Chancery’s conclusion that “it does not follow that plaintiffs are necessarily inadequate representatives because their counsel chose not to follow a recommended strategy in a different action, even one suggested by a preeminent corporate jurist, particularly when they are litigating in a different jurisdiction before a different judiciary.” The Arkansas plaintiffs were not inadequate representatives merely because they failed to make a Section 220 demand or because they subsequently failed to adequately plead demand futility.
James G. (Jay) McMillan is a partner in the Wilmington, Delaware office of Halloran Farkas + Kittila LLP. He concentrates his practice in complex corporate and commercial matters, with a particular focus on litigation in the Delaware Court of Chancery. For more information on the firm, visit hfk.law.