In a big decision last week that has immediate implications for companies facing derivative claims in the 9th Circuit and may eventually head to the US Supreme Court, the 9th Circuit Court of Appeals issued a decision in Lee v. Fisher that could have the practical impact of abolishing federal derivative suits. The court, re-hearing the case en banc after a 3-judge panel decision last year in favor of the company, once again upheld a forum selection bylaw at Gap that designated the Delaware Court of Chancery as “the sole and exclusive forum for . . . any derivative action or proceeding brought on behalf of the Corporation.”
The plaintiff in this case had brought a derivative suit in federal court in California, alleging that the company and its directors violated Section 14(a) of the Exchange Act and Rule 14a-9 by making false or misleading statements to shareholders about the company’s commitments to diversity. The decision affirmed the district court’s dismissal of the case on the basis of the exclusive forum bylaw. Since Delaware courts don’t have jurisdiction to hear federal claims, this case could essentially eliminate this type of shareholder suit, at least in the 9th Circuit.
As a policy matter, my problem with the decision is that, contra the Ninth Circuit, in fact, direct claims do not function as a complete substitute for derivative claims. Suppose an acquiring company needs a shareholder vote to complete a merger, and the proxy statement is misleading. Suppose the merger is a bad deal for the company. Under Delaware law, that’s an injury to the company, not the shareholder – and, in fact, in the very Delaware cases cited by the Ninth Circuit for the proposition that these should be brought as direct claims, Delaware also held that it could not identify any injury that would justify an award of damages directly to the stockholders, because the only harms were derivative.
…All of which to say: There is no remedy under Delaware law for negligent proxy statements whether the claim is brought directly or derivatively (with an asterisk), and if federal law is following Delaware, there’s no remedy for shareholders suing directly under federal law for transactions that harm the company, at least not unless shareholders manage to act quickly enough to halt the transaction entirely. That’s the hole that derivative Section 14(a) claims can fill.
The Court of Appeals took a different view – one that tracks with the arguments from U Oregon Law Prof Mohsen Manesh and Stanford Law’s Joe Grundfest set forth in this amici brief and reiterated post-decision in this blog on UCLA Law Prof Steve Bainbridge’s site. (Yes, we have a “who’s who” of corporate governance scholars who all make compelling arguments about what the proper outcome should be here.) Here’s the view that Mohsen Manesh shared:
As Grundfest and I have explained, in recent years, as Delaware courts have cracked down on meritless shareholder litigation, the plaintiff’s bar has sought refuge in federal courts by bringing derivative Borak claims. These federal derivative suits allege corporate harm arising from the board’s mismanagement of matters ranging from executive compensation, to oversight of regulatory compliance, to corporate policies concerning diversity, equity and inclusion.
Stated differently, these derivative suits concern internal corporate affairs—matters that are traditionally governed by state corporate law and, therefore, more sensibly litigated in the Delaware Chancery. But rather than bringing a state law claim for breach of fiduciary duty in Delaware courts, these federal derivative suits make the more tortured argument that the alleged corporate harm was a result of the shareholders being misled by the company’s proxy statement. In doing so, derivative Borak lawsuits transparently aim to establish federal court jurisdiction and, thereby, avoid the likely fate that such suits would face before a skeptical Delaware judge.
The suit in Lee exemplified this trend. In Lee, the plaintiff-shareholder brought a derivative Borak claim in federal court against the directors and officers of The Gap, alleging failures in the management’s efforts to promote racial diversity within the company’s leadership ranks. As a derivative suit, the Lee plaintiff alleged that The Gap’s proxy statements had included materially false or misleading statements about the company’s efforts to pursue diversity, which in turn harmed The Gap by enabling the re-election of the company’s incumbent directors and approval of the officers’ compensation packages.
This side of the argument emphasizes that the decision doesn’t affect direct claims under Section 14(a) and advocates that those are still a distinct and valuable way that shareholders can pursue recovery.
There is one thing that everyone agrees on, though: the Ninth Circuit’s holding squarely conflicts with the 2022 Seventh Circuit ruling in Seafarers v. Bradway. John blogged about that case last year when it was issued. This is a significant circuit split that SCOTUS eventually may be interested in resolving, if & when it gets asked to do so. Ann Lipton lays out a parade of horribles that could follow if SCOTUS takes up this topic and affirms the 9th Circuit’s view, culminating in:
…leaving aside what the effect might be on private contracts, the whole mess is dumped back into Delaware’s lap. Delaware will have to decide how far companies can go in charters and bylaws to waive private securities fraud claims. Delaware will have to decide when enforcing such waivers is a violation of directors’ fiduciary duties, and when directors are conflicted in enforcing such waivers, and whether enforcement of a waiver is a conflict transaction that needs to be reviewed under entire fairness.
It will add a whole separate layer of state litigation on top of the federal, where Delaware will decide the contours of the federal right. And it will be doing so in the shadow of jurisdictions like Nevada, which may very well adopt permissive rules.
We might even start with whether Delaware does, in fact, agree that directors may, consistent with their fiduciary duties, completely bar derivative Section 14(a) claims, especially if a situation comes up where, whether due to 102(b)(7) or Delaware’s vision of the direct/derivative distinction, Delaware would not provide any remedy but federal law would provide a derivative one. And of course, arbitration provisions may make a comeback – even apart from the FAA, Delaware then gets to decide whether and to what extent invoking arbitration for securities claims is consistent with Delaware-imposed fiduciary duties. This is the race to the bottom on the Autobahn.
– Liz Dunshee