Alto's Bryan Ketroser featured in Law360

Alto Litigation's Bryan Ketroser published the article below, "10 Pitfalls For Shareholder Derivative Litigants" in Law360 on November 16 (subscription required). The article was also distributed through Law360's newsletter on November 19.


10 Pitfalls For Shareholder Derivative Litigants

by: Bryan Ketroser

When most attorneys think of “representative” litigation, they think of class actions, in which one party (or perhaps a few) sues on behalf of a group of similarly situated members. But the law recognizes several other types of representative actions. For instance, qui tam and Private Attorney General Act suits enable individuals to sue on behalf of the federal government or California government, respectively, typically with a statutory right to receive a portion of recovered proceeds.

Just as ordinary citizens can, under certain circumstances, sue on behalf of the government, corporate citizens (i.e., shareholders) sometimes can sue to vindicate the interests of the corporation. And like qui tam and PAGA suits, shareholder derivative suits facilitate the adjudication of claims that may not otherwise be asserted. After all, corporate officers and directors who have harmed the corporation generally are not eager to cause that corporation to sue themselves.

The shareholder derivative suit, however, is an interesting animal. The injection of shareholder derivative claims into a case can affect everything from forum selection and jurisdiction, to pleading burdens, to the right to a jury trial, and even the parties’ ability to settle the action. Indeed, the impact of derivative claims extends beyond the courtroom, often affecting parties’ insurance coverage and even their choice of counsel, due to the increased potential for conflicts of interests.

Because the unique nature of shareholder derivative litigation often trips up even experienced litigators, below are 10 practice pointers for the first- (or second- or third-) time shareholder derivative litigant and their counsel.

1. Beware of Forum Selection Clauses

More and more frequently, corporations are including provisions in their governing documents that dictate where breach of fiduciary duty and/or derivative claims must be brought. Practitioners should note that the selected forum can be different from the state that the corporation and its officers and directors call home (e.g., a Delaware corporation may select the Delaware courts as the sole forum for shareholder litigation, despite a California headquarters).

Just last month, the Delaware Court of Chancery began a lengthy dismissal ruling with these harsh words for the plaintiff: “Ignoring a Delaware forum selection clause in the bylaws of the Delaware company whose interest he purports to represent, the plaintiff in this stockholder derivative action has adopted an ill-fated ‘anywhere but Delaware’ litigation strategy.”[1] The Court of Chancery then recounted how courts in Washington and California previously had “pointed to the forum selection bylaw and determined that Plaintiff’s case belonged in Delaware,” before dismissing the action with prejudice and without sympathy: “He gambled and lost, not once but twice. And he forced Defendants to defend in the wrong for a every step of the way.”[2] Don’t make the same mistake.

2. Diversity Jurisdiction: Is a “Nominal Defendant” a Defendant or a Plaintiff?

As most litigators know, federal diversity jurisdiction in cases involving U.S. litigants generally requires complete diversity across the “v”; that is, there can be no overlap in residency between plaintiffs and defendants. But “because a derivative lawsuit brought by a shareholder is ‘not his own, but the corporation’s,’ the corporation ‘is the real party in interest’ and usually properly aligned as a plaintiff.”[3] “Usually,” but not always, counsel will need to consider (and research) the degree to which the corporation’s management is “antagonistic” to the interests of the plaintiff on the facts at bar.[4] Depending on where the corporation and other litigants reside, the issue can make or break the existence of diversity jurisdiction.

3. Has the Corporation “Exculpated” Its Directors for Breaches of Fiduciary Duty?

Corporations often include “exculpatory provisions” in their bylaws, which are provisions that state directors shall not be liable to the corporation for breaches of fiduciary duty except for bad faith conduct or breaches of the duty of “loyalty.”[5] As Judge Charles Breyer of the Northern District of California recently pointed out, such a clause may immunize directors even where their misconduct rises to the level of “gross negligence.”[6] Always check to determine whether the derivative claim you are considering (or defending) has been disclaimed by the corporation itself.

4. Carefully Review Any Insurance Policies

The inclusion of derivative claims in an action can affect the ability of insurance coverage to the corporation and its agents. For instance, some companies have both a director and officer policy and an employment practices liability insurance policy; a breach of fiduciary duty claim might be covered under the former, whereas a wrongful termination claim might be covered under the latter, even if both are brought by the same individual. Moreover, many policies have exceptions, exclusions, exceptions to exclusions, and so on, when significant shareholders and/or former officers or directors are the ones initiating litigation involving the corporation. Depending on the policy or policies at issue, assertion of derivative claims could change the coverage picture.

5. Demand Futility: A Formidable Pleading Burden

Plaintiffs suing on their own behalf usually don’t have to worry about standing requirements. Those asserting derivative claims, however, must demonstrate to the court, through particularized facts in the complaint, that they have either made a litigation demand on the corporation’s board of directors (which board wrongfully refused the demand), or that such a demand would have been “futile.” At the risk of dramatically oversimplifying decades of case law, this usually requires a showing that half or more of the directors on the corporation’s board at the time the complaint is filed (1) lack “disinterestedness” — either because they benefited from the challenged transaction(s) in a way that other shareholders did not or because they otherwise face a substantial likelihood of liability — or (2) lack “independence” from such an interested party.

A pair of Ninth Circuit decisions affirming dismissals of derivative claims for failure to plead demand futility this past summer serve as a reminder of the pleading rule’s potency.[7] Thus, plaintiffs must line up their futility (or wrongful refusal) facts/arguments before the case begins in order to draft a proper complaint, and defendants should always give thoughtful consideration to a demurrer/motion to dismiss on standing grounds.

6. Shareholder Derivative Plaintiffs May Be Required to Post a Bond

Cal. Corp. Code § 800(c) permits courts to require shareholder derivative plaintiffs to furnish a bond of up to $50,000 to cover the corporation and individual defendants’ reasonable expenses, including attorneys’ fees, in the event that the derivative litigation proves unsuccessful. A bond may be required where the court determines “[t]hat there is no reasonable possibility that the prosecution of the cause of action ... will benefit the corporation or its shareholders.” Defendants who believe they have a strong demurrer (whether on standing grounds or otherwise) should consider simultaneously moving for imposition of a bond.

7. Don’t Get DQ’d

While defendants often wish to present a united front (and minimize legal fees), “[c]urrent case law clearly forbids dual representation of a corporation and directors in a shareholder derivative suit, at least where ... the directors are alleged to have committed fraud.”[8] Time and again, I have seen otherwise-experienced litigators represent both nominal and individual defendants at the outset of litigation, only to get caught flat-footed and have to withdraw from the joint representation when the conflict (and case law) is pointed out to them. On that note, while it is not necessarily inconsistent for a plaintiff to assert both derivative and direct (nonderivative) claims in the same suit, it is possible for the overlap to be such that a plaintiff suing a corporation on a particular subject has thus shown themselves to be an inadequate corporate representative.[9]

8. Prepare for a Bench Trial

“‘California entertains no right to jury trial in stockholders’ derivative actions.’”[10] This means that a plaintiff asserting both derivative and direct claims could find themselves with a bench trial on the former and a jury trial on the latter. If you find yourself in such a position, consider whether it makes sense to ask the court to permit a jury trial on all issues and to treat the jury verdict on the derivative claims as “advisory.”[11]

9. Settlement Requires Court Approval, Which Can Take Months

Although the class action settlement procedures set forth in California Rule of Court 3.769 do not expressly include derivative actions, case law makes it clear that they do in fact apply. Thus, the court must “make a preliminary” — and later final — "determination on the fairness, reasonableness, and adequacy of the settlement terms.”[12] Because this generally requires two separate, noticed motions, together with an intervening period of shareholder notice, litigants should be prepared to wait at least six to eight weeks before an agreed-upon settlement can be implemented. Rule 23.1(c) of the Federal Rules of Civil Procedure provides (more explicitly) for court approval of derivative actions pending in federal court.

10. The Plaintiff’s Counsel Can Ask for Its Fees (Just Don’t Ask Too Early)

Because shareholder derivative claims are, by definition, asserted for the benefit of the corporation rather than the nominal plaintiff, the plaintiff and his or her attorney sometimes are entitled to recover reasonable attorneys’ fees from the corporation under either the “common fund doctrine” (if the derivative claims result in a monetary recovery) or the “substantial benefit doctrine” (if they do not, but they nonetheless result in a substantial benefit to the entity). The award of fees under either doctrine is left to the court’s discretion. Should the parties wish to provide for fee shifting in a settlement agreement, they should be cautious about discussing payment of the plaintiff’s fees before the substantive terms of the deal are hammered out, lest the court deny the deal as collusive and not in the best interests of the entity and all of its shareholders.[13]

Bryan Ketroser is a partner at Alto Litigation PC.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Tilden v. Cunningham , No. C.A. 2017-0837-JRS, 2018 WL 5307706, at *1 (Del. Ch. Oct. 26, 2018).
[2] Id. at *1, *15.
[3] In re Digimarc Corp. Derivative Litig ., 549 F.3d 1223, 1235 (9th Cir. 2008) (citation omitted).
[4] Id.
[5] See, e.g., 8 Del. C. § 102(b)(7); Cal. Corp. Code § 204(a)(10).
[6] Oswald v. Identiv Inc. , No. 16-cv-00241-CRB, 2018 WL 1783838, at *5 (N.D. Cal. Apr. 13, 2018)
[7] See Tindall v. First Solar Inc. , 892 F.3d 1043 (9th Cir. 2018); Forestal v. Caldwell , 739 Fed.Appx. 895 (9th Cir. June 29, 2018).
[8] Forrest v. Baeza , 58 Cal. App. 4th 65, 74 (1997).
[9] See, e.g., Bass v. First Pac. Networks , No. C 92-20763 JW, 1993 WL 484715, at *1 (N.D. Cal. Sept. 29, 1993) (dismissing derivative action on behalf of FPN where “Plaintiff’s personal suit against FPN amounts to an outside entanglement fatal to his adequate representation of FPN shareholders”).
[10] Caira v. Offner , 126 Cal. App. 4th 12, 39 (2005) (citation omitted).
[11] Id. at 22 & n.4.
[12] Manual for Complex Litigation § 21.632 (4th ed 2004); see also Robbins v. Alibrandi , 127 Cal. App. 4th 438, 449 (2005).
[13] See, e.g., Robbins, 127 Cal. App. 4th at 450.