Caleb Jones

In Arkansas Teacher Retirement System v. Countrywide Financial Corporation[1](Arkansas Teacher), a derivative claim arising out of the 2008 financial meltdown, the Delaware Supreme Court penned a case study on the procedural pitfalls that derivative suits face before their merits may be argued in court.  This action is the federal companion case to Arkansas Teacher Retirement System v. Caiafa [2] (Caiafa), which was filed in the Delaware Court of Chancery, and appealed to the Delaware Supreme Court.  Arkansas Teacher is the final resolution for both derivative claims and direct claims of fraud and breach of fiduciary duty brought by five institutional investors against Countrywide Financial in October 2007.

Clarifying its Caiafa decision, the Delaware Supreme Court in Arkansas Teacher reaffirms a longstanding rule on derivative standing from Lewis v. Anderson:[3]  A shareholder’s standing to sue for fraudulent breach of fiduciary duty in a derivative suit ends when the ownership in the company is extinguished by a merger, unless the merger itself is a fraud to deprive the plaintiff of derivative standing.

Before broaching the subject, one must have a basic understanding of shareholder lawsuits.  Derivative lawsuits are lawsuits on behalf of a corporation by one or more stockholders against a third party, usually the directors, the CEO, or other executives of that corporation.  Direct lawsuits are lawsuits by the stockholders on behalf of themselves against another party, and not on behalf of the company.  These are typically filed for tortious wrongdoing or mismanagement of company assets and resources.

When shareholders seek damages in a derivative suit for fraud against the directors of a company, it upsets the normal statutory power under Delaware law for the directors of a corporation to manage the affairs of that company.[4]  The Supreme Court has observed that “stockholders in a derivative action could, if unconstrained, undermine the basic principle of corporate governance.”[5]  To guard against this danger, Delaware requires certain prerequisites before shareholders gain standing in a derivative lawsuit.

One of these guards is the “continuous ownership” rule: Plaintiffs in a derivative suit must not only be stockholders at the time of the alleged wrong and at the commencement of the suit, but also throughout the entire litigation.  A “fraud exception” to this rule is recognized: Stockholders who lose their standing to maintain a suit for fraud due to loss of stock ownership in a merger may still continue the action if the merger itself was a fraud to deprive the plaintiffs of derivative standing.[6]

The Arkansas Teacher suit against Countrywide began in October 2007, but Countrywide was acquired by Bank of America in a stockholder-approved stock-for-stock merger on July 1, 2008 in the midst of the financial crisis.[7]  This turned stockholders of Countrywide, including the plaintiffs, into stockholders of Bank of America.  Now, the continuous ownership rule was broken as the plaintiffs were no longer owed a fiduciary duty from the officers and directors they were suing.  The court granted Countrywide’s motion for summary judgment on all derivative claims on December 11, 2008.

Meanwhile in the Caiafa companion suit, direct claims relating to the merger between Countrywide and Bank of America were settled in the Delaware Court of Chancery.[8]  This prompted the district court in Arkansas Teacher to refer all objections to this settlement to the Court of Chancery, but the plaintiffs’ objections were overruled on March 31, 2009.  As a result, both the direct claims and the derivative claims in federal court were extinguished.

However, with the entry of judgment in Caiafa, plaintiffs in Arkansas Teacher seized on language in the decision and filed a motion to reconsider in the district court.  The plaintiffs claimed that Caiafa created a change in Delaware law that “expanded the post-merger standing fraud exception to include situations where, as here, the plaintiffs sufficiently allege fraudulent conduct that necessitated that merger.”[9]  The plaintiffs acknowledged that they did not fit into Lewis v. Anderson’s traditional fraud exception to the continuous ownership rule.[10]  Instead, the plaintiffs argued that Countrywide directors covered massive wrongdoing in a “single, inseparable fraud” which necessitated the merger, and therefore, they fit into a new category of fraud exception defined by the Delaware Supreme Court.[11]

While previous Delaware law required that for a fraud exception to exist, the merger must have been a fraud to deprive plaintiffs of standing, now the plaintiffs essentially claim that a new category was created allowing a fraud that necessitates a merger to be considered a part of the fraud exception. The district court rejected this argument, and on appeal, the Ninth Circuit, acknowledging this is a question of Delaware law, certified the question on the fraud exception to the continuous ownership rule for consideration by the Delaware Supreme Court.

In Arkansas Teacher, the Delaware high court explicitly rejected the plaintiff’s interpretation of the case and declared the traditional fraud standard of Lewis v. Anderson was reiterated in Caiafa, not changed.  The court determined that the Countrywide/Bank of America merger was not a fraud to deprive the plaintiffs of standing but rather an economic necessity, and therefore decided that no alleged preexisting fraud leading to a merger can create an exception to the continuous ownership rule of standing.

The Delaware Supreme Court in Arkansas Teacher reiterated its firm rule for standing in derivative suits, and kept the fraud exception to that rule limited.  If future shareholders seek to hold executives responsible for massive mismanagement, derivative suits sit on shaky ground.  Once extensive mismanagement leads to such company weakness that a merger or painful buyout is a reasonable option, derivative standing is gone forever once that transaction completes.  Pleading a causal relationship will do no good.

But a derivative suit is not the only option for restitution or preventative suits. As the Arkansas Teacher decision acknowledged, direct suits by shareholders for fraud were heard and settled.  While some stockholders may not have been satisfied with the settlement deal, the settlement itself shows the validity of direct suits in this situation.  Likewise, criminal action is another option that, while it requires a difficult high burden of proof, is always available.[12]

The current controversy shows, for good or for ill depending on the viewpoint, that derivative standing is a difficult route for restitution in massive economy-shaking debacles.  The rules for standing are set and do not bend or change even in these extreme circumstances.  As the preexisting case law on derivative standing was firmly upheld in this decision, there are few legal bombshells on which to report.  Instead, the overarching lesson from Arkansas Teacher might not be one of continuous ownership, fraud exceptions, or anything about litigation at all.  The real lesson is more than just a legal lesson, older than any Lewis v. Anderson precedent, and hardly confined to the jurisdiction of Delaware law.  Namely, “If you come at the king, you best not miss.”[13]