By: Megan Doyle

In September, the Delaware Supreme Court answered a question at the request of the Second Circuit regarding gross negligence and shareholder derivative suits.[1] The Second Circuit was concerned with correctly applying principles of Delaware law, and requested the Delaware Supreme Court review the following question: Where a shareholder demands that a board of directors investigate an underlying wrongdoing and corporate officers’ statements about the wrongdoing, what factors should a court consider in determining whether the board acted in a grossly negligent fashion when they focused their investigation solely on the underlying wrongdoing?[2] The Second Circuit hoped to apply the response to Espinoza v. Dimon. In Espinoza, the plaintiffs, stockholders of JPMorgan Chase & Co. (hereinafter JPMorgan), requested that the board of directors for JPMorgan investigate two issues concerning a high profile situation that the Second Circuit refers to as the “London Whale Debacle.”[3]

Plaintiffs contended they had a right to demand the full investigation of possible wrongdoings during the “London Whale Debacle”.[4] The issues the plaintiffs prompted the board to investigate were: 1) the failure of JPMorgan’s risk management policies in preventing trading resulting in corporate losses; and 2) supposed false and misleading statements JPMorgan management made when the problem emerged.[5] Plaintiffs contended that the JPMorgan board’s investigative committee only made findings on the first issue, constituting gross negligence.[6] The Supreme Court of Delaware acknowledged several undisputed facts in this case: the committee was entirely comprised of independent directors, experts of the committee’s choosing advised them and conducted a detailed investigation that involved the review of massive amounts of materials and varied witness interviews, which all culminated in the issuance of a detailed report explaining why it recommended refusal of the demand.[7]

The Delaware Supreme Court held that they could not prescribe a particular formula for this determination, and that they could not provide an abstract analysis where the situation is inherently contextual.[8] The Delaware Supreme Court declined to answer the question as they felt it was too general, particularly given it was an issue that the Court itself was not deciding.[9] The Delaware Supreme Court rather chose to affirm that determining whether plaintiff’s contention, that a committee has been grossly negligent in investigating a demand, requires a “classic line-drawing exercise.”[10] The Delaware Court re-affirmed the traditional standards used to determine whether or not a board erred in their investigation of a shareholder claim.[11]

While this decision declines to provide the Second Circuit with specific guidance on what may constitute gross negligence in the situation in Espinoza, The Delaware Supreme Court does provide information that affects the business community because it ultimately supports a new standard of review. This is the first case in which the Second Circuit adopts de novo review of shareholder derivative suits, which means that the Second Circuit will review shareholder derivative suits without giving deference to a lower court’s findings.[12] The Delaware Supreme Court’s refusal to provide more concrete guidance leaves the Second Circuit without clear guidance on how to determine where gross negligence occurred under de novo review.[13] This lack of guidance could likely lead to an increase in the number of shareholder derivative suits where shareholders feel a board has not taken adequate steps to investigate a matter. This decision also means that banks and corporate boards must be a great deal more stringent when responding to shareholder requests so as to avoid future shareholder derivative suits because shareholders now have far more power to appeal any decisions in a lower court. De novo review opens up the possibility that more shareholder derivative suits will be heard in appeals courts, and therefore puts a higher burden on banks and boards to investigate within the purview of a shareholder’s request. Ultimately, this decision empowers shareholders to request more deference in board investigations because of the ease with which a shareholder can now appeal a decision and have a more favorable standard of review. The Delaware Supreme Court’s reluctance to weigh in on what is required of corporate boards ultimately leaves them far more open to suit, and does not provide a clear standard under which the Second Circuit could conduct de novo review. Thus, the courts may see an increase in shareholder’s derivative suits.

[1] See Espinoza v. Dimon, 2015 U.S. App. 10129, at *1 (2d Cir. Sep 15, 2015).

[2] Id. at *1.

[3] Id. at *n2 (describing that the actions plaintiffs requested be investigated were one of many involved in the “’London Whale’ trading debacle, which cost JPMorgan Chase billions.”).

[4] Id.

[5] Id. at *2.

[6] Id.

[7] Id.

[8] Cf. Id. at *7 (holding that because the briefs of the parties in the Second Circuit spend very little time discussing the issue in question, the Delaware Supreme Court has no viable way of determining the importance of the misstatements in the context of the London Whale debacle)

[9] Id. at *8.

[10] Id. at *9.

[11] . See e.g. Levine v. Smith, 591 A.2d 194, 207 (Del. 1991) (decrying that where a board refuses a demand, the key issues to be examined by a higher court are both the good faith and reasonableness of the investigation); Spiegel v. Buntrock, 571 A.2d 767, 777 (Del. 1990) (same).

[12] Cf. Second Circuit Seeks Advice in JPM Case, Adopts Tougher Standard for Derivative Suits, Bloomberg BNA, (2015) (asserting that the 2nd Circuit’s adaptation of de novo review in this case is a huge win for shareholders and shareholder’s rights).

[13] See Espinoza, 2015 U.S. App. 10129, at n11 (internal citations omitted) (pointing out that in context of decision-making, governed by a gross negligence standard, “the inquiry is necessarily fact-specific).

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