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Nov022012

South v. Baker and the Race to the Courthouse in Caremark Actions (Part 1)

South v. Baker, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) represents another step in VC Laster's efforts to slow the race to the courthouse at least in cases involving Caremark allegations.  It is in many ways a refinement of the analysis in Pyott

In this case, he created a presumption that counsel filing derivative claims containing Caremark allegations would be subjected to a presumption of inadequate counsel unless the suit was preceded by an effort to obtain documents under Section 220.  The analysis was an attempt not only to slow the race to the courthouse but also to reduce the number of lawsuits filed.  There may be some impact on the latter but not on the former. 

The case arose following statements by Hecla Mining Company that lowered projections for silver production and a statement by the United States Mine Safety and Health Administration ("MSHA") that disclosed safety violations by Hecla.  The statement was quickly followed by two securities cases alleging violations of Rule 10b-5 and seven derivative suits.  Some were filed in Delaware and some in Idaho, both in state and federal court.  Two stockholders who did not file suit sought documents under Section 220.  With respect to the case in Delaware, plaintiffs alleged a Caremark claim. 

Defendants sought dismissal and the court found that the complaint lacked "particularized facts supporting a reasonable inference that a majority of the Board faces a substantial risk of liability".  As a result, plaintiffs had not sufficiently alleged demand futility.  The court then addressed the consequences of the dismissal. 

The Vice Chancellor had a point to make.  In his court, those who did not precede a Caremark claim with the exercise of inspection rights risked punishment, at least where the failure was unexplained . "Wholly missing was any explanation as to why the Souths did not use Section 220 before filing suit, as the Delaware Supreme Court has recommended repeatedly."  As a result, "dismissal of the complaint with prejudice as to the Souths is a fitting consequence that does not seem likely to work any prejudice on the corporation."

A dismissal with prejudice, however, did little to slow the race to the courthouse.  Plaintiffs still had an incentive to file quickly, even if they risked dismissal.  The Vice Chancellor, however, addressed this incentive.  He noted that dismissal with prejudice of someone who filed quickly essentially penalized the shareholders that took steps to invoke their inspection rights. 

As noted, good faith disagreements exist over the extent to which a dismissal with prejudice as to the named plaintiff could have preclusive effect on the efforts of other stockholders to bring suit, including those stockholders who have attempted to use Section 220. After considering the Souths' pleading, it concerned me that if a different stockholder carefully investigated the events at the Lucky Friday mine, uncovered a meritorious claim, and wished to pursue it, the potential combination of a broad preclusion rule together with all-too-predicable results of the Souths' litigation strategy could bar the diligent stockholder from suing.

He ultimately decided that the dismissal with prejudice applied only to the existing plaintiffs, not to other possible plaintiffs.  To reach that result, he concluded that "another stockholder still can sue if the first plaintiff provided inadequate representation."  He then made a "finding of inadequacy" and, as a result, determined that the dismissal of the complaint "should not have preclusive effect on the litigation efforts of more diligent stockholders".  

The finding of inadequacy was grounded on the failure of plaintiffs to first seek to inspect documents under Section 220.  The failure, according to the court, created a presumption that the shareholder had acted in a disloyal fashion. See Id. ("When a stockholder rushes to file a Caremark claim without first conducting an adequate investigation to determine whether or not there is a connection between the corporate trauma and director action or conscious inaction, the stockholder acts contrary to the interests of the corporation but consistent with the interests of the plaintiffs' firm that files the suit. This recurring scenario supports a presumption that the plaintiff has acted disloyally and is not an adequate fiduciary for the corporation.").

The presumption was limited to Caremark claims.  Id.  ("This requirement differentiates a Caremark claim from other types of derivative actions in which a plaintiff challenges a specific and identifiable board decision. In such a case, a plaintiff may well be able to plead particularized allegations without using Section 220 that are sufficient to survive a Rule 23.1 motion to dismiss"). 

The court left open the possibility that the presumption could be rebutted.  The shareholder could either produce "evidence that calls into question the requisite facts giving rise to the presumption" or could rebut the presumption by "producing evidence directly contrary to the presumptive inference."  The former could be accomplished by alleging facts "showing that the plaintiff did not file hastily and conducted a meaningful and thorough investigation."  The latter could be accomplished by adducing facts demonstrating that a quick filing "benefited the corporation and not just the plaintiffs' law firm."  Plaintiffs, however, were unable to rebut the presumption. 

We will discuss the implications of this decision in the next post.

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