On February 13, U.S. District Judge Robert Sweet of the Southern District of New York issued a potentially groundbreaking opinion dismissing a number of shareholder derivative suits against officers and directors of Facebook Inc. in In re Facebook IPO Securities and Derivative Litigation, MDL No. 12-2389, 2013 U.S. Dist. LEXIS 19631 (S.D.N.Y. Feb. 12, 2013). Not only is the decision a significant victory for the Facebook defendants, but it also lays out a blueprint for defendants in other derivative litigation as to how they might obtain an early dismissal on standing and ripeness grounds. In addition, the case provides helpful guidance for companies wishing to include a binding, exclusive forum selection clause in their articles of incorporation.

Background

The Facebook shareholder derivative litigation stems from alleged problems with the company's May 18, 2012, initial public offering (IPO), in which Facebook offered 421 million shares of its common stock for $38 per share. According to Sweet's opinion, Facebook's registration statement and prospectus, filed with the U.S. Securities and Exchange Commission (SEC) prior to the IPO, cautioned prospective investors that the company might experience slowed revenue growth as Facebook users increasingly access the website through mobile devices rather than personal computers, that the company had only recently begun to advertise on its mobile products, and that it had no proven ability to monetize them. The opinion explains that, on May 19, the day after the IPO, Reuters reported that, during a roadshow the week before the IPO, Facebook "'altered its guidance for research earnings'"; that, on May 22, Reuters revealed that Facebook's lead IPO underwriters "had cut their earnings forecasts for the company prior to the IPO, but that it was 'unclear whether Morgan Stanley only told its top clients about the revised view or spread the word more broadly'"; and that Facebook's stock price closed on May 22 at $31 per share, more than 18 percent below the IPO price. Also on May 22, as the court noted, Facebook amended its certificate of incorporation by, inter alia, adding a "choice of forum" provision specifying that the Delaware Chancery Court shall be the "sole and exclusive" forum for any derivative suits or suits alleging a breach of fiduciary duty.

Shortly thereafter, according to the court, three separate derivative suits were filed against the Facebook defendants in California state courts and one in federal court in the Southern District of New York, alleging, inter alia, that, during Facebook's pre-IPO roadshow, the company's executives disclosed to the lead underwriters that certain negative trends were causing its revenues for the second quarter of 2012 to fall short of earlier estimates; that the lead underwriters reduced their own forecasts for Facebook's earnings; and that they conveyed this information only to a select group of potential investors. Further, the court explains, the derivative plaintiffs alleged that the Facebook defendants "failed to disclose that the company was, at the time of the IPO, experiencing a reduction in revenue growth due to an increase of users of its Facebook application and website through mobile devices rather than a traditional personal computer"; that, despite this alleged knowledge, the Facebook defendants "took no action to stop the IPO from taking place"; and that the pre-IPO documents Facebook filed with the SEC contained improper and incomplete statements in violation of federal and state securities laws.

As described in the court's opinion, on June 28, 2012, the Facebook defendants removed the California state actions to federal court in the Northern District of California and, on the next day, sought to transfer the actions to the Southern District of New York by the U.S. Judicial Panel on Multidistrict Litigation. The opinion further notes that the MDL panel granted the Facebook defendants' motion to transfer on October 4, 2012, and all of the derivative actions were consolidated before Sweet. Subsequently, the California derivative plaintiffs filed motions to remand the actions to California state court, and the Facebook defendants moved to dismiss "on the independent threshold grounds of venue, standing and ripeness," according to the court.

Resolving Threshold Issues Before Jurisdiction

Sweet's opinion first addresses whether the court has the power to dismiss based on certain threshold issues prior to addressing subject-matter jurisdiction. The court acknowledged that "a federal court generally may not rule on the merits of a case without first determining that it has jurisdiction over the category of claim in suit (subject-matter jurisdiction) and the parties (personal jurisdiction)," and that "this is equally true in the context of removal." The court went on to explain, however, that the Supreme Court has recognized that "a federal court has leeway to choose among threshold grounds for denying audience to a case on the merits," and that the U.S. Court of Appeals for the Second Circuit has held that justiciability, which includes questions of ripeness and standing, "'is also a threshold question, which a court may consider before subject-matter jurisdiction.'"

Turning to the facts of the case, the court noted that "procedural convenience, efficiency and judicial economy warrant consideration of the threshold dismissal issues first." Indeed, the court pointed out that a remand might result in inconsistent rulings between the three derivative actions in California state courts and the fourth derivative action that would remain with it. Taking these considerations together, the court held that the derivative cases required "issues concerning venue and justiciability ... be considered first."

The Forum Selection Clause

Addressing issues of justiciability, the court first held that Facebook's forum selection clause was unenforceable as to the derivative plaintiffs. The court explained that, under Delaware law, a certificate of incorporation or any amendment thereto does not become effective until it is filed with the Delaware secretary of state. According to the court, Facebook waited until four days after the IPO to file its amended certificate of incorporation with the Delaware secretary of state. Thus, the court explained, the company's original certificate of incorporation was in force when the derivative plaintiffs purchased Facebook shares on the day of the IPO. But, the court pointed out, the original certificate did not contain the forum selection clause; only the amended certificate did. Therefore, the court held that the derivative plaintiffs were not bound by the forum selection clause, and their complaints could not be dismissed on that ground.

Standing

The court next held that the derivative plaintiffs did not have standing because they did not own Facebook stock during the time of the alleged misconduct. The derivative plaintiffs purchased their Facebook shares during the IPO, but they alleged only pre-IPO misconduct, such as alleged misstatements in Facebook's registration statement and prospectus.

The court then pointed out that, even if the derivative plaintiffs could establish standing through contemporaneous ownership of Facebook stock, they still failed to meet the demand requirement of Federal Rule of Civil Procedure 23.1. As the court explained, the derivative plaintiffs "made no demand to the board, failed to rebut the presumption that the majority of the board was [disinterested] and have not pled sufficient facts demonstrating the board's conscious inaction [when faced with some egregious wrong]." Accordingly, the court dismissed the derivative complaints for lack of standing.

Ripeness

Finally, in a brief and straightforward analysis, the court went on to hold that the derivative plaintiffs' claims were not yet ripe since the damages they sought were contingent upon the outcome of separate, pending securities fraud actions against Facebook. Specifically, the court explained, the derivative plaintiffs sought to recover alleged costs incurred by Facebook in defending the separate securities actions, as well as costs from paying any "potential settlement or adverse judgment." As the court pointed out, however, the securities cases were still pending and had not yet been adjudicated or resolved. Thus, the derivative plaintiffs sought damages for what might not turn out to be a corporate wrong. Accordingly, the court held that the claims were not yet ripe and should be dismissed on this alternative ground.

Practice Pointers

The Facebook opinion presents at least two key practice pointers:

First, a Delaware company that wants to have a binding, exclusive forum selection clause in its certificate of incorporation after its IPO is launched must add the provision to the certificate and file the amended certificate with the state of Delaware before the IPO if the provision is to be held enforceable against investors who buy stock through the IPO.

Second, defendants in derivative actions should consider asking for dispositive relief early on lack of standing and/or ripeness grounds. In situations where they have removed the case to federal court, they should be prepared to file a motion to dismiss before the plaintiffs have a chance to file a motion to remand the case to state court.

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