United States: Delaware Chancery Court Rules That A Plaintiff Who Hastily Files A Caremark Claim Is Presumptively Disloyal And Inadequate To Represent The Corporation In A Derivative Case

In a ruling dismissing a shareholder derivative suit, Vice Chancellor J. Travis Laster took another step in forcing shareholders that seek to bring derivative claims to use all available tools to research and develop their claims before commencing suit. This ruling is the latest in a series of decisions by the Delaware Chancery Court requiring would-be derivative plaintiffs, before resorting to litigation, to act in a manner consistent with the corporation's interest rather than the interest of their attorneys. Vice Chancellor Laster applied a new rebuttable presumption of disloyalty when plaintiffs hastily file a shareholder derivative suit asserting Caremark claims without first making a books and records demand pursuant to 8 Del. C. § 220. The opinion again levels scathing criticism of the "race to the courthouse" / "first-to-file" mentality in the plaintiff 's bar in derivative cases.

Background

Hecla Mining Company ("Hecla") is a Delaware corporation that owns and operates two mines in Alaska and Idaho. Hecla mines "precious and base metals such as silver, gold, lead, and zinc." Hecla's Board of Directors is comprised entirely of independent outside directors, other than its CEO. The Court characterized those outside directors as having a vast wealth of knowledge and experience in the mining industry.

In 2011, Hecla's Idaho mine had three separate accidents, which ultimately led to the deaths of two employees. Each of these incidents precipitated investigations from the United States Mine Safety and Health Administration ("MSHA"). Following these investigations, MSHA issued reports or statements with its findings. None of the reports or statements cited director involvement in or responsibility for the incidents. While the final incident was being investigated in December 2011, Hecla projected that its silver production would reach 9.5 million ounces in 2012. In January 2012, MSHA ordered Hecla to close the primary access point to its Idaho mine for reasons unrelated to the incidents. As a result, Hecla reduced its projection to 7 million ounces. Shortly thereafter on January 25, 2012, MSHA issued a press release regarding the final incident, stating that it had issued 59 citations and 15 orders related to Hecla's "repeated failure" to adhere to industry guidelines and best practices.

Within a week of MSHA's press release, the first of two securities class action suits was filed in the United States District Court for the District of Idaho. Within four months, seven shareholder derivative suits were filed in Idaho state and federal courts and the Delaware Chancery Court, all asserting claims under In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996). None of those putative derivative plaintiffs served a books and records demand on Hecla pursuant to 8 Del. C. § 220 to review the basis for their claims before filing suit. Hecla moved to dismiss the Delaware complaint filed on behalf of Steven and Linda South pursuant to Court of Chancery Rule 23.1 for failure to plead demand futility.¹ Vice Chancellor Laster then requested that the parties provide supplemental briefing regarding the adequacy of the Souths' representation of the corporation and its shareholders in the derivative suit.

Chancery Court Ruling

Vice Chancellor Laster dismissed the suit with prejudice for failure to make a demand on the Hecla board of directors. As with his prior rulings dismissing derivative claims prior to the appointment of a derivative plaintiff, Vice Chancellor Laster ruled that the dismissal would have no preclusive effect on subsequent "bona fide" claims. For the first time, Vice Chancellor Laster held that the Chancery Court would apply a rebuttable presumption of disloyalty by a putative derivative plaintiff that hastily files Caremark claims without conducting a books and records review. See South v. Baker, C.A. No. 7294-VCL, 2012 WL 4372538 at **14-15 (Del. Ch. Sept. 25, 2012).

First, Vice Chancellor Laster addressed the sufficiency of the Caremark claims under Rule 23.1. Caremark and its progeny hold that directors may be held liable for "knowingly causing or consciously permitting the corporation to violate positive law, or for failing utterly to attempt to establish a reporting system or other oversight mechanism to monitor the corporation's legal compliance." Id. at *1. To plead demand futility, a plaintiff must allege particularized facts that a majority of the Board faced substantial liability for the harm suffered by the company due to the oversight failures alleged. See id. at *9. A plaintiff may satisfy this burden by alleging that a majority of the board (1) knowingly made a decision that violated positive law, (2) consciously ignored so-called red flags concerning managerial conduct, or (3) presided over a sustained or systematic failure to exercise oversight. See id. at **9-10.

Vice Chancellor Laster ruled that the Souths' complaint failed to meet any of the three tests. Rather, he found that the plaintiffs relied solely on publicly available information and the fact that the corporation experienced trauma. See id. at **11-13. Consistent with a developing trend in Delaware Court of Chancery jurisprudence, Vice Chancellor Laster faulted the Souths for failing to pursue a § 220 books and records demand. See id. at *9. Without the benefit of that investigation, the Souths were incapable of pleading "any factual allegations regarding internal board deliberations, director decision-making, or knowledge or involvement of the Hecla directors in the accidents . . . or the MSHA-mandated closure . . . ." Id. at *19.

Vice Chancellor Laster then turned to the question of whether the failure to "use the tools at hand" and the lack of "deep reflection" in filing the claim constituted a failure by the Souths to meet their fiduciary obligations as purported representatives of the corporation. See id. at **1 n.1, 15, 19 (internal quotations omitted). Vice Chancellor Laster applied his prior holding in Allergan and found that Rule 23.1 has no preclusive effect if the plaintiff provided inadequate representation of the corporation. See id. at *1, **15-16.

On this issue, Vice-Chancellor Laster broke new ground and held that the court will apply "an evidentiary presumption that a plaintiff who files a Caremark claim hastily and without using Section 220 . . . has acted disloyally to the corporation and served instead the interests of the law firm who filed suit." Id. at *16. Vice Chancellor Laster recognized that Caremark claims do not typically require a speedy filing in part because the underlying harm (exposure to litigation claims) will develop over time. See id. at *17. Moreover, in circumstances where the corporation is defending itself in connection with the conduct underlying the Caremark claim, Vice Chancellor Laster recognized that the lawsuit may be "contrary to the interests of the corporation" while the underlying litigation is ongoing. Id. (emphasis added). In these circumstances, the only real beneficiary of a hastily filed Caremark claim are the plaintiff's attorneys attempting to gain control of the litigation. Vice Chancellor Laster found that placing an attorney's interest over that of the corporation is disloyal and will be presumed to demonstrate the plaintiff's inadequacy to act as a fiduciary of the corporation and its shareholders. See id.

This presumption is rebuttable if the plaintiff can establish that it conducted an adequate investigation addressing the merits of the claims or if it can demonstrate that by acting quickly it benefitted the corporation. See id. at *17. The Souths were incapable of establishing either. The lawsuit was filed only one month following the commencement of the underlying securities class actions in Idaho. The Souths' complaint was drafted in mere hours and relied solely on publicly available documents. See id. at *18. At oral argument, the Souths' attorney could not raise any "entity-beneficial reason for filing" quickly. See id. at *19. Vice Chancellor Laster found that Hecla's interests would have been furthered by a deliberate and thorough pre-suit investigation, and as Hecla's self-appointed fiduciaries, the Souths should have furthered those interests instead of the interests of their attorneys.

Conclusion

The Hecla ruling continues the Chancery Court's recent efforts to force fundamental changes in the way complex derivative litigation is conducted. The presumption of disloyalty applied by the Chancery Court will almost certainly chill hastily filed derivative cases in Delaware. We anticipate that the plaintiff's bar, in response, will become more aggressive in seeking extensive pre-suit discovery through books and records demands conducted pursuant to 8 Del. C. § 220.

Footnotes

1 Rule 23.1 requires a shareholder, pre-suit, to prove that a demand was made on the board that was unreasonably denied or that demand is futile ("demand futility").

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