For years, Delaware courts have set a high bar for shareholders to win cases that allege a breach of oversight duties by corporate directors. With a recent decision, the Delaware Chancery Court upheld that idea.

The Delaware Chancery Court ruled September 25 in South v. Baker that a derivative suit by shareholders could be dismissed if the plaintiffs do not demonstrate that they are acting with authority on behalf of the company.

The decision, authored by Vice Chancellor Travis Laster, found that any shareholder who hastily files a Caremark claim and without first conducting a review of the company's books and records will be presumed by the court as having “acted disloyally and served, instead, the interests of the law firm who filed suit.” As a result, any such complaint will be at risk of being dismissed with prejudice, as South v. Brown was.

The downside for companies and boards is that it could encourage an increase in demands for books and records releases.

Under a Caremark claim—a legal theory established by the Chancery Court in its landmark decision for In re Caremark International Inc.—directors may be found liable in the absence of acting in good faith. Plaintiffs must show, however, that the directors knowingly caused or consciously allowed the company to violate the law, or failed to attempt to establish a system of oversight to monitor the corporation's legal compliance. In the South case, Laster said that the shareholders failed to satisfy either requirement.

Stephen Lamb, a partner in the corporate and litigation departments of law firm Paul Weiss and a former vice chancellor of the Chancery Court, says what makes the ruling interesting is the unusual analysis Laster offered in reasoning that, because the shareholders did not act diligently prior to filing the derivative lawsuit, they did not adequately represent the interests of the corporation. Simply filing a derivative case does not necessarily mean shareholders are acting with authority on the behalf of the company. "Thus, it was appropriate to dismiss the complaint with prejudice only as to the named plaintiffs," he says.

Because derivative suits by their nature are brought by shareholders on behalf of a company, legal experts say they expect the wider implications of the South decision to significantly thwart the race-to-the courthouse mentality by shareholders and their plaintiffs' lawyers. Since many companies are incorporated in Delaware, the ruling has “fairly broad implications for corporate entities,” says Daniel Perry, partner with the law firm Milbank, Tweed, Hadley & McCloy.

In addition, “states tend to look to Delaware for guidance on cutting-edge issues of corporate law,” adds Perry, so the decision “has potentially relatively broad implications outside the narrow purview of Delaware Chancery Court litigation.”

Case Background

The South case stemmed from allegations that directors of silver producer Hecla Mining failed to act in good faith by disregarding federal mining safety regulations preceding three unrelated mining accidents in 2011 that injured several miners and killed two.

Following the accidents, the U.S. Mine Safety and Health Administration (MSHA) cited Hecla management for numerous safety violations relating to “repeated failure” to ensure appropriate safety at the mine. The MSHA also ordered Hecla to close one of its mines—although, apparently unrelated to the safety incidents—forcing Hecla to lower its estimated silver production for the year.

“Although the court has set a high threshold for holding directors liable, the duty of oversight remains a critical part of the board's function.”

—Steven Haas,

Partner,

Hunton & Williams

Within weeks, enraged shareholders filed a flurry of lawsuits, including the South case filed in the Chancery Court. In dismissing the complaint, however, Laster specifically faulted the plaintiffs for failing to utilize their rights under Section 220 of Delaware's corporate code, which allows shareholders to demand access to books and records for a “proper purpose.”

Rather, plaintiffs in the South case premised their claims of director liability entirely from public filings and press releases. “The complaint lacked any factual allegations regarding internal board deliberations, director decision making, or knowledge or involvement of the Hecla directors in the accidents,” Laster wrote.

The principle articulated by Laster is that when shareholders hastily file derivative complaints alleging that directors breached their oversight duties, “they usually lack any information connecting the board to the alleged ‘corporate trauma,' including information that they might have learned through a books and records demand,” says Brian Lutz, a partner at the law firm Gibson, Dunn & Crutcher.

Public vs. Private Record

According to the ruling, by failing to conduct a “meaningful investigation,” neither the plaintiffs nor their counsel could establish a self-evident link between the events and conscious inaction by the board. For this reason, Laster said the court would leave the door open for other Hecla shareholders to file future derivative lawsuits with the caveat that those complaints are the result of an adequate investigation.

“That part of the court's ruling is troubling, because it gives stockholders multiple bites at the apple,” says Steven Haas, a partner with law firm Hunton & Williams. “Companies may end up litigating the same issue two or three times.”

In light of the decision, legal experts say, companies should anticipate an increase in books and records demands in the wake of what Laster refers to as a “corporate trauma.”

In some rare circumstances, Lamb says, shareholders may be able to gather enough evidence from public documents—such as proxy materials and litigation—to support a Caremark claim without making a books and records demand. One example could be if the government, following a settlement with a company, releases a report that reveals enough insight about the company's board structure and board deliberations so that shareholders are able to conduct an adequate investigation. “It's hard to imagine, but it could happen,” says Lamb.

In Stone, the court further rejected the plaintiffs' argument that three mining accidents in a year support a reasonable inference of board involvement and bad faith, especially where the incidents appeared to be unrelated. “In a large corporation engaged in a dangerous business, three incidents could readily happen in a single year because of decisions made and actions taken sufficiently deep in the organization for the board not to have been involved,” Laster wrote.

CASE DISMISSED

The following excerpt from South v. Baker explains, in part, why Vice Chancellor Travis Laster decided to dismiss the case with prejudice:

If a statute of limitations bar loomed, permitting a new representative plaintiff and different counsel to intervene might be appropriate. In this situation, however, 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. There are at least two stockholders who served Section 220 demands on Hecla and who appear to be proceeding (at least to date) in accordance with the best interests of the corporation and the recommendations of the Delaware Supreme Court. Dismissing the current complaint with prejudice as to the Souths comports with the expectations set by Rule 15(aaa) and freshen[s] the litigation environment so other plaintiffs whose lawyers … conducted a pre-suit investigation might feel that they could now lead the case.

Source: South v. Baker.

The court further found no evidence that Hecla's board deliberately breached its duty of oversight, or knowingly disregarded safety problems. “An allegation that the underlying cause of a corporate trauma falls within the delegated authority of a board committee does not support an inference that the directors on that committee knew of and consciously disregarded the problem,” Laster wrote.

To the contrary, Hecla had in place a safety committee made up of four independent members of the board who were experts in mining and safety issues, supporting the conclusion that the company had a “reasonable reporting and oversight system.”

In this respect, Laster did not address the issue of whether the board did or did not do enough, but rather makes the point that Hecla's board was functioning properly, says Perry. “I'm not sure how much you can take from a broader compliance perspective, other than that, at least based on the record available to the court, these were all directors who had appropriate experience, and nothing in the complaint suggested they were doing anything other than acting in good faith,” he says.

Lutz agrees. The decision serves as the latest reminder for companies of “the importance of maintaining an adequate internal control structure and the difficult burden shareholders face in pleading that a board failed to exercise proper oversight,” he says.

“Although the court has set a high threshold for holding directors liable, the duty of oversight remains a critical part of the board's function,” says Haas. “An adequate system of internal controls and a proper compliance program that's tailored to a company's particular business remains paramount.”

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