Delaware Supreme Court Gives Preclusive Effect to Federal Court Dismissal of Derivative Suit for Failure to Show Demand Futility

In its highly anticipated opinion in California State Teachers’ Retirement System v. Alvarez, the Delaware Supreme Court unanimously affirmed the dismissal of a group of Delaware shareholders’ derivative actions, holding that a previous dismissal by a federal court for failure to plead demand futility precluded other shareholders from pursuing additional derivative actions so long as the other shareholders were adequately represented in the earlier suit.

Following the New York Times 2012 exposure of Wal-Mart executives’ alleged mishandling of bribery allegations, Wal-Mart shareholders brought derivative suits in the Western District of Arkansas and the Delaware Court of Chancery. In May 2015, the Arkansas court dismissed the case before it, because the shareholders had failed to adequately plead demand futility. Prompted by the Arkansas dismissal, the Delaware Court of Chancery initially dismissed the Delaware action, but, after some ping-ponging back and forth between the Court of Chancery and the Delaware Supreme Court, the Court of Chancery issued a supplemental opinion, recommending that the Supreme Court adopt a rule proposed in EZCORP Inc. Consulting Agreement Deriv. Litig., which held that constitutional Due Process permits a derivative suit to have a preclusive effect on a subsequent derivative suit only if the plaintiff in the first suit has been authorized by the corporation to pursue the litigation, either by express authorization given by the board of directors or implicitly by showing demand futility in response to and surviving a Rule 23.1 motion to dismiss.

Concerned that following the EZCORP decision would impair the delicate balance between a state’s interests in governing its internal affairs and the national interest in respecting another jurisdiction’s judgment, the Delaware Supreme Court rejected the Court of Chancery’s suggestion, opting instead to yield to the national interest and respect the Arkansas court’s judgment. In reaching this decision, the Court explained that, because of the nature of derivative claims, the shareholders were not pursing claims in their individual capacity but rather on Wal-Mart’s behalf. As such, the shareholders’ interests were sufficiently aligned, and the Arkansas and Delaware shareholders were found to be in privity. Additionally, because of the shareholders’ aligned concerns and shared economic interest in pursuing their claims on behalf of Wal-Mart, the Court determined that the Delaware shareholders were adequately represented in the Arkansas case. Accordingly, the Court was satisfied that giving preclusive effect to the Arkansas judgment would not violate the shareholders’ Due Process rights.

By refusing to adopt the approach set forth in EZCORP, the Delaware Supreme Court’s decision affirms longstanding federal precedent that dismissal for failure to demonstrate demand futility generally has a preclusive effect on a subsequent derivative suit brought in another jurisdiction. While the impact this decision will have on future derivative litigation remains to be seen, it is safe to say that the decision should help corporate boards limit shareholders pursuing derivative actions to just one opportunity to show demand futility.

Kelsey A. Ball, an Associate in the Gibbons Commercial & Criminal Litigation Department, and Christopher Viceconte, a Director in the Gibbons Commercial & Criminal Litigation Department, authored this post.