Under Delaware law, when a derivative plaintiff loses its stockholder status as the result of a merger, the plaintiff usually also loses its standing to pursue a derivative suit on behalf of the corporation. This rule is subject to only two limited exceptions: (1) when “the merger itself is the subject of a claim of fraud, being perpetrated merely to deprive shareholders of the standing to bring a derivative action,” and (2) when “the merger is in reality merely a reorganization which does not affect plaintiff’s ownership in the business enterprise.” Lewis v. Ward, 852 A.2d 896, 902 (Del. 2004) (clarifying exceptions identified in Lewis v. Anderson, 477 A.2d 1040 (Del. 1984)). In a decision revisiting a 2010 mining tragedy in which dozens of miners were killed, the Delaware Court of Chancery recently concluded that neither exception applied to preserve the standing of stockholders of Massey Energy Company (“Massey”) to bring derivative claims, and that plaintiffs had not brought direct claims for an “inseparable fraud.” In re Massey Energy Co. Derivative & Class Action Litig., Consol. C.A. No. 5430-CB (May 4, 2017).
Backstory: The Court of Chancery Refuses To Enjoin The Massey-Alpha Merger
In 2011, stockholder plaintiffs attempting to enjoin a merger between Massey and Alpha Natural Resources, Inc. (“Alpha”) argued that Massey should be forced to assume and transfer derivative claims against certain Massey fiduciaries to a trust for the benefit of Massey stockholders, rather than allowing the claims to pass to Alpha. While finding “little doubt” that plaintiffs’ derivative claims could survive a motion to dismiss, the Court also concluded that plaintiffs were likely to lose standing to pursue those claims if the merger was consummated.
The Court of Chancery noted that a corporation reasonably may conclude that the risks arising from a lawsuit outweigh the potential risk-weighted recovery, even when the corporation clearly has been harmed. As a practical matter, a corporation with strong claims against former executives may choose not to pursue those claims for valid reasons, including a wish to avoid pleading formal admissions that potentially could be used against the corporation by third parties, such as insurance carriers, government agencies, and employees and other individuals with personal injury and other claims. Delaware courts have declined to hold that these kinds of dilemmas – which arise because the corporation itself is conflicted, and not because the directors suffer a personally disabling conflict of interest – justify excusing a would-be plaintiff from the requirement of a pre-suit demand. In its injunction opinion, the Court in Massey similarly refused to create another exception to the general rule that a merger extinguishes the ability of a former stockholder plaintiff to pursue claims derivatively on behalf of the corporation. In addition, the Court noted that if a potential buyer cannot rely on the fact that a merger will eliminate derivative claims, bids for troubled assets will be reduced, if not deterred completely, because the buyer must discount the value of the assets to reflect the uncertainty. As a result, the Court could not conclude that the Massey-Alpha merger was unfairly priced. “That Massey might be selling to Alpha at a price lower than it would have had the company been better managed is an idea one can embrace without also then concluding that there is a basis to conclude that the Merger with Alpha ought to be enjoined.”
Flash Forward: The Court of Chancery Confirms Its Preliminary Analysis
On May 4, 2017, the Court of Chancery issued an opinion granting a post-bankruptcy motion to dismiss fiduciary duty claims in the Massey case. Plaintiffs alleged that fourteen former directors and officers of Massey breached their fiduciary duties by “causing Massey to employ a deliberate and systematic business plan of willfully disregarding both internal and external safety regulations.” Plaintiffs conceded that the merger deprived them of standing to pursue derivative claims, but argued they should be allowed to pursue claims directly, relying on dicta in Arkansas Teacher Retirement System v. Caiafa, 996 A.2d 321 (Del. 2010). In Caiafa, the Delaware Supreme Court approved a settlement of claims against Countrywide directors and officers, which did not carve out derivative claims into a separate litigation trust. The Court noted that the derivative claims – which were dismissed after a merger – were “functionally worthless.” However, the Court also commented that “Delaware law recognizes a single, inseparable fraud when directors cover massive wrongdoing with an otherwise permissible merger,” and that “[a]n otherwise pristine merger cannot absolve fiduciaries from accountability for fraudulent conduct that necessitated the merger.” The Supreme Court later clarified in another Countrywide opinion that this language did not create a new exception to the rule of Lewis v. Anderson, and concerned only direct claims, not derivative claims.
The Court in Massey found that plaintiffs had failed to state a direct claim under the dicta in Caiafa. The Court read this language as requiring a plaintiff to plead facts showing that (1) a defendant engaged in serious pre-merger misconduct that would support a direct claim, and (2) the merger was “necessitated” or made “inevitable” by that misconduct. The Court viewed plaintiffs’ claims as focusing on “prototypical examples of corporate harm that can be pursued only derivatively,” i.e., mismanagement, not direct harm to individual stockholders. Defendants allegedly violated laws intended to protect third parties, but were not alleged to have acted to enrich themselves at the expense of other stockholders. Moreover, defendants were alleged to have acted with open hostility to regulators and were not alleged to have attempted to conceal their actions. As for the second prong of this standard, the Court referred to the 2001 finding that the Massey-Alpha merger was not “necessitated” by the alleged misconduct, but also concluded it did not need to reach this issue because the claims were clearly derivative.
The Court also stated that although plaintiffs would not be able to pursue viable derivative claims, the result was equitable because Alpha had in 2011 paid “a substantial sum” to acquire all of Massey’s assets, including the derivative claims at issue.
Finally, the Court in Massey remarked in dicta that it did not believe that stockholder ratification was at all relevant to the motion to dismiss:
The policy underlying Corwin, to my mind, was never intended to serve as a massive eraser, exonerating corporate fiduciaries for any and all of their actions or inactions preceding their decision to undertake a transaction for which stockholder approval is obtained. Here, in voting on the Merger, the Massey stockholders were asked simply whether or not they wished to accept a specified amount of Alpha shares and cash in exchange for their Massey shares or, alternatively, to stay the course as stockholders of Massey as a standalone enterprise, which would have allowed plaintiffs to press derivative claims. Massey’s stockholders were not asked in any direct or straightforward way to approve releasing defendants from any liability they may have to the Company for the years of alleged mismanagement that preceded the sale process. Indeed, the proxy statement for the Merger implied just the opposite in stating that control over the derivative claims likely would pass to Alpha as a result of the Merger. To top it off, if defendants’ view of Corwin were correct, it would have the disconcerting and perverse effect of negating the value of the derivative claims that Alpha paid to acquire along with Massey’s other assets.
Practice Point: Which Mergers Fail to Eliminate Claims?
The exceptions to the Lewis v. Anderson rule all concern mergers which are “otherwise permissible,” which generally means that they are mergers that comply with the statutory requirements of Delaware law. Although every case is subject to its own analysis, and specific facts may lead to a different result in a particular case, certain generalizations are possible, and the following types of mergers should be viewed as more risky than others.
The “laundering” merger
Under the first exception to the rule of Lewis v. Anderson, a merger that is undertaken merely to deprive stockholders of standing will not, in fact, deprive stockholders of standing. Importantly, none of the parties in Massey argued that the merger between Massey and Alpha was such a merger. To the contrary, the Court referred to record evidence that Massey’s board of directors had considered several strategic alternatives, including a “standalone” plan in which Massey would continue to operate its business without a merger or other business combination. The board concluded that the standalone plan was less preferable for reasons including Massey’s “tarnished reputation and history of missing management projections,” but still considered it to be “viable.” Moreover, even if Massey had undertaken the merger because it had been weakened by the alleged misconduct of defendants, that is not the same as a merger undertaken for the purpose of limiting the liability of the directors approving it.
The “deja vu” merger
In the “mere reorganization” merger, a stockholder continues to have the same ownership interest as before, only in a newly reorganized corporation. This issue did not arise in Massey.
The “fruits of fraud” merger
Under Caiafa as interpreted in Massey, a plaintiff may continue to pursue direct claims based on serious pre-merger misconduct, where that misconduct makes a merger “inevitable.” (With the subsequent limitation to direct claims in Countrywide II, this observation has become somewhat obvious, as mergers generally do not extinguish standing to bring any claims directly.) The merger between Massey and Alpha was not deemed to be an “inevitable” merger, despite the fact that, as noted above, Massey was seriously weakened by the alleged misconduct. The Court was persuaded by the record that Massey’s board viewed the standalone plan as “a viable option,” even though it was “not the best choice available.”