Opinion ID: 6929866
Heading Depth: 2
Heading Rank: 1

Heading: Whether the Proposed Claims are Derivative or Direct

Text: We agree with the well-reasoned conclusions reached by Judges Sweet and Lifland that the claims submitted by the Preferredholders to the bankruptcy court are derivative under Delaware law (which the parties agree is governing). They therefore belong exclusively to the Eastern Estate and were extinguished by its settlement of those claims. In re Ionosphere Clubs, Inc., Nos. 89 B 10448, 89 B 10449, 91 B 10287 (Bankr.S.D.N.Y. Oct. 1, 1992); In re Ionosphere Clubs, Inc., 156 B.R. 414, 438-39 (S.D.N.Y.1993). Starting from the proposition that a shareholder asserting a direct action against a third party must allege “special injury,” Elster v. American Airlines, Inc., 34 Del.Ch. 94, 100 A.2d 219, 222 (1953), the Delaware courts have several times undertaken to describe how to distinguish between shareholders’ direct and derivative actions. See, e.g., Lewis v. Spencer, 577 A.2d 753 (Del.1990), No. 8651, 1990 WL 72615, -2, 1990 Del. LEXIS 154,  (Del. May 11, 1990) (text in Lexis); Lipton v. News Int'l, PLC, 514 A.2d 1075, 1078 (Del.1986); Moran v. Household Int'l, Inc., 490 A.2d 1059, 1069-70 (Del.Ch.), aff'd, 500 A.2d 1346 (Del.1985). How the language of these opinions bears on the facts of a new case is not always clear. In their Objections filed with the bankruptcy court, the Preferredholders described their claims as contractual entitlements that Eastern was rendered unable to perform because it was made insolvent by the Intercor-porate Transactions. They contend the Proposed Defendants are liable because, in violation of their fiduciary duties to Eastern and in tortious interference with the Preferred-holders’ contractual rights, they caused Eastern to enter into the Intercorporate Transactions. The Preferredholders contend the Proposed Claims come within the languáge of the Delaware Chancery Court’s Moran opinion, subsequently repeated by the Delaware Supreme Court in Upton and in Lewis. In Moran, the Chancery Court stated: To set out an individual action, the plaintiff must allege either an injury which is separate and distinct from that suffered by other shareholders, or a wrong involving a contractual right of a shareholder, such as the right to vote, or to assert majority control, which exists independently of any right of the corporation. Moran, 490 A.2d at 1069 (citations omitted). The Preferredholders contend they come within both branches of this test. As to the first branch, the Preferredhold-ers contend that because Eastern’s sole common shareholder was Texas Air and the wrongful diversion of Eastern’s assets was in favor of other Texas Air affiliates, Eastern’s common shareholder suffered no injury through the Intercorporate Transactions; it merely transferred its property from one pocket into another. The Preferredholders allege that the injury to them is thus “separate and distinct” from that suffered by Texas Air, the common shareholder. Moran, 490 A.2d at 1069. Although ingenious, this argument was correctly rejected below. Under Delaware law, the inquiry is whether the other shareholders suffered the same injury in their role as shareholders. See Weinberger v. Lorenzo, No. 10692, 1990 WL 156529, 1990 Del.Ch. LEXIS 169 (Del.Ch. Oct. 11, 1990); In re Tri-Star Pictures, Inc. Litig., No. 9477, 1989 WL 112740, 1990 Del.Ch. LEXIS 80 (Del.Ch. June 14, 1990). See also Davis v. United States Gypsum Co., 451 F.2d 659 (3d Cir.1971). In its role as the common shareholder of Eastern, Texas Air suffered the same type of injury as the Preferredholders from the diversion of Eastern’s assets to other corporations, even though in another role, it may have recouped the injuries. Thus, the Preferredholders did not suffer an injury that was separate and distinct from that suffered by Eastern’s common stockholder. 3 Judges Sweet and Lifland correctly rejected this argument. As to the second branch of the Moran test, the Preferredholders ask us to compare the chancery court’s words to their situation, literally, without reference to the meaning or purpose of the doctrines involved. 4 They contend that they meet this test because the failure to pay the preferred dividends and make sinking fund payments, as required in Eastern’s corporate charter, is “a wrong involving a contractual right of a shareholder” that “exists independently of any right of the corporation.” Moran, 490 A.2d at 1069. We reject their contention for two reasons. First, cursory consideration of the purposes of direct and derivative actions demonstrates that it would make no sense to adopt their interpretation. Second, a recent reiteration of the test by the Delaware Supreme Court clearly excludes the Proposed Claims from the scope of direct actions. The distinction between derivative and direct claims turns primarily on whether the breach of duty is to the corporation or to the shareholder(s) and whether it is the corporation or the shareholder(s) that should appropriately receive relief. In some cases, where a wrong has been committed by a third party against a corporation, shareholder intervention is necessary to cause the corporation to sue for rectification of the wrong. The classic case occurs where officers or directors of the corporation appropriate for themselves (or their friends) an opportunity of the corporation, or embezzle its funds. Because the managers of the corporation responsible for causing it to bring suit are the very ones who wrongfully took from the corporation, ■ shareholder initiative is likely to be necessary to cause suit to be brought. Such an action brought by the shareholder is derivative; it is brought in the name of the corporation for the benefit of the corporation — not for the shareholder’s direct benefit. Return of the stolen funds to the corporation would rectify the injury; payment of damages directly to the plaintiff-stockholders for the diminution in the value of their stock would be inappropriate. Where the wrong committed by a third party consists of an injury inflicted on stockholders’ rights rather than upon the corporation, the stockholders’ action seeks relief awarded directly in their favor against the third party. A direct action would lie where third parties contrived to destroy or circumvent the participatory or commercial rights of certain stockholders in a manner that does no injury to the corporation, as. where directors contrived to exclude certain stockholders from voting, or from participating in an advantageous offer. See, e.g., Rabian v. Philip A. Hunt Chemical Corp., 547 A.2d 963, 969 (Del.Ch.1986) (citing R. Franklin Balotti and Jesse A. Finkelstein, The Delaware Law of Corporations and Business Organizations, § 13.6, for proposition that direct claims lie where a proposed merger or other transaction unfairly affects minority shareholders). In such a case, the wrong can be rectified only by relief to that class of stockholder; because the corporation has not been injured, relief to the corporation would not cure the wrong. 5 The Proposed Claims are very similar to the classic derivative action described above. The alleged wrongs of the Proposed Defendants consisted of the diversion of Eastern’s assets. The only significant difference is that here the diversion of assets by the insiders was so extreme that the corporation was left bankrupt and unable to fulfil its contractual obligations, including the obligations to the Preferredholders. That difference, however, does not justify an action seeking payment directly to the Preferred-holders. To the contrary, it provides additional reason why the recovery must be to the corporation rather than to the Preferred-holders. Eastern is in bankruptcy, and the law provides for a strict order of priorities for the distribution of its assets. If the Proposed Defendants were to pay damages directly to the Preferredholders rather than to Eastern’s Estate, the Preferredholders would receive compensation for their foregone dividends while claimants senior in priority to them went unpaid, thus defeating the bankruptcy code’s system of priorities. On the other hand, a complete recovery by the corporation would rectify the injury suffered by the Preferredholders; were Eastern to recover the diverted funds and thus be restored to financial health, it would then be able to fulfill its contractual obligations to the Preferredholders. The Delaware Supreme Court’s most recent articulation of the distinction between derivative and direct actions, in Lewis v. Spencer, 577 A.2d 753 (Del.1990), No. 8651, 1990 WL 72615, 1990 Del. LEXIS 154 (Del. May 11, 1990) (text in Lexis), clarifies the test earlier stated in Moran. In explaining “special injury” in the sentences which immediately precede and follow its quotation of the Moran test, the Lewis opinion states: “To have standing to sue individually, rather than derivatively on behalf of the corporation, a plaintiff must allege more than an injury resulting from a wrong to the corporation .... For a plaintiff to have standing to bring an individual action, he must be injured directly or independently of the corporation.” Id. at  (citations omitted). These words reaffirm the admonition of the chancery court in Elster, 100 A.2d at 222, that a special injury justifying a direct action could not be “an indirect injury as a result of the wrong done to the corporation.” The Proposed Claims do not meet this test. The injury to the Preferredholders’ contractual rights to receive dividend and sinking fund payments was not inflicted “directly” or “independently of the corporation.” Their Proposed Claims result from injuries inflicted by the Proposed Defendants upon Eastern; the injuries to the contract rights of the Preferredholders occurred only as an indirect consequence of those wrongs against Eastern. 6 We therefore agree with Judges Sweet and Lifland that the Preferredholders’ Proposed Claims are • derivative claims that are the property of the Eastern Estate. It necessarily follows that those claims were extinguished when settled and the Eastern Estate.