Opinion ID: 1907537
Heading Depth: 1
Heading Rank: 7

Heading: The Derivative Suit Issue

Text: A shareholder derivative action is a unique and anomalous legal remedy. The purpose of the derivative action was to place in the hands of the individual shareholder a means to protect the interests of the corporation from the misfeasance and malfeasance of `faithless directors and managers.' Kamen v. Kemper Financial Svcs., Inc., 500 U.S. 90, 95, 111 S.Ct. 1711, 1716, 114 L.Ed. 2d 152, 163 (1991) (quoting Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541, 548, 69 S.Ct. 1221, 1226, 93 L.Ed. 1528, 1537 (1949)). The action functions as both a sword and a shield to directors. It is a sword in the hands of shareholders, yet it shields directors from direct shareholder actions for certain injuries. In their treatise, Shareholder Derivative Litigation, Ralph C. Ferrara, Kevin T. Abikoiff, Laura Leedy Gansler and Shon Morgan give an example of directors' misconduct that may give rise to both a derivative action and a direct shareholders' action. The example is of directors making a worthless investment in untested technology while touting the optimistic potential of the technology. Investors deceived by the recklessly optimistic statements that occasioned shareholders to buy or retain their shares may sue for the direct injuries that they suffered. Shareholders may also sue for the derivative injury to the corporation for the imprudent and wasteful investment in faulty technology. The distinction between the two types of action is crucial. See Ralph C. Ferrara, et al., Shareholder Derivative Litigation § 1.02 (1996). A corporation is regarded as an entity separate and distinct from its shareholders. Dep't of Labor v. Berlanti, 196 N.J. Super. 122, 481 A. 2d 830 (App.Div.), certif. granted, 99 N.J. 151, 491 A. 2d 666 (1984), and appeal dismissed, 101 N.J. 568, 503 A. 2d 846 (1985). It is a principle of corporation law that [r]egard for the corporate personality demands that suits to redress corporate injuries which secondarily harm all shareholders alike are brought only by the corporation. Note, Distinguishing Between Direct and Derivative Shareholders' Suits, 110 U. Pa. L.Rev. 1147, 1148 (1962) (citing Smith v. Hurd, 53 Mass. 371, 384-85 (1847)) (hereinafter Distinguishing ). Reasons of policy and practicality more than abstractions about the nature of a corporation underlie the principle. The policy reasons include maintaining the investment resources of the corporation, avoiding a multiplicity of suits, providing equal benefit for all shareholders and avoiding partial dividends or partial liquidation. Distinguishing, supra, 110 U.Pa. L.Rev. at 1148. The prevailing American rule is that [w]hen an injury to corporate stock falls equally upon all stockholders, then an individual stockholder may not recover for the injury to his stock alone, but must seek recovery derivatively in behalf of the corporation. Cowin v. Bresler, 741 F. 2d 410, 414 (D.C. Cir.1984). New Jersey accepts the general principle. Shareholders cannot sue for injuries arising from the diminution in value of their shareholdings resulting from wrongs allegedly done to their corporations. Pepe v. General Motors Acceptance Corp., 254 N.J. Super. 662, 666, 604 A. 2d 194 (App.Div.), certif. denied, 130 N.J. 11, 611 A. 2d 650 (1992). Under the BCA shareholders may not bring derivative actions except in compliance with statutory requirements and Rules of Court. N.J.S.A. 14A:11-7, R. 4:32-5. See In re Prudential Ins. Co. Derivative Litigation, 282 N.J. Super. 256, 268-70, 659 A. 2d 961 (Ch.Div. 1995) (outlining history and purposes of Rule). The general rule that claims of diminution in share value are derivative permits a special injury exception, which has yet to be widely addressed in our courts. A special injury exists where there is a wrong suffered by [a] plaintiff that was not suffered by all stockholders generally or where the wrong involves a contractual right of the stockholders, such as the right to vote. In re Tri-Star Pictures, Inc., 634 A. 2d 319, 330 (Del. 1993). The statement of such principles is easy. The actual determination of whether a suit involves derivative or individual claims of shareholders is not. Delaware, which has a well developed body of law on this subject, has long recognized a sharp distinction between derivative and individual actions. The distinction is important because derivative actions are deemed to belong to the subject corporation whereas individual actions do not. Weinberger v. Lorenzo, 1990 WL 156529 at []2 (Del. Ch. Oct. 12, 1990) (quoting DeMott, Shareholder Derivative Actions Law and Practice § 2:01 (1987)). To determine whether a complaint states a derivative or an individual cause of action, courts examine the nature of the wrongs alleged in the body of the complaint, not the plaintiff's designation or stated intention. Lipton v. News Int'l Plc, 514 A. 2d 1075, 1078 (Del. 1986). Elster v. American Airlines, Inc., 34 Del. Ch. 94, 100 A. 2d 219 (1953), held that a shareholder may maintain an individual action against a corporation or its directors if the shareholder sustained a special injury. The court defined a special injury as a wrong inflicted upon [the shareholder] alone or a wrong affecting any particular right which [the plaintiff] is asserting, such as ... pre-emptive rights as a stockholder, rights involving the control of the corporation, or a wrong affecting the stockholders and not the corporation. Id. 100 A. 2d at 222. In Moran v. Household Int'l, Inc., 490 A. 2d 1059 (Del. Ch.), aff'd, 500 A. 2d 1346 (Del. 1985), the court explained: 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. Id. at 1070 (citations omitted). In Lipton, the Delaware Supreme Court combined the Elster and Moran tests, stating that a plaintiff alleges a special injury and may maintain an individual action if he complains of an injury distinct from that suffered by other shareholders or a wrong involving one of his contractual rights as a shareholder. Moreover, while Moran serves as a quite useful guide, the case should not be construed as establishing the only test for determining whether a claim is derivative or individual in nature. Rather, as was established in Elster, we must look ultimately to whether the plaintiff has alleged special injury in whatever form. [ Lipton, supra, 514 A. 2d at 1078.] Claims of waste (recall the example of the investment in faulty technology) will always be derivative claims. Shearin v. E.F. Hutton Group, Inc., 652 A. 2d 578, 591 (Del. Ch. 1994) (A claim for corporate waste is classically derivative.). Claims of breach of fiduciary duty on the part of directors will also be generally regarded as derivative claims unless the injury to shares is distinct. See Small v. Goldman, 637 F. Supp. 1030 (D.N.J. 1986) (holding plaintiff had individual cause of action arising out of conspiracy by directors to compel sale of plaintiff's shares below value). If the breach of duty causes a special injury, shareholders may sue directly. For example, claims against directors for the selective dissemination of information to one group of shareholders over another are not derivative in nature because the unfair dealing unequally affects shareholders that were deprived of the information. Tri-Star, supra, 634 A. 2d at 331-32; Barbieri v. Swing-N-Slide Corp., 1996 WL 255907 (Del. Ch. May 7, 1996). Claims of entrenchment by directors often fall into the same category of stating either a direct or derivative claim, depending on whether the entrenchment affects shareholders unequally. For example, Spillyards v. Abboud, 278 Ill. App. 3d 663, 215 Ill.Dec. 218, 662 N.E. 2d 1358 (1996), held that a breach of fiduciary duty engaged in for the purpose of entrenchment stated an individual claim and not a derivative claim. Spillyards involved a challenge to a stock purchase agreement under which the purchasers were bound to vote their shares for incumbent directors. The court agreed with the plaintiff shareholders that that voting restriction had the purpose of entrenchment and affected the other shareholders' voting rights in that the shareholders' ability to have nominees other than the Board's nominees elected was diluted. Id. 215 Ill.Dec. at 223, 662 N.E. 2d at 1363. Claims of entrenchment without corresponding allegation of direct harm to shareholders' contractual rights, however, set forth derivative claims only. Moran, supra, 490 A. 2d at 1070. Concededly, a thin line often separates actions that are derivative or individual. Kramer v. Western Pac. Indus., Inc., 546 A. 2d 348, 352 n. 3 (Del. 1988). For example, when preferred shareholders of Eastern Airlines complained that Frank Lorenzo had manipulated the assets of Eastern by switching assets from Eastern to Continental Airlines, the non-union airline under the common control of the parent, Texas Air, the Eastern preferred shareholders claimed that they had suffered a special injury to their preferred status. Yet, the court held that they did not suffer any injury distinct from that of all other Eastern Airline shareholders. Weinberger, supra, 1990 WL 156529 at []1. In Yanow v. Teal Indus. Inc., 178 Conn. 262, 422 A. 2d 311 (1979), the majority had misused its powers by systematically looting assets from one corporation to the special detriment or injury of minority shareholders because the assets were transferred to a corporation wholly owned by the majority interests. That did not occur here. A closer case is Williams v. Geier, 671 A. 2d 1368 (Del. 1996). In that case, the board of directors of Cincinnati Milacron approved a recapitalization of stock that diluted the voting rights of non-long-term share owners (analogously younger-generation shareholders). The long-term shareholders were afforded greater voting rights. The Geier court concluded that the claims of the newcomer Cincinnati Milacron shareholders were individual and not derivative. The claims of waste in the context of derivative actions have already been discussed. See supra at 551, 683 A. 2d at 830. The remaining claims in the North Jersey action, listed supra at 546, 683 A. 2d at 827, are more troubling. The Liquidity Plan adopted in April 1991 granted the company a ninety-day right of refusal before shareholders could sell shares to a non-descendant. Plaintiffs allege that, contrary to company representations, the plan reduced liquidity and deprived them of a substantial portion of their share value. The directors rejected the $64.00 per share proposal Bowater made in August 1991. Plaintiffs allege that the proposal established that the company knew the true value of the company in 1991. During that same period, in fact, Bowater purchased 100,000 shares from Frank H. Wheaton, Jr. Plaintiffs allege the voting trust was part of a plan of misrepresentation intended to prevent shareholders from realizing the full value of the shares. Finally, under the December 1991 recapitalization plan, shareholders would have been required to exchange their common stock for one of two new classes of stock. Class A stock has ten votes per share, but cannot be transferred outside the Wheaton family without losing 9 of its 10 votes. Class B stock is freely transferrable and pays slightly higher dividends, but has only one vote per share. The recapitalization may have had the effect of diluting the voting rights of the dissenting class of shareholders (the younger generation) because they were presumably the only shareholders seeking a public market for their stock. Despite the varied wrongs alleged, the essential nature of the injuries claimed is a diminution in share value. For the most part, the North Jersey complaint alleges that artificially deflated stock values resulted from the directors' actions. Nothing in their allegations suggests that the diminution in value of Wheaton's stock did not affect all of Wheaton's shareholders, young or old. The allegation that the older shareholders benefitted through depressed estate taxes fails to show a special injury that would allow the younger-generation shareholders to bring individual actions for damages. On balance, then, we believe that the claimed actions of misconduct on the part of the Wheaton directors, if they resulted in an injury, resulted in an injury to all shareholders and not to individual classes of shareholders. The activities engaged in by the directors did not impair or dilute any voting rights that the dissenters possessed as shareholders. Unlike the Cincinnati Milacron shareholders, Wheaton shareholders were all given the same opportunity. They simply had to make a choice. Nor did the directors deprive the dissenting shareholders of any information upon which they might base their decisions as shareholders. Actions that have the effect of depressing stock value harm all shareholders and are therefore classed as giving rise to derivative claims. Kramer, supra, 546 A. 2d at 353; Bokat v. Getty Oil Co., 262 A. 2d 246, 249 (Del. 1970). Likewise, because the nature of the injuries claimed in the North Jersey action is essentially to shareholder values, the RICO claims are also regarded as derivative. Loewen v. Galligan, 130 Or. App. 222, 882 P. 2d 104, 112-13, review denied, 320 Or. 493, 887 P. 2d 793 (1994). We would be less likely to reach this result in the North Jersey action were it not for the concession of the Wheaton directors that the claims of disparate impact can be evaluated fairly in the appraisal action. Breed, supra, 444 N.Y.S. 2d at 611, 429 N.E. 2d at 130. New Jersey is firmly committed to majoritarian principles of corporate governance. Musto v. Vidas, 281 N.J. Super. 548, 560, 658 A. 2d 1305 (App.Div. 1995), certif. denied, 144 N.J. 588, 677 A. 2d 761 (1996) (citing Brenner v. Berkowitz, 134 N.J. 488, 511, 634 A. 2d 1019 (1993)). If the misconduct of Wheaton's directors damaged the corporation, Alusuisse-Lonza, as the majority shareholder, is now in the best position to determine whether to pursue that action if its merger agreement permits that. In sum, because we believe that any injury from self-dealing on the part of the directors was to all shareholders and because that conduct can be considered in the appraisal action, we reverse the judgment of the Appellate Division in the North Jersey action.