In Pyott v. Louisiana Municipal Police Employees’ Retirement System, No. 380, 2012, 2013 WL 1364695 (Del. Apr. 4, 2013), the Delaware Supreme Court held the Delaware Court of Chancery erred in refusing to dismiss a derivative complaint nearly identical to one brought by different stockholders in federal court in California, which the federal court had earlier dismissed for failure to plead demand futility. According to the Supreme Court, the Chancery Court’s constitutional obligation to give full faith and credit to other state and federal judgments required it to apply California (not Delaware) collateral estoppel law, and that law clearly precluded the Delaware action. The Supreme Court also held the federal plaintiffs’ failure to first conduct a books and records inspection of Section 220 of the Delaware General Corporation Law (“Section 220”), 8 Del. Code § 220, before filing suit did not, by itself, give rise to an irrebuttable presumption that they had inadequately represented the corporation. The Court of Chancery had applied such presumption in further refusing to dismiss the Delaware action on collateral estoppel grounds. This decision provides greater certainty to Delaware corporations hit with derivative actions in multiple jurisdictions.

On September 1, 2010, following a Department of Justice investigation, Allergan, Inc. (“Allergan”) announced it had pled guilty to a pharmaceutical misbranding violation, agreeing to pay $600 million in fines. Two days later, a pension fund stockholder filed a derivative action in the Delaware Court of Chancery. Over the next three weeks, other stockholders filed derivative actions in the United States District Court for the Central District of California, which were consolidated.

Allergan and its directors moved in both courts to dismiss the actions for failure to plead demand futility under Delaware Chancery Rule 23.1 and its federal equivalent, Federal Rule of Civil Procedure 23.1. The Chancery Court postponed briefing to allow another Allergan stockholder, also a pension fund, to complete a Section 220 books and records inspection and intervene as a party in the Delaware action. Ultimately, in July 2011, the Delaware and California plaintiffs “filed essentially the same amended complaint in their respective courts,” and Allergan again filed motions to dismiss in each court. Shortly before argument on the motion in Delaware, the California federal court, applying Delaware law, dismissed with prejudice the California action for failure to plead demand futility. The parties in the Delaware action thereafter addressed the preclusive effects of the California judgment in supplemental briefing.

The Chancery Court determined collateral estoppel did not apply. Collateral estoppel requires privity between the current plaintiffs and those in the former action. Because the corporation, Allergan, is the real plaintiff in a derivative suit, numerous jurisdictions, including California, would find the requisite privity between the Delaware and California plaintiffs. But the Chancery Court, purporting to apply Delaware’s demand futility law, determined no privity existed because the California plaintiffs had not yet survived a motion to dismiss for failure to make a demand on the board, and so were not acting for Allergan at the time of dismissal. It further ruled that by failing to first conduct a Section 220 inspection before filing suit, the California plaintiffs acted “to maximize the potential returns of the specialized law firms who filed suit on their behalf” and, by presumption, inadequately represented Allergan. For this reason as well, the Chancery Court held that the California dismissal could have no preclusive effect. It went on to find the Delaware amended complaint stated a claim for relief.

The Delaware Supreme Court reversed. It first found that the Chancery Court failed to afford the California federal court’s decision the “same force and effect as it would be given under the preclusion rules of the state in which the federal court is sitting” — in this case, California. According to the Supreme Court, the Chancery Court “conflated collateral estoppel with demand futility.” The motion to dismiss, however, was “based [solely] on collateral estoppel, [and] was about federalism, comity, and finality.” Thus, the Chancery Court should have applied California law, which deems “differing groups of shareholders who can potentially stand in the corporation’s stead . . . in privity for the purposes of issue preclusion.” Without deciding the issue, the Supreme Court noted that the Courts of Chancery are in fact split on the privity issue.

With respect to the Chancery Court’s ruling on the inadequacy of the California stockholder plaintiffs, the Supreme Court characterized the Chancery Court as having “sua sponte announced and applied an irrebuttable presumption that derivative plaintiffs who file their complaints without seeking books and records, very shortly after the announcement of a ‘corporate trauma,’ are inadequate representatives.” The Supreme Court declared, however, that “[w]e reject the ‘fast filer’ irrebuttable presumption of inadequacy.” Although it acknowledged that “fast filers” may be inadequate, there “is no record support for the trial court’s premise that stockholders who file quickly, without bringing a § 220 books and records action, are a priori acting on behalf of their law firms instead of the corporation.” Without the presumption, it held the Chancery Court had no basis to deem the California plaintiffs inadequate, particularly since the California complaint was so similar to the Delaware complaint, which the Chancery Court found adequately stated a claim for relief. The Supreme Court added that trial court efforts to address the “fast filer” problem “should be directed at the lawyers, not the stockholder plaintiffs or their complaints.”

Pyott strongly reaffirms the use of collateral estoppel by defendants to ensure that dismissals outside Delaware on for failure to plead demand futility have preclusive effect within Delaware. At the same time, by refusing to draw an inadequacy-of-representation inference from “fast filer” conduct alone, Pyott casts doubt on the use of any form of “fast filer” presumption, including the rebuttable presumption the Chancery Court adopted just last year to ensure that its dismissal of a derivative complaint (filed before any books and records inspection) had no preclusive effect on the future litigation efforts of other stockholders whose inspection demands were pending. See South v. Baker, C.A. No. 7294-VCL, 2012 Del. Ch. LEXIS 229 (Del. Ch. Sept. 25, 2012) [blog article here]. In fact, by stating that trial courts should direct their efforts to address “fast filer” behavior at plaintiffs’ counsel, and not plaintiffs (or their complaints), the Delaware Supreme Court is arguably signaling that the fast-filing issue is not a proper collateral estoppel consideration.

For further information, please contact John Stigi at (310) 228-3717 or John Landry at (213) 617-5561.