Business Litigation

Delaware Court of Chancery Applies Direct/Derivative Distinction In Voting Context

By Lewis H. Lazarus, R. Eric Hacker and Tyler O’Connell of Morris James LLP

The disenfranchisement of an investor with voting or consent rights often is considered to be a direct harm, thus permitting the investor to bring direct claims.  Sometimes, however, the alleged harm from the violation of voting rights is to the company, and it does not directly affect the investor.  The Court of Chancery’s recent decision in Clifford Paper, Inc. v. WPP Investors, LLC, 2021 WL 2211694 (Del. Ch. Jun. 1, 2021), illustrates that, in such instances, a court applying Delaware law may treat those claims as derivative.

Plaintiff Clifford Paper, Inc. (“CPI”) formed World Pac Paper, LLC (“WPP” or “Company”) with the defendants.  CPI and the defendants shared management duties, and CPI separately performed services for the Company.  CPI withdrew from the Company in 2018 after asserting that the defendants had breached the Company’s operating agreement in numerous ways, including by taking unilateral action on matters where CPI had voting or veto rights, and that the defendants had breached their fiduciary duties.

CPI subsequently sued in 2020 alleging various breaches of the Company’s operating agreement, including that it had been disenfranchised.  The defendants moved to dismiss on the theory that CPI lacked standing because its claims were derivative and that, under Delaware’s LLC Act, former members do not have standing to bring derivative claims.  See 6 Del. C. § 18-1001. 

In considering the defendants’ motion to dismiss, the Court first addressed CPI’s argument that Delaware’s so-called Tooley framework to differentiate between direct and derivative claims did not apply in the context of a two-member LLC.  The Tooley test asks whether (i) the company or the individual suffered the harm, and (ii) the company or the individual would receive the benefit of any remedy.  See Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A. 2d 1031, 1039 (Del. 2004). 

Here, the Court rejected CPI’s proposed distinction and concluded that the claims were derivative.  The Court noted that the LLC Act does not recognize an exception for two-member companies when discussing the requirements for derivative actions.  And the precedents CPI relied upon were inapt, as they involved dissolved companies, or other circumstances where a plaintiff with standing properly brought derivative claims, but the court reasoned a remedy might flow directly to investors.  See, e.g., In re Cencom Cable Income Partners, L.P., 2000 WL 130629 (Del. Ch. Jan. 27, 2000) (addressing direct/derivative distinction in the context of a dissolved limited partnership); In re El Paso Pipeline P’rs, LP Deriv. Litig., 132 A.3d 67, 121 (Del. Ch. 2015) (discussing equitable grounds to allow stockholders to recover on derivative claims directly), rev’d on other grounds sub nom. El Paso Pipeline GP Co., L.L.C. v. Brinckerhoff, 152 A.3d 1248 (Del. 2016).  Such precedents did not support, however, disregarding the derivative nature of the claims in this different context. 

The Court then explained, claim by claim, that the benefit of any remedy here would flow first to the company.  Specifically, CPI argued it would not have approved of (i) creating a new lucrative executive position for a relative of one of the defendants, and (ii) hiring a new financial advisor.  The Court reasoned, however, that CPI alleged such actions resulted in financial harm to the Company, for which CPI sought compensatory damages.  Accordingly, the claims were derivative.  Because CPI withdrew from the Company before filing the action, CPI lacked standing to pursue such claims.  Accordingly, the Court granted the defendants’ motion to dismiss. 

Stockholders Lack Derivative Standing to Challenge Transactions Whose Terms Were Set Before They Became Stockholders

By K. Tyler O’Connell and Barnaby Grzaslewicz, of Morris James LLP

Under the “contemporaneous ownership rule,” to have standing to bring derivative claims, stockholders in a Delaware corporation must own stock at the time of a challenged transaction.  The general rule is that the time of the transaction is when the terms were established, but there are narrow exceptions, such as where the terms were modified and not disclosed, in which case a court may look to when the transaction was consummated.  In In re SmileDirectClub, Inc., 2021 WL 2182827 (Del. Ch. May 28, 2021), the Delaware Court of Chancery found that the general rule applied where plaintiffs challenged the terms of a transaction related to an IPO through which they became stockholders.

In connection with its IPO, SmileDirectClub issued a prospectus that disclosed, among other things, the company’s intent to use some of the proceeds of the IPO to finance an insider transaction in which the company would purchase the shares of some pre-IPO investors at the IPO price.  Shortly after the IPO, however, the company’s share price dropped, allegedly due to certain undisclosed regulatory and financial challenges.  The plaintiffs, who purchased stock and became stockholders as part of the IPO, brought derivative claims for breaches of fiduciary duty against the board of directors, alleging that these challenges were known before the board approved the insider share repurchases at the allegedly inflated IPO price. 

The defendants moved to dismiss on the grounds that the plaintiffs were not stockholders at the time of the relevant transaction and so lacked standing.  The defendants argued that, under the general rule, the terms of the insider transaction were established before the IPO and before the plaintiffs became stockholders.  The plaintiffs argued that an exception should apply because the declining stock price and regulatory challenges became public knowledge only after the terms of the insider transaction were established.  The Court found that inapt, however, because the terms themselves were disclosed as part of the IPO and were not modified.  Because the time of the challenged transaction was when the terms were established, a point before the plaintiffs became stockholders, the Court granted the defendants’ motion to dismiss. 

The Supreme Court Grants Certiorari to Determine if Federal Courts Have Subject Matter Jurisdiction to Confirm or Vacate an Arbitration Award  

By: Leslie A. Berkoff

On May 17, 2021, the U.S. Supreme Court granted certiorari to address the question as to whether federal courts have subject matter jurisdiction to confirm or vacate an arbitration award under Sections 9 or 10 of the Federal Arbitration Act (“FAA”) where the only basis for jurisdiction is that the underlying dispute involves a question of federal law.  See Badgerow v. Walters, No. 20-1143 (Cert. granted 5-17-21).  The appeal seeks to challenge a decision by the Fifth Circuit finding that under Section 4 of the FAA, a petition to compel arbitration can be determined by “any United States district court which, save for [the arbitration] agreement, would have jurisdiction under title 28, in a civil action . . . of the subject matter of a suit arising out of the controversy between the parties.”  9 U.S.C. § 4.

The underlying case involves a suit by an employee (“Employee”) who was terminated by her employer REJ Properties (“REJ”), whose principals (collectively, “Principals”) worked for an independent company, Ameriprise Financial Services, Inc. (“Ameriprise”).  Badgerow had agreed to arbitrate any disputes with Ameriprise, its affiliates, or the Principals, before the Financial Industry Regulatory Authority (“FINRA”).  Badgerow commenced an arbitration proceeding against the Principals before FINRA and Ameriprise then moved to compel arbitration in a separate federal action.  In response, Badgerow brought a declaratory judgment claim against Ameriprise, but FINRA dismissed all of Badgerow’s claims against both the Principals and Ameriprise.  Badgerow then filed an action in a Louisiana state court (“State Court Action”) to vacate the FINRA award.  The Principals removed the State Court Action to federal court and Badgerow responded with a motion to remand, asserting that no federal jurisdiction over the dispute existed.  (The Principals also filed a motion to confirm the FINRA arbitral award).  The district court found that it had federal subject matter jurisdiction, denied the motion to remand, and confirmed the award.  On appeal, the Fifth Circuit found that the federal claims asserted against Ameriprise in the FINRA arbitration provided federal jurisdiction over the petition to vacate the FINRA arbitrators’ dismissal award, and Badgerow then filed a petition for cert.

In Vaden v. Discover Bank, 556 U.S. 49 (2009) the Supreme Court previously held that the proper analysis to determine federal court jurisdiction over petitions to compel arbitration under Section 4 of the FAA should focus on whether the underlying dispute involves a federal claim and analyze whether the court would have jurisdiction absent the arbitration agreement.  See 556 U.S. at 66 (known as the “look through” approach).  However, the Vaden decision and its focus on the text of Section 4, has caused confusion and led to a circuit split.  The First, Second, Fourth and Fifth Circuits apply the “look through” approach to applications to confirm or vacate an arbitration award, but the Third and Seventh Circuits do not.  Compare Ortiz-Espinosa v. BBVA Securities of Puerto Rico, 852 F. 3d 36 (1st Cir. 2017), Landau v. Eisenberg, 922 F.3d 495, 498 (2d Cir. 2019), McCormick v. America Online Inc., 909 F.3d 677 (4th Cir. 2018), and Quezada v. Bechtel OG&C Const. Servs., Inc., 946 F.3d 837 (5th Cir. 2020) with Magruder v. Fidelity Brokerage Servs., LLC, 818 F.3d 285 (7th Cir. 2016) and Goldman v. Citigroup Global Mkts. Inc., 834 F.3d 242 (3d Cir. 2016).  Further, the Fifth Circuit has concluded that all sections of the FAA should be treated as a “single, comprehensive statutory scheme” and has applied the “look through” analysis to petitions to compel arbitration under Section 4, as well as, to petitions to confirm, vacate or modify awards under Sections 9-11.  Quezada, 946 F.3d at 842-43. 

Given that the enforcement of arbitral awards is an important issue for the federal courts, particularly in light of the continued growth of ADR as a means for resolving disputes, the Supreme Court’s resolution of Badgerow could have far-reaching consequences.  Of course, this will depend on whether the Court renders a decision limited to Section 4, focused solely on the language of that Section or chooses to apply a broader approach to all arbitration related proceedings consistent with the overall policy of the FAA.

Merits briefing in Badgerow is to be completed in September 2021.



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