It appears to be the best of times for securities class action defense attorneys. Since the date of last year's conference, appellate courts have started to interpret the Private Securities Litigation Reform Act of 1995. Their opinions portend the eventual emergence of a clarity that will assist defense attorneys in counseling clients on how to avoid a securities lawsuit; that most courts to date have ruled favorably to securities defendants means that our counsel need not be gloomy if a lawsuit materializes. In addition, Congress enacted the Securities Litigation Uniform Standards Act of 1998. In consequence, the State law securities fraud lawsuit - at least as asserted on a class-wide basis - has been consigned to the dust bin of history.

Accompanying this progress, however, is a spectre haunting the securities defense bar: the spectre of the derivative lawsuit. To be certain, there have always been derivative lawsuits that followed on the heels of the federal securities class action lawsuit. In the first half of this decade, however, this was the rare exception to the rule. In my observation, that is no longer the case. Prudent defense attorneys should anticipate that a federal securities class lawsuit will give birth to what I shall call a parallel derivative lawsuit - that is, a lawsuit seeking redress for injuries on purported behalf of the corporation against those directors and officers who allegedly committed or allowed to occur the violation of securities law alleged in the underlying class action lawsuit.1 The Uniform Standards Act has allowed this development by exempting derivative suits from the full scope of its coverage.2 And some litigants who may believe that they purchased a corporation's stock at an inflated price, but are now ineligible or unable to plead a securities class action claim, may be tempted to express their displeasure in a derivative capacity if they still retain that stock.3

My central thesis is that the parallel derivative lawsuit presents qualitatively different dangers to the corporation than the traditional derivative lawsuit (that is, a lawsuit challenging the board's conduct in a discrete corporate transaction or decision such as a merger or the distribution of corporate largesse).4 I explain why this is so in the first section of this article. In the second section, I discuss why traditional means of screening or resolving unwarranted derivative lawsuits may not function effectively in the context of a parallel derivative lawsuit. In the third and final section, I discuss alternative doctrines and procedures (both old and new) to allow courts and defense counsel to respond to the parallel derivative lawsuit. My intent is to be suggestive and evocative rather than definitive; indeed, one of my conclusions is that the empirical attention that has been paid to class action lawsuits since the enactment of the Reform Act should also be extended to derivative lawsuits.

1.  The Special Nature of Parallel Derivative Lawsuits

INSULT TO INJURY

Shareholders own corporations, but it is a vicarious form of ownership. Shareholders do not run the corporation and they certainly are not its attorneys. Rather, decisions to file or refrain from filing lawsuits on behalf of a corporation are the exclusive province of the Board of Directors.5 All derivative lawsuits threaten this authority. That is why a shareholder must either demand that the Board protect the corporation's interests by bringing a lawsuit on the corporation's behalf, or explain why demand would have been futile, in order to establish his or her standing to bring a derivative lawsuit.6

It is unusual enough for any party to find itself a plaintiff without its consent. Yet a parallel derivative extends the displacement of litigation authority. In a traditional derivative lawsuit, a shareholder seeks to challenge a corporate decision where the corporation may not have decided to assert such a challenge. In a parallel derivative lawsuit, the subject matter of the derivative claim is itself entwined with preexisting litigation: namely, the underlying securities class action lawsuit. For this reason, by necessity, the derivative shareholder infringes upon two sets of litigation prerogatives: the decisions in a lawsuit asserting claims on behalf of a corporation against its officers and directors, and the decisions in a claim against the corporation and its officers and/or directors.

This factor presents real dangers to the corporation. A securities class action lawsuit poses a very serious threat to a corporation and its shareholders. Yet where the Board must look over its shoulder in defending the corporation and its officers against securities fraud allegations, to a second lawsuit asserting the same allegations in the name of the corporation, the Board's litigation discretion may be limited. For example, the existence of parallel derivative suit, which asserts that a corporation's officers and directors are malevolent persons who owe the corporation money, at least implicitly contradicts a corporation's decision to advance defense expenses for its officer and directors.7 The longer the derivative claim proceeds - and especially if it proceeds to discovery, or if a Special Litigation Committee is appointed to investigate the substantive allegations against the officers and directors - the greater the probability exists that the underlying securities class action lawsuit will be affected in a manner that the Board would not have chosen had it been allowed to decide how to proceed in its own. To the injury of a securities class action lawsuit, the parallel derivative lawsuit adds the insult that the Board is incapable of deciding what to do about that lawsuit.

CRUEL TO BE KIND

In practice, the parallel derivative lawsuit may be regarded as an action that cannot succeed in recovering damages from officers and directors for the corporation without rendering the corporation liable to the securities class action plaintiffs. In this respect, vigorous pursuit of a parallel derivative lawsuit actually threatens to create securities fraud liability that would not otherwise exist against a corporation.

The first reason why a parallel derivative lawsuit threatens to create securities fraud liability against a corporation that would not otherwise exist arises from the intersection of the securities class action plaintiff's requirement to plead and prove corporate scienter and the derivative plaintiff's requirement to plead demand futility. The means by which the former may be done are largely uncharted. Plaintiffs typically contend that, at the very least, the scienter of senior management personnel may imputed to the corporation.8 In today's environment, however, securities class action plaintiffs most often do not accuse a corporation's outside directors of fraud.9 Derivative plaintiffs, however, display no such reticence. An integral part of their litigation strategy is to seek to disable the directors from considering demand by accusing them of knowing participation or acquiescence in the malfeasance alleged in the underlying securities class action lawsuit. See Section 2, infra. By this strategy, derivative plaintiffs may actually expand the set of persons whose scienter may be imputed to the corporation (under the class action plaintiffs' theory). It is difficult to imagine why a rational corporate Board would choose to take this action if it had a choice.10

The second reason why a parallel derivative lawsuit threatens to create securities fraud liability against a corporation that would not otherwise exist is simpler: especially under present interpretations of the Reform Act, it may be impossible to state a federal securities fraud claim. A rational corporation has no interest in pursuing derivative claims (including developing a factual record therein) seeking recovery against the officers or directors alleged to have submitted the corporation to securities fraud liability, where it has already been held that a securities fraud claim cannot be stated against the corporation and its officers and/or directors. At present, however, there is no certainty that once the federal securities class action lawsuit is dismissed, dismissal of its parallel derivative counterpart will follow. Indeed, the Reform Act discovery stay increases the probability that the derivative lawsuit will be litigated on a faster track than its class action antecedent. Thus, a corporation may discover itself contesting a derivative lawsuit against litigants who contend that the corporation has been injured, when the only real threat of injury is the derivative lawsuit itself.

For both of these reasons, the interference with litigation decisions posed by the parallel derivative lawsuit must be carefully scrutinized. Indeed, even (and especially) if there is no pending securities fraud lawsuit, there is no benefit to litigating a derivative case that seeks to or would have the effect of establishing a corporation's securities fraud liability. A critic of this perspective may contend that if a corporation's officers or directors committed fraud, they should not complain if their malfeasance is uncovered by the prosecution of a separate derivative lawsuit. Even if all allegations are credited as true, the shareholders of the corporation in whose purported name a derivative lawsuit is pursued would assume a different view. All securities class action defendants, be they corporate and individual, have legal responsibilities to truthfully respond to plaintiffs' allegations. A Board need not, and some would argue cannot, go further and acquiesce or participate in an admission of fraud. Rather, it has an affirmative legal responsibility to manage the business of a corporation for the benefit of the shareholders.11 Thus, shareholders should expect that their Board will contest securities class action allegations as vigorously as possible. Nor is it reasonable to insist that, in every case, as much litigation as possible should proceed in order to establish exactly who (if anyone) is responsible for false or misleading statements to investors. The theoretical damages attendant to securities class action claims are too large to worry about assigning individual financial responsibility for those damages, when the imposition of liability against the corporation is at stake.

2.  The Ineffectiveness of Traditional Screening Methods in the Parallel Derivative Lawsuit Context

That the derivative lawsuit threatens principles of corporate governance does not, by itself, require its abolition. Rather, courts (predominantly in Delaware) have developed doctrines and methods to screen unwarranted derivative lawsuits from those lawsuits that should be pursued because demand would be futile. Unfortunately, rightly or (as I contend) wrongly, these methods may be ill-suited to apply the type of scrutiny that should inhere to the parallel derivative lawsuit.

INDEPENDENCE ANALYSIS AND THE TRANSACTION LIMITATION

A key method by which courts screen unwarranted derivative lawsuits is to analyze whether plaintiffs have pleaded with particularity that the majority of the directors could not consider asserting the would-be derivative claims at the time the lawsuit was filed because they either lacked independence or possessed disabling personal interests. Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984). To plead director interest, the derivative plaintiffs must show that the directors "received . . . a personal financial benefit from the challenged transaction which is not equally shared by the stockholders."12 To plead lack of independence, "[plaintiff] must show that the directors are 'beholden' to [management] or so under their influence that their discretion would be sterilized."13 A derivative plaintiff may proceed if and only if he or she can plead demand futility on either basis.

This screening method is well suited to the traditional derivative lawsuit because the information needed to plead demand futility on this basis usually is in the public domain. If, for example, the terms of a major corporate transaction of the type challenged in the traditional lawsuit are disclosed in SEC filings, would-be derivative plaintiffs can review those filings and set forth their best argument as to why the transaction confers a personal benefit on the directors who voted in favor of it; and a court may determine very quickly whether plaintiffs have pleaded enough to demonstrate director interest. Thus, in the past year one Delaware Chancery Court opinion applied this screen and found that demand futility had been pleaded under the circumstances of the case, while another opinion carefully applied this test to different circumstances and determined that demand futility had not been pleaded.14

This screening method also should function effectively in the parallel derivative lawsuit context because pleading director interest or lack of independence is the only means by which demand may be excused in a derivative lawsuit that does not challenge a specific Board decision or transaction - i.e., a vote. Aronson holds that where a derivative plaintiff challenges a Board vote, he or she also may plead demand futility via particularized allegations that there is a reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment.15 Courts have held that where there is no challenged "transaction" at issue, plaintiffs cannot use this second part of the Aronson test to excuse their failure to make demand.16 Securities class action lawsuits, however, usually do not challenge a Board vote or decision. Rather, they challenge a corporation's public statements over a period of time (i.e., the class period). Thus, the second part of Aronson should not matter in the parallel derivative lawsuit context, which is based on the circumstances of the underlying securities class action; and a court should need only consider the first part of Aronson.

The apparent strength of this screen, however, may be circumvented (rightly or wrongly) in the prototypical parallel derivative lawsuit. First, the derivative plaintiffs may accuse a majority of the Board of involvement in or knowledge of the violation of securities law alleged in the underlying class action lawsuit. In a related move, the derivative plaintiffs may accuse those directors who happened to sell stock during the class period in the underlying securities case of "insider trading" under Delaware or California corporate law. By these allegations, parallel derivative plaintiffs may create the appearance of interest in the subject matter of the derivative claims on the part of directors whose independence and lack of interest otherwise could not be compromised.

Second, derivative plaintiffs may fashion a linguistic argument that the challenged corporate conduct constitutes a transaction or decision of the Board. Most securities class action lawsuits challenge a series of corporate public statements during a class period, and not a specific transaction such as a Board-approved merger or distribution. Most non-management directors would have little, if any, involvement with the corporation's public statements, other than (perhaps) approving their release in the course of their routine service as directors. Derivative plaintiffs, however, may contend that the "decision" to release the statements is a transaction to which the second Aronson prong may be applied. For example, if the underlying securities class action lawsuit alleges the publication of false financial statements, derivative plaintiffs may contend that at each Board meeting before the statements were published, the Board made a "decision" to allow their publication. Even if the derivative defendant responds to these arguments, the result is often to devolve the debate to a matter of semantics (if not metaphysics), in which a court inclined to allow a case to survive the pleading stage will find a way to do so.

Thus, while there is no valid reason why courts cannot continue to screen derivative lawsuits by asking whether a majority of the Board was independent of management or received a unique personal benefit from the challenged conduct, the effectiveness of this screen cannot be assured because in a parallel derivative lawsuit, the serious allegations typical of a securities class action lawsuit are leveled against the directors as well as officers. Indeed, as I explain in the next section, parallel derivative plaintiffs must make such allegations in order to survive the demand requirement.

BUSINESS JUDGMENT OR SUBSTANTIAL LIKELIHOOD OF BREACH OF DUTY

Another method by which courts screen unwarranted derivative lawsuits is to apply the second Aronson prong; that is, to analyze whether plaintiffs have pleaded particularized allegations giving rise to a reasonable doubt that the challenged Board decision was the product of a valid exercise of business judgment. To meet this standard, derivative plaintiffs must overcome the "powerful presumption" under the Business Judgment Rule,17 that the Board in question acted or refused to act "on an informed basis, in good faith and in the honest belief that [its actions were] taken in the best interests of the company."18 Plaintiffs must also show that as a consequence, there is a substantial likelihood that the directors will be found liable for the breach of duty.19 It should only be in rare cases that derivative plaintiffs should be able to meet this standard by pleading that a Board decision went "so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith."20 It should also be difficult for derivative plaintiffs to plead a substantial likelihood that the directors face personal liability because most corporations have enacted provisions in their Articles of Incorporation insulating directors from personal liability for the breach of fiduciary duty, other than if they acted in bad faith. Such provisions are authorized by Delaware law,21 and the authority is ample for enforcing them at the pleading stage in a derivative or breach of fiduciary duty lawsuit.22

Again, however, the effectiveness of this screening method is problematic in the parallel derivative lawsuit context. At the outset, if a court faced with a demand futility motion reaches the second Aronson prong, it probably already has rejected the above-referenced argument that only the first Aronson prong applies. Moreover, in contending that the second Aronson prong does not apply because there is no specific Board decision to which the presumptions of the Business Judgment Rule may be applied, a corporation may engender the misimpression that a demand futility motion (and, indeed, all deliberations of the Board of Directors) does not implicate the Business Judgment Rule.

Beyond these threshold difficulties, the main method by which parallel derivative plaintiffs seek to circumvent the second Aronson screen is familiar: by accusing a majority of the Board of actual involvement in or knowledge of the violation of securities law alleged in the underlying class action lawsuit. Such allegations may tempt a court to find that the directors are so implicated in the malfeasance of which plaintiffs complain that they cannot rely on the protections of the Business Judgment Rule or of director liability provisions in the Articles of Incorporation.23 Parallel derivative plaintiffs also may assert that they have satisfied the second Aronson prong because the directors face personal liability for their failure to prevent the irregularities giving rise to the underlying securities class action claim. Such allegations supposedly state a breach of fiduciary duty claim under In re Caremark Int'l, Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996). In other words, the plaintiffs may contend that had the Board faces liability because, had it instituted better internal control or systems, it would have detected and prevented the securities fraud before it occurred.

In sum, because the second Aronson prong and director liability provisions require that strong and harsh allegations be made in against a corporation's directors order to survive the pleading stage, parallel derivative plaintiffs inevitably must make such allegations. To be certain, all derivative plaintiffs may need make such allegations to bring a derivative lawsuit when a majority of Board members are independent of management. In the parallel derivative lawsuit context, however, these allegations harm the corporation in whose purported interests the derivative suit is brought by increasing the set of defendants whose scienter (arguably) may be imputed to it. See Section 1, supra. Furthermore, there is considerable irony in the fact that at the same time federal law is narrowing the scope of allegations (especially stock trading allegations) that suffice to state a securities fraud claim, the same allegations may be cited to circumvent the demand requirement in a parallel derivative lawsuit based on a purported securities fraud. And while there is ample precedent for courts to find such allegations insufficient to excuse demand,24 there can be no assurance that a court inclined to let a case proceed past the pleading stage will do so.

THE SPECIAL LITIGATION COMMITTEE

A third method of responding to a derivative lawsuit is not so much a screen as an alternative dispute mechanism: a Board may commission a Special Litigation Committee to investigate and report on the derivative allegations; and, if appropriate, recommend termination of the derivative lawsuit [2022 note — actually, make a decision on the lawsuit].25 It is easy to ascertain why the Special Litigation Committee alternative is not the optimal strategy in the parallel derivative lawsuit context. At least at present, it does not allow the corporation to resolve a case at the pleading stage. Moreover, a Special Litigation Committee investigation involves not only considerable expense and management distraction, but the risk (albeit remote) that the findings will affect the corporation adversely in the underlying securities class action lawsuit. In essence, it is a procedure to relive the traumas of a securities class action lawsuit by another name.

Moreover, a recent decision reaffirms that a Special Litigation Committee may not be effective in terminating a derivative lawsuit. In Electra Investment Trust PLC v. Crews, No. 15890, 1999 WL 135239 (Del. Ch. Feb. 24, 1999), the Delaware Chancery court was called upon to approve the settlement of a derivative case brought against a CEO had who allegedly misappropriated corporate funds. The court found that the settlement solved the CEO's "most egregious (alleged) abuses" by requiring reimbursement of the funds associated with most of the alleged transgressions. Nevertheless, the court refused to approve the settlement and terminate the lawsuit because, in its opinion, the Special Litigation Commission had not thoroughly investigated three other allegations. The court reached this conclusion even though two of those allegations involved very small sums ($2,600 in unauthorized child support payments, and unspecified travel and entertainment expenses).

3.  Alternative Methods to Screen the Unwarranted Parallel Derivative Lawsuit

If the parallel derivative lawsuit presents qualitatively different dangers to the corporation than the traditional derivative lawsuit, yet may not be as amendable than its counterpart to judicial methods of screening out unwarranted suits, then alternative methods are required. In this section, I suggest just a few of the methods and doctrines that courts can and should apply if the circumstances of the case and the arguments of counsel warrant.

JUDICIAL RECOGNITION OF THE DANGERS

My first suggestion is simple: in adjudicating a demand futility motion, courts should recognize the particular dangers of the parallel derivative lawsuit. The court's recognition may involve nothing more than applying careful scrutiny to allegations of director involvement in or knowledge of the underlying allegedly securities fraud. See p.6 & n.24, supra. In the alternative, the court may go further and find that under the circumstances of the case (as argued by counsel), as a matter of law, the interests of the corporation would not be served by the litigation of the parallel derivative case. In this regard, the court should apply the most rigorous scrutiny possible to assertions that directors committed acts or omissions that would render them liable under the securities fraud laws, where no such allegations have been made against those directors in the underlying securities class action case (or at all).

Until the past year, one case was in the vanguard of judicial recognition of the dangers of a pursuing a derivative lawsuit that could hurt the corporation in a related lawsuit against the corporation. In In re E.F. Hutton Banking Practices Litigation, 634 F. Supp. 265 (S.D.N.Y. 1986), derivative plaintiffs sued a corporation's officers and directors, alleging that they knew or should have known of excessive overdrafts that had caused the company to plead guilty to criminal mail and wire fraud charges.26 Pending at the same time were fourteen other lawsuits (and a possible SEC investigation) "based upon, among other things, the conduct claimed to have been approved by the directors that plaintiffs now seek to have the Corporation sue . . ."27 The district court cited the presence of these lawsuits in suggesting that even if the derivative claims against "many - if not all - of the defendants named in the complaint had merit" (which was a distinct possibility given the corporation's guilty pleas), a disinterested Board might nevertheless decide that pursuing the derivative claims was not in the corporation's best interests:

It seems obvious that the directors whom plaintiffs wish to sue would be important witnesses for the Corporation in all of the existing and threatened litigation, and that a disinterested board might well - upon the advice of counsel retained to defend the Corporation in this litigation - conclude it to be unwise to subject them to further litigation clearly calculated to undercut their veracity and general effectiveness as witnesses.28

In the past year, another Chancery Court has recognized the special nature of challenges to a Board's decision-making authority, where a different course of action (as suggested by derivative plaintiffs) could subject the corporation to harm in a separate lawsuit arising from the same facts. In dismissing breach of duty claims against a Board that allowed an unsuccessful president to resign without fault and accept an ample severance package, the Chancery Court in In re the Walt Disney Co. Derivative Litig., 731 A.2d 342, pointed to the possibility that, if the derivative plaintiffs had their way, the corporation would expose itself to the dangers of separate litigation:

Alternatively, the Board might have terminated [the president] for good cause and, in the process, exposed Disney to the risk and exposure of a protracted court battle. The Board might have sued [the president] for breach of contract. This, too, could have exposed [the president] to various risks, including the nuisance of having to defend a countersuit brought by [the president] . . . [&] The Board made a business decision to grant [the president] a Non-Fault Termination. Plaintiffs may disagree with the Board's judgment as to how this matter should have been handled. But where, as here, there is no reasonable doubt as to the disinterest of or absence of fraud by the Board, mere disagreement cannot serve as grounds for imposing liability based on alleged breaches of fiduciary duty and waste.29

These cases illustrate that the concept that a derivative suit should be dismissed because it interferes with and threatens to create legal liability in a related suit against the corporation is not foreign to derivative case jurisprudence. They also show that courts are capable of judging whether a derivative lawsuit in fact implicates the dangers presented in a separate lawsuit against the corporation.30 As suggested by E.F. Hutton's reference to "the advice of counsel retained to defend the Corporation in this litigation," the corporation's counsel - perhaps counsel for a new form of Special Litigation Committee given the authority to determine, at the pleading stage, whether pursuing a derivative lawsuit would be in the best interests of the corporation - should be prepared to articulate to the court the reasons why such dangers are present. If, in contrast, a corporation believes that the derivative claims should be pursued notwithstanding their potential danger, then this, too, may be communicated to the court.

DOCTRINES OF DELAY AND DEFERENCE

If a court cannot be persuaded to dismiss a parallel derivative case based on the dangers of such a lawsuit to the corporation, then defense counsel should consider asking it for the next best alternative: stay the derivative lawsuit until the underlying securities class action lawsuit proceeds to judgment, so as to eliminate (or at least drastically reduce) the probability that the derivative lawsuit will create corporate liability that otherwise would not exist.

Staying a derivative suit until the underlying securities class action case is resolved is consistent with many pertinent doctrines. It is consistent with Delaware Corporations Code Section 145(e), which allows a corporation to advance the defense costs of its officers and directors, upon the signing of an undertaking that obligates the indemnitee to reimburse the corporation if, in the future, it is determined that he or she is not entitled to indemnification.31 It also is consistent with the Reform Act, which provides new procedures for determining the parties' relative liabilities at the end of the lawsuit.32 It is further consistent with the Uniform Standards Act, which looks to the federal courts for guidance in interpreting securities fraud law.

In the past year, a Delaware Chancery Court decided to delay a derivative suit in favor of a pending non-derivative case under circumstances far less compelling than those presented in the typical parallel derivative lawsuit. In Apple Computer, Inc. v. Exponential Technology, Inc., No. 16315, 1999 WL 3954 (Del. Ch. Jan. 21, 1999), a corporation's largest shareholder brought both direct and derivative claims alleging that the corporation's sale of its patent portfolio and granting of "litigation support agreements" constituted a breach of fiduciary duty, corporate waste, and an inappropriate attempt to underwrite a separate breach of contract lawsuit that the corporation was pursuing in California against the shareholder. The Chancery Court dismissed most of the direct claims and all of the derivative claims.33 The Court then stayed the remaining claims because the factual record developed in the California action would be "useful" in resolving the Delaware dispute - even though the substantive disputes in the two actions were not the same, and a judgment in the California case would not conclusively resolve the Delaware action.34

If a court cannot be persuaded to stay the parallel derivative lawsuit in favor of its federal securities court cognate, then defense counsel should contend that, at a minimum, to the extent the derivative claim is predicated on the existence of the corporation.s breach of the federal securities laws or their State law counterparts, federal pleading standards should be applied. While it may not be possible to remove a derivative case to federal court, it would be inconsistent with the Reform Act and the Uniform Standards Act to allow an end-run around federal pleading standards by applying liberal State pleading rules to essentially federal claims. Moreover, incorporating federal pleading standards reduces the possibility that the same allegations that would not state a securities fraud claim would suffice to allow a parallel derivative suit to proceed. Furthermore, as courts in the past year have reaffirmed, the imposition of strict pleading standards to demand futility allegations is consistent with the protection for the Board's authority embodied in the demand requirement.35

TAKE CAREMARK SERIOUSLY - OR NOT AT ALL

If a court cannot be persuaded by dismiss or stay a parallel derivative lawsuit, then defense counsel also should pay particular attention to demand futility arguments premised on the existence of a Caremark claim for the failure to institute adequate internal control systems.

In point of fact, the "claim" discussed by Caremark is dictum. The opinion arose in the context of an uncontested settlement of derivative claims alleging that the directors had failed to prevent certain officers from conduct that led to criminal bribery charges and huge monetary losses. The defendants moved to dismiss the derivative lawsuit on the basis that demand had not been excused and that Caremark's articles of incorporation precluded holding the directors personally liable for monetary damages.36 In approving the settlement, Chancellor Allen reasoned that the Delaware Supreme Court, if confronted with the issue, would not rule out the possibility that a director could be liable for the failure to prevent corporate officials from violating the law, notwithstanding the Supreme Court's rejection of a similar claim in Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125 (Del. 1963).

If courts are inclined to follow Caremark's dictum, then it is only fair that they also recognize that case's restriction of the claim hypothecated therein. Chancellor Allen opined that "only a sustained or systematic failure of the board to exercise oversight - such as an utter failure to attempt to assure a reasonable information and reporting system exists - will establish the lack of good faith that is a necessary condition to liability. Such a test of liability - lack of good faith as evidenced by sustained or systematic failure to exercise reasonable oversight - is quite high."37 Crucially, in assessing whether such a claim may be stated, the directors' decisions to set a particular level or system of controls to monitor and ensure compliance with the law are itself protected by the Business Judgment Rule: "[O]bviously, the level of detail that is appropriate for such an information system is a question of business judgment."38 Moreover, in monitoring the corporation's compliance with the law, as a matter of law, the directors may rely on the bona fides of the corporation's employees: "[N]either corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the company's behalf."39 Even if the directors are misled by their reliance, they cannot be faulted: "[O]bviously, too, no rationally designed information and reporting system will remove the possibility that the corporation will violate laws or regulations, or that senior officers or directors may nevertheless sometimes be misled or otherwise fail reasonably to detect acts material to the corporation's compliance with the law."40

In sum, as Caremark itself states, the potential theory of theoretical claim therein is "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."41 It should not provide comfort to parallel derivative plaintiffs seeking to excuse demand. If anything, the invocation of Caremark should entice a court to dismiss a derivative lawsuit. If the complaint pleads that directors took any action or made any decision whatsoever regarding the subject matter of the underlying securities class action lawsuit, then the directors are entitled to the presumption that they took those actions or made those decisions (and made "decisions" not to take other actions) in the belief that they established internal controls adequate to ensure the corporation's compliance with the securities laws.

MINOR REPAIRS

In addition to the measures discussed above, there are smaller steps that courts, counsel, and commentators should heed in conferring sensible treatment to the parallel derivative lawsuit.

First, courts must be vigilant in applying the law of the State of incorporation to define and delimit the fiduciary duties of officers and directors. For their part, the Delaware courts do not hesitate (where appropriate) to apply the law of the State of incorporation, even if that State is not Delaware.42 Other courts, however, may be tempted to follow the law of the State in which a corporation has its principal place of business. This temptation should be resisted. A corporation is a creation of its State of incorporation, and owes its existence to the laws of that State.43 Moreover, in those cases where the shareholders have voted to reincorporate their corporation in a particular State, a few shareholders suing derivatively should not be allowed to override that vote by asserting that another State's law governs the responsibilities of the corporation's officers and directors.44

Second, the limitations on professional securities class action plaintiffs should be applied to derivative lawsuits. There is no reason why litigants should be allowed to file multiple derivative lawsuits.45 There is no reason why the derivative plaintiff should not be required to certify that he or she did not become a shareholder for the purpose of bringing a lawsuit. There are good reasons to apply both limits to derivative litigants.

Finally, the empirical attention that has been paid to class action lawsuits since the enactment of the Reform Act should be extended to derivative lawsuits. The data collected on the number and types of securities fraud claims has assisted both the plaintiffs and defense bar. If this article is correct, the significance of derivative lawsuits (and, perhaps, of lawsuits alleging the breach of disclosure-related fiduciary duties in connection with a corporation's public statements) will increase as the federal securities class action window closes (and, in all probability, even if it reopens). As a result, both motive and opportunity exist for the commentator and practitioner to pay attention to this phenomenon.

Footnotes

1. In California courts alone, parallel derivative cases filed since the enactment of the Reform Act include Conway v. Ellison, No. 407042 (San Mateo Cty. Super. Ct. Nov. 17, 1998); Angard v. Lorsch, No. BC200290 (Los Angeles Cty. Super. Ct. Nov. 5, 1998); Durrett v. McCabe, No. 406767 (San Mateo Cty. Super. Ct. Oct. 26, 1998); In re Sybase II Derivative Litig., No. C-98-1538 CAL (N.D. Cal. Apr. 15, 1998); In re Sybase, Inc. Derivative Litig., No. 793459-9 (Alameda Cty. Super. Ct. Jan. 27, 1998); Frezza v. Johnson, No. CV770254 (Santa Clara Cty. Super. Ct. Nov. 20, 1997); Sucher v. Alon, No. C 98-203 CRB (N.D. Cal. Oct. 10, 1997); In re Informix Derivative Litig., No. 401818 (San Mateo Cty. Super. Ct. Aug. 25, 1997); Great Neck Cap. Appreciation Inv. Partnership, L.P. v. Brown, No. 762040 (Santa Clara Cty. Super. Ct. Nov. 8, 1996); Tinkler v. Hasler, No. 776206-4 (Alameda Cty. Super. Ct. Nov. 20, 1996); Shockley v. Carrington, No. 762109 (Santa Clara Cty. Super. Ct. Nov. 3, 1996); The Lauren Group v. Huh, No. 760270 (Santa Clara Cty. Super. Ct. Aug. 23, 1996); and Nitti v. Iftikar, No. 766779-8 (Alameda Cty. Super. Ct. Apr. 29, 1996). Undoubtedly, more have been filed. See p.11, infra (calling for empirical data on this phenomenon).

2. See Malone v. Brincat, 722 A.2d 5, 13 (Del. Dec. 18, 1998) (discussing so-called "Delaware carve-outs" to Uniform Standards Act, which preserve derivative actions and class actions alleging the breach of fiduciary disclosure obligations to shareholders in limited contexts). I will consider the scope and implications of this exception in a separate article.

3. For example, the Reform Act now provides that a person is ineligible to file a securities class action lawsuit if he or she already has filed five such actions in the preceding three years. Securities Act of 1933 Section 27(a)(3)(B)(vi); Securities Exchange Act of 1934 Section 21D(a)(3)(B)(vi).

4. Recent examples of such "traditional" derivative lawsuits (some of which were also asserted as direct shareholder actions, but not as securities fraud class actions) include Lewis v. Austen, No. C.A. 12937, 1999 WL 378125 (Del. Ch. June 2, 1999) (challenge to adjustments to stock option plan that allegedly gave directors more stock than the amount to which they were entitled); In re Dairy Mart Convenience Stores, Inc. Deriv. Litig., No. C.A. 14713, 1999 WL 350473 (Del. Ch. May 24, 1999) (challenge to complex of transactions transferring voting control of corporation); Solomon v. Armstrong, No. Civ. A. 13515, 1999 WL 182569 (Del. Ch. Mar. 25, 1999) (challenge to transactions spinning off subsidiary and its tracking stock); Emerald Partners v. Berlin, 726 A.2d 1215 (Del. Mar. 16, 1999) (challenge to merger); PaineWebber R & D Partners II, L.P. v. Centocor, Inc., No. 14405, 1999 WL 160123 (Del. Ch. Mar. 15, 1999) (challenge to series of marketing agreements); Boyer v. Wilmington Materials, Inc., No. 12549, 1999 WL 39549 (Del. Ch. Jan. 20, 1999) (challenge to sale of substantially all of corporation's assets); and In re the Walt Disney Co. Derivative Litig., 731 A.2d 342 (Del. Ch. Oct. 7, 1998) (challenging to severance package given to corporation's president).

5. Delaware Corporations Code Section 141(a); see, e.g., Grimes v. Donald, 673 A.2d 1207, 1215 (Del. 1996) ("it is the corporation, acting through its board of directors, which must make the decision whether or not to assert the claim"); Zapata Corp. v. Maldonado, 430 A.2d 779, 782 (Del. 1981) (Board's "decision making power . . . encompasses decisions whether to initiate, or refrain from entering, litigation[.]").

6. See Kamen v. Kemper Fin. Serv., Inc., 500 U.S. 90, 101 (1991) (demand requirement implements "the basic principle of corporate governance that the decisions of a corporation-including the decision to initiate litigation-should be made by the Board of directors or the majority of the shareholders.") (quotation omitted): Spiegel v. Buntrock, 571 A.2d 767, 772-73 (Del. 1990) (demand requirement assures that the Board has "the opportunity to address an alleged wrong without litigation, to decide whether to invest the resources of the corporation in litigation, and to control any litigation which does occur."); Nelson v. Anderson, 72 Cal. App. 4th 111, ___, 84 Cal. Rptr. 2d 753, 763-64 (May 17, 1999) (failure to comply with California statutory demand requirement "deprives a litigant of standing"); Shields v. Singleton, 15 Cal. App. 4th 1611, 1619 (1993) (one purpose of demand requirement is "to protect the managerial freedom of those to whom the responsibility of running the business is delegated.").

7. See Delaware Corporations Code Section 145(e).

8. See, e.g., Nordstrom v. Chubb & Son, Inc., 54 F.3d 1424, 1435 (9th Cir. 1995) (insurance coverage dispute) ("[A] corporation may be liable for actions by senior management personnel that are 'intrinsically corporate and bear the imprimatur of the corporation itself.' . . . "); Hanon v. Dataproduct Corp., 976 F.2d 497, 507 (9th Cir. 1992) (fact issue as to company's scienter existed where employees knew of problems with company's key product at time company made optimistic statements regarding product). Defendants often respond that Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), eliminated all non-statutory forms of secondary liability for securities fraud, included the theory that scienter may be imputed under doctrines of agency or respondeat superior. See Converse, Inc. v. Norwood Venture Corp., No. 96 Civ. 3745, 1997 U.S. Dist. LEXIS 19106, *10 (S.D.N.Y. Dec. 1, 1997) (finding "claims based on agency liability are no longer viable after Central Bank"); In re Fidelity/Micron Sec. Litig., 964 F. Supp. 539 (D. Mass. 1997) (no respondeat superior liability); ESI Montgomery County, Inc. v. Montenay Int'l Corp., 94 Civ. 0119 (RLC), 1996 U.S. Dist. LEXIS 592, *8 (S.D.N.Y. Jan. 23, 1996) (Central Bank precludes holding corporation liable for alleged misrepresentations of its officers based on respondeat superior); 9 Louis Loss & Joel Seligman, SECURITIES REGULATION, Ch.11 s. (1)(c), 1998 Supp. at 957 (after Central Bank, "there would appear to be no principled basis for other forms of implied derivative liability under Section 10(b) such as respondeat superior."). In addition, a provision in the Reform Act suggests that only the scienter of the executive officer(s) who made or approved a corporation's public statement may be imputed to the corporation. Securities Exchange Act of 1934 s. 21E(c)(1)(B)(ii) (with respect to a statement made on behalf of a corporate entity, a plaintiff must prove that a forward-looking statement was "made by or with the approval of an executive officer of that entity . . . with actual knowledge by that officer that the statement was false or misleading.") (emphasis added).

9. To take one factor, even assuming that the group pleading doctrine survives the Reform Act and allows a plaintiff to attribute a corporation's public statement to individuals who did not make that statement, see Coates v. Heartland Wireless Communications, No. 98-CV-0452-D, 1998 U.S. Dist. LEXIS 17383, *11 (N.D. Tex. Nov. 2, 1998) (it does not); Allison v. Brooktree Corp., 999 F. Supp. 1342, 1350 (S.D. Cal. 1998) (it may not), courts generally do not apply that doctrine to non-management directors.

10. A corollary of this proposition is that a parallel derivative lawsuit alleging a violation of securities law on the part of persons whose scienter may not be imputed to the corporation presents different considerations, and arguably (but by no means conclusively) a stronger claim to be in the corporation's best interests.

11. See Malone, 722 A.2d at 9.

12. Pogostin v. Rice, 480 A.2d 619, 624 (Del. 1984); see also Allison ex rel. General Motors Corp. v. General Motors Corp., 604 F. Supp. 1106, 1114 (D. Del.) (demand not excused unless plaintiff "makes sufficiently particular allegations of participation, self-dealing, bias, bad faith, or corrupt motive"), aff'd, 782 F.2d 1026 (3rd Cir. 1985).

13. Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993).

14. Compare Mizel v. Connelly, No. Civ. A. 16638, 1999 WL 550369 (Del. Ch. July 22, 1999) (demand excused where CEO \ largest shareholder and two management subordinates constituted majority of board); and In re the Walt Disney Co. Derivative Litig., 731 A.2d at 356-361 (dismissing derivative claim following director-by-director independence analysis).

15. 473 A.2d at 814.

16. See Rales, 634 A.2d at 934 n.9 (second Aronson prong does not apply to cases in which "directors are sued derivatively because they have failed to do something (such as the failure to oversee subordinates)"); In re the Walt Disney Co. Derivative Litig., 731 A.2d at 379 (same); In re Baxter Int'l, Inc. Shareholders Litig., 654 A.2d 1268, 1269 (Del. Ch. 1995) (second Aronson prong inapplicable where derivative plaintiffs alleged that directors had failed to prevent company salespersons from making misrepresentations); Abbott Lab. Derivative Litig., No. 93 C 3826, 1994 U.S. Dist. LEXIS 884, * 4 (N.D. Ill. Jan. 31, 1994) (second Aronson prong does not apply where plaintiffs alleged that Board acquiesced in one director's alleged antitrust violations).

17. Rales, 634 A.2d at 932.

18. Aronson, 473 A.2d at 812.

19. Id. at 815.

20. Parnes v. Bally Entertainment Corp., 722 A.2d 1243, 1246 (Del. Jan. 25, 1999) (en banc) (quotation omitted); see also Aronson, 473 A.2d at 815 ("[T]he mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge either the independence or disinterestedness of directors, although in rare cases a transaction may be so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists."); Seminaris v. Landa, 662 A.2d 1350, 1354 (Del. Ch. 1995) (rejecting argument where allegations did not plead the "rare case . . . where defendants' action were so egregious that a substantial likelihood of director liability exists"); In re Baxter Int'l, Inc. Shareholders Litig., 654 A.2d 1268, 1271 (Del. Ch. 1995) (same).

21. See Delaware Corporations Code Section 102(b)(7).

22. In re Wheelabrator Tech., Inc. Shareholders Litig., No. 11495, 1992 WL 212595, **11-12 (Del. Ch. Sept. 1, 1992); Rothenberg v. Santa Fe Pacific Corp., No. Civ. A. 11749, 1992 WL 111206, *4 (Del. Ch. May 18, 1992); In re Dataproducts Corp. Shareholders Litig., [1991 Tr. Binder] Fed. Sec. L. Rep. (CCH) & 96,227, 91,178 (Del. Ch. Aug. 22, 1991).

23. Cf. Malone, 722 A.2d at 14 n.44 (speculating that plaintiffs who did not formally denominate lawsuit as derivative suit nevertheless anticipated demand futility by alleging that "all the directors are . . . implicated in the wrongdoing").

24. See, e.g., Decker v. Clausen, Nos. 10684, 10685, 1989 WL 133617, *2 (Del. Ch. Nov. 6, 1989) (allegations that directors "participated in and/or approved the alleged wrongs . . . . have been rejected consistently by our courts"); Shields, 15 Cal. App. 4th at 1616 (applying California law determined to be identical to Delaware law) (review of financial statements as part of Audit Committee duties did not constitute participation in wrongful conduct for purposes of demand futility demurrer); Citron v. United Tech. Corp., 796 F. Supp. 649, 652 (D. Conn. 1992) (rejecting claim that Audit Committee's failure to detect and correct improprieties involving government bribery scandal established demand futility); In re E.F. Hutton Banking Practices Litig., 634 F. Supp. 265, 272 (S.D.N.Y. 1986) (allegations that entire board abdicated its responsibilities to the shareholders by failing to prevent, or at least uncover and stop, the illegal scheme," not particular enough to excuse demand); In re Stratus Computer, Inc. Sec. Litig., Civ. A. 89-2075-Z, 1992 WL 73555, *9 (D. Mass. Mar. 27, 1992) (allegations that directors should have known of circumstances giving rise to government bribery charges insufficient to excuse demand).

25. See Kaplan v. Wyatt, 499 A.2d 1184 (Del. 1995); Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).

26. Id. at 267-68.

27. Id. at 270.

28. Id. at 269, 270.

29. Id. at 364. In an instance of related reasoning, in PaineWebber R & D Partners II, 1999 WL 160123, a combined class action and derivative litigation, the Chancery Court approved a class representative that had decided not to sue related persons who were directors of the defendant corporation, where the representative had "convincingly articulated legitimate reasons supporting the decision that advancing claims against [the directors] would not be in the interests of the Class." Id. at *13.

30. To similar effect, in Sanders v. Wang, No. C.A. 16640-NC, 1998 WL 842281 (Del. Ch. Nov. 19, 1998), the Chancery Court refused to allow three plaintiffs in a pending federal court securities class action to intervene in a subsequently filed Delaware derivative case, notwithstanding some common facts in the corporate decisions being challenged, where the federal case focused "wildly in contrast" on the alleged manipulation of stock trading prices. Id. at *2. In contrast, the court allowed intervention by a fourth plaintiff who had asserted in federal court "a claim similar to any based on the same factual premise" as the derivative claim. Id. at *3.

31. Delaware Corporations Code Section 145(e); see also VonFeldt v. Stifel Financial Corp., No. Civ. A. 15688, 1999 WL 413393, *3 (Del. Ch. June 11, 1999) (placing the burden on corporation to show indemnitee's lack of good faith).

32. See, e.g., Securities Exchange Act of 1934 Section 21D(c) (requiring Rule 11 findings at final adjudication of action); id. Section 21D(g)(3)(B) (creating proportionate liability special interrogatories); id. Section 21D(g)(8) (recognizing right of contribution by person judged jointly and severally liable for damages).

33. Id. at **14-16.

34. Id. at **15-16.

35. See Lewis v. Austen, No. C.A. 12937, 1999 WL 378125, *4 (Del. Ch. June 2, 1999) (fraud by hindsight doctrine required dismissal of derivative claim asserting director self-dealing); Apple Computer, Inc., 1999 WL 39547 at *12 (demand futility not pleaded where complaint made "no particularized allegations of why the agreements [in question] were wasteful or how the board grossly neglected its duties in approving them."); Sucher v. Alon, No. C98-203 CRB, slip op. at 2 (N.D. Cal. Nov. 5, 1998) (dismissing derivative suit accusing directors of failing to prevent accounting improprieties, where complaint lacked specific facts demonstrating that the "outside directors knew about the alleged inside information").

36. 698 A.2d at 965. Note that Caremark sold the business involved in one of the criminal indictments for $310 million - $276 million less than its corporate predecessor had paid for the business eight years earlier. Id. at 964 n.8. During the pendency of the motion to dismiss, Caremark also agreed to pay over $250 million to settle the criminal charges and related civil lawsuits. Id. at 965-66 & n.10. Thus, the corporation lost over $500 million as a consequence of the officers' misconduct - yet Chancellor Allen found that a settlement of derivative claims that paid no money to the corporation was fair, reasonable, and adequate.

37. 698 A.2d at 971.

38. Id. at 970.

39. Id. at 969; see also Delaware Corporations Code Section 141(e) (A director "shall, in the performance of such member's duties, be fully protected in relying in good faith upon . . . such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, . . . or by any other person as to matters the member reasonably believes are within other such person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation."); Federal Deposit Ins. Corp. v. Castetter, ___ F.3d ___, 1999 WL 511339, *5 (9th Cir. July 21, 1999) (applying California law) (bank directors made prima facie showing of reasonable investigation of bank's financial condition through their reliance on opinions of consultants, bank regulators, and a national accounting firm).

40. Id. at 971.

41. Id. at 967; see also Sucher, slip op. at 2 (citing Caremark language to dismiss contention that potential liability under Caremark pleaded demand futility).

42. Clark v. Kelly, No. C.A. 16780, 1999 WL 458625, *4 (Del. Ch. June 24, 1999) (applying California law to resolve stock ownership issues involving California corporation); cf. In re First Interstate Bancorp Consolidated Shareholder Litig., 729 A.2d 851, 855 n.1 (Del. Ch. Oct. 7, 1998) (applying Delaware law to breach of duty claims involving Delaware corporation headquartered in California).

43. See Clark, 1999 WL 458625 at *4 (citing In re Santa Fe Indus., Inc. v. Green, 97 S.Ct. 1292, 1304 (1977)); Riley v. Fitzgerald, 178 Cal. App. 3d 871, 877 (1986) (the State of incorporation has "an interest in controlling actions, rights and liabilities of its domestic corporations and in the uniform regulation of affairs of business corporations created under the authority of [its] statutes."); Wait v. Kern River Mining, Milling, & Dev. Co., 157 Cal. 16,21 (1909) (a corporation located in California but incorporated in another State "is created in another state and continues to enjoy corporate life by permission of that state").

44. But see Clark, 1999 WL 458625 at *4 (expressing doubt that choice of law provision in Operating Agreement governing transfer of shares determined choice of law in dispute over share ownership).

45. But see Kahn v. Icahn, No. Civ. A. 15916, 1998 WL 832629, *1 n.1 (Del. Ch. Nov. 12, 1998) (denigrating factor in motion to dismiss derivative lawsuit).