Distinguishing Direct from Derivative Claims | Practical Law

Distinguishing Direct from Derivative Claims | Practical Law

An update concerning the distinctions between direct shareholder claims and derivative claims asserted by shareholders on behalf of corporations.

Distinguishing Direct from Derivative Claims

Practical Law Legal Update w-001-0268 (Approx. 4 pages)

Distinguishing Direct from Derivative Claims

by Practical Law Litigation
An update concerning the distinctions between direct shareholder claims and derivative claims asserted by shareholders on behalf of corporations.
Corporate shareholders may bring direct or derivative claims against corporate officers and directors. Direct claims assert that the defendants harmed the shareholders themselves. Derivative claims assert that the defendants harmed the corporation. Because plaintiffs assert derivative claims on the corporation's behalf, special procedures apply. For example, the shareholders usually need to demand that the corporation bring suit before they file suit on its behalf, or show that a demand of that kind would be futile.

Is Your Claim Direct or Derivative?

Determining whether a claim is direct or derivative is not necessarily easy. Even federal appellate courts sometimes have difficulty with it. For the second time in 13 months, the US Court of Appeals for the Second Circuit has certified to the Delaware Supreme Court a question about how to distinguish direct claims from derivative claims.

NAF Holdings, LLC v. Li & Fung (Trading) Limited

In NAF Holdings, LLC v. Li & Fung (Trading) Limited, plaintiff NAF, a Delaware limited liability company, sought to have two of its subsidiaries merge with a public company. To satisfy a condition of the financing necessary for the merger, NAF entered into a contract with defendant Li & Fung. According to NAF's complaint, Li & Fung later repudiated the contract, which caused:
  • The NAF entities to lose their financing.
  • NAF's subsidiaries to lose $30 million when the merger fell through.
  • NAF to incur substantial losses.
Li & Fung moved to dismiss, claiming that NAF's claims were really derivative claims on behalf of the subsidiaries, which had already settled their claims arising out of the failed merger. (772 F.3d 740, 740-41 (2d Cir. 2014).)
Li & Fung relied on the Delaware Supreme Court's decision in Tooley v. Donaldson, Lufkin & Jenrette, which held that a court should determine whether a claim is direct or derivative by looking to the nature of the wrong and to whom any relief should go. To assert a direct claim, the court held, a shareholder plaintiff must be able to show that the defendant breached a duty to the shareholder and that the plaintiff can prevail without showing injury to the corporation. (845 A.2d 1031 (Del. 2004).)
The Second Circuit found that NAF alleged the breach of a direct duty to itself but that it could not prevail without showing injury to its subsidiaries. The court expressed concern, however, that reading Tooley literally might interfere with contractual rights. It therefore certified a question to the Delaware Supreme Court about when claims are derivative. (NAF, 772 F.3d at 743-46.)
In June, the Delaware Supreme Court held that, read in context, Tooley does not bar a party to a contract from bringing a direct claim against another party to the contract. Rather, it addresses "determining the line between direct actions for breach of fiduciary duty suits by stockholders and derivative actions for breach of fiduciary duty suits subject to the demand excusal rules" of Delaware law. (NAF Holdings, LLC v. Li & Fung (Trading) Limited, 118 A.3d 175, 179 (Del. 2015)).

AHW Investment Partnership, MFS, Inc. v. Citigroup Inc.

AHW Investment Partnership, MFS, Inc. v. Citigroup Inc. presented the Second Circuit with just that kind of fiduciary duty claim. As a result of two corporate mergers, the plaintiffs in this case owned over 17 million shares of defendant Citigroup. They allege that they planned to sell those shares but that misstatements by Citigroup and its defendant officers and directors caused them to delay the sales. The delays ultimately cost them over $800 million. (, at *1-2 (2d Cir. Nov. 25, 2015).)
The defendants moved to dismiss, arguing that the plaintiffs lacked standing because their claims are derivative and failed to state a cause of action. The district court observed an inconsistency in Delaware precedent about when claims are derivative but concluded that the claims in this case qualify as direct because any injury was to the plaintiffs rather than Citigroup. However, the court held that the plaintiffs failed to state a claim. Both sides appealed. (, at *2.)
The Second Circuit agreed that Delaware law is inconsistent, and therefore concluded that it could not determine the standing question. The Second Circuit described the inconsistency as follows:
  • In holding that the direct versus derivative analysis turns on who was injured and to whom relief would go, Tooley rejected previous Delaware holdings that a plaintiff asserting direct claims must assert a special injury separate and distinct from any harm suffered by the company's other shareholders. (, at *3-4 (discussing Tooley).)
  • More recently, however, the Delaware Supreme Court held that a claim is derivative if all of a corporation's shareholders are injured and would recover proportionally to their ownership interests. A direct claim requires that the plaintiff have suffered some harm not suffered by all stockholders. (, at *5-6 (discussing Feldman v. Cutaia, 951 A.2d 727 (Del. 2008)).)
  • Other post-Tooley Delaware decisions have focused on whether the shareholders' claims are independent of a general reduction in the corporation's value (, at *5).
This suggests, according to the Second Circuit, that Tooley may no longer reflect the current state of Delaware law.
Here, the choice of a direct versus derivative test likely determines the standing issue. If the question is only who is injured and can recover, the plaintiffs' claims are direct. They allege that they lost money, not the company, and any recovery would flow to them. On the other hand, the plaintiffs do not allege injury different from any other Citigroup shareholder who held shares during the relevant time. Faced with a dispositive conflict within Delaware law, the Second Circuit again certified a question to the Delaware Supreme Court about how to interpret and apply Tooley.

What Counsel Need to Know

Unless and until the Delaware Supreme Court clarifies the analysis for distinguishing direct claims from derivative claims, counsel should be aware of the inconsistent precedent and prepare to argue for the standard most favorable to their clients. Attorneys should also watch for guidance from the Delaware Supreme Court that could substantially alter when shareholders can bring direct claims.
Whether a claim is direct or derivative, Practical Law can help. Counsel considering shareholder claims should consider resources such as: