Significant Developments in Corporate Litigation Law: Bulletin No. 2008-01 February 2008

February 19, 2008

Delaware Supreme Court Declines to Extend Standing to Bring Derivative Claims to Non-Shareholder Directors

The Supreme Court of the State of Delaware has declined to extend standing to assert derivative claims on behalf of Delaware corporations to directors who are not also shareholders.  Schoon v. Smith, 2008 WL 375826 (Del. Supr.  Feb. 12, 2008) (“Troy Corp.“).

Troy Corp. affirmed an order of the Delaware Court of Chancery dismissing derivative claims asserted by a single, non-shareholder director of Troy Corporation.  Troy Corporation is a privately held Delaware corporation with a capital structure consisting of three series of common stock.  Four of Troy’s five directors were appointed by the majority owner of the Series A stock, Daryl Smith, Troy’s CEO and Chairman; the owner of the majority of outstanding Series B shares elected the final director, Richard Schoon.  

In his derivative complaint, Schoon alleged that the Series A directors were beholden to Smith, and in violation of their fiduciary duties of loyalty and care, had approved measures that were designed to entrench Smith and thwart potentially value-maximizing transactions at the expense of Troy and its public shareholders.  Because the other directors were beholden to Smith, Schoon alleged that he was the only board member able to exercise independent judgment as to the rights and interests of the corporation and its shareholders, and should be permitted to pursue derivative claims to safeguard those rights and interests. 

The Court of Chancery granted the defendant directors’ motion to dismiss, concluding that “Delaware law does not recognize the right of a director, acting in that capacity, to sue on behalf of the corporation he or she serves . . .”  On appeal, Schoon argued that such standing should be conferred upon directors as a matter of equity and public policy. 

While affirming, the Delaware Supreme Court rejected the Chancery Court’s blanket conclusion that “any decision” to extend derivative standing to a director must be made by the Delaware General Assembly.  On the contrary, the Supreme Court noted that shareholder derivative standing was judicially created – not legislatively created – to prevent a “failure of justice.”  That is, shareholders may sue in the corporation’s name only when those otherwise responsible for doing so – i.e., the directors – refuse to do it or may be presumed to be incapable of making an independent judgment as to whether suit should or should not be brought.   The Delaware legislative enactment regarding derivative claims, 8 Del. C. ยง 327, which requires that any derivative plaintiff either own shares at the time of  the transaction in issue or obtained the shares thereafter by operation of law, limits rather than creates equitable derivative standing.

The Delaware Supreme Court wrote that whether or not derivative standing should be extended judicially hinges on whether “new exigencies” require such an extension.  The Court pointed out that, under existing Delaware precedent, a director does not have an affirmative obligation “to remove the debate from the boardroom to the courtroom to resolve his or her differences with the board.”  Nor does the requirement of director “independence include a duty to sue on behalf of the corporation in his or her capacity as a director.”  Having determined that directors are not required to bring suit, the Supreme Court rejected Schoon’s argument that “a director should be able to sue derivatively because the director is in a better position to know and to make his allegations against the board without waiting for a stockholder to do so.”  This perceived efficiency, the Court concluded, is not an exigency tantamount to a “complete failure of justice.”  The Court noted that because shareholders can bring suit (an option which in fact the majority owner of the Series B shares was pursuing by commencing a books and records action), there is no need for individual directors to be granted that power.1

Finally, the Court rejected Schoon’s recommendation that Delaware adopt the 1994 proposal of the American Law Institute expressly extending derivative standing to directors.  The Supreme Court noted that, other than Pennsylvania, no state supreme court had adopted that provision to date, and that New York has provided for such standing by legislative enactment – which the Delaware General Assembly has not yet done.

Troy Corp., then, maintains the status quo by rejecting the judicial expansion of derivative standing to directors as a blanket proposition, leaving in place the existing remedial scheme by which the corporation’s shareholders can pursue claims on behalf of the corporation.  The decision, however, leaves open the possibility that judicial expansion may be appropriate if, under the particular circumstances, a “complete failure of justice” were threatened (such as if, for whatever reason, it were not possible for a shareholder to prosecute a claim derivatively).  Additionally, the decision signals the possibility that derivative standing in Delaware may be extended legislatively at some point in the future.

1   The Court noted, however, that as a practical matter, most directors are in fact shareholders of the corporations they serve.