The Delaware Supreme Court in Pyott v. Louisiana Municipal Police Employees’ Retirement System reversed on April 4 a controversial ruling by the Chancery Court that a California federal court’s dismissal with prejudice of a shareholder derivative action under Delaware Chancery Rule 23.1 does not preclude other shareholders from maintaining identical derivative actions in Delaware courts.1 The Chancery Court’s decision, if left to stand, could have resulted in further proliferation of shareholder derivative suits, each of which would have to be litigated on an individual basis.

In a shareholder derivative action, shareholders seek to bring claims on behalf of a corporation by either demanding that the board of directors file the requested suit or by filing the suit on their own and alleging that a pre-suit demand on the board would have been futile. In Pyott, two groups of shareholders filed separate actions in California federal court and Delaware Chancery Court on behalf of Allergan, Inc., a pharmaceutical company and the maker of Botox. The actions were filed shortly after Allergan pled guilty to misbranding charges based on allegations of off-label marketing, and agreed to pay $600 million in civil and criminal fines. Both shareholders claimed that demand on the board would have been futile and should be excused. The California federal court granted defendants’ motion to dismiss, with prejudice, finding that plaintiffs had failed to establish demand futility under Rule 23.1. The defendants in the Delaware Chancery Court then moved to dismiss on the grounds that plaintiffs in that case were collaterally estopped from pursuing their action by the California court’s ruling.

The Chancery Court denied the defendants' motion, holding that the Delaware plaintiffs were not collaterally estopped from proceeding for two reasons.2 First, the Chancery Court held that, under Delaware law, a shareholder who brings a derivative action is not in privity with the other shareholders unless and until the defendant’s Rule 23.1 motion to dismiss is denied and the shareholder has received permission from the court to litigate on behalf of the company. Second, the Chancery Court, sounding a familiar refrain against so-called “fast filers,” held that the California plaintiffs were not adequate representatives because they failed to make a request for the corporation’s books and records under Section 220 of the Delaware General Corporation Law.

Practitioners and commentators expressed concern that the Chancery Court’s opinion, if adopted by other courts, would make it more difficult for companies to defend derivative suits. In the wake of a corporate trauma, shareholders often file multiple derivative suits in courts around the country. One of the most effective ways for companies to dispose of such actions is to obtain dismissal of one action based on demand futility, then move to dismiss the other actions based on principles of collateral estoppel. The Chancery Court’s ruling threatened to take this arrow from the defendant’s quiver and allow plaintiff’s law firms to engage in consequence-free nationwide forum-shopping.

The parties appealed, and the Delaware Supreme Court reversed.

As a threshold matter, the Delaware Supreme Court held that the Full Faith and Credit Clause of the U.S. Constitution required the Chancery Court to apply California or federal collateral estoppel standards. Because California and federal courts have held that shareholders are in privity with one another prior to a Rule 23.1 dismissal, the Delaware Supreme Court held that the Delaware action was barred by the California court’s ruling. The Delaware Supreme Court declined to rule on whether shareholders were in privity with one another prior to denial of a Rule 23.1 motion under Delaware law. The court noted that the Delaware Chancery Courts are divided on the issue, but that courts in other jurisdictions have held that privity exists between shareholders prior to denial of a motion to dismiss.

The Delaware Supreme Court also held that the Chancery Court erred in announcing an irrebuttable presumption that derivative plaintiffs who file suit without first seeking books and records under Section 220 are inadequate representatives. While expressing sympathy for the Chancery Court’s concerns about shareholders who file before having thoroughly investigated their claims, the court held that the remedies for the problems created by such fast filers should be directed at the lawyers, not the shareholders, and that a shareholder who files a derivative suit immediately after a corporate trauma is not per se inadequate.

The Delaware Supreme Court’s ruling in Pyott is, for the most part, a victory for corporate defendants. By holding that a Rule 23.1 dismissal can be issue-preclusive as to other shareholders, Pyott may save companies from having to litigate the same demand futility allegations in multiple forums. However, the Delaware Supreme Court’s refusal to find that shareholders who fail to make a Section 220 books and records request before filing a derivative action are per se inadequate representatives could give comfort to plaintiff’s firms whose practice has been to race to the courthouse without having conducted any real investigation into the merits of their purported claims.