A recent decision by the Delaware Supreme Court – Schoon v. Smith, No. 554, 2008 Del. LEXIS 67 (Feb. 12, 2008) – further reinforced a principle well entrenched in Delaware jurisprudence – namely, that an individual, who is a member of the board of directors, cannot initiate a derivative suit on behalf of the corporation unless he or she complies with Section 327 of the Delaware General Corporation Law. Section 327 states that, “[i]n any derivative suit instituted by a stockholder of a corporation, it shall be averred in the complaint that the plaintiff was a stockholder of the corporation at the time of the transaction of which such stockholder complains . . . .” 8 Del. C. § 327. Plaintiff Schoon attempted to ignore this longstanding rule by arguing that equity should step in and permit a director to maintain a derivative action, notwithstanding the fact that the director does not personally own stock in the corporation.
Troy Corporation is a privately held Delaware corporation that had issued three series of common stock. The owners of Series A shares were entitled to elect four of the five Troy directors. Daryl Smith, the CEO and Chairman of Troy, owned the majority of the Series A shares and voted to elect himself and three others to the board. Schoon, 2008 Del. LEXIS 67, at *2. Series B stockholders of Troy had the right to elect the final member of the board. Id. Steel, a privately held Delaware corporation, owned the majority of the Series B shares and voted to elect Plaintiff Schoon to Troy’s board. Schoon, however, owned no stock in Troy. Id.
Schoon alleged that, shortly after he became a director of Troy, he discovered that the other three board members were “‘beholden to Smith,’ which enabled Smith to dominate and control the board.” Id. at *3. Schoon alleged that Smith had “taken actions on several occasions that were designed to entrench himself in power and, in turn, thwart potential value-maximizing transactions for the benefit of Troy and its stockholders.” Id. In his derivative complaint, Schoon alleged that Troy was “being injured by the actions of his fellow directors and that his boardroom attempts to save the corporation from their breaches of fiduciary duties have been thwarted by Smith’s dominance.” Id.
The defendants responded to the complaint by moving to dismiss based on Mr. Schoon’s lack of standing. Id. The Delaware Court of Chancery, “relying on 8 Del. C. § 327, Court of Chancery Rule 23.1, and Moran v. Household Int’l, Inc., concluded 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 or on behalf of its stockholders.’” Id. at *4.
On appeal, Schoon argued “that as a matter of equity and public policy, a director should be entitled to assert a derivative claim on behalf of the corporation for the same reasons that stockholders are permitted to do so.” Id. In rejecting Schoon’s argument, the Delaware Supreme Court first explained that, by statute, derivative suits were to be pursued only by individuals that maintained stock of the corporation. Id. at *14-*17. The court did note, however, that it may “exercise its inherent authority to extend the doctrine of equitable standing to include a director at a time when the General Assembly has not spoken on the subject.” Id. at *20.
The court, however, refused to do so, explaining that “the reason equitable standing doctrine was adopted . . . [wa]s to prevent a complete failure of justice on behalf of the corporation.” Id. at *30. The court observed that “[n]o such complete failure is presented in this case. Here, the stockholder who elected Schoon is not only aligned with him, but also is actively litigating other matters involving Troy before the Court of Chancery. We take judicial notice that Steel has already begun using the ‘tools at hand’ to obtain books and records information from Troy. Given the well-established duties of a director and the ability and the right of . . . a stockholder, to bring a derivative action if Steel deems it necessary, we perceive no new exigencies that require an extension of equitable standing to Schoon, as a director.” Id. *31-*32.