Legal Alert

Shareholder Derivative Suits – The Next Wave of COVID-19 Litigation?

By Shannon Farmer, David Margules, Karli Lubin, and Andrew D’Aversa
April 13, 2021

The COVID-19 pandemic has led to a variety of claims brought by employees, as well as government enforcement actions. Recently-filed cases are taking a new tack; shareholders are bringing derivative suits and securities claims related to companies’ coronavirus responses. We answer ten questions about these lawsuits and the types of workforce issues that could lead to them.

1. What is a shareholder derivative suit?

It is a lawsuit brought by a shareholder or group of shareholders to assert a claim belonging to the company against, most often, directors and officers. They may, although rarely, be asserted against third parties. Shareholder derivative suits often allege directors and officers breached their fiduciary duty of loyalty or care to the corporation.

2. What kinds of companies are subject to a shareholder derivative suit?

This type of litigation can be brought against a privately-held or publicly-traded company. They are not limited to corporations and, generally, are available for alternative entities such as limited partnerships and limited liability companies. Companies may have provisions in their governance documents that regulate or limit the assertion of derivative claims.

Particularly when it comes to COVID-19, all companies can incorporate lessons from these derivative lawsuits into their governance practices.

3. Who files these actions?

A shareholder derivative action is brought by a shareholder or group of shareholders. Generally, the plaintiff must be a legal or beneficial owner of stock security, or other equity—options, warrants, or other rights to purchase or receive stock do not confer standing. There may also be questions about whether a particular plaintiff can serve as a named plaintiff in a derivative case where, for example, the plaintiff has an actual or potential conflict of interest with equity holders generally.

For those actions brought against publicly-traded corporations, it is not unusual for plaintiffs’ firms to inform shareholders that they are conducting an investigation and invite shareholders to contact them after a materially adverse event is publicly disclosed.

4. What makes a claim “derivative”?

In general, if the claim asserts an injury to the entity and not to equity holders directly, it is likely derivative. In such cases the injury to the equity holders in the general diminution of the value of their investment because the entity as a whole has been injured. In such cases damages would be paid to the entity. If equity holders are injured directly, and if they would receive the damages, the claim likely is individual. These categories are not mutually exclusive, claims can be both derivative and individual.

5. How does a derivative suit proceed in litigation?

Derivative suits proceed differently depending on the state of incorporation and whether suit is brought in state or federal court. For example, the jurisdiction of incorporation sets the requirements for how long the shareholder bringing suit must have owned shares and the minimum value of those shares. We provide two examples of how derivative suits may proceed.

In Delaware, a stockholder has standing to assert a derivative claim only if she held stock continuously from the date of the breach of duty through the trial, and if the stockholder did not have a conflict of interest with holders generally. Before filing suit, the stockholder must make a demand on the board of directors to enforce the company’s right, or must plead specific facts showing that a demand is excused. Typically, they alleged that a majority of the board of directors was involved in the challenged action, is beholden to those who benefited from the challenged transaction, or otherwise has a conflict of interest with regard to it. The Delaware Court of Chancery Rules also set out specific matters that must be set forth in the complaint. A derivative plaintiff has fiduciary obligations to the rest of the equity holders in pursuing the case.

In Delaware, making a demand is viewed as an admission that a majority of the board is disinterested. If a majority of the board is disinterested or if a special litigation committee of disinterested directors asserts control over the claim, the company may have the authority to dismiss or settle the claims, subject to limited court review of that decision.

In Pennsylvania, the shareholder must first file a demand on the board of directors to address the issue about which they are complaining. Once received, the board of directors may establish a special litigation committee—composed of two or more disinterested individuals—to investigate the demand and recommend to the board the course of action in the best interests of the corporation. The recommendations may include, among other things, bringing claims—or not—or settling them.

Based on the recommendation of the special litigation committee, if the board of directors accepts the action, the corporation files the lawsuit. This rarely occurs. In most cases, the special litigation committee advises the board of directors to reject the demand. A shareholder may then bring the action on behalf of the corporation.
If the special litigation committee rejects the demand and the shareholder decides to bring a derivative suit, a court will examine two things. First, it will determine whether the special litigation committee was only comprised of members meeting the statutory definition. Second, it will determine whether the special litigation committee acted in good faith, independently, and with reasonable case. If a court finds these requirements were met, it must enforce the determination of the special litigation committee and dismiss the derivative claims.

Although not derivative in nature, derivative complaints may also include federal securities law claims, like claims for misleading statements by officers or false statements in public disclosures, like proxy statements.

Where the assertion of a derivative claim results in a benefit to the entity, plaintiff’s counsel may be entitled to have reasonable attorneys’ fees paid by the entity. This is the case even if the matter is resolved through a settlement—and even if it is resolved without the filing of litigation. A benefit may involve a payment to the entity, governance reforms, or other relief. Fees may be awarded even where the entity resolves the matter unilaterally, without a negotiated settlement, as long as the plaintiff’s efforts are found to have been a cause of the resolution. Settlements and fee awards are subject to judicial review for fairness.

6. What is the legal theory for these coronavirus outbreak suits?

The allegations generally fall into two categories:

  • The first relates to the company’s failure to implement appropriate safety measures to reduce the risk of infection to employees, customers, or the general public. Shareholders allege that these actions (or inactions) harm the company by reducing its value. Because these claims allege harm to the company, rather than to the stock (although it may also be affected), they are derivative claims.
  • The second relates to public statements made by the company regarding its health and safety protocols and its understanding of the impact the virus has had or will have on operations. The harm alleged is that shareholders invested based on false or inaccurate statements by the company. The derivative portion of such a claim is that the company will face litigation costs and reputational harm from the allegedly false statements that the Board allowed the company to make. In addition, although not a derivative claim, another claim may be that the shareholder invested based on false or incomplete statements and suffered direct damages.

The shareholder derivative actions allege that directors breached their fiduciary duties, either of care or of loyalty to the company. Although duty of care claims may be styled as “failure to monitor” claims, directors satisfy their duty of care if they address known “red flags.”

For example, shareholders of Tyson Foods initiated a suit alleging that the board failed to protect its workforce adequately from the coronavirus pandemic. Specifically, the suit alleges that the named officers and directors “took minimal precautions to prevent the outbreak of COVID-19 at its facilities,” risking the health of the company and its employees. As a result of the insufficient precautions, the complaint alleges that the company suffered a massive outbreak of the coronavirus, resulting in temporary closures which negatively impacted both employee health and production. The suit further alleges that “Tyson had triple the amount of COVID-19 cases and twice as many related deaths compared to other companies” in its industry.

A separate suit against Tyson Foods alleges that the company published materially false or misleading statements regarding its knowledge of the pandemic’s spread throughout its workforce and the sufficiency of its safety protocols.

There also have been several suits against cruise lines alleging false and misleading statements regarding policies and procedures implemented to prevent the spread of coronavirus and the effect of the pandemic on the company’s business. One such case, asserted against Norwegian Cruise Lines, was dismissed because a Florida federal judge determined the shareholders did not show any material misrepresentations by the cruise line. The judge reasoned that some of the alleged misrepresentations were inactionable “corporate puffery” while others were not actually misleading.

7. What does this mean for handling employee vaccination issues and coordinating a return to the office?

The boards of directors of all companies should ensure that management has developed and implemented a COVID-19 response plan, including return to work and vaccination plans. Management will likely need to conduct careful and regular reviews of orders and guidance at the federal, state, and local level and keep a pulse on “best practices” in the company’s industry. The board may rely in good faith on the suggestions of management. The fiduciary duty of care requires the board to address known “red flags,” but they must also ensure that the company has in place robust systems and mechanisms to address all workplace issues as well as financial and product issues.

Companies also need to ensure that their SEC filings and public statements about their operations are complete and accurate.

8. Have companies faced shareholder litigation over employee issues outside the context of COVID-19?

Yes. Shareholder derivative suits were filed against a number of companies based on workplace harassment and sexual misconduct allegations, particularly during the #MeToo movement. Those suits generally fall into the same two categories as the current COVID-19 related litigation. First, that the company’s mismanagement (e.g., ignoring misconduct, failing to safeguard against misconduct, or conditioning settlements on anonymity) caused a decrease in company value, and second, that the company made false or misleading statements to the public (e.g., covering up allegations or representing the maintenance of a zero tolerance policy for harassment) and that the subsequent disclosure of the truth led to a drop in the company’s stock price. As stated previously, the first claim is a derivative claim while the second is not, even if it is sometimes asserted in the same suit.

Recently, Key West Police Officers’ and Firefighters’ Retirement Plan filed a derivative suit against the founder and board of directors of Pinterest on the heels of a number of lawsuits against the company by former female executives and the corresponding negative press. The complaint alleges that the Pinterest board fosters and permits a culture of discrimination and retaliation on the basis of race and gender, contrary to the company’s public disclosures that it promotes a diverse and inclusive workplace, and each director is in breach of their fiduciary duties to the company. The complaint further alleges that the board’s actions violated state and federal law, cost the company substantial legal fees, and damaged its reputation among its primarily female user base. The plaintiff “seeks to ensure that the Pinterest Board is held accountable for overseeing and permitting a sustained practice of sexual and racial discrimination that has resulted in material harm to [Pinterest’s] position, reputation and goodwill.”

The theories under which these suits proceed conceivably could apply to any workforce issue—whether it is mismanagement of any aspect of the employment relationship (for example, independent contractor misclassification), misrepresentation of company policies or standards to the public, or a combination of the two. Even so, this type of litigation is very difficult for a plaintiff. Not only must the shareholder make a demand (under, for example, Pennsylvania law as described above) or show its futility (under, for example, Delaware law as described above), a shareholder must also prove a breach of the duty of care. This type of claim, called a Caremark claim, is among the most difficult to prove in corporate law.

9. How does this intersect with Environmental, Social, and Governance (ESG) efforts of activist investors, shareholder proponents and investors generally?

ESG issues are of increasing importance to investors. The growth of shareholder proposals on ESG topics—climate change, worker safety, diversity, gender pay inequities, and a host of other topics—have been increasing dramatically over the past few years. COVID-19 responses by companies have added to this interest. Many investors consider ESG due diligence as one of the primary factors in deciding to invest in a company. Activist shareholders are seeking to replace directors on boards of companies who appear disinterested in tackling ESG issues.

In addition, companies are increasingly tying executive compensation to the company’s achievement of ESG targets.

10. What can companies do to protect themselves?

Companies should create a management team responsible for developing a careful plan focused on worker safety, customer care, and community involvement. This team should be tasked with considering the company’s perspective, actions, and communications on issues garnering public attention, and ensuring that its words and actions are aligned. The company’s plan should include contingencies and identify team members responsible for adapting to and addressing unexpected changes. Companies also should consider establishing employee fora to address concerns. Critically, the tone at the top must be firmly aligned with such a plan. The board should ensure that a plan is in place and, as always, review the company’s public disclosures for accuracy.

In some states, such as Delaware, entities have some ability to regulate the assertion of derivative claims. For example, the Delaware Courts have upheld governance document provisions requiring that any derivative claims be brought in the state where the entity is incorporated, or where its headquarters or principal operations are located.

These best practices extend beyond COVID-19 to any workforce issues that involve a significant risk of liability to the company or a significant risk of harm to employees or the community, including ESG, diversity, wage and hour compliance, and safety practices, among others.

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Copyright © 2021 by Ballard Spahr LLP.
www.ballardspahr.com
(No claim to original U.S. government material.)

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the author and publisher.

This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.

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