Shareholder Class Action Disclosure Claims: Direct or Derivative?

By Amanda Miller

In a recent class action suit pending in the U.S. District Court for the Southern District of Texas, Magistrate Judge Andrew Edison recommended the denial of class certification, finding the plaintiffs lacked standing to assert claims under Section 14(a) of the Securities Exchange Act of 1934 in connection with the defendants’ alleged false statements in the proxy statement that plaintiffs argued prevented shareholders from casting an informed vote and caused them losses when the truth became known and the subject company’s stock price declined. Edwards v. McDermott Int’l, Inc., 2023 U.S. Dist. LEXIS 159957 (S.D. Tex. Sep. 11, 2023). While Magistrate Judge Edison found the plaintiffs’ disclosure claims were direct, he also found their damages theory was derivative in nature because the plaintiffs were unable to “demonstrate that . . . [they] can prevail without showing an injury to the corporation.’” Id. at *21-23.  Accordingly, because the plaintiffs’ damages theory was derivative and plaintiffs failed to satisfy Fed. R. Civ. P. 23.1, Magistrate Judge Edison found the plaintiffs lacked standing to assert Section 14(a) claims.

On September 29, 2023, Judge Hanks rejected the Magistrate Judge’s Recommendation and ordered that Lead Plaintiffs file a new Motion for Class Certification that focuses solely on the requirements of Rule 23(a) and (b)(3).[1] However, this intra-Court dispute highlights the confusion surrounding the issue of whether a claim is direct or derivative.

As courts recognize, the question of whether a claim is derivative or direct is not always clear. In determining whether the plaintiffs’ claims were direct or derivative, Magistrate Judge Edison relied on the Fifth Circuit’s decision in Smith v. Waste Mgmt., Inc., 407 F.3d 381, 384 (5th Cir. 2005), which held that “[s]tate law determines whether a shareholder may maintain a nonderivative action”—here, Delaware law. Under the Delaware Supreme Court’s decision in Tooley v. Donaldson, Lufkin & Jenrette 845 A.2d 1035 (Del. 2004), whether a claim is direct or derivative turns on “[w]ho suffered the alleged harm—the corporation or the suing stockholder individually—and who would receive the benefit of the recovery or other remedy?” (the “Tooley Test”).

Applying Tooley to McDermott, it is clear that the plaintiffs had standing to assert Section 14(a) claims. In McDermott, the plaintiffs alleged that defendant McDermott International issued false and misleading proxy materials to solicit shareholder votes in favor of a proposed merger between McDermott and CB&I, where McDermott acquired CB&I for .82407 shares of McDermott stock for each share of CB&I. After the merger closed, McDermott reported consecutive quarterly operating losses, causing the new company’s stock price to decline, culminating in a restructuring bankruptcy, SEC investigation, and a securities fraud lawsuit.

In the defendants’ motion to dismiss, they argued that the plaintiffs pled a derivative claim which should be dismissed for lack of standing. District Judge Hanks dispensed of that argument, holding that “shareholders have long been able to bring direct Section 14(a) claims when those shareholders have been deprived of the right to cast an informed vote.” Edwards v. McDermott Int’l, Inc., 2021 U.S. Dist. LEXIS 71758, at *19 (S.D. Tex. Apr. 13, 2021) (citing Mills v. Electric Auto-Lite Co., 396 U.S. 375, 381, 397 (1970)). At the class certification stage, Magistrate Judge Edison revisited the direct versus derivative issue and found that, while plaintiffs’ inability to cast an informed vote on the merger was a direct claim, plaintiffs’ “theory of class wide damages confirms the derivative nature of its claim:”

Plaintiff’s theory of liability may be direct, but its damages claim is derivative. Delaware law does not permit Plaintiff to paint its derivative damages claim with a disclosure coating. There is no dispute that Plaintiff has not satisfied Rule 23.1’s procedural requirements for bringing a derivative claim against McDermott. Accordingly, Plaintiff lacks standing under Rule 23.1 and its proposed class should not be certified.

Id. at *26. In finding the plaintiffs’ damages theory was derivative, Magistrate Judge Edison reasoned that “a drop in Plaintiff’s shares’ price is ‘an injury suffered by all [McDermott] shareholders in proportion to their pro rata share ownership.’” Id. at *21-22 (quoting Smith v. Waste Mgmt., 407 F.3d381, 385 (5th Cir. 2005)). “As such, Plaintiff cannot prove its injury without also proving an injury to the corporation.” Id. at *22.

The confusion, thus, appears to lie in the fact that a stock price decline arguably harms both the shareholder through the loss in value of his or her shares of stock, and the corporation through a decline in market cap value. As the plaintiffs correctly argued, their damages theory is not derivative under the Tooley Test because the plaintiffs “are seeking damages to be paid to stockholders for the decline in the value of their own shares.” However, Magistrate Judge Edison failed to consider this and other important distinctions that demonstrate the plaintiffs’ standing under Tooley. First, (as the plaintiffs correctly pointed out), the damages plaintiffs sought—to be paid a higher price for their shares in the merger—flowed directly from their disclosure claim. Moreover, Magistrate Judge Edison did not fully consider the second prong of the Tooley Test—“who would receive the benefit of the recovery or other remedy.” Because McDermott no longer existed as a standalone company, there was no McDermott that could benefit from a financial recovery. Further, any financial recovery received would go directly to, and for the benefit of, the pre-merger McDermott shareholders. Also, as the plaintiffs pointed out, “[u]nder the MR’s incorrect theory of the law, every stock decline would also injure the company,” leading to the “absurd result” that all “indisputably direct claims, such as those under Section 10(b) of the Exchange Act and Section 11 of the Securities Act, [are] somehow derivative.”

While Judge Hanks did not provide any further clarification in his decision rejecting Magistrate Judge Edison’s recommendation, Judge Hanks appears to have put the issue to rest for now. This showdown, however, indicates that Counsel should be aware of the critical distinctions between direct and derivative claims and that even courts are confused, leading to inconsistent rulings, including between Judges in the same court.

[1] Edwards v. McDermott Int’l, Inc., 2023 U.S. Dist. LEXIS 176267 (S.D. Tex. Sept. 29, 2023).

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