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From Securities Regulation Daily, November 30, 2015

Direct or derivative? Delaware asked to weigh in on holder claims

By Anne Sherry, J.D.

Can former stockholders directly sue the company for damages from continuing to hold stock in reliance on misrepresentations, or must “holder” claims be brought derivatively in Delaware? Concluding that this issue is unsettled and will have significance beyond the instant case against Citigroup, the Second Circuit certified this question to the Delaware Supreme Court (AHW Investment Partnership v. Citigroup Inc., November 25, 2015, Carney, S.).

Background. The plaintiff entities held on to Citigroup stock between May 2007 and March 2009, while the stock was allegedly overvalued due to the defendants’ fraudulent and negligent misrepresentations. As a result, the plaintiffs lost over $800 million. They sued directly in the Southern District of New York, whose court ruled that they had standing to sue. On cross-appeal, the defendants argue that the plaintiffs’ holder claims may only be brought derivatively, not directly. Because the plaintiffs no longer own Citigroup stock, their standing to sue hinges on this issue.

Tooley analysis. The Second Circuit agreed with the district court in finding some “tension” between the leading Delaware Supreme Court case on direct and derivative cases, Tooley v. Donaldson, Lufkin & Jenrette, Inc. (Del. 2004), and later state court decisions. Tooley suggests that the characterization of a claim as direct or derivative must turn on who suffered the alleged harm and who would benefit from any recovery. This test would support the plaintiffs’ direct claims: although both the corporation and the shareholders suffered harm, the shareholders’ injury was more particularized, and they would receive the benefit of any recovery.

The appeals court noted a number of subsequent cases, however, where the Chancery Court found that claims that would be direct under the Tooley test must be brought derivatively because they are not independent of any injury to the corporation. The Delaware Supreme Court itself held that a claim based on dilution in stock value is generally derivative because it is “merely the unavoidable result … of the reduction in the value of the entire corporate entity.” In the Second Circuit’s analysis, the cases indicate that the Tooley test may have evolved so that the plaintiffs’ claims, tied to the plunge in Citigroup’s value, may not be direct claims after all under Delaware law. A further statement by the Delaware Supreme Court seems to require that a direct claim be founded on “some individualized harm not suffered by all of the stockholders at large.” While this case purports to rely on Tooley rather than overrule it, it appears to the Second Circuit to revive the “special injury” requirement disclaimed in that earlier case.

Certified question. The Second Circuit certified the following question, inviting the Delaware Supreme Court to expand, alter, or reformulate it: “Are the claims of a plaintiff against a corporate defendant alleging damages based on the plaintiff’s continuing to hold the corporation’s stock in reliance on the defendant’s misstatements as the stock diminished in value properly brought as direct or derivative claims?”

The case is No. 13-4488-cv(L).

Attorneys: Jacob H. Zamansky (Zamansky LLC) and Robert Kelsey Kry (MoloLamken LLP) for AHW Investment Partnership and MFS, Inc. Susanna M. Buergel (Paul, Weiss, Rifkind, Wharton & Garrison LLP) for Citigroup Inc.

Companies: AHW Investment Partnership; MFS, Inc.; Citigroup Inc.

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