Federal Court Finds Representative Plaintiff Has Conflict of Interest
The Bencher—September/October 2018
By Francis G.X. Pileggi, Esquire
A recent decision of the U.S. District Court for the Southern District of New York found that a shareholder pursuing both direct claims and derivative claims against a corporate director had a conflict of interest that prohibited him from pursuing both claims at the same time in the same suit. The case styled Tatintsian v. Vorotyntsev, 2018 WL 2324998 (S.D.N.Y. May 22, 2018), involved claims by a shareholder in a startup company who was an early investor, along with about eight others. The shareholder plaintiff claimed that the defendant director looted the company by using corporate funds to support a lavish lifestyle. The shareholder filed suit and brought direct claims for securities fraud, as well as derivative claims for breach of fiduciary duty. The defendant director sought to dismiss the derivative claims based on the argument that Federal Rule of Civil Procedure 23.1 bars a plaintiff from bringing direct claims and derivative claims in the same action when it creates a conflict of interest.
Rule 23.1, which governs shareholder derivative actions, provides that a derivative action “may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.” The Second Circuit has not held that there is a per se rule against bringing derivative and direct claims simultaneously, but that suits with both claims need to be scrutinized for actual conflicts.
The court stated that an actual conflict may exist where “substantial recovery on the direct claim may reduce the potential recovery on behalf of the corporation on the derivative claim.” The court wrote that direct and derivative claims can be brought in the same action, for example, when the company at issue in the litigation “has been dissolved or is no longer in existence.” Both claims have also been allowed to move forward simultaneously in the Second Circuit where the plaintiffs and the defendants are the only shareholders in the company. Neither of those situations applied in this case.
The court found an actual conflict of interest. The primary reasoning was that the bylaws provided for indemnification of the defendant director. The court reasoned that because the defendant director “must be indemnified pursuant to these bylaws, recovery for the direct and derivative claims could ultimately come from the same pool of money.” Therefore, the court granted the motion to dismiss the derivative claims.
The court did not discuss the nuanced prerequisites of the right to indemnification. If the defendant director did not satisfy the generally applicable conditions for indemnification, he might not be entitled to indemnification. It appears that the corporation involved was a Delaware corporation. Delaware General Corporation Law Section 145(b) provides that, with respect to claims brought by or in the right of the corporation itself, “no indemnification shall be made in respect to any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation….” Section 145 would require that the defendant director have acted in good faith if he did not prevail on the underlying claim.
This column cannot address all the issues raised in this decision, but it is instructive that in Delaware there is no per se disqualification of a representative plaintiff who brings direct claims and derivative claims in the same suit. Although the representative plaintiff is required to satisfy several criteria, it is not common for Delaware courts to disqualify the shareholder plaintiff—especially on the primary basis that the defendant director might be entitled to indemnification. One treatise has described the state of the law in Delaware on this point to allow one to conclude that “disqualification of a derivative plaintiff will result only where the record reveals a conflict of interest on the part of the shareholder-plaintiff that is of such a fundamental and egregious nature that the effect of attending abuse could not be adequately precluded or deterred by the judicial oversight mandated by Rule 23.1.” See Donald J. Wolfe, Jr. and Michael A. Pittenger, Corporate and Commercial Practice in the Delaware Court of Chancery, § 9.02(b)(1) at 9-35 (2017). See generally In re Fuqua Indus., Inc. S’holders Litig., 752 A.2d 126, 130 (1999) (discussing multiple factors that the court will consider to determine the adequacy of a representative plaintiff).
There are many facets to the analysis of when a derivative plaintiff could be or should be disqualified when pursuing derivative and direct claims at the same time and in the same case. The issue is one that should be identified before a plaintiff files a complaint with both direct and derivative claims.
Francis G.X. Pileggi, Esquire is a litigation partner at Eckert Seamans Cherin & Mellott, LLC. He comments on key corporate and commercial decisions, and legal ethics rulings, at www.delawarelitigation.com.