When A Derivative Action Does Not Benefit The Corporation, A Settlement Should Not Be Approved

• Posted on: Dec 9 2016

Jane is a shareholder in ABC Co. Over the past three years, the company has been losing money, due in large part to an increase in expenses. Jane learns the truth about the company’s financial condition and discovers that senior managers of the company are reporting their personal use of the company’s jet, cars and houses as a business expense. Because of managements’ failure to properly report the use of company property, the company’s expenses have skyrocketed. Jane wants to recover the expenses incurred because of the managers’ misuse of corporate property. Jane can do so by filing a shareholder derivative action.

A derivative action is a lawsuit brought by a shareholder of a company, on behalf, and for the benefit, of the company to enforce or defend a legal right or claim. Derivative actions seek the recovery of damages and/or equitable relief arising from unlawful or improper conduct engaged in by officers, directors, or other persons in control of the company. Such conduct includes, but is not limited to: breaches of fiduciary duty; fraud; self-dealing by insiders; conflicts of interest; waste of company assets; insider trading; options backdating; inflated, false, or misleading financial statements; improprieties related to executive compensation; conduct leading to regulatory investigations; and management or board decisions that expose the company to harm or risk (e.g., violations of consumer protection laws, environmental violations). A derivative action allows current shareholders to bring an action in the name of the company to redress the harm caused by management where it is unlikely that management will redress the harm itself.

In addition to the recovery of damages, which are awarded to the company and not to the individual shareholders that initiate the action, a successful derivative action may include corporate governance reforms that strengthen and protect shareholder value. Any recovery of money or implementation of governance reforms by way of settlement must be approved by the court. Approval must be based on facts and circumstances showing that the result is fair and reasonable to the company and in its best interest.

Although a shareholder has the derivative action in his/her arsenal, he/she cannot immediately run to court to redress the alleged wrongdoing. The shareholder must first formally demand the company’s board of directors act in the manner that the shareholder requires, such as suing the wrongdoers. The “demand” requirement, however, can be waived if the suing shareholder can show that such a demand would have been futile.

If the shareholder makes a demand on the board, then the board must be allowed time to determine the proper course of action to pursue. To assist it, the board will often seek outside counsel and/or create a committee of disinterested directors who were not involved in the transaction about which the shareholder is complaining. If the board and/or committee recommend legal action, then the board will likely file an action against the wrongdoers who have pursued, or are pursuing, the illegal or improper course of conduct. If, however, the board and/or the committee determine that legal action is not appropriate, then the demanding shareholder may commence an action on his/her own for the benefit of the company.

In addition to the demand requirement, many jurisdictions require a shareholder to prove that he/she has standing to bring the action. These laws often require the shareholder to meet certain qualifications, such as maintain a minimum value of the shares held and the hold the shares for a certain period of time.

Culligan Soft Water Company v. Clayton Dubilier & Rice, LLC

As noted above, any settlement of a derivative action must be approved the court. See, e.g., Section 626(d) of the New York Business Corporation Law. In June 2015, the Honorable Jeffrey K. Oing, Justice of the Supreme Court, New York County, approved such a settlement.  However, on November 29, 2016, the First Department reversed that approval because, among other reasons, the settlement did not confer a benefit on the company. Culligan Soft Water Co. v. Clayton Dubilier & Rice, LLC, 2016 NY Slip Op. 08021.

The Motion Court Proceedings:

On June 8, 2015, Justice Oing approved the partial settlement of a derivative action brought by minority shareholders of Culligan Soft Water Company (“Culligan”).  The action arose from the $610 million leveraged buyout (“LBO”) of the company by Clayton Dubilier & Rice, LLC (“CD&R”), a private equity firm.  The suing shareholders claimed that after CD&R bought Culligan, it saddled the company with more debt than it could repay. At the same time, CD&R extracted the company’s value for its own benefit through a series of transactions, including a $375 million dividend, and allowed its debt to be sold at a steep discount to investment firms Angelo Gordon & Co., Silver Oak Capital LLC and Centerbridge Partners LP (the “Lenders”).

The shareholder plaintiffs reached a settlement with Angelo Gordon, Centerbridge and a related entity.  Under the settlement, the Lenders agreed to pay the shareholders $4 million to be held in trust and used to settle the plaintiffs’ past legal fees, as well as fund the derivative action against CD&R and the current and former Culligan officers and directors.

CD&R and the director defendants objected to the proposed settlement, arguing, among other things, that the proposed settlement only benefited the plaintiffs – the minority shareholders – and not the company or its two largest shareholders, both CD&R entities.

At oral argument, Justice Oing rejected these arguments, though he expressed skepticism at first, questioning whether it would be better to keep the $4 million in escrow, pending the final resolution of the case.  Justice Oing found that the partial settlement was fair since it resolved the claims against the Lenders (which related to the restructuring and the acquisition of Culligan’s assets pursuant to a 2012 exchange transaction) and provided money for the claims against the remaining defendants, in addition to cooperation from the Lenders in the continued litigation. Justice Oing noted that the proposed partial settlement “compartmentalized” the suit by removing peripheral claims, while keeping the focus on the central allegations of the action – those concerning the LBO and the allegedly illegal distributions paid to CD&R and the Culligan officers and directors.

In his bench ruling, Justice Oing underscored the fact that, under the settlement, the minority shareholders would receive $4 million and cooperation from the Lenders to pursue the larger case, which was in the best interest of the broader case: “Those are factors they had to weigh and think about, not only for their benefit but also for the company’s benefit, and at the end of the day, that is something I cannot ignore.”

The First Department’s Holding:

On November 6, 2016, the First Department heard argument on CD&R’s objections to the partial settlement. As an initial matter, CD&R argued that the plaintiffs, minority holders of beneficial shares of the company, did not have standing to settle the claims. CD&R noted that the plaintiffs were Culligan franchisees and “business partners” with the defendant investment firms that bought Culligan’s debt after CD&R’s $610 million LBO.

Additionally, CD&R argued that the settlement provided no benefit to Culligan. According to CD&R, the settlement benefited the minority shareholders and not the corporation. “The money is going straight into the pockets of the dealers, their trade association and its attorneys,” said CD&R’s counsel. “[T]hey haven’t obtained anything except cash for their trade association.” Notably, the minority shareholders did not disagree, stating: “The $4 million is to be used for legal fees and to the extent that there’s anything left, it would go to the company.” Neither the trade association nor the dealers would receive any money outside of what they had spent on legal fees.

Approximately three weeks later, the First Department agreed with CD&R and the company defendants and reversed the approval of the partial settlement. In a unanimous, terse opinion, the Court accepted the reasons advanced by these defendants for vacating the judgment below:

The settlement does not provide for payment to the company. Plaintiffs are to receive the bulk of the $4 million settlement in reimbursement for their legal fees in this case, and the remainder is to be turned over to their franchisee organization for future legal fees or for distribution, at the organization’s discretion, to plaintiffs. Moreover, because they have not obtained a substantial benefit for the company, but have accomplished only getting their lawyers paid, plaintiffs, who, after four attempts, have yet to plead properly that they have standing to sue derivatively, are not entitled to legal fees. It was an abuse of discretion to approve the settlement of a derivative action purporting to bind the company and all shareholders that was obtained by plaintiffs who had not established — and may never establish — their standing to bring the action. Contrary to plaintiffs’ argument, defendants, as shareholders in the company who received notice of the settlement and had an opportunity to and did object to the settlement, have standing.

Internal citations omitted.

Takeaway:

It is well-established that the fundamental purpose of a derivative action is to vindicate a wrong done to the company. Because that is the purpose of the derivative action, New York courts have long held that any recovery obtained in a derivative action should be for the benefit of the injured company. Thus, any monetary payment recovered and/or non-monetary benefit obtained in the action must be paid and/or flow to the company whose claims are at issue.

The settlement before the Court in Culligan, however, did not comport with these principles. The record showed that in exchange for a broad release of Culligan’s claims against the settling parties, the minority plaintiffs would receive: (1) $4 million to be paid directly to their franchise dealers association, which was given complete discretion –without court review– to distribute attorney’s fees, hold “up to $1 million” in trust “to fund future legal expenses,” and to pay the balance “directly to [the] Plaintiffs” in proportion to their fundraising efforts for the association; and (2) cooperation in the continued litigation (i.e., the ability to subpoena documents and testimony from the settling parties) – consideration that was opposed by the company and its majority shareholder because it only conferred a benefit on the plaintiffs and their attorneys. The Court rightly found that neither form of consideration provided any benefit to Culligan or its majority shareholder.

Where derivative actions are concerned, courts must be vigilant in protecting the interests of the corporation and shareholders, especially in the context of settlement. The reason courts are given such a responsibility is “to discourage the private settlement of a derivative claim under which a shareholder-plaintiff and his attorney personally profit to the exclusion of the corporation and the other shareholders….”  Mokhiber on Behalf of Ford Motor Co. v. Cohn, 783 F.2d 26, 27 (2d Cir. 1986). By examining the substance of the proposed settlement in Culligan, the Court fulfilled its role as gatekeeper and ensured that the relief obtained was fair and reasonable and would go to the company. As the Court found, however, the partial settlement did not provide a real or substantial benefit to the company but, instead, allowed the plaintiffs to negotiate fees in exchange for illusory benefits to the corporation and broad general releases for the alleged wrongdoers.