The Rise (and Eventual Fall?) of Derivative Section 10(b) Claims

The Bottom Line

• Section 10(b) derivative litigation claims, a relatively new occurrence, may sometimes be of questionable merit.
• These claims present legal and practical problems, including that they are conceptually flawed.
• Corporate defendants should develop strategies for these claims as they continue to arise.

Stockholder derivative litigation has reflected a notable shift in recent years: the increasing inclusion of claims under Section 10(b) of the Securities Exchange Act, which prohibits material misstatements or omissions in connection with the purchase or sale of a security. But these claims have received little attention from the bar and commentators.

As derivative Section 10(b) claims continue to proliferate, defense attorneys should develop strategies to manage them. And as the case law continues to evolve in this realm, litigants must remain attuned to these important issues and be ready to respond.

Section 10(b) Claim Evolution

In a typical stockholder derivative lawsuit, a plaintiff asserts breach-of-fiduciary-duty claims under state law, which governs the relationship between a corporation and its stockholders. Many corporations have forum selection provisions requiring these cases to be filed in state court—often in Delaware.

But many stockholder plaintiffs view federal courts as a more favorable forum, particularly over jurisdictions that they believe may be less friendly to their claims. So they tack on federal securities claims, which can only be heard in federal court, to create federal jurisdiction and, if necessary, circumvent forum provisions that would otherwise require a state court forum.

Stockholders for years did this by including a derivative claim under Section 14(a) of the Exchange Act, which prohibits misleading statements in proxy statements. But that path may be closing.

Sitting en banc, the US Court of Appeals for the Ninth Circuit explained in Lee v. Fisher that these sorts of Section 14(a) claims are really direct, not derivative, claims. If other circuits (or the US Supreme Court) agree with the Ninth Circuit, plaintiffs would no longer be able to use Section 14(a) to establish federal court jurisdiction and circumvent forum selection provisions.

Given these developments, more plaintiffs have turned to Section 10(b). In the typical direct Section 10(b) action, stockholders claim a company made false statements that artificially inflated its stock price; the stockholders relied on those false statements and purchased stock at an inflated price; and when the truth was later revealed and the stock price fell, the stockholders suffered losses.

Because many public companies periodically buy back their own stock, derivative plaintiffs have begun asserting that the companies themselves were also harmed when they repurchased stock at the allegedly inflated price.

Particularly after Lee, defense counsel should expect to see more of these Section 10(b) derivative claims in light of the roadmap developed to date. The claims provide a new jurisdictional hook—and they can also drive significant damages claims.

In many cases, derivative plaintiffs will be able to piggyback on direct securities fraud actions already underway by simply copying the allegations already pleaded by direct plaintiffs. But these claims suffer from theoretical and practical problems that have so far been underdeveloped.

The Reliance Paradox

Perhaps derivative Section 10(b) claims’ most notable problem is that they are often self-contradictory. In In re Verisign, Inc., Derivative Litigation, one of the earlier cases to confront these claims, the plaintiffs alleged the company made false statements about backdated stock options granted to executives, inflating the company’s stock price, and that the company was harmed when the company repurchased stock at the inflated price.

The plaintiffs brought derivative Section 10(b) claims on behalf of the company. But it is well-settled that stockholders suing under Section 10(b) must show they relied on the alleged misrepresentation in buying stock. In Verisign, the court explained that the company couldn’t have relied on the allegedly false statements when buying stock because the statement was made by the company through its directors.

If the directors knew the statements were false, they couldn’t have been defrauded by relying on those same statements. The same individuals who were responsible for those statements (that is, directors) were also responsible for authorizing repurchases.

In both cases, the directors act on behalf of the company, and their knowledge is imputed to the company. In other words, the theory is that the company somehow relied on its own misstatements and therefore defrauded itself.

The District of Delaware reached the same conclusion in two recent cases. In Elfers ex rel. AbbVie, Inc. v. Gonzalez, the court dismissed a derivative Section 10(b) claim, explaining that “[a] story of deception needs two characters: the liar and the dupe” and that the directors can’t play both roles because they “could not have both lied about the wrongdoing and yet been tricked by those lies.”

Similarly, in Franklin ex rel. Sealed Air Corp. v. Doheny, the court recommended dismissal of a derivative Section 10(b) claim on the grounds that the theory that “directors spread misleading information and then the same directors relied on and were deceived by that false information when they approved stock buy backs—is factually impossible.”

But some courts have disagreed with the reasoning in Verisign, Elfers, and Franklin. In In re Countrywide Financial Corp. Derivative Litigation, the plaintiffs alleged that directors caused the company to make misleading statements about credit risk, and that the directors caused the company to buy back stock, including from themselves, at an inflated price. The court decided that the directors’ knowledge shouldn’t be imputed to the company in those circumstances.

Derivative plaintiffs also have successfully pleaded reliance in the context of stock option grants, where directors allegedly caused the company to issue themselves underpriced grants premised on false statements.

These cases were at least limited by having involved prominent allegations of self-dealing. In that specific context, the courts reasoned that it may make some sense not to impute knowledge to the company, because the allegations are that the directors acted for their own benefit and at company’s expense.

More recently, however, a few courts have permitted derivative claims that look exactly like typical, direct securities fraud claims. In each, following a corporate trauma, the plaintiffs alleged the company made false statements.

The plaintiffs didn’t allege that the directors had any personal stake in repurchases, or that they somehow benefited from the alleged fraud. The plaintiffs argued that because the company had engaged in stock repurchases while the stock price was inflated, the company was the victim of securities fraud. This expansion of the case law is particularly troublesome, as the decisions suggest that essentially any direct Section 10(b) claim can be converted into a derivative claim if the company repurchased stock.

We are likely to see more of these types of claims. But courts shouldn’t put companies in the same position as any other stockholder without grappling with knowing that the company, as the maker of the allegedly false statement, can’t be said to rely on those alleged misstatements as any other stockholder would.

At the motion to dismiss stage, and particularly when faced with claims such as those in Shaev and Abbott, companies should continue to press Verisign’s reasoning that plaintiffs can’t establish reliance where the makers of a false statement also authorize the repurchase.

Defendants can also distinguish cases departing from Verisign as limited to transactions where directors stood to personally benefit (for example, where directors allegedly induced the company to issue underpriced stock option grants to themselves). But even in those circumstances, asserting reliance by the company is inherently contradictory, and the claims are better thought of as breach-of-fiduciary-duty claims under state law.

Indeed, Delaware has a well-developed body of law to address allegations of director self-dealing that doesn’t present the same contradictions as a derivative Section 10(b) claim. Both the contradictory nature of these claims and the fact that they are better suited as state law claims counsel in favor of dismissal. Companies must clearly present the incoherence of these claims to courts so that they receive careful judicial scrutiny before they proliferate.

From Lee’s Playbook

Section 10(b) claims also may not be the end run around forum selection provisions that plaintiffs hope. Many companies have forum selection clauses requiring that all derivative claims be brought in the Delaware Court of Chancery.

Because claims brought under the Exchange Act can only be heard in federal court to enforce the forum selection clause, courts must dismiss the Exchange Act claims. The Ninth Circuit did exactly that in Lee, dismissing Section 14(a) claims to enforce a forum selection clause.

Although Lee didn’t involve Section 10(b) claims, at least one court has since dismissed a derivative Section 10(b) claim on forum non conveniens grounds. In Sobel v. Thompson, a stockholder brought a derivative Section 10(b) claim against SolarWinds Corp. executives, alleging that the individual defendants “failed to disclose known deficiencies in the Company’s cybersecurity systems in various public filings prior to [a] cyberattack.”

The executives moved to dismiss the claim pursuant to a forum selection clause requiring that any derivative action be brought in the Delaware Court of Chancery. Even though enforcement of the provision would leave the derivative plaintiff with no forum for their Section 10(b) claims, the Western District of Texas reasoned that the plaintiff could bring similar derivative state-law claims under Delaware law. The Chancery Court’s available remedies, the Sobel court explained, were thus not “so clearly inadequate or unsatisfactory” to be “no remedy at all.”

On the other hand, the Northern District of California recently denied a motion to dismiss a derivative Section 10(b) claim where the relevant forum selection clause in the company’s bylaws contained an express exception for Exchange Act claims. In In re Block Inc. Shareholder Derivative Litigation, the district court found that the derivative action fell within the scope of the Exchange Act exception, and accordingly never addressed the defendants’ Sobel-style arguments that the forum selection provision could be enforced, and the Exchange Act claims dismissed, because the plaintiff had adequate remedies in the Delaware Court of Chancery.

The court’s reasoning in Sobel offers several lessons for defendants. Enforcing forum selection clauses is beneficial for litigants because it preserves a stockholder plaintiff’s ability to seek relief while concentrating claims related to alleged breaches of fiduciary duties in a Delaware state forum recognized for its “expertise in the field of state corporation law.” Additionally, as noted by the court in Sobel, Delaware law claims have “available remedies that are commensurate to those available under [plaintiffs’] federal derivative claims.”

Enforcing forum selection clauses merely maintains the status quo: Stockholders have long brought similar actions as state law claims in the context of breaches of fiduciary duties. Bringing such claims under state law remains a viable path to relief, avoids the logical contradictions presented by derivative Section 10(b) claims discussed above, and coincides with longstanding judicial and corporate views on the benefits of litigating breach-of-fiduciary-duty claims in Delaware.

Key Takeaways

Defense attorneys can use a couple of strategies to handle Section 10(b) claims. They can argue that derivative Section 10(b) claims are fundamentally flawed because plaintiffs can’t establish reliance, following the framework of Verisign, Elfers, and Franklin. Defendants should remind courts that these are legal claims better suited to be brought as Delaware breach-of-fiduciary-duty claims and that the reliance paradox results from plaintiffs forcing their claims into a mismatched framework.

Companies also can adopt and leverage forum selection clauses. Where such clauses limit the forum for derivative suits to Delaware Chancery Court, the Exchange Act’s exclusive jurisdiction provision may require the dismissal of Section 10(b) claims.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Christopher Viapiano is a partner in S&C’s litigation group and co-head of the firm’s securities litigation practice.

Lenny Traps is a partner in S&C’s litigation group, where his practice focuses on commercial matters.

Oliver Engebretson-Schooley is a partner in S&C’s litigation group, where he works on a wide range of complex civil litigation matters.

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