Derivative suits against the board members of companies that suffered data breaches appears to be a losing proposition for shareholders. On Wednesday, U.S. District Judge Thomas Thrash of Atlanta tossed a shareholder derivative suit against board members of Home Depot, which was hacked over the course of several months in 2014. Judge Thrash agreed with Home Depot’s lawyers at Alston & Bird that plaintiffs in the consolidated case failed to prove that it would have been futile for shareholders to demand the board take action against directors and officers in the name of the corporation. This is the second big data breach derivative suit, after a similar case against Target’s board, to be dismissed in the last six months.
But there was an intriguing nugget in Judge Thrash’s opinion. Home Depot shareholders, represented by lead counsel from Faruqi & Faruqi and Schubert Jonckheer & Kolbe, asserted Delaware state law actions for breach of duty and waste of corporate assets – but also claimed board members violated Section 14 of the Securities and Exchange Act because, according to the plaintiffs, board members signed off on proxy statements in 2014 and 2015 that falsely assured shareholders the board was taking care to secure the company’s data.
Board members, of course, denied they said anything misleading in proxy statements, argued that whatever they did say wasn’t material and asserted that regardless, shareholders couldn’t show any harm to the company. They also said plaintiffs hadn’t shown demand futility on the Section 14 claim.
Here’s where things get interesting: Shareholders said in their brief opposing dismissal that they didn’t need to show directors were too self-interested to respond to a demand on the Section 14 claim. According to the brief, there is a narrow fissure among federal trial courts on this question, after a 2003 decision, Vides v. Amelio, from U.S. District Judge Louis Stanton of Manhattan. In Vides, Judge Stanton ruled in a stock options backdating suit against board members of SBC Communications that plaintiffs did not have to show demand futility to move forward with a proxy disclosure claim under Section 14.
“Whether a proxy statement properly omitted an item is regarded as a question of materiality, not one protected by the business judgment rule,” the judge wrote. “Thus, under Delaware law and federal policy, there is no need for prior demand upon the board of directors with respect to the claim of misstatements and omissions in the proxy statement.”
Home Depot shareholders also cited 1993’s In re Westinghouse, in which U.S. District Judge Brooks Smith – like Judge Stanton – said deference to the board’s business judgment does not apply to federal claims of disclosure failures. “Misapplying the business judgment rule to a pure allegation of securities fraud ... would emasculate the federal policy of ‘preventing management or others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation,” the Westinghouse opinion said.
The Home Depot board characterized Vides as an outlier that was quickly repudiated by other state and federal courts. In a 2008 decision, Bader v. Blankfein, U.S. District Judge Sandra Townes of Brooklyn listed several of the decisions rejecting Vides after explaining her own reasoning that shareholders must prove demand futility when they plead Section 14 violations. According to Judge Townes, Judge Stanton went astray because he “ignored the fact that directors must still use their business judgment in deciding what course of action to take when alerted to a materially false statement in a corporate proxy statement,” she wrote. “Under such circumstances, the directors must do more than simply engage in a legalistic determination of whether the defects are material; they must also decide whether litigation is the best avenue to rectify the problem.”
In the Home Depot ruling Wednesday, Judge Thrash gave the issue of demand futility for derivative claims under federal law a thorough airing before concluding, like Judge Townes and many others, that Judge Stanton’s analysis in the Vides opinion falls short. Even if proxy disclosures are a matter of law, not business judgment, “directors must still use their business judgment in determining whether to pursue a lawsuit on account of those proxy statements,” he wrote. So shareholders are not excused from the requirement that they ask the board to take action for proxy omissions before they bring a derivative claim.
As I’ve reported, the shareholder bar is increasingly disgruntled about the outcome of derivative litigation in Delaware Chancery Court. Plaintiffs' lawyers are voting with their filing fees, filing suits in federal court in addition to or instead of suing in Delaware. Cornerstone Research has already reported a rise in securities filings in federal court. And though the rise is rooted in shareholder class actions challenging M&A deals – in which shareholders typically assert direct federal securities claims rather than derivative claims – I’m pretty sure plaintiffs' lawyers are also more likely to file ordinary shareholder derivative suits in federal court, citing Section 14.
It would sure be a big help to them not to have to prove demand futility. The bar for a Section 14 case is still incredibly high, since fraud claims have to meet a tough pleading standard. But the vast majority of derivative suits die before any consideration of the merits of the claims because plaintiffs can’t establish that it would have been pointless to ask the board to act because of directors’ self-interest. Shareholders would love to bypass that obstacle.