NY District Court Dismisses Merrill Lynch Derivative Suit for Lack of Standing to Sue

Holding:

The U.S. District Court for the Southern District of New York has dismissed two derivative shareholder actions against executives and directors of Merrill Lynch & Co., Inc. (“Merrill”). In ruling against plaintiffs filed on behalf of the company, the district court applied the “continuing ownership rule” followed by Delaware and federal courts. This rule requires stockholders to own stock in a corporation to be able to institute derivative suits. Here, the district court found that when Bank of America acquired Merrill in a stock-for-stock transaction, plaintiffs lost their standing to bring derivative suits on behalf of Merrill because they no longer owned any Merrill stock. True, plaintiffs did seek to bring themselves within the so-called “fraud exception” – a rule which requires that “the merger was fraudulent and done merely to eliminate derivative claims.” But plaintiffs’ fraud allegations were inadequate and conclusory to make their complaint fall under that exception. On this basis, the district court granted defendants’ motion to dismiss the derivative action for lack of standing. This dismissal was without prejudice to plaintiffs’ filing of another suit if and when they already have standing, such as a derivative action against the Bank of America.

Detailed Summary:

This suit arose from the huge losses experienced by defendant Merrill as a result of its aggressive investment in collateralized debt obligations and similar mortgage-backed securities.

This case originally involved securities class actions, ERISA actions, and derivative actions. But before oral argument could be heard, a tentative settlement in an amount in excess of $500 million was reached in the securities class actions and the ERISA actions, subject to the district court approval. This settlement left, inter alia, the derivative actions, which consisted of the consolidated lawsuit known as the “Derivative Action,” docketed as No. 07 Civ. 9696 and the later-filed action, Lambrecht v. O’Neal, docketed as No. 08 Civ. 6582.

Both actions were brought by persons who, at the time of filing, were Merrill shareholders who sought to recover on behalf of the company from Merrill executives and board members who had allegedly breached their fiduciary duties, wasted corporate assets, and the like, all in violation of Delaware law. The difference between the two actions is that the plaintiffs in the Derivative Action did not make a demand on the Merrill board that it proceed with the action, whereas the plaintiff in Lambrecht did make such a demand, which the Merrill board rejected.

Defendants moved to dismiss the actions on the ground that, as a result of the acquisition of Merrill by Bank of America in a stock-for-stock transaction, the plaintiffs are no longer Merrill shareholders and therefore lacked standing to pursue these derivative actions as filed.

At issue was whether Delaware law or what plaintiffs call “federal common law” should determine standing to bring a derivative action against a Delaware corporation in federal court.

Under Delaware law, “[a] plaintiff who ceases to be a shareholder, whether by reason of a merger or for any other reason, loses standing to continue a derivative suit.” Opinion, p. 3, citing Lewis v. Anderson, 477 A.2d 1040, 1049 (Del. 1984). Here, the district court held that in acquiring Merrill in a stock-for-stock transaction, Bank of America thereby extinguished plaintiffs’ standing to bring derivative suits on behalf of Merrill because they no longer owned any Merrill stock. The district court noted that such a result has been affirmed repeatedly. Id, citing Feldman v. Cutaia, 951 A.2d 727, 731 (Del. 2008); Lewis v. Ward, 852 A.2d 896, 901 (Del. 2004).

The exception to this rule was the Third Circuit case of Blasband v. Rales, 971 F.2d 1034 (3d Cir. 1992). In Blasband, the Third Circuit after correctly stating the prevailing rule laid under Ward, nonetheless chose to preserve plaintiff’s standing under its interpretation of the broad leeway provided by Delaware’s principles of equity.

But the district court noted that Blasband has subsequently been marginalized, if not abandoned by Delaware courts themselves. Id., citing Ward at 903.  Here, plaintiffs did not even argue that the merger is “merely a reorganization” in which the emergent entity is substantively identical to the pre-merger entity.

True, plaintiffs did seek to bring themselves within the so-called “fraud exception” – which requires that “the merger was fraudulent and done merely to eliminate derivative claims.” Id., p. 4, citing Ward, 852 A.2d at 905.  But they did so by alleging in largely conclusory fashion that the individual defendants “(i)n an attempt to eliminate their personal liability for (their prior) wrongdoing, . . . hastily and without appropriate due diligence agreed to sell Merrill to Bank of America for . . . an extreme discount . . . .” Id., pp. 4-5, citing Verified Second Amended Shareholder Derivative and Class Action Complaint.

But plaintiffs failed to provide the particularized allegations necessary to substantiate this claim of fraud, as required by Fed. R. Civ. P. 9(b), contenting themselves, instead, with simply listing standard practices of such a merger, such as indemnification of the acquired company’s directors.  This is patently inadequate, added the district court,  to draw this action within the ambit of the “fraud exception” to the rule of Lewis v. Anderson.

On the basis of the foregoing, the district court granted defendants’ motion to dismiss the derivative action for lack of standing.  This dismissal was without prejudice to plaintiffs’ filing of another suit if and when they already have standing, such as a derivative action against the Bank of America.

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