On appeal from the United States District Court for the District of Delaware. (D.C. Civil Action No. 91-166)
Before: Greenberg and Scirica, Circuit Judges, and Debevoise, District Judge*fn*
GREENBERG, Circuit Judge:
FACTUAL AND PROCEDURAL HISTORY
Alfred Blasband appeals from a district court order of August 15, 1991, dismissing his complaint pursuant to Fed. R. Civ. P. 12(b)(6) and Fed. R. Civ. P. 23.1 in this shareholder derivative suit. This appeal raises difficult issues regarding shareholder standing and demand futility in derivative actions brought under Delaware law. In view of the procedural posture of the case, we will accept Blasband's allegations in our Disposition of the appeal.
Blasband is a former shareholder of Easco Hand Tools, Inc. On September 1, 1988, while Blasband was an Easco shareholder, Easco initiated a public offering of $100 million of 12.875% Senior Subordinated Notes (the "Note Offering"). In the prospectus for the Note Offering, Easco disclosed that the proceeds would be used for repayment of outstanding indebtedness, general corporate purposes, and expansion of Easco's business through internal growth and acquisitions. The prospectus further stated that "pending such uses, the Company will invest the balance of the net proceeds from this offering in government and other marketable securities which are expected to yield a lower rate of return than the rate of interest borne by the Notes."
After the Note Offering was completed, Easco invested at least $61.9 million of the proceeds in high-yield, highly speculative debt securities, commonly known as junk bonds. In its Form 10-K filed with the Securities and Exchange Commission for the year ended December 31, 1988, Easco disclosed these investments as "temporary investments in marketable securities and cash equivalents." One year later, in its 1989 Annual Report and 10-K, Easco disclosed that it still held these investments but that "during 1989, the market for these securities became volatile and some market values declined significantly." Explaining that "greater risk is generally associated with these high-yield securities, for which a thinly traded market exists and for which market quotations are not always available," Easco stated that it had reduced the carrying value of its portfolio by $14 million and that it would probably suffer further losses if the remaining issues were sold. Easco disclosed an additional $1 million loss in its March 31, 1990 Form 10-Q filed with the SEC.
In February 1990, Easco entered into a merger agreement with the nominal defendant Danaher Corporation and Combo Acquisition Corporation, a wholly owned subsidiary of Danaher, providing for Easco shareholders to receive .4175 shares of Danaher common stock for each of their shares of Easco common stock. The merger was consummated in June 1990 with Easco surviving as a wholly owned subsidiary of Danaher. Consequently, Blasband's 1,100 shares of Easco were converted into 458 shares of Danaher.*fn1
Prior to the merger, Mitchell P. Rales was Chairman of Easco's board of directors and owned approximately 25% of Easco's common stock. His brother, Steven M. Rales, was a director of Easco and owned 27% of its stock. Mitchell Rales is also President and a director of Danaher, and Steven Rales is Chairman of the board of directors of Danaher. Together the brothers own 44% of Danaher's common stock. Beginning sometime in the mid-1980's, the Rales brothers retained Drexel Burnham Lambert Incorporated to assist in the Rales' corporate acquisition strategy. Through junk bond financing arranged by Drexel, the Rales brothers expanded Danaher by acquiring Western Pacific Corporation and Chicago Pneumatic Corporation. In 1988 the Rales brothers hired Drexel in connection with an ultimately unsuccessful $2.5 billion bid to acquire another company. In addition, Drexel assisted the Rales brothers in acquiring an interest in Easco in 1986 by partially providing the financing.*fn2 Furthermore, Drexel was selected as the sole underwriter for the Note Offering.
The junk bond investment of the proceeds of the Note Offering did not go unnoticed for, on October 25, 1990, Blasband's counsel sent a letter to the boards of directors of Easco and Danaher setting forth the discrepancy between the proposed use of the proceeds in the prospectus for the Note Offering and Easco's financial statements disclosing the actual investments in junk bonds. The letter requested additional information to explain, inter alia : (1) why the junk bond portfolio had lost $14 million in one year; (2) what securities Easco had purchased and sold between September 1, 1988, and December 31, 1989, and at what prices and through which brokerage house; (3) which Easco officers and directors approved or selected the purchases and sales; and (4) why Easco used the proceeds of the Note Offering in a manner contrary to that described in the prospectus. Counsel for Blasband stated that, although much of this information "could be obtained through a formal demand for inspection of the Company's books and records, we believe that it is in our mutual interest to proceed on a less formal basis."
Counsel for Danaher and Easco responded in a letter dated December 17, 1990, that "it would be inappropriate at this time to provide" the requested information. Further, counsel stated that "Easco fully and fairly complied with the requirements of the federal securities laws and regulations in disclosing all material information concerning the Note Offering and the subsequent use of the proceeds of that offering to its shareholders in its public financing." Additionally, counsel stated that compliance with the request "would impose a substantial burden on our clients . . . [and] would be time-consuming and highly disruptive of the day-to-day management of the business . . . ."
Unsatisfied with this response, Blasband filed this derivative action in the United States District Court for the District of Delaware on behalf of Danaher on March 25, 1991. The essence of Blasband's claim is that the Rales brothers violated their fiduciary duties owed to Easco by investing proceeds of the Note Offering in highly speculative junk bonds as consideration for their business dealings with Drexel and not for a legitimate corporate purpose. Blasband named the Rales brothers and ten "John Does" who were officers and directors of Easco at the time of the Note Offering as defendants. Danaher was joined as a nominal defendant. Blasband has not specifically identified the John Doe defendants and thus the Rales brothers remain the only actual defendants and we therefore refer to them as the appellees.
Prior to discovery, the appellees moved to dismiss the complaint pursuant to Rules 12(b)(6) and 23.1 on the grounds that Blasband had not made an appropriate demand on the directors of Danaher to take action and did not establish demand excusal.*fn3 Furthermore, the appellees contended that Blasband lacked standing to bring this action.
The district court granted the appellees' motion. Applying Delaware law, the district court held that demand excusal should be measured with regard to the Danaher board, and that Blasband did not adequately plead that demand would have been futile. Additionally, the court agreed with the appellees that Blasband lacked standing as a result of the merger. Accordingly, on August 15, 1991, the court dismissed the complaint with prejudice. Blasband on behalf of Danaher Corp. v. Rales, 772 F. Supp. 850 (D. Del. 1991). Blasband filed a timely notice of appeal on September 12, 1991.
We agree with the district court that Blasband has not adequately established that he is excused from making a proper demand. However we also believe, contrary to the district court, that Blasband does have standing to maintain this derivative action, and we therefore hold that Blasband should be given the opportunity to move to amend the complaint to allege additional facts establishing that a proper demand would have been futile. Accordingly, we will vacate the order of August 15, 1991, and will remand the case for further proceedings.*fn4
Blasband argues that our review is plenary to the extent that the district court granted the motion to dismiss pursuant to Rule 12(b)(6). See Scattergood v. Perelman, 945 F.2d 618, 621 (3d Cir. 1991). The appellees, on the other hand, assert that the district court exercised its discretion in dismissing this action pursuant to Rule 23.1, and accordingly we may reverse only if we find an abuse of discretion. In fact, the district court's order recited that it granted the motion to dismiss under both Rules 12(b)(6) and 23.1. However, the district court's label is not binding on us. Rather, we must look to the course of the proceedings in the district court and the basis for its decision to determine the standard of review. Melo v. Hafer, 912 F.2d 628, 633 (3d Cir. 1990), aff'd, 116 L. Ed. 2d 301, 112 S. Ct. 358 (1991); Rose v. Bartle, 871 F.2d 331, 340 (3d Cir. 1989).
Rule 23.1 requires the plaintiff in a derivative action to allege that he or she was a shareholder at the time of the challenged transaction, and to set forth "with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors . . ., and the reasons for the plaintiff's failure to obtain the action or for not making the effort." As we later discuss, the rule does not require a plaintiff to make a demand upon the directors to take action where to do so would be futile. Generally, the district court's determination of demand futility depends upon the facts of each case and is reviewed for abuse of discretion. Peller v. Southern Co., 911 F.2d 1532, 1536 (11th Cir. 1990); Starrels v. First Nat'l Bank, 870 F.2d 1168, 1170 (7th Cir. 1989); Gaubert v. Fed. Home Loan Bank Bd., 863 F.2d 59, 68 n.10 (D.C. Cir. 1988); Lewis v. Graves, 701 F.2d 245, 248 (2d Cir. 1983). See also Lewis v. Curtis, 671 F.2d 779, 783 (3d Cir.), cert. denied, 459 U.S. 880, 103 S. Ct. 176, 74 L. Ed. 2d 144 (1982).
However, on this appeal Blasband challenges the legal precepts employed by the district court in making its determination that he did not adequately plead demand futility. We exercise plenary review over a district court's choice and interpretation of legal precepts. Mellon Bank, N.A. v. Metro Communications, Inc., 945 F.2d 635, 642 (3d Cir. 1991) (citing Universal Minerals, Inc. v. C.A. Hughes & Co., 669 F.2d 98, 101-02 (3d Cir. 1981)), cert. denied, 112 S. Ct. 1476 (1992)). We apply this standard regardless of whether the district court is applying federal law or state law. See Salve Regina College v. Russell, 113 L. Ed. 2d 190, 111 S. Ct. 1217 (1991).*fn5 Accordingly, while we review both the district court's determination of demand futility and its decision to dismiss the complaint with prejudice under an abuse of discretion standard, see Lewis v. Curtis, 671 F.2d at 783, we exercise plenary review over its choice of legal precepts upon which those determinations were based. Furthermore, as we are deciding the standing issue by the application of legal precepts our review on this point is plenary.
Although the district court primarily dismissed Blasband's complaint because of his failure to satisfy the demand requirement, we will first address the issue of standing. The appellees argue that as a result of the merger Blasband lacks standing to bring this derivative action. Blasband counters that he meets the statutory standing requirements and further that he has "successor derivative standing" by virtue of his status as a former Easco shareholder and his current status as a Danaher shareholder.
In general under Delaware law which the parties agree is applicable a plaintiff must have been a shareholder at the time of the challenged transaction to have standing to maintain a shareholder derivative suit. Delaware General Corporation Law § 327, Del. Code Ann. tit. 8, § 327 (1983).*fn6 The sole purpose of section 327, as stated by Chancellor Seitz, is "to prevent what has been considered an evil, namely, the purchasing of shares in order to maintain a derivative action designed to attack a transaction which occurred prior to the purchase of the stock." Rosenthal v. Burry Biscuit Corp., 30 Del. Ch. 299, 60 A.2d 106, 111 (Del. Ch. 1948). In addition to section 327's requirement, the Delaware courts require that the plaintiff remain a shareholder at the time of the filing of the suit and throughout the litigation. Kramer v. Western Pacific Indus., Inc., 546 A.2d 348, 354 (Del. 1988); Lewis v. Anderson, 477 A.2d 1040, 1046 (Del. 1984). This requirement ensures that the plaintiff has sufficient incentive to represent adequately the corporation's interests during litigation. See Portnoy v. Kawecki Berylco Indus., Inc., 607 F.2d 765, 767 (7th Cir. 1979). Additionally, as with section 327, the continuing ownership requirement is intended to prevent abuses associated with derivative actions. Lewis v. Anderson, 477 A.2d at 1046.
Where there has been a cash-out merger, it is clear that a former shareholder may not maintain a derivative action, for he or she would no longer have an interest in a subsequent corporate recovery. See, e.g., Kramer, 546 A.2d 348. However, where, as here, the plaintiff receives shares of a new corporate entity, the standing issue is less clear, as the plaintiff will have a financial interest in the derivative action. For example, in Helfand v. Gambee, 37 Del. Ch. 51, 136 A.2d 558 (Del. Ch. 1957), the plaintiff was a shareholder in a corporation required to reorganize and separate certain aspects of its business pursuant to a consent decree resulting from an antitrust action brought by the United States. As a result of the breakup, the plaintiff's shares were exchanged for shares of two new corporations. In denying the defendants' motion to dismiss the complaint on the ground that the plaintiff lacked standing to challenge activities that took place prior to the share exchange, the court observed:
In Rosenthal v. Burry Biscuit Corp., supra, this Court stated that the sole purpose of § 327, Title 8 Del.C. was to prevent an evil, namely the purchase of shares for the purpose of bringing a derivative action based on transactions antedating such purchase. Plaintiff is not such a purchaser and the fact that she holds two pieces of paper rather than one as evidence of her . . . investment . . . should not, in my opinion, foreclose her from complaining of acts antedating the incorporation of [the post-merger corporation] when such corporation is in effect a successor to [the pre-merger corporation].
Similarly, in Schreiber v. Carney, 447 A.2d 17 (Del. Ch. 1982), a merger resulted in the shareholders receiving a share-for-share exchange of stock with a newly formed holding company. The court held that the plaintiff maintained "equitable derivative standing" to bring a derivative action to challenge acts that occurred prior to the reorganization since the "merger had no meaningful effect on the plaintiff's ownership of the business enterprise . . . ." Id. at 22. However, the court carefully distinguished cases involving "either cash-out mergers or mergers with outside or pre-existing corporations with substantial assets." Id. See, e.g., Bonime v. Biaggini, No. 6925, slip op. at 7 (Del. Ch. Dec. 7, 1984) (refusing to extend Schreiber where the new entity had a "corporate mix [that was] distinctly different from that of" the prior corporation).
In view of the principles reflected in cases such as Schreiber and in the recognition of the need to avoid the shielding of fraudulent transactions, the Delaware courts regularly indicate that there are two exceptions to the general rule that a plaintiff loses standing where he or she loses stock as a result of a merger. These exceptions apply (1) where the merger itself is the subject of a claim of fraud; see, e.g., Cede & Co. v. Technicolor, Inc., 542 A.2d 1182, 1188-89 (Del. 1988); or (2) where the merger is in reality a reorganization not affecting the plaintiff's ownership in the business enterprise, see, e.g., Schreiber, 477 A.2d at 22. See generally Kramer, 546 A.2d at 354; Lewis v. Anderson, 477 A.2d at 1046 n.10.*fn7 In this case, however, Blasband does not contend that either of these exceptions applies to him.
Rather, the focus in this appeal is on Lewis v. Anderson, the seminal Delaware Supreme Court case concerning the contemporaneous ownership requirement in the merger context. The plaintiff in Lewis v. Anderson, a shareholder of Conoco, Inc. ("Old Conoco"), filed a derivative suit on its behalf against various Old Conoco officers and directors, asserting that "golden parachutes" granted by Old Conoco to these individuals constituted a waste of corporate assets. Shortly after the plaintiff filed his complaint, Old Conoco merged with Du Pont Holdings, Inc., a wholly owned subsidiary of E.I. Du Pont de Nemours and Company ("Du Pont") and the surviving corporation was renamed Conoco, Inc. ("New Conoco"). The merger provided for Old Conoco shareholders to receive common stock of Du Pont in exchange for their shares of Old Conoco. Du Pont became the sole shareholder of New Conoco. 477 A.2d at 1042.
The court rejected the plaintiff's contention that the derivative cause of action passed not to New Conoco or Du Pont, but rather to the former shareholders of Old Conoco. The court stated that under 8 Del.C. § 259(a), any derivative claim against the individual directors of Old Conoco was a property right of Old Conoco which passed to New Conoco following the merger.*fn8 477 A.2d at 1044-47. Additionally, the court noted that neither of the two exceptions to a shareholder's loss of standing upon merger which we have already described was applicable. Id. at 1046 n.10. Finally, the court rejected the plaintiff's policy argument that permitting dismissal would leave a wrong unremedied, reasoning that the Disposition of the plaintiff's suit was a matter for New Conoco's board of directors. Id. at 1050-51. Accordingly, the court concluded that "[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." Id. at 1049. Because the plaintiff in Lewis v. Anderson asserted that he had standing only by virtue of ...