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Delaware Supreme Court confirms that fraud exception to continuous ownership rule is very narrow

On October 22, 2013 by Schnader in Finance

By Patrick M. Horan

Under Delaware’s continuous ownership rule, in order to bring and maintain a derivative action, a shareholder “must not only be a stockholder at the time of the alleged wrong and at the time of commencement of suit but … must also maintain stockholder status throughout the litigation.”  Last month the Delaware Supreme Court reigned in an effort by former shareholders to expand an exception to the continuous ownership rule known as the “fraud exception.”

In Arkansas Teacher Retirement System, et al. v. Countrywide Financial Corporation, shareholders in Countrywide Financial Corporation initiated a derivative action in the United States District Court for the Central District of California alleging that the former Countrywide CEO and other executives had lied about the company’s lending practices.  When the plaintiffs were divested of their shares in Countrywide as a result of Countrywide’s merger with Bank of America, the district court dismissed the former shareholders’ derivative claims as barred by Delaware’s continuous ownership rule.

On appeal to the Ninth Circuit, the former shareholders argued that, because the merger allegedly was designed to cover up fraudulent activity, their derivative claims should have survived the merger under the “fraud exception” to the continuous ownership rule.  Unable to locate any precedent on the issue, the Ninth Circuit certified the following question to the Delaware high court:

Whether, under the “fraud exception” to Delaware’s continuous ownership rule, shareholder plaintiffs may maintain a derivative suit after a merger that divests them of their ownership interest in the corporation on whose behalf they sue by alleging that the merger at issue was necessitated by, and is inseparable from, the alleged fraud that is the subject of their derivative claims.

The Delaware Supreme Court first confirmed its holding in Lewis v. Anderson, which established the continuous ownership rule.  The Court then addressed the two exceptions to the rule.   Under Lewis, the continuous ownership rule does not bar former shareholders from maintaining claims when: (1) the merger is fraudulently executed simply to deprive a stockholder of standing, and (2) a merger is basically a reorganization that does not extinguish the ownership interest.  The first of the two exceptions is known as the “fraud exception.”

The Court made clear that the fraud exception only is available where shareholders directly allege that a merger fraudulently stripped them of their ownership interest.  Because the shareholders in the case before it alleged that the merger was designed to cover up alleged fraud and not to divest them of their shares, the Court held that the fraud exception to the continuous ownership rule did not apply.  In short, the Delaware Supreme Court confirmed that the fraud exception to the continuous ownership rule is very narrow.