State Law Determines Whether Claim Brought Under Federal Statutory Law is Direct or Derivative

Federal courts should look to state law to decide whether a claim brought under a federal statute is direct or derivative, according to the Eleventh Circuit. The court addressed this issue for the first time in Freedman v. magicJack Vocaltec Ltd., 2020 WL 3467396 (11th Cir. June 25, 2020), a class action filed by a shareholder, alleging that the defendant corporation, magicJack, made material misrepresentations and/or omissions in two proxy statements. The alleged misrepresentations related to the valuation of another company that magicJack acquired and a compensation package for magicJack’s executives. The plaintiff also alleged that he and other shareholders were injured when magicJack agreed to be sold for a lower price than was originally offered. The complaint asserted violations of Section 14(a) of the Securities and Exchange Act of 1934 against magicJack and nine of its current or former directors and that the directors had control-person liability pursuant to Section 20(a) of the Act. The district court for the Southern District of Florida applied Israeli law (the place of magicJack’s incorporation) and held that the plaintiff’s claims were derivative in nature and that he failed to make a demand on magicJack (or, alternatively, allege that such a demand would have been futile), which was a prerequisite for filing a derivative suit. Therefore, the Section 14(a) claim was dismissed. And because the plaintiff failed to plead the underlying violation—i.e., the Section 14(a) claim—the Section 20(a) claim was also dismissed.

The Eleventh Circuit affirmed the dismissal. The main issue on appeal was whether the Section 14(a) claim was derivative. Judge R. David Proctor from the U.S. District Court for the Northern District of Alabama sat on the panel by designation and wrote the opinion. He first addressed which law applies to determine whether a claim is direct or derivative. The opinion held that state law applies and provided several reasons for its holding. First, the court acknowledged that Supreme Court precedent suggested that whether a derivative suit has properly been brought is typically based on state law. Moreover, the Second, Sixth, Seventh, and Eighth Circuits have all recognized that courts must look to the law of the state of incorporation to determine whether an action is direct or derivative. Second, it explained that corporate law is overwhelmingly the province of the states. The application of the law of the state of incorporation achieves certainty and predictability while protecting the expectations of the parties, and the Federal Rules of Civil Procedure provide that state law governs a corporation’s capacity to be sued. Third, it noted that “there is a presumption that state law should be incorporated into federal common law . . . in areas in which private parties have entered legal relationships with the expectation that their rights and obligations would be governed by state-law standards.” Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 98 (1991). Corporate law is such an area where state law standards create the boundaries within which a corporation must operate. Fourth, the court said that looking to the state or place of incorporation was a logical rule, since that is the law that establishes the requirements that a shareholder must satisfy before bringing suit against a corporation.

Having determined that state law should apply to determine whether a claim is direct or derivative, the court looked to the choice of law rules for the law of the forum state—Florida. Under Florida’s choice of law rules, claims involving internal affairs of the corporation, including the relationship between the corporation and stockholder and the corporate officer or director and stockholder, are governed by the laws of the state of incorporation. Because magicJack was incorporated in Israel, the court determined that Israeli law governed.

The Eleventh Circuit next reviewed the district court’s application of Israeli law. The district court examined decisions from Israeli courts, which led it to conclude that the plaintiff’s claims were derivative. The Israeli cases involved similar claims—i.e., allegations of misrepresentations and misleading statements that caused the company’s value to decline, including the value of its shares. And, in each case, the Israeli court concluded that the claims alleged damages to the company and all of its shareholders equally, not to the particular plaintiff. In other words, the claims were derivative. To bring a direct claim under Israeli law, the Eleventh Circuit explained, the plaintiff must allege damage independent of the damage the company sustains, and the requested relief must flow directly to the shareholders, not the corporation. In contrast, with a derivative claim, all shareholders have been damaged to the same degree, and any recovery must go to the corporation. Because the plaintiff failed to allege that he suffered damages independent of the damages that magicJack and its shareholders suffered, the Eleventh Circuit agreed with the district court and concluded that the plaintiff’s Section 14(a) claim was derivative. This finding was further supported by the fact that the plaintiff had brought a class action and alleged that he suffered the same injuries as other shareholders. The recovery sought was for the benefit of magicJack and its shareholders, not the plaintiff. The plaintiff asked the court to enjoin any payments to magicJack’s officers made as a result of the misleading proxy statements. He also sought the difference between the $9.50 per share buyout price magicJack rejected and the $8.71 per share buyout price magicJack accepted.

Finally, the court noted that its holding (under Israeli law) was wholly consistent with Florida law, which limits direct actions to instances where there is direct harm to the shareholder such that the alleged injury does not flow from an initial harm to the company and the shareholder sustains a special injury that is separate and distinct from those sustained by other shareholders.

Posted by Kamryn Deegan.

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