Eleventh Circuit Affirms Dismissal of Derivative Action Against Israeli Company For Failure To Make Pre-Suit Demand
On June 25, 2020, the United States Court of Appeals for the Eleventh Circuit affirmed the dismissal of a putative class action against an Israeli Voice over Internet Protocol (“VoIP”) services provider (“the Company”) and certain of its current and former directors for violations of Sections 14(a) and 20(a) of the Securities Exchange Act of 1934 (“the Exchange Act”). Freedman v. magicJack Vocaltec Ltd., No. 18-15303, 2020 WL 3467396 (11th Cir. June 25, 2020). Plaintiff claimed that two of the Company’s proxy statements contained misrepresentations designed to influence shareholder votes in a board of directors election and on changes to executive compensation packages. The district court dismissed the action, holding that plaintiff’s claims were derivative in nature under Israeli law and that plaintiff failed to satisfy the demand requirement under Federal Rule of Civil Procedure 23.1. The Court affirmed the district court’s dismissal in all respects. In doing so, the Eleventh Circuit for the first time joined many other Circuit Courts that have held that the law of the place a company is incorporated is controlling on the issue of whether a claim is direct or derivative in nature.
The claims arose from two of the Company’s proxy statements, one issued in March 2017 and the other in June 2017. Plaintiff alleged that the March 2017 proxy statement, which was issued prior to a board of directors election, was misleading because it asserted that one of the Company’s recently-acquired subsidiaries had generated a pipeline of “large enterprise opportunities” when the Company knew that the value of the subsidiary had declined by 80%. Plaintiff alleged that the June 2017 proxy statement, which was issued in advance of a special shareholder meeting to approve the employment agreement of the Company’s new CEO and changes to the Company’s executive compensation plans, failed to disclose that Company executives sought to obtain lucrative buy-out packages before news of the diminished value of the Company’s subsidiary was disclosed. In November 2017, the Company entered into a sale agreement providing for the sale of the Company at $8.71 per share. Plaintiff alleged that he and other putative class members were injured as a result of the excessive compensation paid to certain executives and as a result of the Company’s sale at $8.71 per share because the Company allegedly received an earlier, non-binding offer of $9.50 per share.
The district court dismissed the complaint pursuant to Rule 23.1 for failure to satisfy the demand requirement. Although plaintiff argued that the action was direct, rather than derivative, the district court disagreed, noting that plaintiff had not suffered a “special injury” separate and distinct from those sustained by the other shareholders.
On appeal, the Court first noted that the Eleventh Circuit had not yet answered the question of what law applies to the issue of whether a lawsuit is direct or derivative. Following other Circuits, the Eleventh Circuit held that the law of the place where a company is incorporated supplies the relevant law. The Court noted that this approach made sense for two reasons. First, “corporate law is overwhelmingly in the province of the states” because “it achieves the need for certainty and predictability of result while generally protecting the justified expectations of the parties with interests in the corporation.” Second, there is a presumption that that federal law incorporates state law when private parties have entered legal relationships with the expectation that their rights and obligations would be governed by state-law standards. From these two principles, the Court held that “it follows . . . that the rule directing a court to look to the law of the state or place of incorporation to answer the ‘direct vs. derivative’ question is a logical one.”
Acknowledging that whether a claim is direct or derivative does not turn on how a plaintiff labels its claim, the Court next agreed with the district court that Israeli law, which applied because the Company was incorporated there, requires a shareholder to “sustain damage independent of the damage the company sustains” in order to bring a direct claim. The Court further held that plaintiff had “utterly failed to allege that he suffered damages independent of the damages that [the Company] (and all of its shareholders) suffered.” The Court found particularly noteworthy that plaintiff’s requested relief—rescission of payments to executives and damages based on the difference between the $9.50 per share offer and the eventual sale price—was derivative in the sense that the relief, if granted, would inure to the benefit of the Company and all its shareholders. The Court also noted that the case was filed as a class action. Having found plaintiff’s claims were derivative, the Court affirmed the district court’s dismissal because plaintiff failed to make a demand on the Company or show why such a demand would have been futile before filing suit, as required by Rule 23.1.