In Re Sonus Networks, Inc.

United States Court of Appeals
For the First Circuit

No. 06-1937

IN RE: SONUS NETWORKS, INC,
Shareholder Derivative Litigation

MICHAEL PISNOY; MICHELLE BURKE,
Derivatively on behalf of Sonus
Networks, Inc., a Delaware
Corporation; DANIEL WILLIAMS,

Plaintiffs-Appellants,

v.

HASSAN M. AHMED; STEPHEN J. NILL;
EDWARD T. ANDERSON; PAUL J. FERRI;
PAUL J. SEVERINO; SONUS NETWORKS,
INC.; ALBERT A. NOTINI; J. MICHAEL
O’HARA; EDWARD N. HARRIS; PAUL R.
JONES; RUBIN GRUBER,

Defendants-Appellees.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. Douglas P. Woodlock, U.S. District Judge]

Before

Torruella, Circuit Judge,

John R. Gibson, Senior Circuit Judge*

and Lipez, Circuit Judge.

*
Of the United States Court of Appeals for the Eighth Circuit,
sitting by designation.
 Willem F. Jonckheer, with whom Robert C. Schubert, Juden
Justice Reed, Schubert & Reed LLP, Douglas M. Brooks, John
Martland, and Gilman and Pastor, LLP, were on brief for appellants.
Daniel W. Halston, with whom Jeffrey B. Rudman, Peter A.
Spaeth, Melissa B. Coffey, Wilmer Cutler Pickering Hale And Dorr
LLP, Thomas J. Dougherty, Matthew J. Matule, Skadden, Arps, Slate,
Meagher & Flom LLP, Robert S. Frank, Jr., John R. Baraniak, Jr.,
Choate Hall & Stewart LLP, and John D. Hughes, Edwards Angell
Palmer & Dodge LLP, were on brief for appellees.

August 16, 2007
 JOHN R. GIBSON, Circuit Judge. Michael Pisnoy, Michelle

Burke, and Daniel Williams, suing derivatively on behalf of Sonus

Networks, Inc., appeal from the district court's order dismissing

their suit on the basis of issue preclusion. In re Sonus Networks,

Inc., S'holder Derivative Litig., 422 F. Supp. 2d 281 (D. Mass.

2006). They contend that the dismissal of an earlier derivative

suit in Massachusetts state court for failure to plead either

demand on the Sonus board of directors or the futility of such a

demand should not bar this suit because the federal plaintiffs are

not in privity with the state plaintiffs, the issue litigated in

the state action was not identical to the issue presented here, and

the state court dismissal was not "on the merits." We affirm.

I.

Sonus Networks, Inc., is a Delaware corporation

headquartered in Massachusetts, which is in the business of

providing equipment and software that permits speech to be

transmitted in "packets" over the internet. On January 20, 2004,

Sonus announced that it would postpone announcing its fourth

quarter 2003 and 2003 fiscal year financial results pending

completion of the 2003 audit. On February 11, 2004, Sonus

announced that it had discovered that actions of certain non-

executive employees might have improperly affected the timing of

revenue recognition and thus could put into question the accuracy

of Sonus's financial statements for 2003 and possibly earlier

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periods. The announcement stated that Sonus had responded to the

discovery by terminating the employees implicated, launching an

internal review as well as an investigation by the audit committee

of the board of directors, and notifying the Securities Exchange

Commission.

Within days of the announcement, shareholders had filed

derivative lawsuits against officers and directors1 of Sonus in

Massachusetts state court (February 20, 2004), while different

shareholders filed similar suits in the federal court2 for the

District of Massachusetts, where suits filed February 23, February

26, and March 24, 2004, were consolidated. 422 F. Supp. 2d at 285.

The state court complaint alleged that the defendants

were guilty of breach of fiduciary duties to the corporation.

According to the state complaint, as of January 20, 2004, Sonus's

stock had increased by 800% in a year and was trading at $9.91 per

share, fueled by optimistic press releases from Sonus regarding its

future profitability. The complaint alleged that after the

announcement on February 11, 2004, Sonus had "identified certain

issues, practices and actions of certain employees" that could

1
The state complaint in the record before us named as
defendants Directors Hassan M. Ahmed, Rubin Gruber, Edward T.
Anderson, Paul J. Ferri, Albert A. Notini, and Paul J. Severino,
and officers Edward N. Harris, J. Michael O'Hara, Paul R. Jones,
and Stephen J. Nill.
2
The federal suits named as defendants directors Ahmed,
Gruber, Anderson, Ferri, Notini, and Severino, as well as officers
Harris, O'Hara, Jones, and Nill.

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affect the accuracy of its 2003 financials and possibly the

financials from earlier periods, the company's stock fell by 46%.

The state complaint said that the financials had "materially

overstate[d]" earnings and that the 2003 financials would have to

be restated "to remove millions in improperly reported revenues."

The complaint quoted a news article that implied there was reason

to think there had been a leak of information the day of the

announcement because Sonus's stock began falling at 11:00 a.m. on

February 11, although the bad news was not announced until the

close of business. The state complaint listed officers and one

director who had sold Sonus stock at different points in 2003,

including director Anderson's sale of $448,918.34 worth of stock on

October 18, 2003, but the complaint made no particular allegation

that anyone traded before the announcement on February 11, 2004.

The complaint alleged that Sonus was injured by the loss in value

resulting from public distrust of the company's financial reports,

exposure to liability and litigation costs in fraud lawsuits, and

the costs of investigation.

The state plaintiffs pled that they had not made demand

on Sonus's board of directors to file suit on behalf of the

corporation before the plaintiffs filed their derivative suit

because such a demand would have been futile in light of the fact

that the complaint named all of the six directors as defendants and

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so the directors would have had to sue themselves.3 The plaintiffs

also alleged that each of the directors had participated in

wrongdoing because each "knew" of the accounting problems, and

Anderson sold stock while he knew of the problems but before Sonus

had announced them publicly. Moreover, the directors were alleged

to lack independence from each other by virtue of the facts that

two of them (Ahmed and Gruber) worked for Sonus as their principal

occupation and two of them (Ferri and Severino) were on the

compensation committee. Further, three of the defendants

(Anderson, Ferri, and Severino) served on the audit committee and

so were alleged to be financially interested in avoiding liability

for their failures of oversight. Four of the six directors sued

were "outside" directors.

Notably absent from the complaint was any indication of

what the final results of the internal, audit committee or SEC

investigations were, what the effect of the alleged irregularities

would be on financial statements for any year, and whether there

had been any judicial or administrative finding of wrongdoing by

any of the defendants-–absences which are not surprising,

considering the complaint was filed within nine days of Sonus's

February 11, 2004, announcement, apparently on the theory that the

race is to the swift.

3
The state court took notice that there were seven directors.
Thus, all but one of the directors were named as defendants.

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 The state court dismissed the state suits on September

27, 2004, for failure to comply with Mass. R. Civ. P. 23.1, which

requires a shareholder in a derivative action to "allege with

particularity the efforts, if any, made by the plaintiff to obtain

the action he desires from the directors or comparable authority

and . . . the reasons for his failure to obtain the action or for

not making the effort." In re Sonus Networks, Inc. Derivative

Litig., No. 04-0753 BLS (Mass. Super. Ct. Sept. 27, 2004). The

state court held that the complaint before it did not allege a

specific wrongful act by the defendants, but rather a failure of

supervision over the financial statements. The court held that the

state plaintiffs had not pleaded facts that would raise a

reasonable doubt that a majority of the directors had a financial

interest that would prevent them from fairly considering a demand

or that they lacked the independence necessary to consider such a

demand. The court dismissed the complaint without leave to amend.

The state plaintiffs appealed, but later withdrew their appeal

"[in] light of the Securities and Exchange Commission's action as

reported in Sonus's Form 8-K, dated June 9, 2005," as they said in

their motion to withdraw the appeal.

In the meanwhile, the plaintiffs in the consolidated

federal cases filed a Second Amended Consolidated Complaint of some

seventy pages on July 1, 2005. The Second Amended Complaint

included substantially all the allegations made in the state

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complaint, plus some allegations regarding events that had taken

place before the state suit was filed or while it was pending, but

which had not been included in the state complaint, and some

allegations regarding events that occurred after the state suit was

dismissed.

The events antedating the filing of the suits were

statements in Sonus's SEC filings in 2001 and 2002 reporting in the

same language for both years that the company's growth was placing

a "significant strain" on the Company's systems and that the

company would need to "continue to improve our financial,

managerial and manufacturing controls and reporting systems."

Additionally, the plaintiffs alleged that Sonus had been sued on

March 3, 2003, in securities class action complaints alleging the

company's financial statements were overstated in 2001. Notably,

the Second Amended Complaint did not allege that the plaintiffs in

the securities case had prevailed.

Events alleged to have occurred during the pendency of

the state suits were:

(1) On March 29, 2004, Sonus announced it was considering expanding

the previously announced internal investigation to include

additional prior periods, and

(2) On July 28, 2004, Sonus restated its financial results for

2001, 2002, and the first three quarters of 2003. The effect of

the restatements was to reduce the net loss reported in 2001 from

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$645.4 million to $635.6 million and to increase the net losses

reported in 2002 and the first three quarters of 2003 from $68.5

million and $6.4 million, respectively, to $73.8 million and $22

million. Sonus also announced on that date that Stephen J. Nill,

formerly Sonus's chief financial officer, had resigned at the

request of the company. On the same day, Sonus filed a Form 10-K/A

that disclosed that Sonus's internal investigation had "identified

material weaknesses in our internal controls and procedures, as

they existed as of December 31, 2003," and listed nine types of

such weaknesses.

Finally, the Second Amended Complaint alleged that after

the state suit had been dismissed, Sonus filed a Form 10-K for 2004

dated March 15, 2005, which elaborated on the list of material

accounting weaknesses listed in its previous Form 10-K/A listing

and detailing ten types of internal control weaknesses that had

been identified by Sonus's internal investigation.

Like the state court suit, the federal complaint alleged

that the plaintiffs had not made demand on the board of directors

before bringing suit because it would have been futile to do so.

Regarding independence of the directors, the Second Amended

Complaint alleged that the six directors named as defendants were

a majority of the directors. It alleged that Anderson and Ferri

had been described in the press as "like school pals" and a "tag-

team" because they had frequently invested in the same companies

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and that Ahmed, Gruber, and Severino "have a history of

interlocking business relationships among each other and [with]

Ferri and Anderson." The complaint added that Ahmed had been

promoted to Chairman of the Board in 2004 despite the results of

the internal investigation and that both he and Gruber had been

awarded incentive compensation based on inflated financial results

for 2003.

The defendants moved to dismiss the Second Amended

Complaint on the ground that the dismissal in the state suit barred

the federal suit as well. The district court granted the motion,

holding that the plaintiffs were barred by issue preclusion from

relitigating the question of whether it would have been futile

under Delaware law in February and March 2004 to demand that the

Sonus board bring suit on behalf of the corporation based on the

accounting deficiencies alleged. In re Sonus Networks, Inc., 422

F. Supp. 2d at 293-94.

II.

Res judicata is an affirmative defense, Rodriguez v.

Baldrich, 628 F.2d 691, 692 n.2 (1st Cir. 1980), but where, as

here, the defendant has raised the question on motion to dismiss,

the plaintiff does not object to the procedure, and the court

discerns no prejudice, the issue may be resolved on such a motion,

id. The applicability of the doctrine of res judicata on

undisputed facts presents a question of law over which we exercise

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plenary review. Pérez-Guzman v. Gracia, 346 F.3d 229, 233 (1st

Cir. 2003).

Under the full faith and credit statute, 28 U.S.C. §

1738, a judgment rendered in a state court is entitled to the same

preclusive effect in federal court as it would be given within the

state in which it was rendered. Migra v. Warren City Sch. Dist.

Bd. of Educ., 465 U.S. 75, 81 (1984). Thus, the preclusive effect

of the state court judgment at issue here is determined under

Massachusetts law.

Massachusetts recognizes two kinds of res judicata, claim

preclusion and issue preclusion. Kobrin v. Bd. of Registration in

Med., 832 N.E.2d 628, 634 (Mass. 2005). As the names suggest,

claim preclusion operates on the level of the claim, and issue

preclusion operates on the level of the issue. Claim preclusion is

based on the idea that the precluded litigant had the opportunity

and incentive to fully litigate the claim in an earlier action, so

that all matters that were or could have been adjudicated in the

earlier action on the claim are considered to have been finally

settled by the first judgment. Id. In contrast, issue preclusion

does not reach issues unless they were actually litigated and

decided in the first litigation, id.; however, it bars relitigation

of those issues even in the context of a suit based on an entirely

different claim. Id.

Massachusetts applies the doctrine of issue preclusion in

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a traditional manner, Keystone Shipping Co. v. New England Power

Co., 109 F.3d 46, 51 (1st Cir. 1997). The Massachusetts courts use

several formulations interchangeably to describe the prerequisites

for issue preclusion, see infra pp. 12-14, but the Supreme Judicial

Court recently stated that issue preclusion applies when

(1) there was a final judgment on the merits in the prior
adjudication; (2) the party against whom preclusion is
asserted was a party (or in privity with a party) to the
prior adjudication; and (3) the issue in the prior
adjudication was identical to the issue in the current
adjudication. Additionally the issue decided in the
prior adjudication must have been essential to the
earlier judgment.

Kobrin, 832 N.E.2d at 634 (internal citations omitted).

Massachusetts courts also require that appellate review must have

been available in the earlier case before issue preclusion will

arise. Sena v. Commonwealth, 629 N.E.2d 986, 992 (Mass. 1994).

The plaintiffs contend that three elements necessary for

issue preclusion are lacking in this case: privity, identity of

issues, and a judgment "on the merits." We will address these

points in reverse order.

A. "On the Merits"

We ask first whether the state court judgment was "on the

merits" in the sense required to achieve preclusive effect. It is

not entirely clear to what extent the phrase "on the merits"

functions as a separate prerequisite for issue preclusion under

Massachusetts law. The Massachusetts courts use a variety of tests

to establish whether issue preclusion is proper, and not all the

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tests include the phrase "on the merits." For instance, in one

case, Martin v. Ring, 514 N.E.2d 663, 664-65 (Mass. 1987), the

Massachusetts Supreme Judicial Court recited several different

formulations, including one relying on the Restatement (Second) of

Judgments § 27 (1982), and one drawn from California law. The

formulation drawn from the Restatement (Second) says that "[w]hen

an issue of fact or law is actually litigated and determined by a

valid and final judgment, and the determination is essential to the

judgment, the determination is conclusive in a subsequent action

between the parties, whether on the same or a different claim."

514 N.E.2d at 664 (quoting Fireside Motors, Inc. v. Nissan Motor

Corp., 479 N.E.2d 1386, 1390 (Mass. 1985) (quoting Restatement

(Second) § 27)); see Commonwealth v. Rodriguez, 823 N.E.2d 1256,

1259-60 (Mass. 2005); Johnson v. Mahoney, 424 F.3d 83, 93 (1st Cir.

2005) ("Massachusetts courts apply the doctrine of collateral

estoppel as it has been described in the Restatement (Second) of

Judgments (1982)."). The test drawn from California law asks three

questions: "Was the issue decided in the prior adjudication

identical with the one presented in the action in question? Was

there a final judgment on the merits? Was the party against whom

the plea is asserted a party or in privity with a party to the

prior adjudication?" Ring, 514 N.E.2d at 665 (quoting Mass. Prop.

Ins. Underwriting Ass'n v. Norrington, 481 N.E.2d 1364, 1366 (Mass.

1985) (quoting Bernhard v. Bank of America Nat'l Trust & Sav.

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Ass'n, 122 P.2d 892 (Cal. 1942))).

As can be seen from the formulations above, the

requirement that the prior judgment be "on the merits" was omitted

from the Restatement (Second), which has been quoted and relied on

by Massachusetts courts, even as they have continued to reiterate

"on the merits" as a requirement for issue preclusion. The

Restatement, discussing claim preclusion rather than issue

preclusion, explains that the phrase "on the merits" has

traditionally been used to describe the kind of judgments that

should bar later claims: "The prototype case [for claim preclusion]

continues to be one in which the merits of the claim are in fact

adjudicated against the plaintiff after trial." Restatement

(Second) § 19, cmt. a. However, the comment explains that the

trend in the law is that "judgments not passing directly on the

substance of the claim have come to operate as a bar." Id.

Because reaching the "merits" of the claim is no longer

determinative of whether the claim should be precluded, the

drafters of the Restatement eschewed the use of that term. Id.

Just as claim preclusion may result from a determination

that does not reach the substance of a claim, some determinations

may reach the "merits" of a particular issue, but bar only

relitigation of that particular issue, rather than the whole claim.

Professors Wright, Miller, and Cooper explain:

It is commonly said that preclusion can rest only on a
judgment that is valid, final, and on the merits. The

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 phrase "on the merits" has been used of a long time, and
is continued today both in judicial usage and the
language of Civil Rule 41. It is an unfortunate phrase,
which could easily distract attention from the
fundamental characteristics that entitle a judgment to
greater or lesser preclusive effects. The
characteristics that determine the extent of preclusion
may have little to do with actual resolution of the
merits, although the paradigm will always be a judgment
entered after full trial of all disputed matters. Thus
it is clear that an entire claim may be precluded by a
judgment that does not rest on any examination whatever
of the substantive rights asserted. On the other hand,
further litigation of particular issues may be precluded
by judgments that do not bar further litigation on the
underlying claim. The only virtue that redeems the "on-
the-merits" phrase from oblivion is its service as a
shorthand reminder that the extent of preclusion is
measured by factors beyond validity and finality [of the
judgment.]

18A Charles A. Wright et al., Federal Practice & Procedure § 4435

(2d ed. 2002) (footnotes omitted).

These doubts about the utility of the phrase "on the

merits" are not mere academic rumination, but were part of the

analysis in Semtek International Inc. v. Lockheed Martin Corp., 531

U.S. 497, 501-03 (2001), where the Supreme Court held that even if

dismissal of a federal diversity suit is "on the merits" within the

meaning of Federal Rule of Civil Procedure 41(b),4 it does not

necessarily follow that the judgment is entitled to claim-preclusive

4
Fed. R. Civ. P. 41(b) provides: "Unless the court in its
order for dismissal otherwise specifies, a dismissal under this
subdivision and any dismissal not provided for in this rule, other
than a dismissal for lack of jurisdiction, for improper venue, or
for failure to join a party under Rule 19, operates as an
adjudication upon the merits."

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effect.5 Instead, the Court held that the "primary meaning" of the

language of Rule 41(b) is to define the effect of a dismissal on

subsequent attempts to revive the same action that was dismissed,

rather than its effect on cases filed in other jurisdictions. Id.

at 505-06.

We certainly are in no position to excise the phrase "on

the merits" from the Massachusetts law of issue preclusion, but

neither do we credit the plaintiffs' arguments here that this phrase

poses an obstacle to according any preclusive effect to the

Massachusetts state court's dismissal. Whatever confusion may

attend the phrase "on the merits" in the claim preclusion context,

it can be understood in the issue preclusion context to be part of

the requirement that there be a final judgment. See Kobrin, 832

N.E.2d at 634 (finality and on the merits listed as one element).

5
The Supreme Court rejected the argument that a judgment that
was "on the merits" within the meaning of Rule 41(b) necessarily
precluded a later suit:

Implicit in this reasoning is the unstated minor
premise that all judgments denominated "on the merits"
are entitled to claim-preclusive effect. That premise is
not necessarily valid. The original connotation of an
"on the merits" adjudication is one that actually
"pass[es] directly on the substance of [a particular
claim] before the court. . . .
But over the years the meaning of the term "judgment
on the merits" "has gradually undergone change," and it
has come to be applied to some judgments (such as the
one involved here) that do not pass upon the substantive
merits of a claim and hence do not (in many
jurisdictions) entail claim-preclusive effect.

531 U.S. at 501-02 (citations omitted).

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 Although there are Massachusetts cases stating that "'no

[preclusive] effect can be attributed to a decree dismissing a bill

or petition in equity, for want of jurisdiction or any other cause

not involving the essential merits of the controversy,'" Springfield

Pres. Trust, Inc. v. Springfield Library & Museums Ass'n, Inc., 852

N.E.2d 83, 91 (Mass. 2006) (quoting Curley v. Curley, 40 N.E.2d 272,

274 (Mass. 1942)), such cases are either refusing to apply claim

preclusion or holding that the issue decided in the earlier case was

not identical with the issue posed in the later case. See, e.g.,

Springfield Pres. Trust, 852 N.E.2d at 91; Levinton v. Poorvu, 200

N.E. 9, 12 (Mass. 1936); Conley v. Fenelon, 174 N.E. 237, 238 (Mass.

1931). In contrast, in Sadler v. Indus. Trust Co., 97 N.E.2d 169,

171 (Mass. 1951),supplemented, 97 N.E.2d 171 (Mass. 1951), the court

applied preclusive effect to an earlier dismissal for failure to

join an indispensable party, where the plaintiff had brought a

second suit without joining the indispensable party. Failure to

join an indispensable party is expressly listed in Massachusetts

Rule 41(b)(3) as one of the grounds that is not "on the merits."

Thus, Sadler is consistent with the accepted modern view that issue

preclusion does not depend on an earlier adjudication of the

substance of the underlying claim; even adjudications such as

dismissal for lack of jurisdiction or failure to join an

indispensable party, which are expressly denominated by Rule 41(b)

as not being "on the merits," are entitled to issue preclusive

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effect. See, e.g., Muñiz Cortes v. Intermedics, Inc., 229 F.3d 12,

14 (1st Cir. 2000) (dismissal for lack of subject matter

jurisdiction); Brereton v. Bountiful City Corp., 434 F.3d 1213,

1218-19 (10th Cir. 2006) (dismissal for lack of standing); Perry v.

Sheahan, 222 F.3d 309, 318 (7th Cir. 2000)(dismissal for lack of

standing); Kasap v. Folger Nolan Fleming & Douglas, Inc., 166 F.3d

1243, 1248 (D.C. Cir. 1999) (dismissal for lack of subject matter

jurisdiction); Okoro v. Bohman, 164 F.3d 1059, 1062-64 (7th Cir.

1999) (dismissal of forma pauperis suit as frivolous); 18A Federal

Practice & Procedure § 4436.

We need not belabor the abstract question of what "on the

merits" means in modern issue preclusion law because we have in this

Circuit clear guidance on how to treat the very situation presented

here–dismissal of a derivative suit for failure to adequately plead

a demand or futility of a demand. In In re Kauffman Mutual Fund

Actions, 479 F.2d 257 (1st Cir. 1973), we affirmed the dismissal of

a derivative suit for failure to plead with particularity facts that

would excuse demand on the board of directors, but we qualified the

affirmance in one respect: the district court had denominated the

dismissal as "without prejudice," but we held that this

characterization was not entirely correct.

This must mean without prejudice as to the substantive
cause of action. The dismissal is without prejudice as
to the substantive cause of action. The dismissal is
with prejudice on the issue of the obligation to make a
demand on the directors with respect to that substantive
complaint. The principle applies that "[a]lthough, where

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 a judgment for the defendant is not on the merits, the
plaintiff is not precluded from maintaining a new action
on the same cause of action, he is precluded from
relitigating the very question which was litigated in the
prior action." Restatement of Judgments § 49, comment b,
at 195 (1942).

Id. at 267 (emphasis added). Kauffman confirms the generally

accepted principle that dismissal for failure to satisfy a

precondition to suit precludes relitigation of the very same issues

actually decided in the first litigation. See Saez Rivera v. Nissan

Mfg. Co., 788 F.2d 819, 821 (1st Cir. 1986) (per curiam) (dismissal

for failure to effect service of process barred second suit based

on same attempt at service); see generally 18A Federal Practice &

Procedure § 4437. But see Kaplan v. Bennett, 465 F. Supp. 555, 561-

62 (S.D.N.Y. 1979) (holding that dismissal based on failure to

satisfy "procedural requirement" of pleading demand futility is "not

to be given preclusive effect"). Kauffman leads us to conclude that

the state dismissal was "on the merits" on the issue of whether it

would have been futile to demand the Sonus board to sue themselves

on behalf of the corporation.

On the other hand, the defendants' argument that the

dismissal for failure to plead demand is barred because it was "on

the merits" under Massachusetts Rule of Civil Procedure 41 and

Federal Rule of Civil Procedure 41 would take us beyond issue

preclusion to a claim preclusion theory, which would be

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inappropriate for this case.6 The defendants contend that a

dismissal for failure to plead compliance with Massachusetts Rule

of Civil Procedure 23.1 should be governed by the rules for

dismissal for failure to state a claim, which is accorded claim-

preclusive effect, see Mestek, Inc. v. United Pac. Ins. Co., 667

N.E.2d 292, 294 (Mass. App. Ct. 1996); Isaac v. Schwartz, 706 F.2d

15, 17 (1st Cir. 1983) (gauging effect of dismissal of Massachusetts

state action).

In particular, the defendants rely on Bazata v. National

Insurance Co. of Washington, 400 A.2d 313 (D.C. 1979), in which

claim preclusion was applied to a dismissal for failure to plead

demand. There, a plaintiff's first derivative suit was dismissed

for failure to make demand, but the plaintiff later made demand and

refiled. Id. at 314. Despite the plaintiff's satisfaction of the

demand requirement, the D.C. Court of Appeals held that the first

case had been dismissed on the merits, because the questions of

6
We do not mean to say that establishing adjudication on the
merits under Federal Rule 41 always establishes adjudication on the
merits for purposes of claim preclusion. The Supreme Court held in
Semtek that the import of Federal Rule 41 is not to prescribe res
judicata principles, but to determine when the same suit may be
refiled in the same court. 531 U.S. at 506. However, Rule 41 and
claim preclusion doctrine are often applied interchangeably, as in
the defendants' argument. See, e.g., Isaac, 706 F.2d at 17 ("Under
Massachusetts law, as elsewhere, a dismissal for failure to state
a claim, under Mass. R. Civ. P. 12(b)(6), operates as a dimsissal
on the merits, see Mass R. Civ. P. 41(b)(3), with res judicata
effect."); see also Semtek, 531 U.S. at 505 (conceding that whether
a dismissal is with or without prejudice under Rule 41 will
"ordinarily (though not always)" determine res judicata question).

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demand and futility involve substantive assessments of whether the

directors breached their duties. Id. at 315-16. Bazata therefore

affirmed the trial court's dismissal of the second suit on the

ground of "res judicata" (i.e., claim preclusion).7 Id. at 314-16.

The law has evolved on the question of whether a judgment

on the pleadings merely resolves the adequacy of the particular

pleadings or whether it also bars the underlying claims. The older

view was that a dismissal for inadequate pleading did not preclude

a later suit that properly pleaded a cause of action: "Normally, a

judgment for a defendant founded on a demurrer is not a bar to a

subsequent action because 'such a judgment commonly is based not on

the merits but upon the insufficiency of the statement of the cause

of action.'" Spector v. Loreck, 175 N.E.2d 262, 263 (Mass. 1961).

The modern view, which prevails in Massachusetts, is that a party

should be held to account not only for what he actually pleaded, but

for what he could have pleaded in the earlier suit. Mestek, 667

N.E.2d at 294; Isaac, 706 F.2d at 17 (applying Massachusetts law);

see generally 18A Federal Practice & Procedure § 4439, at 194-97

(explaining that the change results from the liberalization of rules

of pleading and the ease of amendment, together with the perceived

burden on the defendant from having to respond to serial complaints,

7
Bazata was expressly rejected in an Alabama state case, which
held that failure to satisfy the demand requirement in a derivative
case did not result in claim preclusion or an adjudication on the
merits under the state analog to Rule 41 Ex Parte Capstone Dev.
Corp., 779 So.2d 1216, 1219 (Ala. 2000).

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which make it fair to hold plaintiff to his pleading).

While dismissal of a derivative suit for failure to plead

demand or excuse is of course a type of dismissal for inadequate

pleadings, it is also a dismissal for failure to accomplish a

precondition, which is a failure that may be remedied by the time

the second suit is filed. The Supreme Court's decision in Costello

v. United States, 365 U.S. 265, 285-88 (1961), confirmed that

dismissal for failure to satisfy a precondition to suit should not

bar a subsequent suit in which the defect has been cured. Accord

Lebrón-Ríos v. U.S. Marshal Serv., 341 F.3d 7, 13 (1st Cir. 2003)

(dismissal of suit for failure to exhaust administrative remedies

would not preclude later suit if plaintiffs exhausted remedies);

Saylor v. Lindsley, 391 F.2d 965, 968-69 (2d Cir. 1968) (dismissal

of derivative suit for failure to post bond did not bar subsequent

suit on same claim if bond posted); Restatement (Second) of

Judgments § 20(2) ("A valid and final personal judgment for the

defendant, which rests on the prematurity of the action or on the

plaintiff's failure to satisfy a precondition to suit, does not bar

another action by the plaintiff instituted after the claim has

matured, or the precondition has been satisfied, unless a second

action is precluded by operation of the substantive law."). We

acted consistently with this principle in González Turul v. Rogatol

Distributors, Inc., 951 F.2d 1 (1st Cir. 1991). There, we reversed

a judgment after trial in a derivative suit because the plaintiff

-22-
had not alleged in the complaint either that she had made demand on

the directors or that demand would have been futile, id. at 1;

however, we dismissed the complaint "without prejudice," id. at 3,

with the implication that suit could be refiled if the plaintiff

complied with Rule 23.1. Thus, the parties' respective rights may

have altered over the course of time between the two suits, which

may make preclusion inappropriate. See DeCosta v. Viacom Int'l,

Inc., 981 F.2d 602, 610-11 (1st Cir. 1992). We therefore conclude

that dismissal for failure to plead demand under Rule 23.1 is not

entirely analogous to dismissal for failure to state a claim. We

do not believe that applying claim preclusion to a dismissal for

failure to plead satisfaction of a precondition to suit is

compatible with the principle of Costello or the holdings in cases

like LeBrón-Ríos that failures to satisfy preconditions generally8

can be cured.

The defendants contend that the dismissal was on the

merits in the sense of reaching a substantive issue, citing Kamen

v. Kemper Financial Services, Inc., 500 U.S. 90, 96-97 (1991), which

stated that the demand requirement is substantive, not procedural.

The preclusive effect of a dismissal for failure to comply with a

8
There may be exceptions to the general rule, such as when the
plaintiff's failure to satisfy a precondition before bringing the
first suit prejudices the defendants, making claim preclusion
appropriate. See Stebbins v. Nationwide Mut. Ins. Co., 528 F.2d
934, 937 (4th Cir. 1975)(per curiam). See also Restatement
(Second)of Judgments § 20, cmt. n.

-23-
precondition to suit does not depend on whether the precondition is

"substantive" or "procedural," but on whether the plaintiff has

satisfied the precondition between the dismissal of the first suit

and the filing of the second. See 18A Federal Practice & Procedure

§ 4437, at 184-85 ("Dismissal for failure to satisfy a procedural

precondition should be treated in the same way as dismissal for

failure to satisfy substantive preconditions. The dismissal is not

an adjudication on the merits that would bar assertion of the same

claim after satisfying the precondition . . . but it should preclude

relitigation of the same precondition issue.").

In sum, we hold that the Massachusetts state court

judgment was "on the merits" in the sense that it is entitled to

issue-preclusive effect, but we reject the defendants' argument that

the Rule 23.1 dismissal was "on the merits" in the sense that no

further suit could be brought on the same claim.

B. Identity of Issues

Issue preclusion prevents relitigation of the same issues

actually adjudicated in an earlier judgment. Kobrin, 832 N.E.2d at

634; Comm'r of Dept. of Employment & Training v. Dugan, 697 N.E.2d

533, 537 (Mass. 1998) (even if there is not complete identity

between the issues, issue preclusion may be appropriate where the

issues overlap substantially). The plaintiffs contend that their

complaint differs so significantly from the state complaint that the

state court's decision was not on the identical issue that we would

-24-
face in deciding whether to dismiss for failure to plead futility.

The question is whether there is anything in the Second Amended

Complaint here that amounts to a "significant change" in the

futility issue from what was presented to the state court. See

DeCosta v. Viacom Int'l, Inc., 981 F.2d 602, 605 (1st Cir. 1992);

Pignons S.A. de Mecanique v. Polaroid Corp., 701 F.2d 1, 2 (1st Cir.

1983) (looking for material difference in facts); see also Bansbach

v. Zinn, 801 N.E.2d 395, 401-02 (N.Y. 2003) (no identity of demand

futility issues in two derivative suits based on different

transactions).

The plaintiffs' threshold difficulty is that the vast

majority of their allegations are not "new" since the state

complaint was dismissed, but only "different." By that we mean that

the evidence was available and could have been brought before the

state court before it dismissed the state action. Our rationale for

distinguishing dismissal for failure to comply with the demand and

futility pleading requirements from dismissal for failure to state

a claim is that the existence vel non of a precondition is dynamic

and may change. This is a rationale for allowing a plaintiff (or

his privies) to plead new events that happened after the first

litigation was dismissed, but not for allowing him to plead facts

that had already occurred and could have been pleaded in the first

suit. Facts excusing a failure to make demand that could have been

pleaded in the first complaint, or by amendment before dismissal,

-25-
should be barred for the very same reasons that support applying

claim preclusion to dismissals for failure to state a claim.9

Moreover, even under the doctrine of issue preclusion, a party who

has litigated an ultimate fact may not bring forward different

evidentiary facts in order to relitigate the finding. In re V&M

Mgmt., Inc., 321 F.3d 6, 9 (1st Cir. 2003); Pignons, 701 F.2d at 2-

3; Miles v. Aetna Cas. & Sur. Co., 589 N.E.2d 314, 317-18 (Mass.

1992); see Restatement (Second) of Judgments, § 27 cmt. c ("[I]f the

party against whom preclusion is sought did in fact litigate an

issue of ultimate fact and suffered an adverse determination, new

evidentiary facts may not be brought forward to obtain a different

determination of that ultimate fact.").

If we refuse to take cognizance of old news that could

have been presented to the state court before dismissal, most of the

plaintiffs' contentions of significant change in the issue

disappear. The plaintiffs contend that they bolstered their

pleading of futility by alleging in the Second Amended Complaint

that there were "red flags" in SEC filings in 2001 and 2002 and in

a securities fraud case filed by other plaintiffs in March 2003.

They further allege that the restatement of financial results for

9
Those reasons, again, are liberality of modern pleading rules
and fairness to the defendant, supra at 21-22. We recognize that
the state plaintiffs did not benefit from the most liberal of
pleading and amendment rules, since Rule 23.1 requires pleading
with particularity rather than notice pleading, and the state court
denied the plaintiffs permission to amend. These rigors are not so
substantial as to exempt the plaintiffs from the ordinary rule that
available facts should be pleaded in the first action.

-26-
2001, 2002, and the first three quarters of 2003, announced on July

28, 2004, together with the identification of material weaknesses

in Sonus's internal controls and procedures announced the same day,

cures the lack of particularity that doomed the state court

complaint. These facts all had been made public and were available

to the state plaintiffs before their suit was dismissed on September

27, 2004. Assuming the other conditions for issue preclusion exist,

the plaintiffs therefore should be precluded from relying on any of

the new facts that were available at the time the state suit was

dismissed on September 27, 2004.

The only material allegation in the Second Amended

Complaint that occurred after the state dismissal was the allegation

about the March 15, 2005 Sonus Form 10-K/A. This allegation was

cumulative to those made about the Form 10-K/A filed on July 28,

2004. This one new allegation by no means transfigures the demand

futility issue so that issue preclusion is inappropriate. We

conclude that the issues are substantially identical.

C. Privity and Adequacy of Representation

The plaintiffs argue that there is no privity between them

and the state court plaintiffs. It is a matter of black-letter law

that the plaintiff in a derivative suit represents the corporation,

which is the real party in interest. Ross v. Bernhard, 396 U.S.

531, 538-39 (1970); Clark v. Lacy, 376 F.3d 682, 686 (7th Cir.

2004). Under Massachusetts law, a derivative suit is prosecuted "in

-27-
the right of a . . . corporation." Mass. Gen. Laws Ann. ch 156D,

§ 7.40. Standing to represent a foreign corporation is governed by

the laws of the state of incorporation, Mass. Gen. Laws ch. 156D,

§ 7.47, and Delaware law is in accord with the prevailing rule that

the shareholder in a derivative suit represents the corporation.

In re M&F Worldwide Corp. S'holders Litig., 799 A.2d 1164, 1174 n.31

(Del. Ch. 2002).

Although no Massachusetts case has specifically said so,

if the shareholder can sue on the corporation's behalf, it follows

that the corporation is bound by the results of the suit in

subsequent litigation, even if different shareholders prosecute the

suits,10 see Nathan v. Rowan, 651 F.2d 1223, 1226 (6th Cir. 1981);

Cramer v. Gen. Tel. & Elecs. Corp., 582 F.2d 259, 267 (3d Cir.

1978), subject to the important proviso that the shareholder must

fairly and adequately represent the corporation. See section II.C

(1), infra.

The plaintiffs contend that the rule that all derivative

plaintiffs represent the corporation should not apply in this case

because the state court judgment did not adjudicate the

corporation's rights, but only the question of whether the state

court plaintiffs should be permitted to bring suit on behalf of the

10
Deborah A. DeMott, Shareholder Derivative Actions § 4:19, at
4-244 (2003)("This structural fact about derivative litigation
makes irrelevant questions of 'virtual representation,' that is,
the representation by a party of a nonparty outside the context of
a class action.")

-28-
corporation. The plaintiffs' argument could have some force if the

question in the state court had concerned some issue peculiar to the

state court plaintiffs or the adequacy of their representation, see,

e.g., Saylor, 391 F.2d at 968-69 (suit by second derivative

plaintiff not barred by first plaintiff's failure to post bond), but

it did not. The question was whether demand on the board of

directors would have been futile, which is an issue that would have

been the same no matter which shareholder served as nominal

plaintiff. The defendants have already been put to the trouble of

litigating the very question at issue, and the policy of repose

strongly militates in favor of preclusion. See Henik v. LaBranche,

433 F. Supp. 2d 372, 380-81 (S.D.N.Y. 2006); see generally Ramallo

Bros. Printing, Inc. v. El Día, Inc., 490 F.3d 86, 2007 WL 1732889,

at *6 (1st Cir. 2007) (policy of repose).

(1) Caveat for adequate representation

However established the principle that the same party, the

corporation, has sued in each derivative action, it is subject to

an important caveat: to bind the corporation, the shareholder

plaintiff must have adequately represented the interests of the

corporation. Nathan, 651 F.2d at 1226; Restatement (Second) of

Judgments §§ 59 cmt. c (whether earlier derivative suit precludes

later litigation depends on rules stated in sections 41 and 42) &

42(1)(d) & (e) (describing when representation is inadequate); cf.

Mass. Gen. Laws Ann. ch 156D, § 7.41 (shareholder may only maintain

-29-
derivative proceeding on behalf of Massachusetts corporation if he

"fairly and adequately represents the interests of the corporation

in enforcing the right of the corporation.")

The adequacy of representation has been a subject of great

concern in derivative suits because of the possibilities for

collusion between the nominal plaintiff and the defendants. See

Note, Res Judicata in the Derivative Action: Adequacy of

Representation and the Inadequate Plaintiff, 71 Mich. L. Rev. 1042,

1043 (1973); 7C Federal Practice & Procedure § 1839, at 175;

Shareholder Derivative Actions § 4:19, at 4-245. Precluding the

suit of a litigant who has not been adequately represented in the

earlier suit would raise serious due process concerns. Cramer, 582

F.2d at 269; Ji v. Van Heyningen, No. CA 05-273 ML, 2006 WL 2521440,

at *5 (D.R.I. Aug. 29, 2006).

Federal Rule of Civil Procedure 23.1 and Massachusetts

Rule of Civil Procedure 23.1 have a number of provisions directed

at the problem of inadequate representation, but neither the state

case nor the federal one has survived to the point at which those

protections would have come into play. First, both the state and

federal rules provide that a derivative action "may not be

maintained if it appears that the plaintiff does not fairly and

adequately represent the interests of the shareholders or members

similarly situated in enforcing the right of the corporation or

association," see Fed. R. Civ. P. 23.1 and Mass R. Civ. P. 23.1, but

-30-
the adequacy of the plaintiffs' representation was not litigated

under this rule in either action. Second, both the state and

federal rules provide that a derivative suit may not be dismissed

without notice to shareholders and court approval. The federal rule

has been interpreted as not requiring notice before involuntary

dismissals. See Burks v. Lasker, 441 U.S. 471, 485-86 n.16 (1979);

Abbey v. Control Data Corp., 603 F.2d 724, 728 n.5 (8th Cir. 1979);

7C Federal Practice & Procedure § 1839, at n.39. However, some

involuntary dismissals have been held to be the functional

equivalent of a voluntary dismissal and thus are subject to the

notice-before-dismissal requirement. The Second Circuit in Papilsky

v. Berndt, 466 F.2d 251 (2d Cir. 1972), held that a dismissal of a

derivative suit for failure to answer interrogatories would not be

accorded res judicata effect because no notice had been given to the

shareholders before dismissal. The holding in Papilsky was based

in part on the ease with which a disingenuous plaintiff could

engineer a dismissal for failure to answer discovery in order to

evade the notice requirement. The holding was also based in part

on the fact that the circumstances of a dismissal for failure to

answer interrogatories suggested that the plaintiff was not an

assiduous litigant. Id. at 258-60. In contrast, in this case, the

state plaintiffs actively litigated the demand futility issue, and

the federal plaintiffs do not urge that notice should have been

given before dismissal of the state suit. Although no one contends

-31-
that the state court was required to give notice before dismissing

for lack of demand or futility, the lack of such notice makes it all

the more important to ascertain, before according that dismissal

preclusive effect, that the state plaintiffs adequately represented

the corporation.

Moreover, Massachusetts Rule of Civil Procedure 23.1 and

its federal analog lack the class certification procedure that the

federal version of Rule 23(1) provides in class actions, which

requires notice and other protections before the representative

becomes vested with power to represent class members. Since the

posture of this case does not bring it within the safeguards set up

by Rules 23 or 23.1, we must carefully consider the plaintiffs'

allegations that the state plaintiffs' representation was

inadequate.

The plaintiffs support their argument by citing

Restatement (Second) of Judgments § 42(1)(e), which states that a

person will not be bound by an earlier suit in which another party

purports to represent him if "[t]he representative failed to

prosecute or defend the action with due diligence and reasonable

prudence, and the opposing party was on notice of facts making that

failure apparent." Comment f to this section demonstrates that the

level of inadequacy specified is not "failure of a representative

to invoke all possible legal theories or to develop all possible

resources of proof," but rather representation "so grossly deficient

-32-
as to be apparent to the opposing party." The federal plaintiffs

argue that the state plaintiffs' representation of the corporation

was inadequate (they do not venture to say "grossly deficient")

because the state plaintiffs did not assert all the facts alleged

in the Second Amended Complaint.

(2) Standard for alleging futility of demand on board

In order to determine whether the state plaintiffs were

seriously remiss in failing to state the facts that are now included

in the Second Amended Complaint, we must set out the substantive

standard for demand futility under Delaware law. See Kamen v.

Kemper Fin. Servs. Inc., 500 U.S. 90, 108-09 (1992) (looking to law

of state of incorporation for demand and excuse requirements). We

determine first, whether allegation of the facts stated in the

Second Amended Complaint would have resulted in a finding of demand

futility, and second, whether failure to allege those facts was so

"grossly deficient" that the defendants were on notice of the state

plaintiffs' inadequacy as representatives. We start with the

premise that Massachusetts Rule 23.1, like the federal analog,

requires the plaintiff to plead demand futility "with

particularity," which is a higher standard than ordinary notice

pleading. See Kauffman, 479 F.2d at 263-64; In re Tyson Foods Inc.,

Consol. S'holder Litig., 919 A.2d 563, 582 (Del. Ch. 2007) (demand

futility must be pleaded in greater detail than ordinary allegations

of breach of duty of loyalty). The state court relied on Delaware

-33-
authority requiring "particularized factual statements," which

reflects the notion that the particularity requirement is not a

procedural, but a substantive rule, and therefore is governed by

Delaware law. See Kauffman, 479 F.2d at 263 (quoting Bartlett v.

N.Y., N.H. & H. R.R., 109 N.E. 452, 456 (Mass. 1915)). We consider

the particular allegations as true for purposes of the motion to

dismiss, see Harhen v. Brown, 730 N.E.2d 859, 862 (Mass. 2000), but

we give no effect to conclusory allegations, see Levine v. Smith,

591 A.2d 194, 207 (Del. 1991), overruled on other grounds, Brehm v.

Eisner, 746 A.2d 244 (Del. 2000).

Delaware law requires that in a case such as this, in

which the directors are accused of nonfeasance rather than

misfeasance, a would-be derivative plaintiff either must make demand

on the board to bring the suit11 or else must allege particular

facts which "create a reasonable doubt that, as of the time the

complaint is filed, the board of directors could have properly

exercised its independent and disinterested business judgment in

11
The reader may wonder why a would-be derivative plaintiff
would not simply make demand and thereby avoid the whole issue of
whether demand is excused. The answer is that if the board agrees
to sue, the shareholder will lose control over the suit, and if the
board declines to sue, the courts will not entertain the
shareholder's derivative suit unless the board's decision can be
proved not to have been a valid exercise of business judgment. See
Aronson v. Lewis, 473 A.2d 805, 813 (Del. 1984), overruled on other
grounds, Brehm v. Eisner, 746 A.2d 244 (Del. 2000); Shareholder
Derivative Actions §§ 5:10, 5:11. Furthermore, by making a demand,
the shareholder concedes that the board was sufficiently
disinterested and independent to consider the demand. Levine, 591
A.2d at 197-98, 212; Shareholder Derivative Litigation § 5:10, at
5-38.

-34-
responding to a demand." Stone v. Ritter, 911 A.2d 362, 366-67

(Del. 2006) (emphasis added)(internal quotation marks omitted).

Demand will be excused only if a majority of the board members are

interested or lack independence. See Rales v. Blasband, 634 A.2d

927, 930 (Del. 1993).

The first way of showing demand futility, "interest" of

the directors, means that the director stands to gain or lose

personally and materially depending on the board's decision. Id.

at 936. Somewhat counterintuitively, the fact that the director

himself is named as a defendant in the suit does not create a

reasonable doubt about whether the director is "interested" in the

decision about whether to bring the suit on behalf of the

corporation. See Aronson v. Lewis, 473 A.2d 805, 809, 818 (Del.

1984) (all directors were sued, but futility of demand not shown),

overruled on other grounds, Brehm v. Eisner, 746 A.2d 244 (Del.

2000). However, a reasonable doubt can be created if the complaint

shows a "substantial likelihood of [the director's] liability" on

the suit. Rales, 634 A.2d at 936. The standard for holding

directors liable for damages resulting from breach of the duty of

care is gross negligence. Aronson, 473 A.2d at 812. If the

corporate charter exculpates the directors from damages liability

for breach of their duty of care (which Sonus's charter does), in

order to establish a "substantial likelihood of liability" on a

claim based on nonfeasance, the plaintiff must plead facts showing

-35-
 the necessary conditions predicate for director oversight
liability: (a) the directors utterly failed to implement
any reporting or information system or controls; or (b)
having implemented such a system or controls, consciously
failed to monitor or oversee its operations thus
disabling themselves from being informed of risks or
problems requiring their attention. In either case,
imposition of liability requires a showing that the
directors knew that they were not discharging their
fiduciary obligations. Where directors fail to act in
the face of a known duty to act, thereby demonstrating a
conscious disregard for their responsibilities, they
breach their duty of loyalty by failing to discharge that
fiduciary obligation in good faith.

Stone, 911 A.2d at 370 (footnotes omitted). "[A] failure to act in

good faith requires conduct that is qualitatively different from,

and more culpable than, the conduct giving rise to a violation of

the fiduciary duty of care (i.e., gross negligence)." Id. at 369.

To prove lack of good faith by virtue of failure to supervise

requires "a showing that the directors were conscious of the fact

that they were not doing their jobs." Guttman v. Huang, 823 A.2d

492, 506 (Del. Ch. 2003). Examples of the kind of allegations

necessary to show conscious neglect of the duty to supervise the

company's financial reporting would be: "contentions that the

company lacked an audit committee, that the company had an audit

committee that met only sporadically and devoted patently inadequate

time to its work, or that the audit committee had clear notice of

serious accounting irregularities and simply chose to ignore them

or, even worse, to encourage their continuation." Id. at 507.

The second way of showing demand futility is to show that

the board members lack independence. "Independence means that a

-36-
director's decision is based on the corporate merits of the subject

before the board rather than extraneous considerations or

influences." Aronson, 473 A.2d at 816. A director's independence

may be compromised by financial, familial or social ties to other

persons who are interested in the board's decision, but only if the

plaintiffs plead facts that would support the inference that the

director would be more willing to risk his or her reputation than

to risk the relationship with the interested person. Beam v.

Stewart, 845 A.2d 1040, 1052 (Del. 2004). Friendships and business

relationships within a board, even such relationships that arose

before the directors became board members, are not enough to create

a reasonable doubt about directors' independence from each other,

although a "particularly close or intimate personal or business

affinity" could do so. Id. at 1051. In practice, the standard is

demanding. For instance, in Stewart, the derivative complaint

described the "longstanding friend[ship]" between the director and

Martha Stewart, the owner of 94% of the stock in the corporation,

and included a news article detailing the "close personal

relationship" between the two. Id. at 1045, 1051. The Delaware

Supreme Court held that the complaint did not present even a "close

call" for establishing a reasonable doubt about the director's

independence from Stewart in order to establish futility of a demand

to sue Stewart. Id. at 1054. "Mere allegations that [the

directors] move in the same business and social circles, or a

-37-
characterization that they are close friends, is not enough to

negate independence for demand excusal purposes." Id. at 1051-52.

(3) Whether differences in federal and state complaints show
deficiency in representation

The federal plaintiffs contend that they have cured the

deficiencies in the state complaint by alleging "red flags" that

made the directors aware of accounting problems in 2001 and 2002 and

so would show a substantial likelihood of liability for the

directors and a corresponding interest in avoiding the suit. These

allegations are not impressive evidence that the directors knew of

problems and chose to do nothing. See Stone, 911 A.2d at 370

(oversight liability requires conscious disregard of known

responsibilities). The so-called red flags are merely statements

that the company's growth would call for increased attention to

accounting and control systems; if anything, these statements are

evidence that the company was attempting to manage the risk that

accompanied its rapid growth, not a concession that Sonus and its

directors were consciously failing in their duties.

The federal plaintiffs also point to their allegations

that certain directors had been sued in March 2003 for securities

fraud on the ground that (1) they overstated the quality and

performance of Sonus's products and (2) that Sonus gave particular

customers undisclosed kickbacks in order to get them to buy Sonus

products. The securities suit alleged that the undisclosed aspects

of Sonus's sales would have an adverse effect on the company's

-38-
financial results and would render its financial statements

misleading. The Second Amended Complaint does not say that the

plaintiffs prevailed on the securities suits. To take the hearsay

assertions alleged in a different complaint as true would circumvent

the requirement of Rule 23.1 that the derivative complaint be

verified, but we can accept the allegations in the securities suit

as indicative that the directors had notice of those allegations in

2003. However, the Second Amended Complaint does not indicate that

the problems with the quality of Sonus's products or the practice

of giving customers undisclosed kickbacks had any part in leading

to the restatement of financial results for 2001-2003. The

derivative complaint is not based on problems with product

development, so the existence of the securities suit at most shows

that the board was on notice of a different problem. As for the

financial reporting effects of undisclosed kickbacks, in the long

list of ten types of internal controls problems unearthed by Sonus's

internal investigation, one perhaps describes the kind of problem

alleged in the securities complaint: "We do not have adequate

procedures and controls to ensure that . . . all significant terms

of our arrangements with customers are documented and understood to

ensure that our revenue recognition criteria are satisfied."

However, the Second Amended Complaint does not allege that this

snippet from the investigation results referred to the same

incidents described in the securities complaint or that those

-39-
incidents contributed to cause the restatements. In short, the

allegations from the securities lawsuits show only that the

directors knew of allegations of some business and accounting

problems, but not necessarily the ones that the derivative suit

relies on.

Regarding the question of whether the directors lacked

independence, the federal complaint adds nothing material to the

allegations in the state complaint of Anderson's insider trading or

the allegations of financial and social relationships among the

board members. The federal plaintiffs contend that they have

transformed the issue by alleging that the board continued to reward

officer-directors Ahmed and Gruber by granting them raises and

titles after the announcement of accounting problems, which, the

plaintiffs say, shows the board was in thrall to the two insiders.

If we were to conclude that continuing to promote inside directors

after the events in question showed lack of independence of the

board, we would truly revolutionize the law of demand futility,

since by the same principle we would also have to infer lack of

independence from the fact that the board continued the officers'

employment, refrained from suing them, etc. The board's decisions

about retaining and promoting corporate officers fall squarely

within its business judgment. Besides, the Second Amended Complaint

alleged that the person most directly involved in the accounting

problem, Chief Financial Officer Nill, was fired; nothing in the

-40-
complaint shows that this was not an adequate response to the

accounting problems uncovered by the internal investigation. The

allegations in the federal complaint about interlocking

directorships of the board members are the kind of "structural bias"

allegations that were held inadequate to show lack of independence

under Delaware law in Beam, 845 A.2d at 1050-54.

The federal plaintiffs maintain that revelations made

after the state court complaint was filed show a substantial

likelihood of liability on the part of the directors. In

particular, they rely on the announcement in July 2004 that Sonus's

financials for 2001, 2002, and the first three quarters of 2003

would be restated, leading to increased operating losses in 2002 and

2003. They similarly rely on the Form 10-K for 2004, which included

a litany of areas in which Sonus's controls had been determined to

be inadequate.

All of these 2004 revelations were made after the

plaintiffs filed their suits in February and March 2004. The

plaintiffs' burden is to show that a demand on the directors would

have been futile at the time they filed their suit, not at a later

time. Aronson, 473 A.2d at 810; Shareholder Derivative Actions at

§ 5:12. Events that occur after the suit is filed are irrelevant

to the extent they show conditions at a later time. See Grossman

v. Johnson, 674 F.2d 115, 124 (1st Cir. 1982) (allegation that

directors announced their opposition to suit in a motion to dismiss

-41-
the suit was irrelevant to futility of pre-suit demand); Vanderbilt

v. Geo-Energy, Ltd., 725 F.2d 204, 211 (3d Cir. 1983) (later

appointment of disinterested special litigation committee irrelevant

to whether board would have fairly considered demand before

committee appointed); Cramer v. Gen. Tel. & Elecs. Corp., 582 F.2d

259, 276 (3d Cir. 1978)(opposition to suit by special litigation

committee after suit filed irrelevant to futility of pre-suit demand

on board). However, revelations made after the suit was filed but

which illuminate conditions prevailing at the time of suit may be

taken into account in deciding whether the board was disinterested

and independent at the time the suit was filed. McCall v. Scott,

239 F.3d 808, 823 (6th Cir. 2001), amended on other grounds on

denial of rehearing, 250 F.3d 997 (6th Cir. 2001); Levine, 591 A.2d

at 201-08 (entertaining motion to reopen judgment on ground that

newly discovered evidence established board was not independent at

time suit was filed). The allegations about the announcements in

2004 thus can be considered only as evidence that there were in fact

inadequacies in Sonus's internal controls and procedures as they

existed as of December 31, 2003, and that such weaknesses resulted

in restatement of the financials for two years and three quarters,

which would illuminate facts that existed when the suit was filed;

the post-suit announcements may not be taken as evidence that the

directors knew of or admitted such weaknesses, because the notice

or admission would not have occurred until after the suit had been

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filed.

Whereas the state complaint alleged that there was reason

to believe that Sonus might have to restate its 2003 financials as

a result of accounting and control irregularities, the Second

Amended Complaint alleged that Sonus did in fact restate financials

for two years and three quarters, increasing the net loss for two

of those years, and it listed the areas in which Sonus found

accounting and control weaknesses. The difference between admitting

irregularities that are suspected to be of a magnitude to require

restatement of financials and admitting irregularities that have

been confirmed to be of such magnitude is a meaningful difference.

Moreover, the increased number of the reporting periods affected is

relevant because it shows the problem was not fleeting or anomalous.

Therefore, the state plaintiffs would have strengthened their

complaint by amending to plead the results of the investigations.

However, we cannot conclude that the state complaint would

have fared better even with the more conclusive evidence of

accounting irregularities. The principal facts on which the Second

Amended Complaint relies to establish directorial liability are (1)

the fact of the restatement of financial results; and (2) the list

of internal accounting and control weaknesses revealed by the Sonus

internal investigation. There is no allegation that Sonus had no

system of information or controls in place. The fact that failures

of internal controls led to the restatement of financials with worse

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results than originally reported is not enough under Delaware law

to establish demand futility. See Stone, 911 A.2d at 370-71 (bank's

failure to comply with laws led to a huge fine, but did not

establish demand futility; bad outcome did not prove bad faith);

Guttman, 823 A.2d at 495, 507 (no substantial likelihood of

directorial liability was shown by the existence of accounting

irregularities that resulted in a restatement of earnings). Nor is

futility established by the fact that Sonus conducted an internal

review that found many material weaknesses in its accounting and

control systems. The findings in the internal review report are

actually evidence of directorial supervision, rather than evidence

of failure to supervise. For instance, in Kenney v. Koenig, 426 F.

Supp. 2d 1175, 1183 (D. Colo. 2006), the corporation confessed to

material weaknesses in internal controls that caused it to restate

its financials for two years; the court held that the admissions did

not show a sustained and systematic failure of oversight by audit

committee members, but "quite the opposite," since the corporation

detected and corrected its failings. To meet the standard

established in Stone, to show directorial liability where there was

a reporting and information system in place, the plaintiffs would

need to show that the directors knew of the inadequacies and failed

to act. Stone, 911 A.2d at 370. In other words, if the plaintiffs

had pleaded that something like the internal investigation report

in this case had been presented to the directors before the period

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in question, not after it, and that the directors had failed to

address the problems revealed in the report, then the complaint

would have met the standards for futility of a demand on that board.

However, allegations that the directors became aware of problems and

promptly conducted an investigation rooting out the causes for

failure does not constitute a showing of conscious neglect and

misfeasance, yet those are precisely the sort of allegations the

plaintiffs contend would have saved the state complaint.

The federal plaintiffs further allege that Ferri and

Severino "were aware of the Company's rampant internal control

deficiencies and financial reporting problems" by virtue of the fact

that they served on the audit committee. Allegations that directors

"knew" of particular problems solely because of their position in

the corporation, without any particularized facts indicating actual

knowledge, are not sufficiently specific to show actionable

nonfeasance leading to demand futility under Delaware law. Guttman,

823 A.2d at 496-98, 507.

(4) Other indicia of inadequate representation

The federal plaintiffs contend that the corporation was

poorly represented by the state plaintiffs because the state

plaintiffs abandoned their appeal. This argument might seem to

raise an issue of fact inappropriate for resolution on the

pleadings, but the plaintiffs do not say so, and the entirety of the

argument in their opening brief consists of a participial phrase in

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a sentence mainly about the inadequacy of the state complaint. Of

course, the more inadequate the state complaint, the less likely the

state plaintiffs would have been to prevail on their appeal. If the

appeal was unlikely to be successful, the state plaintiffs'

abandonment of that appeal does not indicate their representation

was inadequate. Nathan, 651 F.2d at 1228. The plaintiffs' own

brief therefore refutes the notion that the state plaintiffs'

abandonment of their appeal could establish inadequate

representation.

***

In sum, we cannot conclude that the allegations in the

Second Amended Complaint add material allegations that would pass

the test for pleading demand futility under Delaware law. It

follows that the state plaintiffs were not grossly deficient in

failing to include such allegations in the state complaint. The

federal plaintiffs have not come forward with any reason to classify

the state plaintiffs' representation as inadequate. Therefore, we

conclude that the federal plaintiffs are bound by the dismissal of

the state litigation, and this suit was rightly dismissed on the

ground of issue preclusion.

The judgment of the district court must be and is

AFFIRMED.

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