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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