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Protas v. Cavanagh: Delaware Court of Chancery Analyzes Derivative Actions Under the Delaware Statutory Trust Act

May 14, 2012

In Protas v. Cavanagh, 2012 WL 1580969 (Del. Ch. May 4, 2012), the Delaware Court of Chancery applied corporate law tests in dismissing direct and derivative actions brought against Black Rock Credit Allocation Income Trust IV, a Delaware statutory trust ("BTZ"), BTZ's board of trustees and various other parties.

BTZ is a closed-end investment company that issued both common stock and auction market preferred stock. When the auctions on the preferred stock failed, the preferred stock effectively became illiquid, and according to the plaintiff, the value of the preferred stock decreased below its issue price and liquidation preference. In addition, the dividend rate that BTZ was obligated to pay on the preferred stock increased to the maximum rate as a result of the failed auctions. Thereafter, BTZ redeemed the preferred stock.

The plaintiff was a common stockholder of BTZ and brought both allegedly direct and derivative claims against BTZ and the board of trustees in connection with BTZ's preferred stock redemptions. The plaintiff's derivative actions primarily asserted that the redemptions amounted to waste because BTZ redeemed the preferred stock at a substantial premium to its value at a time when BTZ had no obligation to redeem. The plaintiff's purportedly direct action asserted that the redemptions unfairly conferred a benefit on the preferred stockholders that was not shared with the common stockholders.

The Court analyzed whether the plaintiff's purportedly direct claim was a direct or derivative claim under the two-pronged corporate test for determining whether a claim is direct or derivative. The Court considered (1) who suffered the harm from the redemptions and (2) who would receive the benefit of any remedy. The Court concluded that the plaintiff's direct claim was in fact derivative because the harm to the common stockholders was entirely dependent on the harm caused to BTZ by the alleged overpayment for the preferred stock.

The Court then considered whether the plaintiff had met the requirements to bring a derivative action under Section 3816 of the Delaware Statutory Trust Act (the "Act"). Under Section 3816, the plaintiff was required to either make a demand on the board of trustees to bring suit or prove that making such a demand would be futile. The plaintiff did not make a demand on the board of trustees. Instead, the plaintiff asserted that demand was excused because the redemptions were not the product of a valid exercise of business judgment. The Court analyzed the plaintiff's claim under the corporate waste standard. The waste standard requires a plaintiff to assert particularized allegations that a transaction is so one-sided that "no business person of ordinary, sound judgment" could conclude that the corporation received adequate consideration. The Court found that the plaintiff's allegations fell short because, at the very least, the redemptions relieved BTZ of its obligations to pay the preferred stock dividends, which were set at the maximum rate as a result of the failed auctions.

The Court did not have occasion to analyze a feature of Section 3816 of the Act that is unique among Delaware statutes governing business entities. Section 3816 permits the governing instrument of a Delaware statutory trust to make beneficial owners' right to bring derivative actions subject to additional standards and restrictions. Accordingly, Hartsel v. Vanguard Group, Inc., 2011 WL 2421003 (Del. Ch. June 15, 2011), remains the most significant Delaware case addressing such additional standards and restrictions.

In Hartsel, the Delaware Court of Chancery considered whether demand was excused in derivative actions brought against two Delaware statutory trusts (the "Vanguard Trusts") and their boards of trustees. The Court's analysis primarily focused on the standard set by the Vanguard Trusts' governing instruments.1 The governing instruments stated that demand was excused only if "a majority of the Board of Trustees, or a majority of any committee established to consider the merits of such action, is composed of Trustees who are not 'independent trustees' (as that term is defined in the [Act])." With respect to a statutory trust that is a registered investment company, the Act defines "independent trustee" as a trustee who is not an "interested person" (as defined in the Investment Company Act of 1940) of the statutory trust. The Court found that the majority of trustees were independent trustees and therefore demand was not excused under the terms of the Vanguard Trusts' governing instruments. 



1The plaintiffs also argued that Section 3816 of the Act was not the exclusive means for determining whether demand was excused and that demand may also be excused under corporate tests. The Court noted that such an argument was "dubious" but did not address it. Instead, the Court applied the traditional corporate tests and found that, even under the corporate tests, demand was not excused.