Bass, Berry & Sims attorney Chris Lazarini outlines the case in which the court affirmed the dismissal of a derivative lawsuit against JP Morgan applying the abuse of discretion standard of review, but discussing the merits of using the more rigorous de novo review standard. Chris provided the analysis for Securities Litigation Commentator (SLC). The full text of the analysis is below and used with permission from the publication. If you would like to receive additional content from the SLC, please visit the SLC website to sign up for the newsletter.
Espinoza vs. J.P. Morgan Chase & Co. & Dimon, No. 14-1754 (2nd Cir., 6/16/15)
*Delaware law affords directors substantial leeway in conducting an investigation and courts routinely reject derivative lawsuits challenging the form of the investigation.
**A split of authority exists regarding whether dismissals of derivative actions must be reviewed using the abuse of discretion standard or the more rigorous de novo standard.
This case arises out of the London Whale trading debacle, in which JPMorgan suffered over $6 billion in losses on risky derivative investments. When the firm revealed its losses in May 2012, it disclosed that it had modified its risk model, allegedly to hide the fact that the derivatives trading had doubled the firm's risk. In one month, CEO Jamie Dimon went from characterizing the mounting publicity over the losses as "'a complete tempest in a teapot'" to admitting that the investments had been "'flawed, complex, poorly reviewed, poorly executed, and poorly monitored.'" Numerous suits and congressional and regulatory investigations followed.
Plaintiff, a JP Morgan shareholder, sent a letter to the firm's Board demanding an investigation into the trading and the dissemination of false and misleading information about the scandal. Plaintiff also demanded that the Board sue persons responsible for the losses. In response, the Board formed a Review Committee to oversee the firm's internal investigation which resulted in, among other remedial measures, improved risk controls, termination or reassignment of certain individuals, reduced salaries for others, and claw backs of some bonuses. The Board rejected, however, Plaintiff's demand that the Board sue responsible persons, explaining that, in its judgment, further litigation was not in the company's best interests.
Dissatisfied, Plaintiff filed this derivative action. Applying Delaware's business judgment rule, the district court found that the complaint failed to set forth facts showing that the Board "wrongfully refused" the demand for action and dismissed the complaint. On appeal, Plaintiff challenged the district court's deference to the Board. While Plaintiff conceded that the Board adequately investigated the losses, he argued that, if the Board did not investigate the misleading statements minimizing the losses, there was no exercise of "judgment" on that issue that could be presumed reasonable.
The Court affirms, but uses this case to voice its displeasure with the applicable standard of review. Ordinarily, dismissals are subject to a de novo review. In several Circuits, however, including the Second, precedent requires that appellate courts use the less stringent abuse of discretion standard when reviewing dismissals of derivative actions. The Court notes that applying the abuse of discretion standard has been questioned by numerous courts and that the First and Seventh Circuits, and Delaware, have discarded the abuse of discretion standard in recent years.
The Court explains the rationale for applying the more rigorous de novo review standard to derivative actions. First, district courts have no institutional advantage over appellate courts in reviewing the legal sufficiency of pleadings. Second, abuse of discretion review is illogical because questions of law in other circumstances are ordinarily subject to a de novo review. Finally, abuse of discretion review leads to potentially divergent results as appellate courts may be compelled by the standard to affirm differing district court decisions involving similar fact patterns thus creating confusion in an area where clear guidance on management practices is needed. Notwithstanding its view, the Court recognizes the review limitations placed on it by precedent and follows the existing standard.