In re Sonus Networks, Inc. Shareholder Derivative

• Decision Date: 31 March 2006
• Docket Number: No. CIV.A.04-10359 DPW.,CIV.A.04-10359 DPW.
• Citation: 422 F.Supp.2d 281
• Parties: In re SONUS NETWORKS, INC. SHAREHOLDER DERIVATIVE LITIGATION
• Court: U.S. District Court — District of Massachusetts

422 F.Supp.2d 281

In re SONUS NETWORKS, INC. SHAREHOLDER DERIVATIVE LITIGATION

No. CIV.A.04-10359 DPW.

United States District Court, D. Massachusetts.

March 31, 2006.

COPYRIGHT MATERIAL OMITTED

Edward T. Dangel, III, Dangel, Donlan and Fine Boston, MA, William B. Federman, The Law Firm of Federman & Sherwood, Oklahoma City, OK, Willem F Jonckheer, Schubert & Reed, LLP, San Francisco, CA, Alan L. Kovacs, Law Office of Alan L. Kovacs, Boston, MA, Peter A. Lagorio, Gilman and Pastor, LLP, Saugus, MA, Michael K. Mattchen, Dangel & Mattchen, LLP, Boston, MA, Gregory M. Nespole, Wolf, Haldenstein, Adler, Freeman & Herz LLP, New York City, David Pastor, Gilman and Pastor, LLP, Boston, MA, Paul T. Warner, Reich & Binstock, LLP, Houston, TX, Juden Justice Reed, Schubert & Reed LLP, San Francisco, CA, Plaintiffs.

John R. Baraniak, Jr., Choate, Hall & Stewart, Mary' P. Cormier, Edwards & Angell, LLP, Thomas J. Dougherty, Skadden, Arps, Slate, Meagher & Flom LLP, Robert S. Frank, Jr. Choate, Hall & Stewart, Daniel H. Gold, Wilmer Cutler Pickering Hale and Dorr LLP, John D. Hughes, Edwards & Angell, LLP, Matthew J. Matule, Skadden, Arps, Slate, Meagher & Flom LLP, Gregory F. Noonan, Wilmer Cutler Pickering Hale and Dorr LLP, James W. Prendergast, Wilmer Cutler Pickering Hale and Dorr LLP, Jeffrey B. Rudman, Wilmer Cutler Pickering Hale and Dorr LLP, Boston, MA, for Defendants.

Michael F. Germano, Nicole Robbins Starr, Berman DeValerio Pease Tobacco Burt & Pucillo, Boston, MA, for Movants.

MEMORANDUM AND ORDER

WOODLOCK, District Judge.

The issue before me is whether a determination in state court shareholder derivative litigation—that the failure to make demand upon directors may not be excused—precludes different shareholder plaintiffs in a parallel federal derivative suit from relitigating the question of demand futility. I find that it does and accordingly will dismiss this case.

The plaintiffs, as shareholders of Sonus Networks, Inc. ("Sonus" or the "Company"), bring this federal derivative litigation on behalf of the Company arising out of alleged misconduct and negligence by several of Sonus's officers and directors in relation to improper revenue recognition. They made no demand on the directors, claiming such an effort would be futile.

In the meantime, parallel derivative suits by Sonus shareholders in the Massachusetts state court were dismissed for failure adequately to plead justification for their failure to make demand on the directors. The defendants have moved to dismiss the litigation before me on the ground that the state court judgment dismissing on the question of demand is binding on the federal court derivative plaintiffs as well.

I. Background

On January 20, 2004, Sonus announced it was delaying the release of fourth quarter and year 2003 financial results pending completion of a 2003 audit. That announcement was followed, on February 11, 2004, by a press release notifying the public that there were indications certain employees of the company took actions affecting the timing of revenue recognition and that certain non-executive employees had been terminated. Sonus also announced that the Board of Directors Audit Committee had initiated an internal investigation and that the Company had notified the SEC of that fact. The SEC in turn issued a formal order of investigation of the Company's financial reporting.

On July 28, 2004, following completion of the internal review, Sonus released a restatement of its financial results for the fiscal years 2001 and 2002 and the first three quarters of 2003. In the Form 10K/A for the fiscal year 2003 filed with the SEC reporting the restatement, the Company concluded that the "primary impact of the restatements is the adjustment to the timing of revenue recognition and certain other financial statement accounts." Sonus also reported that it had "identified material weaknesses in [its] internal controls and procedures." On March 15, 2005 Sonus filed a Form 10-K for the fiscal year 2004 elaborating on the "material weaknesses includ[ing] both entity-level control weaknesses as well as weaknesses in process, transaction and application controls."

On February 20, 2004, Sonus shareholders filed a derivative lawsuit against certain officers and directors of Sonus in Massachusetts Superior Court without making a pre-suit demand upon the Company's Board of Directors. The case was assigned to the Business Litigation Session and later consolidated with a second derivative action for decision by Judge van Gestel. Other shareholders filed three derivative actions in this Court on February 23, February 26, and March 24, 2004 against six of the seven Directors of Sonus (the "Director defendants"), four of whom were outside directors at the time the Complaint was filed, and against several other Sonus officers. The federal shareholder derivative plaintiffs also failed to make a pre-suit demand with the Company's Board of Directors. I consolidated the federal cases on June 23, 2004.

The defendants in the state action had filed a motion to dismiss the state case on March 22, 2004 because the plaintiffs did not make demand to the Sonus Board of Directors prior to filing and because they failed to allege with sufficient particularity grounds to excuse their failure to make a demand. I scheduled amended pleadings and further filings in these federal proceedings at conferences on June 28, 2004 and August 10, 2004 pending Judge van Gestel's ruling on the motion to dismiss in the state action.

On September 27, 2004, Judge van Gestel granted the motion to dismiss in the state action concluding that "[d]emand has not been shown to be excused in these cases." In re Sonus Networks, Inc., No. 04-0753, 2004 WL 2341395, at *5, 2004 Mass.Super. LEXIS 351, at *14 (Sept. 27, 2004). The federal plaintiffs then filed a Second Consolidated Complaint to which the defendants in the consolidated federal actions before me thereafter moved for dismissal of this litigation arguing that Judge van Gestel's judgment precludes the federal plaintiffs from pressing their argument that demand on the Board should be excused in the instant case. Alternatively, the defendants argue that dismissal is warranted on the merits in any event for the reasons offered by Judge van Gestel. The federal plaintiffs oppose dismissal arguing that they were not in privity with the state plaintiffs and that the federal Complaint alleges new and more detailed facts¹ than the state complaint. As a consequence, the plaintiffs contend issue preclusion does not apply and their failure to make a demand ought to be excused. In order to understand why I find that demand should not be excused, it is necessary first to provide the general legal framework for derivative actions and the demand requirement.

II. The Demand Requirement in Derivative Actions

The derivative form of action gives individual shareholders a means to protect the interests of the corporation from the "misfeasance and malfeasance of `faithless directors and managers" by bringing an action on the company's behalf. Kamen v. Kemper Fin. Services, Inc., 500 U.S. 90, 95, 111 S.Ct. 1711, 114 L.Ed.2d 152 (1991) quoting Cohen v. Beneficial Loan Corp., 337 U.S. 541, 548, 69 S.Ct. 1221, 93 L.Ed. 1528 (1949). To prevent abuse of this remedy and give directors an opportunity to exercise their reasonable business judgment to address the relevant issues the shareholder(s) must demonstrate that the corporation itself had refused to proceed after suitable demand—unless demand is excused by extraordinary conditions—before bringing the derivative action. Id. at 95-96, 111 S.Ct. 1711. The demand requirement is embodied in the cognate Rules 23.1 of the Federal and the Massachusetts Rules of Civil Procedure. The Federal Rule applicable here provides that the complaint shall:

allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and, if necessary, from the shareholders or members, and the reasons for the plaintiff's failure to obtain the action or for not making the effort.

Fed.R.Civ.P. 23.1.

In order to determine whether the demand requirement may be excused by futility as contemplated by Rule 23.1, the law of the corporation's state of incorporation must be considered. Kamen, 500 U.S. at 108-09, 111 S.Ct. 1711. Sonus is a Delaware corporation. Thus, the underlying issue that Judge van Gestel has faced and decided and that I now face in this motion to dismiss is whether the shareholder-plaintiffs alleged facts with sufficient particularity excusing their respective failures to make a presuit demand as required by Delaware law.

To meet their burden, plaintiffs are required under Delaware law to show that reasonable doubt exists about whether a majority of the Board of Directors—here, four out of seven—were disinterested and independent when the Complaint was filed. Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993). The court is required to "analyze whether the underlying conduct complained of in the complaint ... renders any of the board members `interested,' and, if so, whether any of the other members of the board are compromised in their ability to act independently of the directors found to be interested." Guttman v. Huang, 823 A.2d 492, 501-02 (Del.Ch. 2003).

In cases where the allegations do not challenge any particular business decision, reasonable doubt exists as to the disinterestedness of a director when the plaintiff pleads facts showing that the director would have been substantially likely to suffer an adverse personal consequence if the corporation pursued the shareholder's demand. Rales, 634 A.2d at 936. "To create a reasonable doubt about an outside director's independence, a plaintiff must plead facts that would support the inference that because of the nature of a relationship or additional circumstances other than the interested director's stock...