In a case arising out of the inversion transaction where Medtronic merged with Coviden, the Minnesota Supreme Court spoke on the proper test of determining when an action is derivative or direct in In re Medtronic, Inc. Shareholder Litigation. The distinction is important, because derivative claims are subject to the demand and pleading requirements of Minn. R. Civ. P. 23.09. The Plaintiff in this case did not comply with those requirements.
In this transaction, Medtronic acquired Covidien through a new holding company, Medtronic plc, incorporated in Ireland, with Medtronic and Covidien then becoming wholly owned subsidiaries of the Irish holding company (“new Medtronic”). Shareholders of Medtronic had their stock converted into shares in new Medtronic on a one-for-one basis, while shareholders of Covidien received $35.19 and 0.956 shares of new Medtronic for every share of Covidien stock held. Ultimately, former Medtronic shareholders collectively owned approximately 70 percent of new Medtronic and former Covidien shareholders collectively owned approximately 30 percent of new Medtronic.
As a result of the inversion transaction, Medtronic, previously a Minnesota corporation, now operates as a wholly owned subsidiary of an Irish company and thus is subject to Ireland’s tax laws. The Plaintiff alleged that Medtronic reduced the interest of its shareholders to 70 percent of new Medtronic in order to secure and protect the tax benefits it sought in this transaction. In addition, because the Internal Revenue Service treats an inversion transaction as a taxable event for the shareholders of the U.S. company, Medtronic shareholders incurred a capital-gains tax on Medtronic shares held in taxable accounts but received no compensation from the company for this tax liability. On the other hand, Plaintiff alleged, Medtronic officers and directors who incurred an excise-tax liability on their stock-based compensation as a result of the transaction were reimbursed by Medtronic for that expense.
After reviewing Minnesota case law, the Minnesota Supreme Court held that “when shareholders are injured only indirectly, the action is derivative; when shareholders show an injury that is not shared with the corporation, the action is direct.” The Minnesota Supreme Court rejected the Delaware tests set forth in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d 1031 (Del. 2004) which was adopted by the Minnesota Court of Appeals below. The Court noted “[w]e do not see a need to resort to Delaware law to answer the direct-versus-derivative question here given the guidance available from our own precedent. Moreover, the Tooley test has been limited to claims asserting breach of fiduciary duty.”
The Court then examined the various claims at issue to determine if they were derivative or direct. The Plaintiff alleged harm due to the excise-tax reimbursement paid to Medtronic’s officers and directors. The Court found these were derivative claims. According to the Court, these claims essentially alleged that Medtronic improperly reimbursed corporate officers and directors for the excise-tax liability that resulted from the transaction, without following statutory procedures before doing so or in violation of duties owed to Medtronic shareholders. Regardless of the specific theory for these claims, the Court found the claims alleged wrongful conduct caused an injury to Medtronic as a corporation, not to the individual shareholders, because corporate reimbursement of an excise-tax liability resulting from the transaction is at bottom an alleged waste of corporate assets. Further, if Plaintiff were to prevail on these claims, the recovery would go to Medtronic (as a return of the improperly paid funds) rather than to the shareholders.
Next, the Court examined capital-gains-tax claims. The Complaint alleged that the shareholders were harmed because the tax liability is imposed on them solely in their status as shareholders. Medtronic itself did not incur a capital-gains tax liability on the transaction, and therefore could not recover for the injury caused by this alleged harm. Because any recovery would go only to the shareholders who incur a capital-gains tax liability, rather than to the corporation, the Court noted that claims asserting this harm were direct.
Finally, the Court examined allegations of harm due to dilution of Plaintiff’s (and class members’) interest in the corporation. In the Complaint, Plaintiff did not contend that the inversion diluted shareholders’ interests in the company by decreasing the value of the corporation itself. Instead, Plaintiff alleged that Medtronic structured the inversion to secure and then protect the corporation’s expected tax benefit by taking from its shareholders a portion of their interest in the corporation, thus decreasing their ownership share in new Medtronic. Medtronic asserted that this alleged harm is simply a standard overpayment claim, that is, that Plaintiff alleged only that Medtronic paid too much to Covidien shareholders as part of the transaction, which is mismanagement or waste of corporate funds and therefore derivative.
The Court noted that unlike a derivative overpayment claim, in which the shareholders claim that their shares have diminished in value by reason of the decrease in value of the corporation’s assets due to overpayment in a transaction, Plaintiff alleged that class members’ ownership interest and voting power were diluted by Medtronic to provide adequate protection for the tax benefits it sought in the transaction with Covidien. In other words, rather than a simple loss of economic value, Plaintiff alleged an injury based on the loss of certain rightful incidents of his ownership interest, which is an injury that falls only on shareholders and not on the corporation. Therefore, the Court determined this was a direct claim. The Court observed that it must accept the allegations of the Complaint as true at this stage of the case, and therefore the Court was not expressing an opinion on Plaintiff’s ability to prevail on claims that allege a dilution injury.