In the world of securities and corporate governance litigation, we are always in the middle of a reform discussion of some variety. For the past several years, there has been great focus on amendment of corporate bylaws to corral and curtail shareholder corporate-governance claims, principally shareholder challenges to mergers.* Meritless merger litigation is indeed a big problem. It is a slap in the face to careful directors who have worked hard to understand and approve a merger, or to CEOs who have spent many months or years working long hours to locate and negotiate a transaction in the shareholders’ best interest. It is cold comfort to know that nearly all mergers draw shareholder litigation, and that nearly all of those cases will settle before the transaction closes without any payment by the directors or officers personally. And we know the system is broken when it routinely allows meritless suits to result in significant recoveries for plaintiffs’ lawyers, with virtually nothing gained by companies or their shareholders.
There are three main solutions afoot, at different stages of maturity, involving amendments to corporate bylaws to require that: (1) there be an exclusive forum, chiefly Delaware, for shareholder litigation; (2) a losing shareholder pay for the litigation defense costs; and (3) a shareholder stake hold a minimum amount of stock to have standing to sue. I refer readers to the blogs published by Kevin LaCroix, Alison Frankel, and Francis Pileggi for good discussions of these types of bylaws. The purpose of this blog post is not to specifically chronicle each initiative, but to caution that they will cause unintended consequences that will leave us with a different set of problems than the ones they solved.
Exclusive-forum bylaws offer the most targeted solution, albeit with some negative consequences.
Exclusive-forum bylaws best address the fundamental problem with merger litigation: the inability to coordinate cases for an effective motion to dismiss before the plaintiffs and defendants must begin negotiations to achieve settlement before the merger closes. Although the merger-litigation problem is virtually always framed in terms of the oppressive cost and hassle of multi-forum litigation, good defense counsel can usually manage the cost and logistics. Instead, the bigger problem, and the problem that causes meritless merger litigation to exist, is the inability to obtain dismissals. This is primarily so because actions filed in multiple forums can’t all be subjected to a timely motion to dismiss, and a dismissal in one forum that can’t timely be used in another forum is a hollow victory. Exclusive litigation in Delaware for Delaware corporations is preferable, because of Delaware’s greater experience with merger litigation and likely willingness to weed out meritless cases at a higher rate. But the key to eradicating meritless merger litigation is consolidation in some single forum, and not every Delaware corporation wishes to litigate in Delaware.
The closest historical analogy to such bylaws is the Securities Litigation Uniform Standards Act’s provision requiring that covered class actions be brought in federal court and litigated under federal law to ensure that the least meritorious cases are weeded out early, as Congress intended through the Reform Act. The Reform Act’s emphasis on early dismissal of cases that lack merit has been its best feature, and requiring litigation in federal court helped achieved it.
So too would litigation in an exclusive forum, because it would yield a more meaningful motion to dismiss process, which would weed out less-meritorious cases early, which in turn would deter plaintiffs’ lawyers from bringing as many meritless cases. The solution is that simple. There will be consequences, though. Plaintiffs’ lawyers, of course, will tend to bring more meritorious cases that present greater risk, exposure, and stigma, and will bring more in Delaware, which is a defendant-friendly forum for good transactions but a decidedly unfriendly one for bad transactions. So while it certainly isn’t good that there are shareholder challenges to 95% of all mergers, the current system reduces the stigma of being sued and tends to result in fairly easy and cheap resolutions. In contrast, cases that focus on the worst deals and target defendants that the plaintiffs’ lawyers regard as the biggest offenders will require more expensive litigation and significant settlements and judgments.
Fee-shifting and minimum-stake bylaws are overly broad and will cause a different set of problems.
So exclusive-forum bylaws attack the merger-litigation problem in a focused and effective fashion, albeit with downside risk. In contrast, fee-shifting bylaws and minimum-stake bylaws attack the merger-litigation problem, but do so in an overly broad fashion, and will cause significant adverse consequences.
Fee-shifting bylaws, of course, attempt to curtail the number of cases by forcing plaintiffs who bring bad cases to pay defendants’ fees. I find troubling the problem of deterring plaintiffs’ lawyers from bringing meritorious cases as well, since many plaintiffs’ lawyers would be very conservative and thus refuse to bring any case that might not succeed, even if strong. That concern probably will cause the downfall of fee-shifting bylaws, where the Delaware Senate just passed a bill that would outlaw fee-shifting bylaws, and the issue now goes to the Delaware House. (The same bill authorizes bylaws designating Delaware as the exclusive forum for shareholder litigation.) But to me, the bigger problem is an inevitable new category of super-virulent cases, involving tremendous reputational harm (e.g. the plaintiffs’ firm decided to risk paying tens of millions of dollars in defense fees because they decided those defendants are that guilty) and intractable litigation that quite often would head to trial – at great cost not just financially, but to the law as well because it is indeed true that bad facts make bad law.
The Reform Act’s pleading standards have created analogous negative consequences, but much less severe and costly. The pleading standards (and the Rule 11 provision) weed out bad cases early on, but almost never is there a financial penalty to a plaintiff for bringing a bad case. Instead, the bigger plaintiffs’ firms have tended to be more selective in the cases they bring, which has yielded a pretty good system overall – even though they sometimes still bring meritless cases, and meritless cases sometimes get past motions to dismiss. The bigger and still-unsolved problem with pleading standards is the overly zealous and necessarily imperfect confidential-witness investigations they cause, to attempt to satisfy the statute’s elevated pleading requirements. The fee-shifting bylaws would occasion those sorts of problems as well, in addition to the virulent-case problem I’ve described.
Fee-shifting bylaws advocates’ push for ultra-meritorious lawsuits strikes me as an extreme case of “be careful what you wish for.” But it brings to mind a more mainstream situation that has worried me for many years: aggressive arguments in demand motions for pre-litigation board demands and shareholder inspections of books and records. In arguing that a shareholder derivative lawsuit should be dismissed for failure to make a demand on the board, defendants have long asserted that a shareholder failed to even ask the company for records under Section 220 of the Delaware General Corporation Law or similar state laws, to attempt to investigate the corporate claims he or she is pressing. Delaware courts, in turn, have chastised shareholders for failing to utilize 220, though thus far have stopped short of requiring it. Likewise, defendants, sometimes with great disdain, have criticized shareholders for not making a pre-suit demand on the board.
Although these are correct and appropriate litigation arguments, I have observed that, over time, they have succeeded in spawning more 220 inspection demands and pre-suit demands on boards, which over time will create more costly and virulent derivative cases than plain vanilla demand-excused cases brought without the aid of books and records. The solution is to just get those highly dismiss-able cases dismissed, without trying to shame the derivative plaintiffs into making a 220 or demand on the board next time.
Minimum-stake bylaws are problematic as well. They have as their premise that shareholders with some “skin in the game” will evaluate cases better, and will help prevent lawyer-driven litigation. Like fee-shifting bylaws, they will prevent shareholders from brining meritless lawsuits, and likewise tend to yield more expensive and difficult cases to defend and resolve. But they also will create a more difficult type of plaintiff to deal with, much the same way as the Reform Act’s lead-plaintiff provisions have created a class of plaintiffs that sometimes make us yearn for the days when the plaintiffs’ lawyers had more control. More invested plaintiffs increase litigation cost, duration, and difficulty, and increase the caliber and intensity of plaintiffs’ lawyering.
And I have no doubt that, despite the bylaws, smaller shareholders and plaintiffs’ firms will find a way back into the action, much as we’re seeing recently with retail investors and smaller plaintiffs’ firms brining more and smaller securities class actions that institutional investors and the larger plaintiffs’ firms with institutional-investor clients don’t find worth their time and money to bring. So with securities class actions, I think a two-headed monster is emerging: a relatively small group of larger and virulent cases, and a growing group of smaller cases. That, too, likely would happen, somehow, with minimum-stake bylaws.
What’s the harm with taking a shot at as many fixes as possible?
Even if someone could see the big picture well enough to judge that these problems aren’t sufficient to outweigh the benefits of fee-shifting and minimum-stake bylaws, I would still hesitate to advocate their widespread adoption, because governments and shareholder advocacy groups would step in to regulate under-regulation caused by reduced shareholder litigation. That would create an uncertain governance environment, and quite probably a worse one for companies. Fear of an inferior alternative was my basic concern about the prospect that the Supreme Court in Halliburton Co. v. Erica P. John Fund, Inc. would overrule Basic v. Levinson and effectively abolish securities class actions.
Beyond the concern about an inferior replacement system, I worry about doing away with the benefits shareholders and plaintiffs’ lawyers provide, albeit at a cost. Shareholders and plaintiffs’ lawyers are mostly-rational economic actors who play key roles in our system of disclosure and governance; the threat of liability, or even the hassle of being sued, promotes good disclosure and governance decisions. Even notorious officer and director liability decisions, such as the landmark 1985 Delaware Supreme Court decision in Smith v. Van Gorkom, are unfortunate for the defendants involved but do improve governance and disclosure.
One final thought. Shareholder litigation’s positive impact on governance and disclosure makes me wonder: will the quality of board oversight of cybersecurity, and corporate disclosure of cybersecurity issues, improve without the shock of a significant litigation development?