Research Handbook on Representative Shareholder Litigation 1786435330, 9781786435330

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RESEARCH HANDBOOK ON REPRESENTATIVE SHAREHOLDER LITIGATION

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RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE Series Editor: Randall S. Thomas, John S. Beasley II Professor of Law and Business, Vanderbilt University Law School, USA Elgar Research Handbooks are original reference works designed to provide a broad overview of research in a given field while at the same time creating a forum for more challenging, critical examination of complex and often under-explored issues within that field. Chapters by international teams of contributors are specially commissioned by editors who carefully balance breadth and depth. Often widely cited, individual chapters present expert scholarly analysis and offer a vital reference point for advanced research. Taken as a whole they achieve a wide-ranging picture of the state-of-the-art. Making a major scholarly contribution to the field of corporate law and governance, the volumes in this series explore topics of current concern from a range of jurisdictions and perspectives, offering a comprehensive analysis that will inform researchers, practitioners and students alike. The Research Handbooks cover the fundamental aspects of corporate law, such as insolvency governance structures, as well as hot button areas such as executive compensation, insider trading, and directors’ duties. The Handbooks, each edited by leading scholars in their respective fields, offer far-reaching examinations of current issues in corporate law and governance that are unrivalled in their blend of critical, substantive analysis, and in their synthesis of contemporary research. Each Handbook stands alone as an invaluable source of reference for all scholars of corporate law, as well as for practicing lawyers who wish to engage with the discussion of ideas within the field. Whether used as an information resource on key topics or as a platform for advanced study, volumes in this series will become definitive scholarly reference works in the field.   Titles in this series include: Research Handbook on Shareholder Power Edited by Jennifer G. Hill and Randall S. Thomas Research Handbook on Partnerships, LLCs and Alternative Forms of Business Organizations Edited by Robert W. Hillman and Mark J. Loewenstein Research Handbook on Mergers and Acquisitions Edited by Claire A. Hill and Steven Davidoff Solomon Research Handbook on the History of Corporate and Company Law Edited by Harwell Wells Research Handbook on Corporate Crime and Financial Misdealing Edited by Jennifer Arlen Research Handbook on Fiduciary Law Edited by Gordon Smith and Andrew Gold Research Handbook on the Regulation of Mutual Funds Edited by William A. Birdthistle and John Morley Research Handbook on Representative Shareholder Litigation Edited by Sean Griffith, Jessica Erickson, David H. Webber and Verity Winship

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Research Handbook on Representative Shareholder Litigation

Edited by

Sean Griffith T.J. Maloney Chair and Professor of Law, Fordham University School of Law, USA

Jessica Erickson Professor of Law and Associate Dean for Faculty Development, University of Richmond School of Law, USA

David H. Webber Professor of Law, Boston University School of Law, USA

Verity Winship Professor of Law, University of Illinois College of Law, USA

RESEARCH HANDBOOKS IN CORPORATE LAW AND GOVERNANCE

Cheltenham, UK • Northampton, MA, USA

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© The Editors and Contributing Authors Severally 2018 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2018945844 This book is available electronically in the Law subject collection DOI 10.4337/9781786435347

ISBN 978 1 78643 533 0 (cased) ISBN 978 1 78643 534 7 (eBook)

02

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents List of contributorsviii Introduction1 PART I  SECURITIES CLASS ACTIONS   1 The development of securities litigation as a lawmaking partnership Jill E. Fisch

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  2 Securities class actions and severe frauds James J. Park

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  3 The shifting raison d’être of the Rule 10b-5 private right of action Amanda Marie Rose

39

PART II  SHAREHOLDER DERIVATIVE SUITS   4 The (un)changing derivative suit Jessica Erickson

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  5 Claim character and class conflict in securities litigation Richard A. Booth

80

  6 Illegality and the business judgment rule Charles R. Korsmo

98

PART III  MERGER LITIGATION Section A  Managing Multijurisdictional Litigation   7 Fighting frivolous litigation in a multijurisdictional world Adam Badawi

110

  8 Addressing the “baseless” shareholder suit: mechanisms and consequences James D. Cox

121

  9 Who collects the deal tax, where, and what Delaware can do about it Sean J. Griffith and Anthony Rickey

140

10 Forum shopping in the bargain aisle: Wal-Mart and the role of adequacy of representation in shareholder litigation Lawrence A. Hamermesh and Jacob J. Fedechko 11 Limiting litigation through corporate governance documents Ann M. Lipton

156 176

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vi  Research handbook on representative shareholder litigation Section B  Judicial Perspectives on Shareholder Litigation 12 Disclosure settlements in the state courts post-Trulia: practical considerations191 James L. Gale 13 Changing attitudes: the stark results of thirty years of evolution in Delaware M&A litigation J. Travis Laster

202

14 Appraisal rights in complete tender offers in Israel: a look into Israeli case law229 Ruth Ronnen Section C  Appraisal Actions 15 Recent developments in stockholder appraisal Charles R. Korsmo and Minor Myers

243

16 Appraisal as representative litigation Minor Myers

254

PART IV LITIGANTS AND LAW FIRMS Section A  Plaintiffs and Law Firms 17 Lead plaintiffs and their lawyers: mission accomplished, or more to be done? Stephen J. Choi and A.C. Pritchard 18 The mimic-the-market method of regulating common fund fee awards: a status report on securities fraud class actions Charles Silver 19 What do we know about law firm quality in M&A litigation? Steven Davidoff Solomon and Randall S. Thomas

271

287 304

Section B  Officers and Directors 20 Jurisdiction over directors and officers in Delaware Eric A. Chiappinelli

316

21 Stockholder litigation, fiduciary duties, and the officer dilemma Megan Wischmeier Shaner

330

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Contents  vii PART V COMPARATIVE AND INTERNATIONAL SHAREHOLDER LITIGATION Section A  The Globalization of Shareholder Litigation 22 The globalization of entrepreneurial litigation: law, culture, and incentives John C. Coffee, Jr.

351

23 The Teva case: a tale of a race to the bottom in global securities regulation Sharon Hannes and Ehud Kamar

372

Section B  Comparative Shareholder Litigation 24 A transatlantic perspective on shareholder litigation in public takeovers Dan Awrey and Blanaid Clarke

415

25 Private ordering of shareholder litigation in the EU and the US Matteo Gargantini and Verity Winship

439

26 Mapping types of shareholder lawsuits across jurisdictions Martin Gelter

459

27 Securities class actions in Canada: ten years later Poonam Puri

482

Section C  Other Modes of Enforcement 28 CSRC enforcement of securities laws: preliminary empirical findings Chao Xi

513

Index529

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Contributors Dan Awrey is Professor of Financial Regulation and Fellow of Linacre College, University of Oxford. Adam Badawi is Professor of Law at UC Berkeley School of Law. Richard A. Booth is Professor of Law and Martin G. McGuinn Chair in Business Law at Villanova University Charles Widger School of Law. Eric A. Chiappinelli is Frank McDonald Endowed Professor of Law at Texas Tech University School of Law. Stephen J. Choi is Murray and Kathleen Bring Professor of Law and the Co-Director of the Pollack Center for Law & Business at New York University School of Law. Blanaid Clarke holds the McCann FitzGerald Chair in Corporate Law at Trinity College Dublin. John C. Coffee, Jr. is Adolf A. Berle Professor of Law and Director of the Center on Corporate Governance at Columbia Law School. James D. Cox is Brainerd Currie Professor of Law at Duke Law School. Jessica Erickson is Professor of Law and Associate Dean for Faculty Development at the University of Richmond School of Law. Jacob J. Fedechko is a former law clerk in the Delaware Court of Chancery and is now a litigation associate in Wilmington, Delaware. Jill E. Fisch is Perry Golkin Professor of Law and Co-Director of the Institute for Law and Economics at the University of Pennsylvania Law School. James L. Gale is Senior Business Court Judge for Complex Business Cases assigned to the North Carolina Business Court. Matteo Gargantini is Assistant to the Commissioner at the Commissione Nazionale per le Società e la Borsa (“CONSOB”). Martin Gelter is Professor of Law at Fordham University School of Law. Sean J. Griffith holds the T.J. Maloney Chair in Business Law and directs the Fordham Corporate Law Center at Fordham University School of Law. Lawrence A. Hamermesh is Executive Director, Institute for Law & Economics at the University of Pennsylvania Law School, as well as Professor Emeritus and the former Ruby R. Vale Professor of Corporate and Business Law at Widener University Delaware Law School.

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Contributors  ix Sharon Hannes is Professor of Law and Dean of the Buchmann Faculty of Law at Tel Aviv University. Ehud Kamar is Professor of Law at the Buchmann Faculty of Law at Tel Aviv University. He serves as the Director of the Tel Aviv University Batya and Isachar Fischer Center for Corporate Governance and Capital Markets Regulation. Charles R. Korsmo is Professor of Law at Case Western Reserve University School of Law. J. Travis Laster is Vice Chancellor on the Delaware Court of Chancery. Ann M. Lipton is Michael Fleishman Associate Professor in Corporate Law & Entrepreneurship at Tulane University Law School. Minor Myers is Professor of Law at Brooklyn Law School. James J. Park is Professor of Law at UCLA School of Law. A.C. Pritchard is Frances and George Skestos Professor of Law at the University of Michigan Law School. Poonam Puri is Professor of Law at Osgoode Hall Law School, York University. Anthony Rickey is the founder of Margrave Law LLC. Judge Ruth Ronnen is in the Economic Division of the Tel Aviv District Court. Amanda Marie Rose is Professor of Law at Vanderbilt Law School and Professor of Management at the Owen Graduate School of Business, Vanderbilt University. Megan Wischmeier Shaner is Professor of Law at the University of Oklahoma College of Law. Charles Silver holds the Roy W. and Eugenia C. McDonald Endowed Chair in Civil Procedure at the School of Law at the University of Texas at Austin. He is also Professor of Government and Co-Director of the Center on Lawyers, Civil Justice, and the Media. Steven Davidoff Solomon is Professor of Law at UC Berkeley School of Law and Faculty Director of the Berkeley Center for Law and Business. Randall S. Thomas holds the John S. Beasley II Chair in Law and Business, and directs the Law & Business Program at Vanderbilt Law School. He also serves as a Professor of Management at the Owen Graduate School of Management, Vanderbilt University. David H. Webber is Professor of Law at Boston University School of Law. Verity Winship is Professor of Law at the University of Illinois College of Law. Chao Xi is Professor and Vice Chancellor’s Outstanding Fellow of the Faculty of Law at the Chinese University of Hong Kong.

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Introduction Shareholder litigation—primarily representative litigation on behalf of all stockholders of a corporation—has proliferated globally. Shareholder litigation has long been part of the corporate landscape in the United States, where shareholders can challenge nearly any corporate decision. The scope of shareholder suits, however, has been kept largely in check by a set of substantive and procedural rules. But in recent years these suits have proliferated as shareholders have taken advantage of innovative tactics and new doctrines. Moreover, shareholder litigation has begun to spread to jurisdictions other than the US, where it has taken on new forms. This research handbook provides a modernday survey of the state of shareholder litigation and offers empirical evidence of how these suits have developed. Its chapters provide indepth analyses of the forms of shareholder litigation, including securities class actions, merger litigation, derivative suits, and appraisal litigation. Through its examination of these different types of litigation, the book details some of the advantages and disadvantages of shareholder litigation. It explores such issues as the agency costs inherent in representative litigation, the challenges of multijurisdictional litigation and disclosureonly settlements, and the rise of institutional investors. It also surveys how related issues are addressed across the globe, with examinations of shareholder litigation in the United States, Canada, the United Kingdom, the European Union, Israel, and China.

1.  SECURITIES CLASS ACTIONS The book begins, in Part I, by examining securities class actions. In “The Development of Securities Litigation as a Lawmaking Partnership,” Jill E. Fisch discusses the unusual pedigree of federal securities fraud litigation. Unlike most private federal litigation, which is based on an explicit statutory private right of action, the securities fraud cause of action was created by the federal courts. The absence of a statute defining the scope of the claim required the courts to play a significant lawmaking role. Although Congress has in turn responded, its interventions have been limited in scope and largely deferential to the resulting body of judgemade law. As discussed in this chapter, the collaborative process by which Congress, the courts, and the SEC have developed private securities fraud litigation reflects a lawmaking partnership. The chapter defends this partnership as a normatively desirable approach and identifies distinctive advantages over alternatives such as a more detailed statute or a broad delegation by Congress to the courts or an administrative agency. The chapter concludes that, as a result, the Court should use the existence of a lawmaking partnership as a canon of construction in construing the scope of its own lawmaking authority. Where the Court finds evidence of this type of collaborative process, the Court should be empowered to use policy analysis to determine how best to further Congress’s lawmaking objectives rather than limiting its inquiry to the contours of the statutory text. 1

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2  Research handbook on representative shareholder litigation The next chapter, “Securities Class Actions and Severe Frauds” by James J. Park, examines the impact of the Private Securities Litigation Reform Act of 1995 (PSLRA) on securities class actions in light of the severe frauds that occurred in the years after its passage. In what was a fortuitous turn of events for the securities class action, the years after the PSLRA coincided with a period of significant accounting restatements. Securities class actions after the PSLRA thus often addressed what were believed to be severe frauds at large public companies. In light of these lawsuits, the PSLRA’s assumption that securities class actions do no more than harass companies with volatile stock prices is no longer valid. This narrative may have been true before the PSLRA, but it has been displaced in part by examples of securities class actions that have provided investors with a remedy for the worst frauds. This success will likely secure the survival of the securities class action for another generation, but also raises new questions about how to ensure that such actions are effective in addressing severe frauds. In “The Shifting Raison d’Etre of the Rule 10b-5 Private Right of Action,” Amanda Rose recounts the historical evolution of the private right of action under Rule 10b-5, explaining how it began as a cause of action not unlike traditional common law fraud and later morphed into the modern fraud-on-the-market class action. While the early version of the Rule 10b-5 private right was arguably consistent with standard corrective justice and deterrence rationales for private litigation, Rose argues that the modern fraud-on-themarket class action is difficult to defend on these grounds. The historical and theoretical context the chapter provides offers a lens for understanding contemporary scholarly debates over the social desirability of private Rule 10b-5 enforcement.

2.  SHAREHOLDER DERIVATIVE SUITS Part II analyzes shareholder derivative suits and the characterization of representative stockholder litigation. It begins with “The (Un)Changing Derivative Suit,” by Jessica Erickson. Her chapter sets the stage by providing an overview of the available empirical data about derivative suits. It contrasts the reform efforts in securities class actions and merger cases with legislative and judicial inaction in derivative suits. Building on the data and history of problems and reform, the chapter proposes additional scrutiny for derivative suits. It identifies mechanisms such as close judicial review of settlements, use of litigation-limiting charter and bylaw provisions, and the imposition of heightened procedural requirements. Direct and derivative shareholder suits are the subject of Richard Booth’s chapter, “Claim Character and Class Conflict in Securities Litigation.” His detailed analysis of the distinct sources of losses suffered by buyers in a typical securities fraud class action leads him to conclude that courts have mischaracterized many shareholder claims. These claims are properly seen as belonging to the corporation—as derivative claims—rather than direct claims belonging to individual buyers. The chapter identifies legal support for recharacterizing the claims and considers consequences for shareholder litigation. The next chapter, “Illegality and the Business Judgment Rule,” addresses derivative claims that seek to hold corporate officers and directors liable for causing the company to commit illegal acts. Charles Korsmo argues that corporate law should not subject defendants to greater judicial scrutiny in stockholder suits simply because they have caused the

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Introduction  3 company to violate the criminal or civil law. Corporations that violate the law may well face financial penalties and other legal repercussions under the relevant substantive law, and individuals personally involved may also face sanctions of their own. It is less clear, however, whether directors violate their fiduciary duties by approving illegal acts, especially where those acts do not harm the corporation. Many corporations today have made violating, and ultimately changing, the law part of their business model, from Airbnb to Uber and driverless cars. This chapter argues that corporate lawbreaking under this model may be both profitable and socially beneficial. As a result, stockholder litigation seeking director liability for illegal actions threatens to be a formidable obstacle to progress, with few if any countervailing benefits.

3.  MERGER LITIGATION Representative stockholder litigation challenging corporate mergers and acquisitions is the subject of Part III. Much of this merger litigation has been multijurisdictional, and the part begins by addressing how courts, litigants, and companies manage such litigation. Several of the chapters address concerns about the merits of shareholder litigation, particularly in the context of “disclosure-only” settlements in which shareholders’ recovery is limited to additional disclosures. The part then offers judicial perspectives on M&A litigation from prominent judges. It concludes with several chapters on appraisal proceedings. A.  Managing Multijurisdictional Litigation In “Fighting Frivolous Litigation in a Multijurisdictional World”, Adam Badawi interrogates recent efforts by the Delaware Chancery Court to rein in disclosure-only settlements. Under Badawi’s analysis, such suits might constitute a “necessary evil” in service of another goal: “Delaware’s ability to stay at the forefront of corporate law.” Much depends on whether plaintiff law firms know the strength of their cases at filing, or whether they only develop that understanding over time. If the latter, rational firms might bring cases outside of Delaware—even strong cases—for fear that the lack of ability to obtain a disclosure-only settlement would leave them unable to recover costs in Delaware if the case turned out to be weak. Badawi raises the possibility that Delaware’s crackdown on such settlements may be incompatible with its commitment to remain the leading forum for corporate litigation. The next chapter is “Addressing the ‘Baseless’ Shareholder Suit: Mechanisms and Consequences” by James D. Cox. This chapter examines several mechanisms—pretrial hearings, the derivative suit’s demand requirement, and settlements—that exist for screening shareholder suits. Screening serves a dual purpose: discarding meritless suits and enabling, indeed strengthening, meritorious suits so that injuries can be prevented or compensated. Yet not all of these screening mechanisms are created equal. As this chapter details, pretrial hearings and the demand requirement often work fairly effectively, providing courts with an early opportunity to assess a suit’s quality. In contrast, approval of settlements is a far less effective approach to screen shareholder suits. Even outside the specific context of disclosure-only settlements, judges are in a poor position to assess the quality of a settlement at a settlement hearing, given the nonadversarial nature of

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4  Research handbook on representative shareholder litigation the process and the frequent disconnect between the allegations in the complaint and the terms of the settlement. As a result of these concerns, the author argues that judges should withhold approval of the settlement and deny attorneys’ fees if they have reason to believe that the settlement does not provide tangible benefits to the corporation or the class. In “Who Collects the Deal Tax, Where, and What Delaware Can Do About It,” Sean J. Griffith and Anthony Rickey similarly focus on Delaware’s efforts to crack down on disclosure-only settlements. Griffith and Rickey test one theory of plaintiff law firms: that there are “white hat” and “black hat” firms, that is, firms that bring meritorious cases and firms that bring weak ones. They find evidence consistent with the existence of “black hat” firms, but also evidence that “white hat” firms may in fact be “gray”, filing strong cases in Delaware and weaker cases outside it. To deal with the problem of “gray hat” behavior, the authors suggest that Delaware probe lead counsel applicants’ conduct outside of Delaware in making lead counsel appointments. Delaware can use its unique position as the center of corporate law to assure that meritorious cases continue to be brought there. Lawrence A. Hamermesh and Jacob J. Fedechko address the interaction among representative stockholder suits brought in multiple, competing jurisdictions in their chapter, “Forum Shopping in the Bargain Aisle: Wal-Mart and the Role of Adequacy of Representation in Shareholder Litigation.” Focusing on the US and Delaware context, they articulate an approach to limiting litigants’ incentives to file quickly and settle quickly. The chapter proposes a framework for courts to assess adequacy of representation when considering the preclusive effects of a prior judgment. In response to a perceived increase in the amount of frivolous stockholder litigation, corporations have begun to insert provisions in their corporate governance documents that restrict shareholders’ ability to pursue private litigation. In “Limiting Litigation Through Corporate Governance Documents,” Ann M. Lipton sheds light on how these limitations, such as forum selection clauses, arbitration clauses, feeshifting agreements, and minimum stake requirements, could be abused. The chapter begins with the historical evolution of these provisions and the shifting legal justifications for them. It then explores some policy concerns regarding these limitations, including the scope of the limitations, the enforceability of such limitations, and, more broadly, the theoretical inquiry as to whether such limitations are appropriate for inclusion in corporate governance documents in the first instance. The author concludes that the answer can shift one way or another depending on whether one views the function of shareholder litigation as providing for compensation or deterrence. B.  Judicial Perspectives on Shareholder Litigation In “Disclosure Settlements in the State Courts Post-Trulia: Practical Considerations,” Judge James L. Gale of the North Carolina Business Court takes a close look at shareholder class actions following the Delaware Court of Chancery’s 2016 opinion in In re Trulia, Inc. subjecting disclosure settlements to heightened judicial scrutiny. Although Trulia reduced the number of disclosure settlements in Delaware, plaintiffs have shown continued willingness to present such settlements in courts outside of Delaware, where judges may face substantive and procedural obstacles to applying the same standards. In this chapter, Judge Gale reports on the considerations facing judges outside of Delaware

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Introduction  5 in evaluating disclosure settlements under Trulia. First, the chapter draws a distinction between the corporate benefit doctrine and the common fund doctrine to shed light on how Trulia may be applied differently in different states. It goes on to discuss the considerations involved when a court is to apply Delaware law or another state’s laws, including class action procedures, professional responsibility regarding attorney’s fees, and evidentiary rules in assessing the materiality of disclosures. In the next chapter, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery compares how the Delaware Supreme Court applied enhanced scrutiny in M&A settings during the decade that followed the creation of the intermediate standard of review with the Delaware Supreme Court’s current approach to similar issues. The chapter— “Changing Attitudes: The Stark Results of Thirty Years of Evolution in Delaware M&A Litigation”—cautions that the attitudes displayed in the early landmark decisions, and the results they reached, no longer hold. The Delaware Supreme Court’s opinions from Revlon through QVC displayed skepticism towards single bidder sale processes, prioritized the interests of sell-side stockholders over the contract rights of acquirers, and resulted in the issuance of targeted preliminary injunctions to block the effectiveness of problematic provisions. By contrast, current Delaware law supports the use of a single bidder sale process, prioritizes the contract rights of acquirers over the rights of sellside stockholders, and rules out targeted preliminary injunctions. In place of vigorous judicial enforcement, current Delaware law defers to the stockholders to protect themselves by voting down deals that adversely affect their interests. The chapter posits that while multiple factors contributed to this shift, the two most salient are the rise of institutional investors and the generalized failure of stockholder-led M&A litigation. Finally, in “Appraisal Rights in Complete Tender Offers in Israel: A Look into Israeli Case Law”, Judge Ruth Ronnen of the Tel Aviv District Court’s Economic Division examines two ways that courts appraise share value: via expert testimony on a company’s “objective” value, and by reference to market prices. Surveying Israeli case law, and with frequent reference to Delaware Chancery court rulings, Judge Ronnen offers insights into how judges make appraisal decisions. In so doing she discusses numerous relevant concepts, some of which are grappled with by commercial courts worldwide, others of which are more prominent in Israel (where controlling shareholders predominate). These concepts range from discounted cash flow analysis to market checks, consent of the majority of the minority shareholders, consent of sophisticated shareholders, and the presence of actual price negotiations. C.  Appraisal Actions The discussion of appraisal actions continues with “Recent Developments in Stockholder Appraisal.” Charles R. Korsmo and Minor Myers provide an overview of stockholder appraisal activity—including recent data—together with an evaluation of recent legal developments, both judicial and legislative. The year 2015 was a record one for stockholder appraisal in terms of the number of mergers challenged and the dollar amounts involved. The evidence shows, however, that appraisal remains relatively rare and continues to be focused on deals with abnormally low merger premia and sales processes marked by conflicts of interest. As this chapter explains, developments in Delaware suggest a growing acceptance of the recent blossoming of appraisal arbitrage

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6  Research handbook on representative shareholder litigation as an investment strategy, coupled with sensible prophylactic measures against potential abuses of the appraisal remedy. “Appraisal as Representative Litigation” connects appraisal actions to the broad themes of this book by examining the ways in which appraisal is a form of representative litigation. Minor Myers explains that, although appraisal claims cannot be brought as class actions, they are nonetheless a form of collective action. The outcome of an appraisal proceeding binds all dissenting stockholders, not just those who have filed a petition in court, and petitioning stockholders can recover their expenses pro rata from other members of the dissenting group. The representative nature of these suits gives rise to legal questions about control of claims, sharing of expenses, settlement rights, and notice obligations to other dissenters that are familiar but distinct from the class action context. This chapter explores these questions by analyzing the dynamics of an appraisal claim through its life cycle, from the initial decision to dissent to the sharing of expenses following a trial judgment.

4.  LITIGANTS AND LAW FIRMS Part IV examines the dynamics of representative shareholder litigation. It takes a close look at the players involved in these disputes, examining litigants on both sides and interactions within and among the law firms that represent these parties. A.  Plaintiffs and Law Firms Stephen J. Choi and A.C. Pritchard evaluate the effectiveness of the lead plaintiff provisions in the Private Securities Litigation Reform Act in “Lead Plaintiffs and Their Lawyers: Mission Accomplished, or More to Be Done?” The PSLRA created a presumption that courts should appoint as lead plaintiff the class member seeking appointment with the largest financial interest in the relief sought. It also vested the lead plaintiff with authority to select and retain class counsel. More than 20 years has passed since the PSLRA was adopted, and the empirical record shows that, in substantial measure, the PSLRA’s lead plaintiff provision has succeeded. Institutional investors have stepped forward to serve as lead plaintiffs in a substantial number of cases, and they may play a role in ensuring greater recovery for investors in those cases. In addition, institutional investors seem to have reduced the share of recovery that goes to pay lawyers postPSLRA. There is also evidence, however, that the competition among lawyers to serve as lead counsel has not been driven exclusively by price and quality of representation. The larger institutional investors that have most frequently agreed to serve as lead plaintiffs in securities class actions have been government-sponsored pension funds. The political influence over these funds raises suspicion that at least some class action law firms are buying lead counsel status with campaign contributions, that is, lawyers are paying to play. This chapter reviews the empirical record and then suggests specific reforms that might promote additional transparency and competition on price, as well as additional requirements for lead plaintiffs to further enhance the screening role played by the PSLRA. In “The Mimic-the-Market Method of Regulating Common Fund Fee Awards: A Status Report on Securities Fraud Class Actions,” Charles Silver tracks the growth and

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Introduction  7 development of the mimic-the-market approach in setting attorneys’ fees in securities class actions. This approach calls for judges to assess what the market would have paid for the lawyer’s services, rather than the more traditional lodestar calculation. An idea that Silver himself advocated early on, the mimic-the-market approach to setting fees has gained traction in many jurisdictions across the United States, notably in the Second, Third, and Seventh Circuit Courts of Appeal, and in several district courts. Silver points out that following the mimic-the-market approach requires a measure of judicial courage, because it sometimes results in the award of very large fees. Silver also revisits his own prediction that judges would begin to set fees at the outset of cases, and considers why he believes that prediction has not been realized. Steven D. Solomon and Randall S. Thomas inquire into law firm quality as measured by outcomes in class action shareholder litigation. “What Do We Know About Law Firm Quality in M&A Litigation?” reviews the state of the literature on law firm quality and asks what can be known about plaintiff and defense-side firms in class action shareholder litigation. Several dimensions of the question are explored, such as: How do clients select law firms? What substantive and reputational factors influence law firms’ decisions to represent a client? To what extent does the client influence the outcome? How should a law firm’s performance be measured when its client or potential client, particularly a repeat player defendant in M&A litigation, dictates the law firm’s strategy in handling the litigation? The chapter closes by emphasizing the relatively underdeveloped state of the empirical evidence, offering several directions for future research. B.  Officers and Directors Defendant officers and directors are the subject of the final two chapters in this part. Each examines limits on the ability of representative shareholder litigation to reach these actors. In “Jurisdiction over Directors and Officers in Delaware,” Eric Chiappinelli provides an overview of the necessary jurisdictional underpinnings for shareholder litigation, with a focus on Delaware. Over time, the courts and the state legislature have developed a set of statutes and standards that allow Delaware courts to hear cases against nonresident directors and officers of corporations organized in the state. The chapter outlines the multiple sources of adjudicatory power: implied consent statutes, long-arm statutes, and conspiracy jurisdiction. With a critical eye, it analyzes the expansive geographic reach claimed by Delaware courts. Shareholder litigation against corporate officers is the focus of Megan Wischmeier Shaner’s chapter, “Stockholder Litigation, Fiduciary Duties, and the Officer Dilemma.” Tracing the divergence between the development of director and officer fiduciary duties, she points out that stockholder litigation is rarely used to hold officers accountable. The chapter explores the causes and consequences of this gap in corporate law, and suggests remedial approaches targeted at officers’ managerial role.

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8  Research handbook on representative shareholder litigation

5. COMPARATIVE AND INTERNATIONAL SHAREHOLDER LITIGATION A.  The Globalization of Shareholder Litigation “The Globalization of Entrepreneurial Litigation: Law, Culture, and Incentives” introduces the broad themes of this part of the book. John C. Coffee, Jr, examines the expansion of class action litigation in Europe and Asia, comparing the role of law, culture, and incentives in fostering entrepreneurial litigation similar to or different from the forms developed in the United States. This comparative analysis is especially important because the United States Supreme Court’s ruling in Morrison v. National Australia Bank Ltd. effectively limits the ability of shareholders to pursue certain claims within the United States, potentially prompting a renewed emphasis on the availability of representative litigation in other jurisdictions. The chapter begins with a presentation of the representative litigation models utilized in different jurisdictions. In the Netherlands, for example, a device called the “stichting” has been combined with the country’s Act of Collective Settlement to create a form of litigation substantially similar to opt-out securities class actions. Asia, on the other hand, with its relatively modest exposure to class action litigation, currently employs a model that lies somewhere between the United States’ and the European Union’s models. The chapter highlights some of the advantages and disadvantages of each model of collective litigation, ultimately finding strong evidence that “entrepreneurial” litigation has indeed begun to spread to other jurisdictions. In “The Teva Case: A Tale of a Race to the Bottom in Global Securities Regulation,” Sharon Hannes and Ehud Kamar offer a unique perspective on shareholder litigation, describing their experience as plaintiffs in a transformative securities class action lawsuit in Israel. Israel-based Teva is the world’s largest manufacturer of generic drugs and is crosslisted in both the United States and Israel. The company reported its executive compensation in the aggregate, rather than individually, using its crosslisted status to avoid what Hannes and Kamar viewed as a straightforward requirement of both US and Israeli law. In contrast, companies listed only in Israel disclosed individual executive pay, and were therefore the only companies subject to media scrutiny of their compensation practices. Hannes and Kamar’s class action—opposed not just by the company, but by the Israel Securities Authority—eventually led to the requirement that all publicly traded Israeli companies disclose the compensation of each executive individually, regardless of whether the company is crosslisted. A copy of Hannes and Kamar’s groundbreaking complaint is included. B.  Comparative Shareholder Litigation The chapters in this section take an explicitly comparative approach to the broad themes of this book and to some of the specific issues addressed in earlier chapters. The section begins with “A Transatlantic Perspective on Shareholder Litigation in Public Takeovers,” in which Dan Awrey and Blanaid Clarke compare the regulatory environment facing takeovers in the United States, the United Kingdom, and the Republic of Ireland. After recognizing some commonalities among the jurisdictions, including highly developed stock markets and each jurisdiction’s “market-oriented” approach to corporate governance that

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Introduction  9 seeks to maximize shareholder value, this chapter focuses on the major substantive and procedural differences between the regulatory regimes. The chapter offers a comprehensive analysis of the City Code of the United Kingdom and the corresponding Takeover Rules in Ireland that govern public takeovers and explains how these regimes may be preferable to more litigation-based models of takeover. Specifically, Awrey and Clarke identify three advantages of these regimes: the responsive and proactive rulemaking system of expert panels, the speediness of review, and cost savings offered by the difference processes. The next chapter is “Private Ordering of Shareholder Litigation in the EU and the US” by Matteo Gargantini and Verity Winship, which takes a comparative approach to private ordering of shareholder litigation. To what extent can the players in shareholder litigation—companies, management, shareholders, and other investors—set the rules for litigation through private agreement? The chapter begins with the US example, in which dispute resolution provisions emerged in the constituent documents of US companies as a response to pressures from litigation. The contours of permissible provisions have not been exhaustively drawn, but dispute resolution bylaws have been tested in US state courts and were the subject of subnational legislation. The chapter then examines how private ordering of shareholder litigation—both intracorporate and securities suits—might function (or not) in the context of the EU and some of its constituent countries. This comparison highlights many of the similarities, as well as important differences, in how the United States and the European Union approach private ordering in shareholder litigation. In “Mapping Types of Shareholder Lawsuits across Jurisdictions,” Martin Gelter compares the various forms of shareholder lawsuits that are found in the United States, the United Kingdom, and several European and Asian countries. This chapter notes that conflict of interest claims are the most prevalent claims brought by shareholders against directors, managers, and other shareholders. While shareholder litigation may, in some jurisdictions, be primary under the purview of the supervisory board, other, more liberal jurisdictions have procedural mechanisms that allow shareholders to bring a lawsuit on their own with varying limitations of the types of claims or suits that may be brought. This chapter discusses the various types of suits, such as direct, derivative, and rescission suits, that are presented to shareholders in each jurisdiction as well as the mechanisms, the difficulties therein, and the effectiveness of such lawsuits in deterring or remedying unfavorable actions. The chapter concludes with an evaluation of the efficacy of each jurisdiction’s models of shareholder litigation and highlights the difficulties in creating a perfect system that could ensure the protection of shareholders’ rights while preventing nonmeritorious or even abusive lawsuits. The examination of comparative shareholder litigation concludes with “Securities Class Actions in Canada: Ten Years Later.” In this chapter, Poonam Puri reports the results of her comprehensive empirical study of secondary market securities class actions in Canada. The chapter examines ten years of data, beginning with the introduction of statutory secondary market liability in 2006 and ending in 2015. In addition to identifying procedural barriers, she analyses the types of plaintiffs (especially institutional versus retail investors) and defendants (large versus small, but also a concentration in the mining industry), providing a rich account of the Canadian experience with representative shareholder litigation for secondary market misrepresentations.

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10  Research handbook on representative shareholder litigation C.  Other Modes of Enforcement The book concludes with “CSRC Enforcement of Securities Laws: Preliminary Empirical Findings,” by Chao Xi, which considers public enforcement of the securities laws. This chapter sheds empirical light on an important component of the public enforcement of securities laws in China. The securities markets are a relatively recent market institution in China. First appearing in the early 1990s, the Chinese securities markets have expanded phenomenally and today are the second largest in the world. The burgeoning Chinese securities markets have long been plagued by market misconduct and securities law violations. Private enforcement of securities laws, by way of aggrieved investors bringing civil actions against wrongdoers, has been weak, with public enforcement thus significantly greater in amount and intensity. This chapter examines this public enforcement, drawing on a unique, handcollected dataset comprising all 447 sanction decisions taken by the China Securities Regulatory Commission (CSRC), China’s primary securities regulator, during the period from 2006 through 2012. This study reveals that the patterns of those efforts have shifted over time, from an initial focus on violations of disclosure rules to targeting a much wider spectrum of wrongdoing including, in particular, insider trading and investment advisor violations. In enforcing China’s securities laws, the CSRC also does not typically assume individual or corporate liability alone, but frequently holds culpable both firms and the individuals responsible for the malfeasance in question.

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PART I SECURITIES CLASS ACTIONS

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1.  T  he development of securities litigation as a lawmaking partnership Jill E. Fisch*

1. INTRODUCTION Federal securities fraud litigation has an unusual pedigree. Unlike most private litigation, which is based on an explicit statutory private right of action, the securities fraud cause of action was created by the federal courts.1 The absence of a statute defining the scope of the claim required the courts to play a significant lawmaking role. Although Congress has, in turn, responded, its interventions have been limited in scope and largely deferential to the resulting body of judge made law. This chapter takes the position that the collaborative process by which Congress and the courts have developed private securities fraud litigation reflects a normatively desirable approach.2 The chapter terms this approach a lawmaking partnership,3 and argues that the lawmaking partnership offers distinctive advantages over alternatives such as detailed statutes coupled with a narrow judicial adherence to the statutory text, on the one hand, or a broad delegation by Congress to the courts or an administrative agency, on the other. The Supreme Court’s decision in Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II)4 can be understood within this framework. In Halliburton II, the Court considered the continued viability of a judicially created doctrine—fraud on the market (“FOTM”). The Court had previously created FOTM in Basic Inc. v. Levinson as a tool to enable plaintiffs in impersonal public capital markets transactions to address the reliance requirement in federal securities fraud class actions.5 By enabling the class action, FOTM dramatically changed the nature of private securities fraud litigation and generated large scale cases involving substantial potential damages (Fisch 2013). In turn, these developments led to complaints about the resulting scope of litigation and the potential for litigation abuse (Fisch 1997). Some commentators demanded that the Court reconsider its earlier decision (Brief for

*  This chapter was drawn from Federal Securities Fraud Litigation as a Lawmaking Partnership, 93 Wash U. L. Rev. 453 (2016). It is excerpted and reprinted here with the permission of the Washington University Law Review. 1   Judicial creation of a private right of action occurred during a period in which federal courts implied private rights of action far more readily than they do today. 2   This chapter does not address broader questions about possible constitutional limits on congressional authority to delegate lawmaking power. See Arthur (1986). 3   The partnership construct developed in this chapter is conceptually similar to but more bounded than the manner in which Richard Fallon and Daniel Meltzer used the term. Fallon & Meltzer (2007). 4   134 S. Ct. 2398, 2408 (2014). 5   485 U.S. 224 (1988).

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The development of securities litigation  13 Former SEC Commissioners 2014). Commentators also raised concerns in Congress (Levitt 1995). Although the Court did not revisit the validity of FOTM prior to Halliburton II, it responded to claims of abusive litigation by imposing various limits on the private right of action. Similarly, although Congress did not speak directly to the validity of FOTM, it responded by enacting statutory reforms, first in the Private Securities Litigation Reform Act of 1995 (“PSLRA”)6 and then in the Securities Litigation Uniform Standards Act (“SLUSA”).7 Both the Court’s decisions and Congress’s refinements to the statutory framework reflected a common goal of reducing the prospect of costly and frivolous litigation while maintaining the viability of private litigation as a means of enforcing the disclosure obligations of the federal securities laws. The Court in Halliburton II did not discuss this cooperative enterprise in its opinion, basing its decision instead on principles of stare decisis. Nonetheless, this chapter argues that the Court’s adherence to Basic can alternatively be justified in terms of a lawmaking partnership. More broadly, this chapter reasons that the Court should use the existence of a lawmaking partnership as a canon of construction in construing the scope of its own lawmaking authority. Where the Court finds evidence of this type of collaborative process, it should be empowered to use policy analysis to determine how best to further Congress’s lawmaking objectives rather than limiting its inquiry to the contours of the statutory text. The virtues of this approach extend beyond the issue of FOTM and apply generally to federal securities fraud litigation. This chapter proceeds as follows. In section 2, the chapter positions Halliburton II within the context of the development of private securities fraud litigation. Section 3 conceptualizes the lawmaking partnership and identifies its structural advantages. Section 4 extends the analysis beyond FOTM and uses the example of insider trading regulation to explain the potential value of the lawmaking partnership in enabling Congress, the courts, and the Securities & Exchange Commission (“SEC”) to collaborate on the development of federal securities law.

2.  HALLIBURTON II AND PRIVATE SECURITIES FRAUD 2.1  Background—The Development of Private Securities Fraud The general antifraud provision of the Securities Exchange Act of 1934, section 10(b),8 contains no express private right of action.9 Nonetheless, the federal courts recognized a private right of action under the statute and the SEC’s Rule 10b-5, and subsequently

6   Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.). 7   Securities Litigation Uniform Standards Act of 1998, Pub. L. No 105-353, 112 Stat. 3227 (codified as amended in scattered sections of 15 U.S.C.). 8   Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (2015). 9   In contrast, the federal securities laws contain a number of provisions that create an express private right of action, including sections 11 and 12 of the 1933 Act and sections 9(e) and 18 of the 1934 Act. 15 U.S.C. §§ 77k–l, 78i(e), 78r (2015).

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14  Research handbook on representative shareholder litigation delineated the scope of this judge made cause of action.10 As the Supreme Court explained, “[w]hen we deal with private [securities fraud] actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn.”11 The Supreme Court’s early decisions primarily involved articulating limitations on the scope of a securities fraud claim (Kaufman 1990). Thus, in Ernst & Ernst v. Hochfelder, the Court held that a claim could not be predicated upon a showing of mere negligence but required proof of scienter.12 In Blue Chip Stamps v. Manor Drug Stores, the Court limited standing in private litigation to plaintiffs who had purchased or sold securities in connection with the fraud.13 In Santa Fe Industries, Inc. v. Green, the Court rejected an attempt to address a breach of fiduciary duty through federal securities fraud.14 Even before the rise of the new textualism, which heightened the importance of a statute’s language in its interpretation (Eskridge 1990), the Court grounded these decisions primarily in the text of section 10(b). Policy considerations also played a role, however, in the Court’s analysis. Throughout its development of private securities fraud litigation, the Court sought to balance two competing policies—protecting investors and limiting the potential for litigation abuse. In Blue Chip Stamps, for example, the Court justified its restriction on the class of potential plaintiffs in terms of “considerations of policy,” including a desire to limit the potential settlement value of lawsuits that could not easily be dismissed prior to trial.15 Similarly, in Santa Fe, the Court identified the concern that a more expansive interpretation of 10b-5 would create a “danger of vexatious litigation.”16 The 1988 Basic Inc. v. Levinson decision took a somewhat different approach.17 First, the Court relied more heavily on policy considerations than was the case in its earlier decisions. Second, investor protection considerations led the Court to espouse a position that expanded the scope of 10b-5 litigation. In Basic, the Court concluded that private plaintiffs need not offer direct proof of reliance, but can use the FOTM theory to obtain a presumption of reliance for securities that trade in an efficient market tainted by public misrepresentations. Commentators have described the Basic decision as opening the floodgates for private litigation, although, to be fair, this claim is overstated (Fisch 2013). Even in Basic, the Court’s role was one of reining in more expansive lower court lawmaking (Fisch 2013). The Basic Court explicitly justified its holding on the basis that it was necessary to adapt the common law reliance requirement to the realities of the modern securities markets. Moreover, the Court defended the FOTM presumption not by relying on the statutory text or even congressional intent, but on “considerations of fairness, public policy, and

10   The starting point was a district court decision which recognized an implied private right of action in 1946. See Kardon v. Nat’l Gypsum Co., 69 F. Supp. 512 (E.D. Pa. 1946). 11   Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737 (1975). 12   425 U.S. 185, 193 (1976). 13   421 U.S. 723, 731 (1975). 14   430 U.S. 462, 474–76 (1977). 15   Blue Chip Stamps, 421 U.S. at 742–44. 16   Santa Fe Indus., 430 U.S. at 478–79 (quoting Blue Chip Stamps, 421 U.S. at 740) (internal quotation mark omitted). 17   485 U.S. 224 (1988).

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The development of securities litigation  15 probability, as well as judicial economy.”18 The Court reasoned that it was necessary to “balanc[e] the substantive requirement of proof of reliance in securities cases against the procedural requisites of [Federal Rule of Civil Procedure] 23.”19 By eliminating the need for plaintiffs to prove reliance directly, Basic made the modern securities fraud class action possible. The Court did not act alone, however, in developing the parameters of securities fraud class actions. Congress responded to Basic through explicit statutory provisions that clarified and modified the scope of the class action. In 1995, Congress adopted the PSLRA,20 which reflected both congressional acceptance of the judicially created private right of action and a reassertion of congressional authority over the scope of that right of action. Congress included in the statute a heightened pleading standard, a discovery stay, an explicit loss causation requirement, and refinements to the calculation of damages (Fisch 1997). In addition, Congress adopted a lead plaintiff provision in an effort to respond to the argument that securities fraud class actions constituted “lawyer-driven litigation” by mobilizing institutional investors to act as litigation gatekeepers (Fisch 2005). Subsequently, in 1998, Congress enacted SLUSA, which preempted state court litigation for “covered class actions” in order to ensure that those cases were subject to the provisions of the PSLRA.21 Later, as part of the Sarbanes–Oxley Act of 2002, Congress extended the statute of limitations in private securities fraud litigation.22 In legislating with respect to private securities fraud, Congress reaffirmed the critical policy considerations that had previously been identified by the Court. Congress explicitly recognized the importance of private litigation as a supplement to public enforcement efforts. Thus, the statement of managers accompanying the conference report for the PSLRA described private securities litigation as “an indispensable tool,” both for protecting investors and for “promot[ing] public and global confidence in our capital markets.”23 This policy judgment is consistent with the Court’s analysis. As the Court has repeatedly explained, “private securities litigation [i]s an indispensable tool with which defrauded investors can recover their losses—a matter crucial to the integrity of domestic capital markets.”24 At the same time, Congress sought to structure private litigation so as to minimize the potential for vexatious litigation (Fisch 1997). In the PSLRA, Congress chose to retain the private securities fraud class action, but to refine its use by implementing substantive and procedural safeguards against overuse and abuse. These safeguards serve similar policy objectives as the limitations imposed by the Court in cases such as Ernst, Blue Chip Stamps, and Central Bank.

  Basic, 485 U.S. at 245.   Ibid at 242 (internal quotation omitted). 20   Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C.). 21   Securities Litigation Uniform Standards Act of 1998, Pub. L. No 105-353, 112 Stat. 3227 (codified as amended in scattered sections of 15 U.S.C.). 22   Sarbanes–Oxley Act of 2002 § 804, 28 U.S.C. § 1658 (2014). 23   H.R. Rep. No 104-369, at 31 (1995). 24   Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 320 n.4 (2007) (internal quotation marks omitted) (citing Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 81 (2006)). 18 19

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16  Research handbook on representative shareholder litigation 2.2 The Halliburton Decision Halliburton II presented the Court with the question of whether to overrule its prior decision in Basic.25 The petitioner argued that academic consensus and new evidence about market efficiency had undermined the economic theory upon which Basic was based.26 Halliburton also argued that the class action litigation that Basic had spawned was undesirable. Accordingly, it asked the Court to overrule Basic. The Supreme Court disagreed. The Court explained that the petitioner had overstated the degree to which the Basic decision relied on strong claims of market efficiency. Instead, the Court stated that the presumption of reliance rested on the “modest premise” that “public information generally affects stock prices.”27 The Court thereby reasoned that the modern debate about the “degree” to which prices accurately reflect public information is “largely beside the point.”28 Similarly, the Court reaffirmed Basic’s determination that most investors rely on a security’s market price “as an unbiased assessment of the security’s value in light of all public information.”29 Reasoning that Basic’s presumption of reliance, as a substantive doctrine of federal securities law, was entitled to stare decisis principles, the Court concluded that it was inappropriate to overrule Basic. Because Halliburton II relied primarily on principles of stare decisis, the Court did not revisit the policy considerations that had motivated the Basic decision. Under an alternative approach, those policy considerations provide an independent justification for adhering to FOTM. As noted above, a key feature of private securities fraud litigation, and the class action in particular, is the fact that it is the product of a collaborative lawmaking partnership between Congress and the Court. This collaboration is entitled to special weight in evaluating legal questions that bear on the continued viability of securities fraud class actions. As explained above, the Court and Congress both contributed to the development of the private right of action for federal securities fraud. The Supreme Court accepted FOTM in Basic to enable securities fraud class actions to conform to the commonality requirement of Rule 23 of the Federal Rules of Civil Procedure. The Basic Court explained: “Requiring proof of individualized reliance from each member of the proposed plaintiff class effectively would have prevented respondents from proceeding with a class action, since individual issues then would have overwhelmed the common ones.”30 The Court went on to note with approval the District Court’s conclusion that FOTM offered “a practical resolution to the problem of balancing the substantive requirement of proof of reliance in securities cases against the procedural requisites of [Federal Rule of Civil Procedure] 23.”31 25   Prior to Halliburton II, several cases had reached the Court that presented issues regarding the requirements for class certification in securities fraud litigation and thereby raised questions about the appropriate scope of class litigation (Fisch 2013). 26   Brief for Petitioners, Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014) (No 13-317). 27   Halliburton II at 2410. 28  Ibid. 29   Ibid at 2411, citing Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 133 S. Ct. 1184, 1192 (2013). 30   Basic Inc. v. Levinson, 485 U.S. 224, 242 (1988). 31   Ibid (quoting District Court) (internal quotation marks omitted).

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The development of securities litigation  17 This focus was consistent with the intent of the Federal Civil Rules Advisory Committee, which drafted Rule 23 with securities fraud as a model for class litigation.32 As the Committee recognized, the class action device was also an important tool for ensuring effective enforcement of the federal securities laws, explicitly recognizing this function in developing the rule. By accepting FOTM, Basic empowered private securities fraud litigation to serve as a tool for effective enforcement and created the opportunity for the development of the modern securities fraud class action. Similarly, Congress responded in the PSLRA to concerns about abusive litigation with a range of procedural reforms expressly targeted to the class action (Fisch 1997). Section 21D(a) of the PSLRA is entitled “Private Class Actions” and introduces a range of reforms that apply exclusively to securities fraud class actions.33 These reforms placed additional burdens on investors seeking to bring class actions, in an effort to reduce abusive litigation. By tailoring the structure of the class action rather than eliminating it, the PSLRA reflected an implicit congressional decision to retain the class action mechanism and the FOTM theory that made it possible (Black 2009). Importantly, the adoption of these reforms made little sense absent a desire to retain class actions (Langevoort 2015). More broadly, the PSLRA can be understood as a legislative compromise in furtherance of two competing goals: reducing burdensome and potentially frivolous litigation, while preserving the ability of investors to pursue meritorious claims. Empirical evidence suggests that Congress was successful in achieving both goals. Studies show that the adoption of the PSLRA’s heightened pleading standard facilitated courts’ ability to dismiss weak cases (Johnson et al. 2007). A further effect is that, according to some studies, plaintiffs’ lawyers screen more diligently for case quality and do not even file weak cases (Choi et al. 2009). Moreover, because of the PSLRA’s discovery stay, these cases do not impose burdensome litigation costs upon defendants (Klausner et al. 2013). At the same time, the lead plaintiff provision of the PSLRA has dramatically increased the involvement of large institutional investors in securities fraud class actions (Perino 2012). In turn, this has had the effect of increasing settlement amounts in meritorious cases and reducing the fees paid to class counsel (Choi 2005; Perino II 2012). Congress’s adoption of SLUSA reflected similar objectives and enhanced the effectiveness of the PSLRA reforms. SLUSA was adopted in response to efforts by plaintiffs to avoid the procedural requirements of the PSLRA by litigating securities fraud class actions in state court, and eliminated these efforts by preempting state court litigation. Significantly, SLUSA, by its terms, applies to “covered class actions,” demonstrating both an effort to retain the class action mechanism and to ensure that this litigation takes place in federal court under the provisions of the PSLRA.34 In addition, Congress defined the term “covered class action” explicitly to incorporate the FOTM presumption.35

32   Brief for Amici Curiae Civil Procedure and Securities Law Professors in Support of Respondent, Amgen Inc. v. Conn. Ret. Plans & Trust Funds, 133 S. Ct. 1184 (2013) (No 11-085). 33   15 U.S.C. § 78u-4(a) (2014). 34   A “covered class action” is defined as a class action where “damages are sought on behalf of more than 50 persons or prospective class members, and questions of law or fact common to those persons or members of the prospective class, without reference to issues of individualized reliance on an alleged misstatement or omission, predominate.” Ibid § 78bb(f)(5)(B)(i)(I). 35   See ibid.

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18  Research handbook on representative shareholder litigation The foregoing process can be understood as sequential collaboration between the Court and Congress. First, the Court acted in Basic to identify the need for the fledgling class action mechanism to enable the cost-effective litigation of private securities fraud claims in order to ensure the litigation served as a viable means of enhancing enforcement. The SEC evaluated the role of private litigation and defended the class action to the Court and Congress as a necessary supplement to public enforcement. Congress, after observing the development of the class action mechanism, adopted various procedures to refine its operation in securities fraud cases. These adjustments offered the potential for securities fraud class actions to offer more effective deterrence by increasing case quality and limiting the potential for frivolous litigation. The iterative adjustments to the securities fraud class action can be understood as a type of lawmaking partnership in which both the Court and Congress have recognized the objective of structuring a procedural device that facilitates effective enforcement of the disclosure obligations of the federal securities laws and affirmatively acted to further that objective. Because of Congress’s role in responding to Basic and revising the nature of the securities fraud class action in important ways, Basic and its progeny are not properly understood simply as judicial interpretations of section 10(b) of the 1934 Act. In the PSLRA and SLUSA, Congress did more than acquiesce in judicial lawmaking; Congress embraced and sought to improve upon the Court’s work. This lawmaking partnership puts FOTM on a different legal footing than the standard interpretation of a federal statute. Unlike cases of legislative silence, in which multiple inferences can be drawn from Congress’s failure to act, Congress has taken affirmative action by collaborating with the Court to refine the class action mechanism. Put differently, Congress has expanded upon the “building block” of Basic. This expansion reinforces the Basic decision as presumptively correct. Importantly, this chapter reads congressional lawmaking with respect to the securities fraud class action as an implicit endorsement of Basic. Concedly an implicit endorsement is different from an explicit congressional statement codifying the judge made law. Indeed, in the PSLRA, Congress expressly stated that it was neither codifying nor rejecting any implied private right of action. As will be developed further later in the chapter, Congress might have a variety of reasons for failing to codify such a right of action expressly, including political constraints and a reluctance to constrain the scope of future judicial interpretation. These considerations, as will be discussed, are fundamental reasons for the use of a lawmaking partnership in preference to constraining judicial lawmaking through a more restrictive statute. The implications of the lawmaking partnership constitute more than a reason for the Court not to overrule a prior interpretive decision, however. The collaboration reflected in the partnership context suggests that the Court should understand congressional interventions such as the PSLRA as refinements rather than rejections of its approach. 2.3  Conceptualizing the Lawmaking Partnership Halliburton II’s decision to reaffirm Basic is supported by the collaboration between Congress and the Court reflected in their lawmaking partnership. The use of such a lawmaking partnership is not unique to securities fraud litigation, however. Other areas in which Congress and the Court have engaged in collaborative lawmaking warrant a similar

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The development of securities litigation  19 analysis. Simply put, judge made law in the form of a statutory interpretation that has been developed or reinforced through a lawmaking partnership should be viewed by the courts as presumptively correct absent clear congressional action overruling it. A lawmaking partnership, as described in this chapter, has three distinctive features. First, the original statute must be open-textured so as to contemplate judicial lawmaking through the process of statutory interpretation. Second, Congress and the Court must engage in sequential adjustments, in each case cognizant of and responding to concerns that are raised in the other forum. Third, Congress and the Court must make these adjustments to further a common objective. Each of these features is a necessary component of a lawmaking partnership. The first, an open-textured statute, has received considerable attention in the academic literature (Manning 2014). Commentators argue that Congress uses this type of legislation purposefully to enable a common law process (Sunstein 1989). Although this chapter does not take a normative position on whether such congressional delegations are desirable, it is reasonable to conclude that Congress chooses to use an open-textured statute in cases in which it contemplates a more expansive interpretive role for the courts. Reasons for this more expansive role might include limited congressional knowledge of the consequences of specific regulatory choices and a desire to encourage the type of evolutionary approach that characterizes common-law lawmaking (Eskridge 1989). The second feature, sequential adjustments by both the Court and Congress, distinguishes the lawmaking partnership from mere congressional inaction. By taking affirmative steps in response to judicial lawmaking, Congress demonstrates that its failure to reject features of the judge made law is not the result of political gridlock or inattention. By definition, congressional responsiveness to the Court’s interpretation reflects awareness of the Court’s actions. Similarly, the responsive legislation constitutes action rather than inaction, thereby belying arguments that Congress was unable to react to an erroneous interpretation because of gridlock, other policy priorities, or inertia. Finally, a lawmaking partnership is characterized by a common set of policy objectives. This distinguishes the lawmaking partnership as a common enterprise rather than two actors that are competing or working at cross purposes. Specifically, congressional responses to the Court’s interpretation should reflect a consistency rather than a replacement of the policy objectives identified by the Court. Similarly, congressional action that seeks to correct errors in the Court’s approach or to update policies that have become obsolete would not qualify. In the context of private securities fraud litigation, the partnership structure offers distinctive lawmaking advantages. One advantage is that it enables Congress to achieve a level of political insulation with respect to its enforcement policy. Private securities fraud litigation is a political hot potato and, as a result, an area in which interest group politics is a particular concern (Levitan 2014). Corporate issuers and their executives face substantial liability risk in private litigation and incur considerable costs in both insurance and litigation defense. These defendants pressure Congress to reduce the scope of their liability risk by restricting private litigation. On the other hand, the plaintiffs’ bar is a formidable political force as well. One study reports that the amount donated by lawyers, primarily plaintiffs’ lawyers, to federal political candidates since 1990 is more than $1 billion (Copeland 2010). Putting aside the extent to which political donations and lobbying influence congressional policymaking, it is easier for Congress to delegate determination

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20  Research handbook on representative shareholder litigation of the scope of private litigation to the federal judiciary, which enjoys life tenure. Judicial lawmaking also provides a mechanism to overcome the gridlock that might result from high levels of interest group engagement. The lawmaking partnership also exploits the differential institutional competencies of courts and Congress. The evaluation of the scope and quality of private litigation is a subject that is peculiarly within the competence of the judiciary. The courts can readily observe the quality of private lawsuits and the extent to which litigation filings are correlated with serious misconduct. The courts can also determine the effect of various reforms such as a heightened pleading standard on litigation volume and case quality. At the same time, Congress has the capacity to consider evidence that the courts cannot observe. This evidence might include the effect of litigation costs on issuers’ decisions to go public or to list their securities in the United States, or the effect of private enforcement on the capital markets. Thus, even with a common objective, the courts and Congress can bring distinct issues of competence to the question of how best to achieve that objective. By delegating the development of private enforcement to the courts, Congress creates a potential check on the possibility of agency capture. The antifraud provision, like most of the federal securities laws, can be enforced by the SEC as well as private litigants. Some commentators have advocated for the elimination of private securities fraud litigation, arguing for the superiority of public enforcement (Bratton & Wachter 2011). Yet the effectiveness of public enforcement depends critically on the SEC’s exercise of its enforcement authority (Langevoort 2006). An important constraint on public enforcement is the availability of resources—the SEC depends on Congress for funding, and Congress can limit enforcement activity just by pulling the purse-strings closed (Heminway 2005). In addition, the broad scope of regulation and actors subject to federal securities regulation requires the SEC to make policy choices. SEC officials and staff may make such choices for a variety of reasons—such as a desire to appeal to the media, to further personal career objectives, or to assuage congressional critics. The courts are particularly well positioned to observe the areas in which SEC enforcement operates effectively. Although the courts cannot address deficiencies in public enforcement directly, they can identify those areas in which private enforcement is serving as a useful supplement by targeting conduct or defendants that are not the focus of the regulators (Cox 2005). Finally, the lawmaking partnership offers a dynamic process. Common law adjudication has long been defended on the basis of its ability to operate incrementally and to evolve in response to changing circumstances (Fisch 2000). These features prevent the type of obsolescence that can occur in both congressional and agency lawmaking. In the context of financial regulation, this flexibility and responsiveness are particularly valuable because of the speed at which the market changes, creating new regulatory demands. Again, the case of federal securities fraud offers an illustration. The public capital markets have shifted, over the past 60 years, from retail to largely institutional markets in which disclosure takes place primarily through the internet, and which feature new types of traders and financial instruments. As the nature of the market changes, so do the nature of securities fraud and the scope of litigation necessary to deter such fraud effectively, as well as the costs and benefits of an enforcement regime. A lawmaking partnership allows the different expertise and informational access of the courts and Congress to identify and respond to these developments. For example, Basic

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The development of securities litigation  21 responded to the impersonal nature of the public capital markets by recognizing the difficulty for investors of proving reliance directly. The PSLRA responded to the emergence of institutional investors by harnessing their larger stakes and greater sophistication in the form of the lead plaintiff as a way of controlling litigation decisions. SLUSA responded to an effort by the plaintiffs’ bar to shift litigation into state courts in order to avoid provisions such as the discovery stay.

3. THE LAWMAKING PARTNERSHIP AND INSIDER TRADING 3.1  Congressional and Judicial Development of Insider Trading Regulation The analysis in this chapter is applicable beyond federal securities fraud. Although consideration of the lawmaking partnership in the context of other statutory schemes is beyond the scope of this chapter, securities regulation alone offers numerous instances in which the collaborative interplay of congressional and judicial lawmaking suggests that the Court should apply a more flexible and goal-oriented approach to interpreting the applicable statute.36 Within federal securities fraud, evidence of a lawmaking partnership might inform the Court’s analysis of a variety of issues.37 One such issue is insider trading. Federal insider trading liability is based on section 10(b), the same general antifraud provision that provides the basis for private securities fraud litigation discussed earlier in this chapter. The statute itself contains no reference to insider trading or nonpublic information (Brachman 2013). Instead, insider trading liability has been developed through the joint actions of the Court and Congress. In Chiarella v. United States, the Court first accepted the premise that trading on material inside information could constitute securities fraud.38 The Court’s holding was restrictive, however; it concluded that insider trading liability required a breach of fiduciary duty. Importantly, the Court observed that its decision was not grounded in the statutory text or a finding of congressional intent, noting that “neither the legislative history nor the statute itself affords specific guidance” as to the circumstances in which “silence may constitute a manipulative or deceptive device.”39 Chiarella did not address situations in which insiders, rather than trading themselves, disclose inside information to others who subsequently trade. In 1983, the Court addressed this so-called “tipping” in Dirks v. SEC.40 Importantly, Dirks reinforced the Court’s holding in Chiarella that insider trading required a predicate breach of fiduciary duty and concluded that tippees could only be liable if the tipper breached a fiduciary duty in disclosing the inside information and if the tippee knew of the breach. Dirks 36   Similarly, the courts should consider the existence of a partnership in evaluating the legitimacy of agency rulemaking. Fisch (2013 II). 37   See Fisch (2016) (identifying other issues to which the lawmaking partnership may be applicable and the implications of applying that approach). 38   445 U.S. 222 (1980). 39   Ibid at 226. 40   463 U.S. 646 (1983).

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22  Research handbook on representative shareholder litigation further explained that a tipper breached his or her duty by receiving a personal benefit in exchange for the tip or if he or she intended to bestow a gift on the recipient.41 Many commentators were dissatisfied with the limitations on insider trading liability imposed by the Chiarella and Dirks decisions (Phillips & Lavoie 1988). Commentators also raised objections to the regulatory ambiguity (Painter et al. 1998). As Senator Alfonse D’Amato observed: “the present state of uncertainty about the law is simply not acceptable.”42 Between 1986 and 1988, Congress held four separate sets of hearings devoted specifically to insider trading regulation (Joo 2007). In 1984, Congress adopted its first response to the Chiarella and Dirks decisions. The Insider Trading Sanctions Act of 1984 did not revise the judicial approach to insider trading liability or expand the scope of the prohibition but merely made minor modifications to insider trading liability, including a prohibition on the trading of options and other derivatives in circumstances in which it would be illegal to trade stock and a provision providing for treble damages.43 The statute suggested that Congress was aware of the scope of insider trading liability reflected in the Dirks and Chiarella decisions and chose not to alter it. Despite the urging of several witnesses, Congress did not adopt a formal definition of insider trading in the statute (Painter et al. 1998). In 1987, in response to a request from the Senate Securities Subcommittee, the SEC drafted proposed legislation that would have provided a definition of insider trading and modified several aspects of the Supreme Court’s decisions (Macey 1988). A specific issue that had divided lower courts was the extent to which insider trading liability could be premised on an alternative theory: the misappropriation theory (Weiss 1998). The SEC’s draft legislation sought to codify the misappropriation theory and to specify the circumstances and relationships that might give rise to a predicate duty (Macey 1988). Instead, in the Insider Trading and Securities Fraud Enforcement Act of 1988 (“ITSFEA”), Congress increased the penalties for insider trading and also added a private remedy for contemporaneous traders.44 Notably, however, Congress did not codify the misappropriation theory, which was enjoying general acceptance in the lower courts. Rather, the ITSFEA contained explicit findings that the SEC’s rules regarding insider trading were “necessary and appropriate,” and that it had “enforced such rules and regulations vigorously, effectively, and fairly.”45 As Steve Thel argues, these findings can be read as a congressional endorsement of the misappropriation theory (Thel 1997). The Supreme Court finally accepted the misappropriation theory in O’Hagan.46 The O’Hagan decision departed from the narrow approach to insider trading liability reflected in Chiarella and Dirks, relying instead on policy considerations to support its characterization of misappropriation as informational fraud. As Justice Ginsberg explained,

  Ibid at 663–64.  133 Cong. Rec. S16,393 (daily ed. June 17, 1987) (statement of Sen. Alfonse D’Amato). 43   Insider Trading Sanctions Act of 1984, 15 U.S.C. §§ 78c, 78o, 78t, 78u, 78ff (2014). 44   Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No 100-704, 102 Stat. 4677 (1988). 45   Ibid § 2. 46   United States v. O’Hagan, 521 U.S. 642 (1997). The misappropriation theory was based on language in Chief Justice Burger’s dissent in Chiarella. See Chiarella v. United States, 445 U.S. 222, 243–45 (1980) (Burger, C.J., dissenting). 41 42

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The development of securities litigation  23 the misappropriation theory is “tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence.”47 Although O’Hagan did not eliminate all confusion over the scope of insider trading liability exposure, the Court’s acceptance of the misappropriation theory reduced the pressure on Congress to adopt insider trading legislation. This outcome was viewed as less than optimal by some commentators who had argued that the scope of insider trading liability should be definitively resolved through legislation (Nagy 1998). Congress subsequently passed the Stop Trading on Congressional Knowledge Act (“STOCK Act”) which prohibits members of Congress from trading on inside information.48 Two aspects of the STOCK Act reinforce the characterization of the development of insider trading regulation as a collaborative process. First, Congress again declined to provide a statutory definition of insider trading. Second, in extending the prohibition, Congress incorporated the fiduciary duty approach reflected in the Court’s decisions. Specifically, the Act provides that members of Congress owe a duty of trust and confidence to Congress, the federal government, and US citizens “solely for purposes of the insider trading prohibitions.”49 3.2  A Third Partner—The SEC The example of insider trading introduces an additional dynamic into the lawmaking process—the SEC.50 The SEC’s initial role in developing insider trading law took the form of bringing enforcement actions that were, in some cases, supplemented by Department of Justice criminal prosecutions. It was the SEC—not Congress or the courts—that made the initial decision to use the general antifraud provision as a basis for imposing insider trading liability.51 Subsequently, the SEC’s enforcement actions have repeatedly tested the boundaries of existing law and offered new theories of liability (Park 2012). The SEC also responded to restrictive judicial decisions through formal rulemaking. For example, the SEC responded to the narrow scope of the Chiarella decision by promulgating Rule 14e-3, which prohibits insider trading in connection with a tender offer and does not require a fiduciary duty.52 The SEC responded to the information asymmetries authorized by the Dirks decision by adopting Regulation FD.53 The SEC also codified its expansive approach to Rule 10b-5 by promulgating Rules 10b5-1 and 10b5-2.54 Including the SEC in the lawmaking partnership adds an additional dimension to the lawmaking process. In many cases, Congress and the Court have embraced the SEC’s lawmaking initiatives, agreeing that the SEC’s approach furthered their common policy

  Ibid at 658.   Stop Trading on Congressional Knowledge Act of 2012 (“STOCK Act”), Pub. L. No 112105, 126 Stat. 291 (2012). 49   Ibid § 4(g)(1). 50   Commentators have devoted considerable energy to debating the appropriate extent to which Congress should delegate lawmaking authority to federal agencies. (Lemos 2010). 51   See In re Cady, Roberts & Co., 40 S.E.C. 907, 912 (1961). 52   17 C.F.R. § 240.14e-3 (2015). 53   17 C.F.R. § 243.100 (2015). 54   17 C.F.R. §§ 240.10b5-1 & 10b5-2 (2015). 47 48

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24  Research handbook on representative shareholder litigation objectives. Thus, for example, Congress explicitly found, in section 2 of the ITSFEA, that the SEC’s rules and regulations governing insider trading were “necessary and appropriate,” and that the Commission had “enforced such rules and regulations vigorously, effectively, and fairly.”55 Similarly in O’Hagan, the Court both accepted the misappropriation theory proffered by the government as encompassing the necessary deception required by its earlier decisions and upheld the SEC’s adoption of Rule 14e-3.56 In other cases, however, the Court has restrained the SEC’s enforcement zeal. As noted above, even as the Court accepted insider trading liability in Chiarella, and extended that liability to tippees in Dirks, it held that the SEC’s desired scope of liability was too broad. In particular, the Court rejected the SEC’s desired parity-of-information standard. Similarly, in Dirks, the Court insisted that tippee liability be premised both upon a breach of fiduciary duty and the tippee’s awareness of that breach, finding support for this approach in the scienter requirement. Recent enforcements by the SEC have raised similar concerns in the lower courts. Mark Cuban fought a five-year battle with the SEC and won, along the way raising concerns about the validity of Rule 10b5-2 that the court took seriously (Isidore & Wallace 2013).57 In United States v. Newman, the Second Circuit overturned the convictions of two hedge fund managers, third- and fourth-degree “remote tippees,” suggesting the SEC’s prosecution theory stretched beyond the limits established by Dirks.58

4.  IMPLICATIONS OF THE PARTNERSHIP APPROACH As the foregoing analysis explains, insider trading law is the product of a lawmaking partnership. Insider trading liability is premised on section 10(b), an open-textured statute, and the Court, Congress, and the SEC have made multiple adjustments and refinements to insider trading regulation. In each case, these adjustments have been cognizant of and responsive to the efforts of other lawmaking partners. Finally, as with private securities fraud litigation, the lawmaking enterprise seeks to appear to share the common objectives of addressing information disparities in the securities markets and maintaining public confidence while providing sufficient limiting principles to allow the information flow necessary to preserve healthy and efficient markets. Insider trading also demonstrates the advantages of the lawmaking partnership in developing financial regulation. Congress and the SEC, to some degree, have been responsive to politically based concerns such as the public demand for greater enforcement penalties in the wake of Wall Street scandals. The Court, with its greater degree of political insulation, is able to provide a constraint on excess enforcement zeal, balancing these demands with concerns over predictability, information flow, and market efficiency. Judicial oversight can also check headline-driven lawmaking agendas, pushing the SEC in particular to justify its regulatory choices. Thus, for example, the Court’s decision in Dirks 55   Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No 100-704, §2, 102 Stat. 4677, 4677 (1988). 56   United States v. O’Hagan, 521 U.S. 642, 655 (1997). 57   SEC v. Cuban, 634 F. Supp. 2d 713, 730–31 (N.D. Tex. 2009). 58   United States v. Newman, 773 F.3d 438, 443 (2d Cir. 2014).

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The development of securities litigation  25 led the SEC to focus its efforts on reducing information asymmetries on issuer disclosure rather than recipient use of material nonpublic information through the adoption of Regulation FD. The Second Circuit’s decision in Newman may similarly encourage the SEC to direct greater attention to tippers/sources rather than remote tippees. Congress also weighed in to readjust the SEC’s enforcement priorities with the adoption of the STOCK Act. Notably, prior to the legislation, no member of Congress had been the subject of an insider trading enforcement action, despite evidence suggesting widespread use of material nonpublic information (Brick 2013). Finally, the lawmaking partnership is well positioned to respond to the dynamic structure of the securities markets and the evolution of information flow due to changes in technology and market participants. Since the Chiarella decision, the markets have seen the emergence of many new types of traders and trading strategies—hedge funds, highfrequency traders, algorithmic trading, and index funds are all examples. Competition has led to new demands for information, which are met by innovations such as web crawlers, expert network firms, electronic road shows, and more. These developments offer new challenges—both in defining material nonpublic information and in identifying the manners of acquiring that information that should be characterized as improper. While the financial incentives for acquiring an informational advantage are higher than ever, the value of maintaining a rich information environment offers reasons to be cautious about expansive liability provisions. A lawmaking partnership is well suited to maintaining the necessary balance. These insights are of particular value in the aftermath of the Newman decision. Newman renewed the long dormant efforts to have Congress adopt a definition of insider trading (Henning 2015). Properly understanding insider trading regulation as the product of a lawmaking partnership, however, rebuts that claim and demonstrates that judicial oversight has provided a valuable counterbalance to regulatory excess while retaining flexibility to address market innovation. As former-SEC Chair Mary Jo White explained: “I think it’s challenging to codify [insider trading law] clearly in a way that is both not too broad and retains the strength of common law.”59 Moreover, the iterative process of adjudicative lawmaking itself offers the opportunity to reconsider and refine the scope of Newman, as illustrated by the Supreme Court’s subsequent decision in Salman v. United States.60 Salman reaffirmed the personal benefit requirement of Dirks but rejected a narrow interpretation of that requirement, holding that a tipper need not receive “something of a ‘pecuniary or similar nature’ in exchange for a gift to family or friends.”61 Critically, this rationale highlighted the fact that tips of inside information in the family context are distinctive, in that a tipper may receive a personal benefit simply as the result of making a gift of inside information to a close friend or family member (Fisch 2016 II). As a result, the Salman decision reinforced the fact that gifting inside information to family members is illegal, without undermining the concern reflected in Dirks that unduly 59   Ben Conarck, SEC’s White Says Agency Mulled Insider Trading Ban, Law360 (Mar. 24, 2015, 6:58 PM), www.law360.com/articles/635363/sec-s-white-says-agency-mulled-insider-tradingban (quoting then-SEC Chair Mary Jo White). 60   137 S. Ct. 420 (2016). 61   Id. at 428 (citing Newman).

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26  Research handbook on representative shareholder litigation expansive insider trading liability poses a threat to legitimate research and the market efficiency that results from that research (Perino 2014; Fisch 2016 II). The flexibility provided to the Court by the lawmaking partnership enabled it, in Salman, to structure a decision faithful to both these concerns. In playing this role, the Court demonstrated its continued fidelity to Congress’s objectives in developing the law of insider trading.

5. CONCLUSION A variety of structural and political pressures constrain the effectiveness of the lawmaking process with respect to financial regulation (Levitan 2014). The lawmaking partnership offers one possible response. Through a judicial–congressional collaboration, the lawmaking partnership enables the courts and Congress to temper their own institutional shortcomings. This has led, in the context of private securities litigation, to a balance that serves the dual objectives of investor protection and limiting the potential for litigation abuse. The structural advantages of the lawmaking partnership support both deference to this balance and a broader endorsement of the lawmaking partnership. In the case of Halliburton II, the implications of this analysis suggest that the Court reached the correct result in declining to overrule Basic, although perhaps for the wrong reasons. More broadly, the analysis suggests that the Court should be empowered to strike an appropriate balance with respect to the scope of private litigation under section 10(b). Evidence of a similar collaborative process should inform the Court’s analysis of insider trading liability. Because Congress has embraced the Court’s role in a lawmaking partnership and approved of the Court’s choice of regulatory objectives, the Court should view that participation as authorization to engage in its own policy analysis in furtherance of those objectives. Judicial lawmaking in this context should be understood not as unprincipled activism, but as consistent with a congressional choice of a lawmaking approach that offers distinctive advantages.

BIBLIOGRAPHY Arthur, Thomas C., 1986, “Farewell to the Sea of Doubt: Jettisoning the Constitutional Sherman Act,” California Law Review 74: 263. Black, Barbara, 2009, “Eliminating Securities Fraud Class Actions Under the Radar,” Columbia Business Law Review: 802. Brachman, Paul D., 2013, “Outlawing Honest Graft,” New York University Journal of Legislation and Public Policy 16: 261. Bratton, William W. & Michael L. Wachter, 2011, “The Political Economy of Fraud on the Market,” University of Pennsylvania Law Review 160: 69. Brick, Joshua Michael, 2013, “The Stock Act: Is It Necessary and If So Is It a Sufficient Solution?” Duquesne Business Law Journal 15: 179. Brief for Former SEC Commissioners and Officials and Law Professors as Amici Curiae in Support of Petitioners, 2014, Halliburton Co. v Erica P. John Fund, Inc., 134 S. Ct. 2398 (No 13-317). Choi, Stephen J. et al., 2005, “Do Institutions Matter? The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act,” Washington University Law Quarterly 83: 869. Choi, Stephen J. et al., 2009. “The Screening Effect of the Private Securities Litigation Reform Act,” Journal of Empirical Legal Studies 6: 35. Coffee, Jr, John C., 2013, “Introduction: Mapping the Future of Insider Trading Law: Of Boundaries, Gaps, and Strategies,” Columbia Business Law Review: 281.

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The development of securities litigation  27 Copeland, James R., 2010, “How the Plaintiffs Bar Bought the Senate,” Wall Street Journal, www.wsj.com/ articles/SB10001424052748703630404575053330978667138. Cox, James D. et al., 2005, “Public and Private Enforcement of the Securities Laws: Have Things Changed Since Enron?” Notre Dame Law Review 80: 893. Easterbrook, Frank H. & Daniel R. Fischel, 1989, “The Corporate Contract,” Columbia Law Review 89: 1416. Eskridge, Jr., William N., 1989, “Public Values in Statutory Interpretation,” University of Pennsylvania Law Review 137: 1007. Eskridge, Jr. William N., 1990, “The New Textualism,” UCLA Law Review 37: 621. Fallon, Jr., Richard H. & Daniel J. Meltzer, 2007, “Habeas Corpus Jurisdiction, Substantive Rights, and the War on Terror,” Harvard Law Review 120: 2029. Fisch, Jill E., 1997, “Class Action Reform: Lessons from Securities Litigation,” Arizona Law Review 39: 533. Fisch, Jill E., 2000, “The Peculiar Role of the Delaware Courts in the Competition for Corporate Charters,” University of Cincinnati Law Review 68: 1061. Fisch, Jill E., 2005, “Do Institutions Matter? The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act,” Washington University Law Review 83: 869. Fisch, Jill E., 2013, “The Trouble with Basic: Price Distortion after Halliburton,” Washington University Law Review 90: 895. Fisch, Jill E., 2013 II, “The Long Road Back: Business Roundtable and the Future of SEC Rulemaking,” Seattle University Law Review 36: 695. Fisch, Jill E., 2016, “The New Governance and the Challenge of Litigation Bylaws,” Brooklyn Law Review 81: 1637. Fisch, Jill E., 2016 II, “Family Ties: Salman and the Scope of Insider Trading,” Stanford Law Review Online 69: 46. Heminway, Joan MacLeod, 2005, “Rock, Paper, Scissors: Choosing the Right Vehicle for Federal Corporate Governance Initiatives,” Fordham Journal of Corporate and Financial Law 10: 225. Henning, Peter J., 2015, “Court Strikes on Insider Trading, and Congress Lobs Back,” New York Times Dealbook, www.nytimes.com/2015/03/17/business/dealbook/court-strikes-on-insider-trading-and-congresslobs-back.html. Isidore, Chris & Gregory Wallace, 2013, “Jury Rules for Mark Cuban in Insider Case,” CNN Money, http:// money.cnn.com/2013/10/16/investing/cuban-verdict/. Johnson, Marilyn F. et al., 2007, “Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act,” Journal of Law, Economics & Organization 23: 627. Joo, Thomas W., 2007, “Legislation and Legitimation: Congress and Insider Trading in the 1980s,” Indiana Law Journal 82: 575. Kaufman, Michael J., 1990, “The Uniform Rule of Liability Under the Federal Securities Laws: The Judicial Creation of a Comprehensive Scheme of Investor Insurance,” Temple Law Review 63: 61. Klausner, Michael et al., 2013, “When Are Securities Class Actions Dismissed, When Do They Settle, and for How Much? An Update,” http://ssrn.com/abstract=2260831. Langevoort, Donald C., 2006, “The SEC as a Lawmaker: Choices About Investor Protection in the Face of Uncertainty,” Washington University Law Review 84: 1591. Langevoort, Donald C., 2015, “Judgment Day for Fraud-on-the-Market: Reflections on Amgen and the Second Coming of Halliburton,” Arizona Law Review 57: 37. Lemos, Margaret H., 2010, “The Consequences of Congress’s Choice of Delegate: Judicial and Agency Interpretations of Title VII,” Vanderbilt Law Review 63: 361. Levitan, Adam J., 2014, “The Politics of Financial Regulation and the Regulation of Financial Politics: A Review Essay,” Harvard Law Review 127: 1991. Levitt, Arthur, 1995, Chairman, U.S. Sec. & Exch. Comm’n, “Testimony Concerning Litigation Reform Proposals Before the Subcommittee on Telecommunications and Finance, Committee on Commerce,” United States House of Representatives, www.sec.gov/news/testimony/testarchive/1995/spch025.txt. Macey, Jonathan R., 1988, “SEC’s Insider Trading Proposal: Good Politics, Bad Policy,” Cato Institute of Policy Analysis No 101, www.cato.org/publications/policy-analysis/secs-insider-trading-proposal-goodpolitics​-bad-policy. Manning, John F., 2014, “Chevron and Legislative History,” George Washington Law Review 82: 1517. Nagy, Donna M., 1998, “Reframing the Misappropriation Theory of Insider Trading Liability: A Post-O’Hagan Suggestion,” Ohio State Law Journal 59: 1223. Painter, Richard W. et al., 1998, “Don’t Ask, Just Tell: Insider Trading after United States v. O’Hagan,” Virginia Law Review 84: 153. Park, James J., 2012, “Rules, Principles, and the Competition to Enforce the Securities Laws,” California Law Review 100: 115. Perino, Michael, 2012, “Have Institutional Fiduciaries Improved Securities Class Actions? A Review of the Empirical Literature on the PSLRA’s Lead Plaintiff Provision,” http://ssrn.com/ abstract=2175217.

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28  Research handbook on representative shareholder litigation Perino, Michael, 2012 II, “Institutional Activism Through Litigation: An Empirical Analysis of Public Pension Fund Participation in Securities Class Actions,” Journal of Empirical Legal Studies 9: 368. Perino, Michael, 2014, “The Gift of Inside Information,” New York Times, December 12, 2014. Phillips, Richard M. & Larry R. Lavoie, 1988, “The SEC’s Proposed Insider Trading Legislation: Insider Trading Controls, Corporate Secrecy, and Full Disclosure,” Alabama Law Review 39: 439. Sunstein, Cass R., 1989, “Interpreting Statutes in the Regulatory State,” Harvard Law Review 103: 405. Thel, Steve, 1997, “Statutory Findings and Insider Trading Regulation,” Vanderbilt Law Review 50: 1091. Weiss, Elliot J., 1998, “United States v. O’Hagan: Pragmatism Returns to the Law of Insider Trading,” Journal of Corporation Law 23: 395.

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2.  Securities class actions and severe frauds James J. Park

1. INTRODUCTION Congress passed the Private Securities Litigation Reform Act (“PSLRA”) in 1995 to reduce the filing of securities class actions without merit. Much of the scholarship prior to the passage of the PSLRA, as well as its legislative history, reflected a particular narrative about such litigation. The typical case was understood to be a strike suit against an emerging technology company with a volatile stock price. Class action attorneys filed complaints without any evidence of fraud with the hope of extorting a settlement. This portrayal of securities litigation was difficult for opponents of the PSLRA to rebut. At the time, there were not many compelling examples of securities class actions with sufficient merit that could concretely illustrate the benefits of providing investors with a private action to address securities fraud. The PSLRA arguably failed in that it did not reduce the costs of securities class actions. As critics of securities class actions have noted, the size of payments to settle such cases increased substantially in the decade or so after the PSLRA. One significant article began its argument that securities class actions for secondary market fraud should be eliminated by noting: “[m]ore than 3,200 private class action securities fraud lawsuits were filed between 1997 and 2013. Settlements in these actions generated more than $73 billion and comprise six of the ten largest settlements in class action history” (Grundfest 2014, 308). The implication of this preamble was that the PSLRA had failed to manage the costs of securities class actions and so the Supreme Court should do away with them entirely. This argument failed to persuade the Court, which reaffirmed the validity of the fraud-on-themarket presumption in its 2014 Halliburton v. Erica John Fund decision. This chapter will contend that the PSLRA’s impact on securities class actions should be understood in terms of the context of developments after its passage. In what was a fortuitous turn of events for the securities class action, the years after the PSLRA coincided with a period of significant accounting restatements. Some of these restatements helped trigger public company bankruptcies as well as Securities and Exchange Commission (“SEC”) enforcement. Securities class actions after the PSLRA thus often addressed what were believed to be severe frauds at large public companies. Though scholars have analyzed evidence that the PSLRA itself changed the types of cases brought by changing the definition of merit, less attention has been devoted to understanding how events after the PSLRA affected the types of securities class actions filed. The PSLRA’s assumption that securities class actions do no more than harass companies with volatile stock prices is no longer valid. The securities class action has evolved. In certain circumstances, securities class actions address severe fraud at established public companies. This chapter has five sections. Section 2 describes the early and unfavorable conception of the securities class action that influenced passage of the PSLRA. Section 3 discusses studies of the PSLRA’s effect on securities class actions. Section 4 considers how the 29

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30  Research handbook on representative shareholder litigation prevalence of significant accounting restatements by public companies after the passage of the PSLRA impacted securities class actions. Section 5 analyzes how perceptions of securities class actions have changed in response to these developments. Section 6 concludes.

2.  THE SECURITIES CLASS ACTION BEFORE THE PSLRA The PSLRA was primarily directed at securities class actions targeting technology companies with volatile stock prices. Scholars both before and after the passage of the PSLRA understood securities class actions as affecting certain industries that were vulnerable to strike suits. The PSLRA thus focused on reforms that would address such meritless litigation. In an influential article published in 1991, Professor Janet Cooper Alexander examined a sample of lawsuits relating to 17 initial public offerings of “computer and computerrelated companies during the first half of 1983” (Alexander 1991, 507). This set of cases involved an “especially risky segment of the stock market, initial public offerings, with a group of unproven companies in a highly competitive and volatile industry” (Alexander 1991, 507). The advantage of focusing on this particular industry was that it allowed for comparison of “virtually identical” lawsuits that should only vary based on the merits of the case (Alexander 1991, 509). The main finding of the study was that this small sample of securities class actions settled for similar amounts, indicating that the settlements were unrelated to the strength of the case. This story of a wave of strike suits that threatened to choke off innovative industries with meritless suits was understandably compelling to Congress as it considered the PSLRA.1 The Senate Committee on Banking, Housing, and Urban Affairs referred to a “rising tide of frivolous securities litigation” that targeted “American business, particularly younger companies in the high-tech area.”2 The House of Representatives Committee on Commerce issued a report asserting that the “typical case involves a stock, usually of a high-growth, high-tech company, that has performed well for many quarters, but ultimately misses analysts’ expectations.”3 The Committee described these suits as routinely filed after a stock price decline without any evidence of wrongdoing.4 The opponents of the PSLRA were unable to construct a compelling counternarrative by pointing to particular cases that exemplified the virtue of the securities class action. A prominent defense of the securities class action declared that “The Merits Do Matter,” but

1   It is important to note that the perception of the securities class action was far from uniform. One article described securities class actions as being primarily directed at companies facing the possibility of failure. It found that more than half of securities class actions might involve such a situation (Arlen & Carney 1992, 725). The data it cited was limited, though, in that it had settlement and judgment data for only about nine cases (Arlen & Carney 1992, 740). 2   S. Comm. on Banking, Hous., and Urb. Affairs, Private Securities Litigation Act of 1995, S. Rep. 104-98 at 38 (1995). 3   H. Comm. on Comm., Common Sense Legal Reforms Act of 1995, H. Rep. 104-50 at 15 (1995). 4   Ibid at 16.

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Securities class actions and severe frauds  31 spent most of its time criticizing studies by defenders of the PSLRA. The article did not advance examples of cases with merit, perhaps because there were not many prominent examples of such cases (Seligman 1994, 450). It rested its defense mainly on the standard law and economics point that private litigation can deter fraud (Seligman 1994, 455). Such a theoretical argument may not have been compelling to Congress in light of the particular costs that were borne by issuers and other defendants. The influence of the technology company narrative continued for some time after the passage of the PSLRA. One of the most comprehensive empirical studies of securities class actions focused on about 3,500 firms conducting an IPO from 1975 to 1986, in part because “new-growth companies often have volatile stock prices and lack a disclosure track record, making them particularly vulnerable to strike suits” (Bohn & Choi 1996, 908). The study concluded “that most securities-fraud class actions are, in fact, frivolous” (Bohn & Choi 1996, 979). A number of event studies tested the impact of the PSLRA on the value of firms and, tellingly, focused on technology firms. Spiess and Tkac looked at firms in the biotechnology, computer, electronic, and retail industries. They found positive stock returns on the date that Congress voted to override President Clinton’s veto of the PSLRA (Spiess & Tkac 1997). Johnson, Kasznik, and Johnson similarly looked at firms in the pharmaceuticals, computer hardware, and computer software industries, also finding positive returns associated with the veto override (Johnson, et al. 2000). A study by Pritchard, Johnson, and Nelson tested the impact of a more restrictive scienter standard set forth by the U.S. Court of Appeals for the Ninth Circuit. It looked at a sample of 277 technology firms and found a positive stock market reaction to the decision (Pritchard, et al. 2000). The approach of these studies reflected the understanding in the 1990s that securities class actions were primarily a burden on a particular type of firm. Their findings implied that limiting securities class actions would increase the economic value of technology firms that would no longer have to face the threat of a strike suit.

3. THE IMPACT OF THE PSLRA ON SECURITIES CLASS ACTIONS The PSLRA undeniably influenced the sorts of securities class actions that plaintiffs filed after its passage. By changing the definition of merit and encouraging investors with substantial losses to participate in such litigation, the PSLRA created incentives to bring certain types of lawsuits. Empirical studies have found that cases filed after the PSLRA are more likely to include allegations that meet the PSLRA’s requirements. Thus, there is an argument that the PSLRA resulted in the filing of more meritorious securities class actions. By requiring a description of facts in the complaint that would support a “strong inference” of fraudulent intent, the PSLRA favors cases that describe “hard evidence” of securities fraud. A case that simply alleges fraud in conclusory terms and points to a stock price decline is unlikely to survive the motion to dismiss. Because plaintiffs do not have access to the company’s internal files prior to filing the complaint, they must rely on external information indicating the possibility of fraud. Writing soon after the passage of the PSLRA, Professor John Coffee predicted that as a result of the higher standard for

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32  Research handbook on representative shareholder litigation finding scienter, securities class actions might shift to targeting financial statement fraud as opposed to the accuracy of projections (Coffee 1996). Consistent with this prediction, plaintiffs began to base their complaints on publicly available indicators of fraud. One common sign of an accounting fraud is a restatement of the company’s financial statements. In such a restatement, the company concedes that there is an error in its accounting. Though a mistake by itself is not fraudulent, a severe mistake might be an indicator of recklessness that would support a theory of securities fraud. Another event that could signal fraud is unusual insider trading by executives connected with a misstatement. If directors and officers aggressively sell stock during the period of the fraud, it might indicate that they deliberately inflated the stock price for their own advantage. Studies have compared securities class actions filed before the PSLRA with securities class actions filed after the PSLRA and found that the cases filed after the PSLRA are more likely to allege an accounting restatement and abnormal insider trading (Johnson, et al 2006). Another study found that the PSLRA had a screening effect in that plaintiffs were less likely to file lawsuits without hard evidence of securities fraud than prior to the PSLRA (Choi, et al 2009). The PSLRA affected not only the filing of cases, but also their outcomes. Securities class actions without hard evidence of fraud were more likely to be dismissed or settle for nominal amounts after the PSLRA (Choi 2016), and cases alleging a restatement were more likely to settle than end in dismissal (Johnson, et al 2006). In addition to increasing the burden of showing merit at an early stage of the case, the PSLRA created a presumption that the lead plaintiff of the class should be the investor who suffered the largest loss from the alleged fraud. In doing so, the PSLRA encouraged the participation of sophisticated institutional investors in securities class actions. Such investors, often public pension funds, are more qualified than most individuals to monitor the attorneys representing the class, making it less likely that they will quickly settle good cases for too little. Because such monitoring is somewhat costly, one would expect that an institutional investor would be more likely to choose to apply for lead plaintiff status in cases where it believed the merits are strong. Thus, the appointment of an institutional lead plaintiff might signal that a particular case is meritorious. Consistent with this analysis, studies have found that securities class actions with institutional lead plaintiffs tend to be more meritorious on average than cases where a retail investor is the lead plaintiff. Numerous studies have found that securities class actions with a public pension fund lead plaintiff are more likely to result in a higher value settlement (Choi, et al 2005; Cox, et al 2006; Cheng, et al 2010; Perino 2012). There is also evidence that attorney fee awards are lower in cases with pension fund lead plaintiffs (Perino 2012). The increase in settlement values after the PSLRA is thus not necessarily evidence that the PSLRA failed to screen meritorious cases. Rather, part of the increase can be attributed to increasing involvement by institutional investors who can identify meritorious cases and push for larger settlements in such cases.

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Securities class actions and severe frauds  33

4.  SEVERE FRAUDS AND SECURITIES CLASS ACTIONS The PSLRA was not the only factor that influenced securities class actions after 1995. As noted earlier, the period after the passage of the PSLRA saw a rise in the number of substantial settlements of securities class actions. Some of this increase can be explained by changes in the incentives to bring cases with hard evidence of fraud as well as the increasing involvement of pension fund lead plaintiffs. But much of the rise in large settlements also reflects a period of increasingly large accounting restatements that started soon after the PSLRA. The rise and fall of the first internet stock bubble surely played a role in the rise of notable securities class actions filed after the PSLRA. Just a few years after Congress passed the PSLRA, the stock market rose steeply as investors became more willing to believe that the internet offered companies unprecedented opportunities for profit. The inflation of a bubble typically creates opportunities for speculative companies to thrive. When investors are optimistic, they are willing to focus on the future prospects of a company rather than whether there is a risk of fraud. When investor sentiment turns, and the bubble deflates, the resulting decline in stock market prices can make it difficult for a company to continue a fraud that started when times were good. Moreover, even companies that did not commit fraud might find themselves vulnerable to allegations of fraud when their stock prices decline and disgruntled investors try to recover their losses. The political climate might be conducive to aggressive litigation by both private parties and government enforcers. The securities class actions against Enron and WorldCom are perhaps the most prominent cases that can be linked to the fall of the internet bubble. Both companies saw great success in an era when investors were willing to speculate on the future. Enron was a company that promised to both revolutionize the energy market and create a wide range of innovative ventures. WorldCom was a telecommunications company that sought to capitalize on a growing market spurred by regulatory changes in that industry. Both companies fell in the wake of the collapse of the internet bubble in the early 2000s, as willingness to believe in the future profitability of innovative companies subsided and the economy declined. The unraveling of these companies was also spurred by the discovery of fraud that resulted in accounting restatements. Enron was found to have utilized special purpose vehicles to hide significant amounts of its debt from the market. WorldCom brazenly inflated its profits by misclassifying what were clearly expenses. High-level executives at both companies were convicted of criminal securities fraud and sentenced to substantial prison terms. Though it is difficult to deny that there was significant fraud at both of these companies, there might be an argument that some of their troubles were the result of the misfortune of significant market shifts that caused substantial stock price declines. While the deflation of the internet bubble was an important reason for the increase in very large securities class action settlements, it was not the only cause. Many significant securities class actions were filed prior to the collapse of the internet bubble. These cases often alleged earnings manipulation by companies that were often acknowledged by restatements. Securities class actions were filed against companies restating their earnings, such as Cendant, HealthSouth, Rite Aid, and Sunbeam, prior to 2000. Each of these cases resulted in a settlement of more than $300 million (Park 2014, 610).

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34  Research handbook on representative shareholder litigation The number of accounting restatements significantly rose in the period after the PSLRA. A study by the United States Government Accountability Office reported that the number of restatement announcements by public companies rose from 92 in 1997 to 225 in 2001; and reached 523 in 2005 (US Government Accountability Office 2006, 12). The same study found that the percentage of listed public companies restating their earnings rose from 8 percent in the period 1997–2001 to 16 percent in 2002–5 (US Government Accountability Office 2006, 12). The size of restatements also increased significantly, ranging into the billions of dollars for some companies: Xerox inflated its earnings by $1.5 billion dollars, WorldCom inflated profits by $11 billion, Qwest inflated its revenues by $3.8 billion (Park 2009, 54). One explanation for the rise in restatements was greater SEC scrutiny of earnings reports. In a famous 1998 speech at NYU Law School, Chairman Arthur Levitt famously highlighted what he called the “earnings game,” where companies manipulated revenue rules to meet earnings projections (Levitt 1998). Soon after, as might have been predicted after a policy-setting speech by its chairman, SEC enforcement activity targeted public company accounting. The number of SEC enforcement actions relating to financial reporting rose from 79 in 1998 to 199 in 2003 (US Government Accountability Office 2006, 43). The SEC also began asserting its power to assess penalties more aggressively with regard to larger public companies (Cox & Thomas 2005). The SEC made it clear that it would evaluate financial misstatements based on a broader qualitative materiality standard that did not rely on strict numerical cutoffs (SEC 1999). The increasing threat of SEC scrutiny, coupled with a much broader materiality standard for financial misstatements, likely contributed to companies voluntarily restating their earnings. Thus, the rise in securities class actions alleging restatements likely reflected not only an increased incentive to allege restatements in private securities class action complaints, but also a greater opportunity to do so as the number of restatements grew. Restatements increased not only in number, but also in size. Multibillion-dollar restatements became more common. As a result, the potential damages that could be attributed to the fraud also grew. As restatements became larger, they potentially affected the solvency of even large public corporations. Enron and WorldCom are both examples of companies that filed for bankruptcy after a substantial restatement. The number of large public companies that filed for bankruptcy rose from 20 in 1995 to 97 in 2001 (LoPucki Bankruptcy Research Database). The percentage of securities class actions involving a bankrupt company rose from approximately 15 percent in 1996 to 25 percent in 2001 (Park 2013, 561). It is worth noting that the impact of a fraud resulting in bankruptcy would have a permanent rather than temporary impact on the company’s stock price. The increase in the severity of fraud after the PSLRA is roughly reflected by an increase in cases in which bondholders received part of the recovery. Because bondholders have bankruptcy priority over shareholders, only a fraud that threatens the solvency of the company will significantly affect bond prices. When there is such a substantial fraud, bond investors often have a right to bring a securities class action. From 1996 to 2000, only 3 percent of securities class action settlements involved some recovery by bondholders. From 2001 to 2005, almost 8 percent of securities class action settlements resulted in a bondholder recovery. Additionally, 19 of the largest 30 settlements from 1996 to 2005 involved a bondholder recovery (Park 2014).

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Securities class actions and severe frauds  35 An argument might be made that there was a causal link between events protecting defendants from securities fraud liability and the increase in accounting restatements. Auditors were shielded by not only the PSLRA, but also the Supreme Court’s 1994 decision in Central Bank v. First Interstate Bank.5 That decision eliminated Rule 10b-5 aiding and abetting liability, making it more difficult for plaintiffs to sue secondary actors such as auditors. Without the deterrent of Rule 10b-5, auditors may have perceived that they would not be held responsible for failing to stop questionable accounting by their clients (Coffee 2004). However, it is unlikely that auditor attitudes changed so quickly that these developments can be said to have caused a rise in restatements. Regardless of the cause of the increase in restatements, securities class actions changed in response to the increased scrutiny of public company accounting. The typical defendant named in such a case is not necessarily an emerging technology company, but can be an established public corporation from a wide variety of industries. Cases are more typically triggered by a significant accounting error or SEC investigation rather than solely by a drop in the stock price. Many cases target permanent declines in value rather than temporary stock price fluctuations.

5. IMPLICATIONS FOR THE FUTURE OF SECURITIES CLASS ACTIONS The increasing severity of fraud after the PSLRA changed not only the type of securities class actions that were brought, but also what we might think of as the typical securities class action. It is now difficult to describe all securities class actions as reflecting strike suits against emerging technology companies. Instead, they often target hard evidence of fraud that can result in real destruction in value. Regardless of whether these restatements reflected an increase in fraud, courts believed that they did and became less likely to dismiss securities class actions that they perceived to be meritorious. Cases such as Enron and WorldCom now provide “paradigm cases” that can be utilized in defending the need for securities class actions. Constitutional law scholars use that phrase in noting how constitutional provisions can be directed at vivid examples of governmental abuse (Rubenfeld 2005). Similarly, examples of meritorious securities class actions can be a powerful argument for maintaining private causes of action for securities fraud. While severe frauds will not always be as common as they were in the early part of the twenty-first century, securities fraud that results in the failure of a significant public company is now more than an abstract possibility. Because the existence of a restatement in itself does not establish that there was a securities fraud, an argument could be made that the surge of litigation arising out of such restatements did not reflect real fraud. Restatements often reflect accounting issues that result from innocent error rather than as part of a scheme to defraud investors. Class action attorneys may have exploited the rise in restatements to bring cases against companies that did not truly commit fraud. Though the SEC does not have a profit motive, it may have political incentives to bring cases showing it is tough on accounting fraud.   511 U.S. 164 (1994).

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36  Research handbook on representative shareholder litigation Even if these restatement cases did not truly reflect an increase in fraud, it is undeniable that the perception of increasing fraud affected how certain actors viewed the securities class action. Many courts believed that there was a wave of severe fraud. Judge Gerard Lynch, a former Columbia Law School professor, noted in an opinion in the Global Crossing case, that “plaintiffs have alleged a fraud of a magnitude only rarely seen—at least until recent years.”6 Some courts responded with a greater willingness to find that complaints sufficiently alleged fraudulent intent. For example, the Southern District of New York loosened the standard for finding whether an auditor acted with scienter with respect to severe frauds. As one judge noted, “[a]llegations of particularly large frauds might go far toward creating a compelling inference of auditor scienter based on recklessness even where actual knowledge of the fraud by the defendant auditor is not alleged.”7 When judges are confronted with severe fraud, there is evidence that they decide cases differently. A prior analysis of securities class actions involving a bankrupt company showed that judges are less likely to dismiss such cases, which are more likely to result in a substantial settlement (Park 2009). The higher rate of success for these cases persists even after controlling for obvious indicia of the merit of the case, suggesting that the bankruptcy in itself influences the decisions of courts and parties. Judges may be using a heuristic where they view suits in which the fraud is severe to be more likely to reflect a good claim. This might be irrational, but it also may reflect the practical wisdom of judges. In the wake of an era of severe fraud, it should not be surprising that the fraud-onthe-market presumption survived the 2014 Halliburton v. Erica John Fund appeal. The Supreme Court did not take the opportunity to revisit its creation of the presumption, relying largely on the principle of stare decisis. Perhaps the case for overruling the fraudon-the-market presumption would have been stronger if there had not been so many cases where securities class actions appeared to have substantial merit. Though the Supreme Court explicitly denied any consideration of policy in deciding Halliburton,8 the many examples of securities class actions addressing what seemed to be severe frauds made it difficult for Halliburton to establish that fraud-on-the-market cases are completely without any purpose. It is telling that criticism of the securities class action has shifted from the claim that they are meritless to more abstract arguments about whether they effectively compensate investors. Rather than criticizing them as strike suits, scholars who are skeptical of securities class actions have focused on whether investors need protection from fraud given their ability to diversify. For secondary market suits, commentators have argued that Rule 10b-5 recoveries are circular in that investors bear part of the cost of their own compensation. Securities class actions have also been criticized for ineffectively deterring fraud because liability most often falls on the entity rather than the individuals who actually commit the fraud (Coffee 2006; Rose 2008).   In re Global Crossing, Ltd. Securities Litig., 322 F. Supp. 2d 319, 347 (S.D.N.Y. 2004).   In re IMAX Sec. Litig., 587 F.Supp.2d 471, 484?85 (S.D.N.Y. 2008). 8   It is worth noting that Chief Justice Roberts, in particular, has been willing to invest substantial amounts in individual stocks. In order to participate in a case, he sold more than $250,000 in Microsoft stock (Sherman 2016). As a substantial holder of individual stocks, Chief Justice Roberts might find the argument that a rational investor will choose to invest in index funds to be unpersuasive. 6 7

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Securities class actions and severe frauds  37 These arguments may be theoretically compelling, but they may not be persuasive to judges and legislators who lived through the Enron and WorldCom era of securities fraud. Just as the abstract argument of deterrence voiced by supporters of securities class actions prior to the PSLRA was unsuccessful without clear examples of cases with merit, abstract arguments of circularity may not gain much policy traction when defenders of secondary market class actions can point to the scores of such cases where the merit seemed clear. While securities class actions do not deter or compensate perfectly, what cause of action does? The success of the securities class action post-PSLRA does not mean that additional reform is unnecessary. A large settlement may indicate that a case had merit, but it also might be the result of considerations unrelated to the true merit of the case. Private class action attorneys have incentives to bring cases whenever there is an appearance of fraud. There may be a danger of overenforcement where securities class actions are filed at a higher rate than is optimal (Rose 2008). The fact that the severity of fraud appears to have increased post-PSLRA does not necessarily mean that more cannot be done to ensure that securities fraud causes of action are not abused. The incidence of severe fraud began declining toward the latter part of the 2000s. The number of securities class actions has decreased, even with the significant stock price drops of the 2008–9 financial crisis. Future work should examine why more securities class actions were not filed in the wake of an economic decline that eclipsed the collapse of the internet stock bubble. One possible explanation is that the number of multibilliondollar restatements declined beginning in 2006. From 2007 through 2009, there were no accounting restatements that exceeded $1 billion (Audit Analytics 2014, 13). Securities class actions are no longer routinely filed in the wake of a stock price decline, but are more likely to be triggered by an accounting restatement.

6. CONCLUSION The success of the post-PSLRA litigation directed at what was believed to be a period of severe fraud has likely secured the survival of the securities class action for another generation. The narrative of the strike suit against a technology company may have been true before the PSLRA, but it has been displaced in part by examples of securities class actions that provide investors with a remedy for the worst frauds. Though it has survived for now, there is still much work to do in ensuring that securities class actions target real cases of fraud. The securities class action will continue to evolve, and courts, scholars, and policymakers have much work to do in ensuring that such actions will be effective in addressing severe frauds.

BIBLIOGRAPHY Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L. Rev. 497–598 (1991). Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 Ill. L. Rev. 691–740 (2012). Audit analytics, 2014 Restatements Review (posted April 27, 2015), www.auditanalytics.com/blog/2014-financialrestate​ments-review

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38  Research handbook on representative shareholder litigation James Bohn & Stephen Choi, Fraud in the New-Issues Market: Empirical Evidence on Securities Class Actions, 144 U. Pa. L. Rev. 903–82 (1996). C.S. Agnes Cheng, Henry He Huang, Yinghua Li, & Gerald Lobo, Institutional Monitoring Through Shareholder Litigation, 95 J. Fin. Econ. 356–83 (2010). Stephen J. Choi, Do Institutions Matter? The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act, 83 Wash. U. L. Q. 869–905 (2005). Stephen J. Choi, Do the Merits Matter Less After the Private Litigation Reform Act, 23 J.L. Econ. & Org. 598–626 (2006). Stephen J. Choi, Karen K. Nelson, & A.C. Pritchard, The Screening Effect of the Private Securities Litigation Reform Act, 6 J. Empirical Legal Stud. 35–68 (2009). John C. Coffee Jr, The Future of the Private Securities Litigation Reform Act: Or, Why the Fat Lady Has Not Yet Sung, 51 Bus. Law. 975–1007 (1996). John C. Coffee Jr, Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301–64 (2004). John C. Coffee Jr, Reforming the Securities Class Action: An Essay on Deterrence and its Implementation, 106 Colum. L. Rev. 1534–86 (2006). James D. Cox & Randall S. Thomas, Public and Private Enforcement of the Securities Laws: Have Things Changed Since Enron? 80 Notre Dame L. Rev. 893–908 (2005). James D. Cox, Randall S. Thomas, & Dana Kiku, Does the Plaintiff Matter? An Empirical Analysis of Lead Plaintiffs in Securities Class Actions, 106 Colum. L. Rev. 1587–1640 (2006). Joseph A. Grundfest, Damages and Reliance Under Section 10(b) of the Exchange Act, 69 Bus. Law. 307–92 (2014). Johnson, M., Kasznik, R., & Nelson, K., Shareholder Wealth Effects of the Private Securities Litigation Reform Act of 1995, 5 Rev. Account. Stud. 217–33 (2000). Marilyn F. Johnson, Karen K. Nelson, & A.C. Pritchard, Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act, 23 J.L. Econ. & Org. 627–52 (2006). Arthur Levitt, Speech at NYU Center for Law and Business: The Numbers Game (Sept. 28, 1998). James J. Park, Assessing the Materiality of Financial Misstatements, 34 J. Corp. L. 513–65 (2009). James J. Park, Securities Class Actions and Bankrupt Companies, 111 Mich. L. Rev. 547–90 (2013). James J. Park, Bondholders and Securities Class Actions, 99 Minn. L. Rev. 585–648 (2014). Michael Perino, Institutional Activism Through Litigation: An Empirical Analysis of Public Pension Fund Participation in Securities Class Actions, 9 J. Empirical Leg. Stud. 368–92 (2012). Lynn Lopucki, Bankruptcy Research Database, http://lopucki.law.ucla.edu/tables_and_graphs/Filings_by_year. pdf (last visited Mar. 7, 2017). Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship between Public and Private Enforcement of Rule 10b-5, 108 Colum. L. Rev. 1301–64 (2008). Jed Rubenfeld, Revolution by Judiciary: The Structure of American Constitutional Law (2005). Joel Seligman, The Merits Do Matter, 108 Harv. L. Rev. 438–57 (1994). SEC Staff Accounting Bulletin: No 99, 17 CFR Part 211 (Aug. 1999). Mark Sherman, Chief Justice John Roberts Sold More than $250,000 in Microsoft Stock that Will Allow Him to Take Part in a Supreme Court Case, U.S. News & World Rep. (Feb. 4, 2016 3:23AM), www.usnews.com/news/ politics/articles/2016-02-04/roberts-sold-more-than-250-000-in-microsoft-stock. Spiess, K. & Paula A. Tkac, The Private Securities Litigation Reform Act of 1995: The Stock Market Casts Its Vote. . . 18 Managerial & Decision Econ. 545–61 (1997). U.S. Gov’t Accountability Office, GAO-06-678, Financial Restatements Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities (2006).

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3. The shifting raison d’être of the Rule 10b-5 private right of action Amanda Marie Rose

A research handbook on shareholder litigation would be incomplete without a treatment of the Rule 10b-5 private right of action, often called the most important liability provision in the federal securities laws (Prentice 1997; Thel 2014). If importance is measured in terms of total dollars recovered and total amount of judicial and scholarly attention spent on a cause of action, then this assertion is undeniably correct. Private Rule 10b-5 suits constitute nearly half of all class actions filed in federal court (Coffee 2006), claim a disproportionate amount of judicial time and attention due to their procedural complexity, and are responsible for the “vast majority” of money involved in class action settlements (Fitzpatrick 2010)—averaging more than $5 billion annually for the past ten years (Bulan et al. 2015). Private Rule 10b-5 suits have also inspired volumes of academic literature, much of it focused on their social function (or lack thereof, depending on the author’s perspective). The purpose of this chapter is to introduce readers to this aspect of the Rule 10b-5 literature, which is best understood in light of the historical and doctrinal evolution of Rule 10b-5. Toward that end, section 1 begins at the beginning, recounting the origins of the Rule 10b-5 private right of action. It explains how, in the early years, the private right served to promote the goals of corrective justice and deterrence in much the same way as the common law fraud cause of action. Section 2 discusses how Rule 10b-5’s doctrinal evolution served to unmoor it from its common law roots, facilitating the emergence of the “fraud-on-the-market” (FOTM) class action that characterizes private Rule 10b-5 litigation today. Section 3 explains why FOTM class actions are more difficult to reconcile with corrective justice and deterrence theory than the early Rule 10b-5 suits, situating the scholarly debates over the social desirability of private Rule 10b-5 enforcement within this theoretical framework. Section 4 briefly concludes.

1.  THE EARLY YEARS In 1942 the Securities and Exchange Commission (SEC) exercised its authority under Section 10(b) of the Securities and Exchange Act of 1934 to promulgate Rule 10b-5.1 In relevant part, Rule 10b-5 renders it unlawful for any person “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make 1   Section 10(b) provides that “[i]t shall be unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe.” 15 U.S.C. § 78j(b).

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40  Research handbook on representative shareholder litigation the ­statements made, in the light of the circumstances under which they were made, not misleading . . . in connection with the purchase or sale of any security.”2 At the time of its adoption, Rule 10b-5 “had no relation in the commission’s contemplation to private proceedings” (Freeman 1967). Instead, its purpose was merely to close a loophole in the SEC’s securities fraud enforcement authority, allowing the SEC to pursue fraud committed in connection with the purchase as well as the sale of securities. Previously enacted rules prohibited only the fraudulent sale of securities, or applied only to brokers and dealers.3 The period of exclusive government enforcement of Rule 10b-5 proved short lived, however. Not long after its adoption, the federal judiciary recognized a private right to sue under Rule 10b-5. The first case to do so was Kardon v. National Gypsum Co., decided by the District Court for the Eastern District of Pennsylvania in 1946.4 Kardon was subsequently followed by “an overwhelming consensus of the District Courts and Courts of Appeals,”5 and by the Supreme Court a quarter century later in Superintendent of Insurance v. Bankers Life & Casualty Co.6 Kardon’s rationale was that “the disregard of the command of a statute is a wrongful act and a tort,” entitling the injured party to compensation.7 The Supreme Court has since rejected this approach to the implication of private rights to sue in favor of one focused on Congressional intent.8 The existence of several express private causes of action in the federal securities laws would almost certainly preclude any inference that in 1934 Congress intended to create a private right to sue to enforce rules promulgated under Section 10(b) (Grundfest 1994). But even though Kardon would not have been decided the same way under modern precedents, “the existence of a private cause of action for violations of [Rule 10b-5] is now well established” and has been repeatedly reaffirmed.9 In Kardon and other early cases, the implied right under Rule 10b-5 operated as essentially a federalized version of the common law fraud cause of action. The service of process provisions attached to Rule 10b-5 were more generous, but otherwise there was little difference between Rule 10b-5 and common law fraud claims. The elements of a private Rule 10b-5 claim were interpreted more or less coextensively with the e­ lements of a common law fraud claim—requiring, inter alia, a plaintiff to prove actual reliance on the defendant’s misstatements (Rose 2015). Typical factual allegations were also

  17 C.F.R. § 240.10b-5.   See Exchange Act Release No 3230, 7 Fed. Reg. 3804, 3804 (May 21, 1942). 4   69 F. Supp. 512, 513–14. 5   Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 79 (2006) (internal quotation marks omitted). 6   404 U.S. 6, 13 n.9 (1971). 7   69 F. Supp. at 513. 8  See  Alexander v. Sandoval, 532 U.S. 275, 286–88 (2001)  (discussing the evolution of the Court’s jurisprudence on implied private rights of action). 9   Ernst & Ernst v. Hochfelder, 425 U.S. 185, 196 (1976);  see also  Herman & Maclean v. Huddleston, 459 U.S. 375, 380 (1983)  (“The existence of this implied remedy is simply beyond peradventure”). Indeed, Congress has enacted significant pieces of legislation that acknowledge the existence of the right. See, e.g., Pub. L. No 104-67, Sec. 101(a)–(b), §§ 21D, 27, 109 Stat. 737, 737, 743 (codified as amended at 15 U.S.C. §§ 77z-1, 78u-4 (2006)); Pub. L. No 105-353, Sec. 101(a) (2), 101(b)(2), § 21D, 27, 112 Stat. 3227, 3230, 3233 (codified at 15 U.S.C. §§ 77z-1, 78u-4). 2 3

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The Rule 10b-5 private right of action  41 similar—both types of suit tended to involve face-to-face dealings and privity of contract between the plaintiff and the defendant (Langevoort 2010).10 Neither type of claim was susceptible to aggregation via anything remotely similar to the modern optout class action. Not surprisingly, then, the early version of the Rule 10b-5 private right could be justified in much the same way as the common law fraud cause of action: as serving (to some extent at least) the goals of both corrective justice and deterrence. 1.1  Corrective Justice The leading deontological defense of American tort law is based on corrective justice theory. Corrective justice is served when a wrongdoer is made to make whole the party they have wronged for the harm caused. The “duty to rectify is based not on the fact of injury but on the conjunction of injury and wrongdoing”; in other words, the “injurer must do wrong [] as well as do harm [], and the victim must be wronged [] as well as harmed” (Posner 1981). Early Rule 10b-5 cases brought against individual defendants clearly fit this mold, as did their common law counterparts. Again, these cases typically involved a defendant who stood in privity with the plaintiff, having either sold the plaintiff securities at a fraudulently inflated price or purchased securities from the plaintiff at a fraudulently deflated price. The defendant’s gain therefore approximated the plaintiffs’ loss. So whether defendants were forced to disgorge their profits or pay compensatory damages, the cases resulted in wrongdoers making whole their victims, consistent with corrective justice ideals. Early fraud cases involving corporate defendants, whether brought under Rule 10b-5 or the common law, fit less comfortably with traditional notions of corrective justice. Corporations are not themselves moral agents capable of doing “wrong.” Nor did corporate liability in such cases turn on whether the shareholders standing behind the corporate fiction acted in a morally blameworthy manner. Instead, it was strictly imposed upon a showing of culpability by the corporate agent responsible for the misstatement or omission, under common law principles of respondeat superior liability.11 As Ernest Weinrib (Weinrib 1995, 186) has explained: Since corrective justice is the normative relationship of sufferer and doer, respondeat superior fits into corrective justice only if the employer can, in some sense, be regarded as a doer of the harm. Corrective justice requires us to think that the employee at fault is so closely associated with the employer that responsibility for the former’s acts can be imputed to the latter.

Weinrib points to the preconditions for respondeat superior liability—viz., that the agent responsible for the harm (1) was an employee subject to the employer’s control (rather than an independent contractor) and (2) committed the act in the scope of employment (rather than within an independent course of conduct not intended by the employee to

10   Suits by clients against broker-dealers represent another paradigmatic early Rule 10b-5 case. Such suits are outside the scope of this chapter. 11   The common law doctrine of respondeat superior liability has long been applied in Rule 10b-5 cases, notwithstanding the 1934 Act’s express provision imposing liability on “control persons” (Prentice 1997).

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42  Research handbook on representative shareholder litigation serve any purpose of the employer)—as creating the conditions under which it might be appropriate to treat the employer as if it were a “doer” of the harm, and thus morally responsible. Weinrib’s account provides at least a plausible corrective justice defense of the early Rule 10b-5 cases brought against corporate defendants. When corporate defendants were sued in these early cases, they typically stood in privity with the plaintiffs—having either issued securities to, or repurchased securities from, those plaintiffs (Langevoort 2010).12 So the corporate defendants (and, ultimately, their shareholders) directly benefited from the fraud, such that it was arguably appropriate to treat the corporation as the “doer” of the fraud committed by the corporate agent. 1.2 Deterrence The leading utilitarian defense of American tort law is grounded in deterrence theory. According to this theory, law should incentivize socially efficient behavior, with the ultimate goal of maximizing social welfare (Coase 1960; Calabresi 1970; Landes & Posner 1987). Securities fraud creates no social benefits but creates real social costs. For example, it increases the cost of capital, upsets the efficient allocation of economic resources in the economy, and may entice wouldbe victims to incur deadweight costs in an effort to avoid being victimized (Fox 2009a). To the extent that early private Rule 10b-5 cases operated to discourage people from committing fraud or from taking inefficient measures to protect themselves from becoming fraud victims, then, it could potentially be defended on deterrence grounds—only potentially, because the costs created by the liability system must also be taken into account. To be justified under deterrence theory, a liability regime must save more in social costs than it creates in enforcement costs; optimal deterrence is achieved when the sum of those costs is minimized.13 Early cases against individual defendants, whether brought under Rule 10b-5 or the common law, likely helped to discourage securities fraud. By threatening wouldbe fraudsters with personal liability, these cases made committing fraud less profitable on an expected value basis. To be sure, looked at in isolation the damage awards threatened by these early private suits would have been inadequate to fully deter. While the actual remedy imposed would work to roughly offset the gain to the defendant, the likelihood that suit would be brought and relief awarded was less than 100 percent. Thus, the specter of private liability alone could not have been expected to completely eliminate the incentive to commit securities fraud. But private liability was not (and has never been) the only source of sanction for securities fraud: the possibility of criminal punishment, civil fines imposed by public authorities, and reputational costs must also be factored into the wouldbe fraudster’s cost–benefit analysis. 12   See also Joseph v. Farnsworth Radio & Television Corp., 99 F. Supp. 701, 706 (1951) (“As to the corporate defendant, there is no allegation of its involvement in either a purchase or sale of stock and, this indispensable ingredient lacking, its motion to dismiss . . . must be granted without leave to plead over”). 13   To be truly optimal, the liability regime must also minimize social costs relative to other possible forms of legal intervention (Shavell 2004).

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The Rule 10b-5 private right of action  43 In light of these alternative sanctions, perhaps more important to the deterrence justification for early private Rule 10b-5 liability was the promise of compensation it held out to potential victims.14 By promising potential victims compensation for fraud losses, early Rule 10b-5 cases served to discourage potential victims from taking socially inefficient measures to protect themselves from fraud. Notice that this could be achieved even if the defendant made to pay the sanction were not the wrongdoer, just as the goal of deterring would-be fraudsters could be achieved even if the injured party did not receive the sanction. Granting victims the right to sue wrongdoers, in other words, is not inherently required by deterrence theory; who prosecutes wrongdoers, and who compensates victims, depends instead on context-specific efficiency considerations. By contrast, “corrective justice repudiates reasons for liability that are normatively relevant to either of the parties in isolation from the other” (Weinrib 2011). For this reason, early securities fraud suits brought against corporate defendants are easier to defend under a deterrence theory than under a corrective justice theory. The deterrence theorist is not bothered by the lack of culpability on the part of the corporate defendant, he cares only whether exposing the corporate defendant to liability furthers efficiency goals. Respondeat superior liability has the potential do so in a few well-recognized ways.15 First, when liability forces an employer to internalize the social costs of its agent’s delicts, it creates incentives for the employer to invest a socially efficient amount in internal controls to prevent those delicts. Of course, a corporate employer is not a natural person but rather a legal fiction, one characterized by a separation of ownership from control. As its residual claimants, it is ultimately the shareholders of the corporation who bear the cost of corporate-level liability. A more precise statement of what respondeat superior liability is hoped to do in the corporate context, then, is to incentivize shareholders to use the corporate governance tools available to them to push managers to take efficient steps to deter misconduct within the organization. A second oft-cited efficiency justification for respondeat superior liability flows from the reality that the employees responsible for a harm might be judgment proof; in light of this, respondeat superior liability can help assure potential victims that they will be compensated if harmed, thereby reducing their incentive to invest in precautions. Finally, it has been argued that respondeat superior liability can increase social welfare by serving essentially an insurance function, shifting the risk of loss from a less to a more efficient risk bearer. Each of these economic justifications for corporate liability could be invoked to defend early Rule 10b-5 cases, just as they could be invoked to defend traditional common law fraud cases. Recall that in these early cases the corporation’s shareholders typically benefited from the fraud because the corporation had issued securities to, or repurchased securities from, the plaintiff. If not held liable for such fraud, shareholders might not only cause their firms to underinvest in efforts to prevent it, but might actively encourage it. Second, the increased potential for compensation likely encouraged potential victims 14   Potential victims could also seek redress under the common law of fraud, but state law service of process provisions stood as an obstacle in certain cases. 15   The discussion that follows is necessarily simplified; for more rigorous analyses of the potential efficiency of vicarious liability see Kornhauser 1981; Kornhauser 1982; Sykes 1984; Sykes 1988; Arlen 1994; and Arlen & Kraakman 1997.

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44  Research handbook on representative shareholder litigation to rely on their counterparty’s statements with less perceived need to invest in expensive verification efforts or to take other precautions. Finally, these early suits may have resulted in efficient risk shifting, as they typically served to spread the losses of a single or discrete set of plaintiffs across a larger group of corporate shareholders. Nothing has been said thus far about the costs of the early Rule 10b-5 private liability system, which, as noted at the outset, must be accounted for in the deterrence equation. These costs include both the direct costs of litigating cases as well as potential overdeterrence costs. Fraud liability can produce overdeterrence costs when potential defendants react to the fear of erroneous prosecution and legal error. Such fear might lead potential defendants to spend more time and money than is socially useful verifying the accuracy of disclosures, for example. It might also prompt them to withhold information that could be helpful to investors, out of fear it will be deemed misleading, or, conversely, to bury investors in an avalanche of trivial information, out of fear that its omission will give rise to liability. Fraud liability can also produce overdeterrence costs even if only meritorious cases are anticipated, if it is vicariously imposed on employers and expected sanctions are set above fraud’s social costs; this would incentivize rational employers to overinvest in fraud prevention measures relative to what is socially optimal. While it is difficult to know for sure, the costs generated by private Rule 10b-5 enforcement in the early years were probably not significant, or at least not so great as to dwarf its deterrence benefits. The measure of damages used in these cases may have been a good proxy for the social costs of the fraud, or at least not wildly in excess. Moreover, given that the defendants in these cases stood in privity with the plaintiffs, use of either a disgorgement or out-of-pocket measure of damages was necessary to eliminate the defendant’s gain from the fraud. In addition, the American Rule for attorney’s fees, combined with the traditional common law restrictions which applied to these claims—such as the need to prove actual reliance and damages—likely served to discourage frivolous litigation (Stewart & Sunstein 1982).

2. THE BASIC METAMORPHOSIS In the decades following Kardon, doctrine evolved in such a way as to unmoor the private Rule 10-5 cause of action from its common law roots. These changes facilitated the emergence of the “fraud-on-the-market” (FOTM) class action that dominates private Rule 10b-5 litigation today. This section describes the development and key characteristics of the FOTM class action. The following section 4 explains why FOTM class actions are more difficult to reconcile with corrective justice and deterrence theory than the early Rule 10b-5 suits, situating the scholarly literature regarding the social desirability of private Rule 10b-5 enforcement within this theoretical framework. 2.1  Doctrinal Innovation The first doctrinal development of note was the abandonment of any privity requirement. Beginning in the 1960s, courts began to recognize the right of plaintiffs to sue defendants under Rule 10b-5 even if the defendant was neither a counterparty to the plaintiff’s trade nor a contemporaneous trader (Langevoort 2010). Thus, courts interpreted Rule 10b-5

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The Rule 10b-5 private right of action  45 as permitting suit by a secondary market purchaser or seller against a nontransacting corporate defendant for misstatements or omissions made by the corporation’s agent, assuming (at first, at least) that the plaintiff actually relied upon those misstatements in entering into the secondary market transaction. The need to prove actual reliance was the next feature of the common law to be modified. In Basic v. Levinson the Supreme Court recognized a presumption of reliance in private Rule 10b-5 cases involving securities that trade in efficient markets.16 According to Basic, plaintiffs are entitled to this presumption if they can show that: (1) the alleged misrepresentation was publicly known; (2) it was material; (3)  the stock traded in an efficient market; and (4) the plaintiff traded the stock between the time the misrepresentation was made and when the truth was revealed. The presumption Basic endorses is not that the plaintiffs actually relied on the alleged misstatement itself, but rather that they relied on the integrity of the stock’s market price, which is itself presumed to have been distorted by the fraud through the operation of the efficient capital markets hypothesis. The reliance presumed by Basic is therefore “fundamentally different” from the reliance that had traditionally been required in common law fraud cases (Fox 2005). Basic, combined with the Supreme Court’s earlier recognition of a presumption of reliance in omission cases,17 thus extended the right to sue nontransacting corporate defendants under Rule 10b-5 to all secondary market purchasers of the company’s stock, at least if that stock was listed on an exchange and actively traded. This includes passive investors who pay no attention to corporate disclosures and thus would be unable to state a common law fraud claim. Of course, most passive investors have (and, according to modern portfolio theory, should have) only a small amount invested in any particular firm. Therefore, it would be uneconomical for most passive investors to enforce this right in an individual suit. But another innovation served to remove this barrier to enforcement. Revisions to the Federal Rules of Civil Procedure introduced in 1966 made it possible for plaintiffs to aggregate claims in an optout class action under Rule 23(b)(3), assuming that common issues predominate over individualized ones. Allowing investors to access this procedural device was a major goal of the Supreme Court’s decision in Basic.18 By eliminating the need for plaintiffs to prove individual reliance, that decision both expanded the universe of investors who can state a claim and facilitated the aggregation of their claims via the class action. 2.2  FOTM Class Actions: Some Key Characteristics Thus was born the modern “FOTM class action”, which is defined here to mean a Rule 10b-5 class action brought on behalf of secondary market traders against a nontransacting public company defendant for alleged misstatements or omissions by corporate agents, upon which the plaintiff class did not directly rely. The FOTM class action bears little resemblance to early Rule 10b-5 cases or to traditional common law fraud cases. In addition to involving an expanded set of plaintiffs and defendants, an altered set

  485 U.S. 224 (1988).   Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972). 18  See Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2408 (2014). 16 17

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46  Research handbook on representative shareholder litigation of ­elements, and the aggregation of claims—as described below—FOTM class actions involve defendants with different motives, raise different stakes, and create different incentives to sue and settle than existed in the early years of private Rule 10b-5 enforcement. When a fraud case involves privity of dealing between the plaintiff and the defendant, there is no mystery concerning the defendant’s probable motive. It is obvious why individual defendants selling (or buying) securities for their own account would lie to plaintiffs in an attempt to inflate (or deflate) the securities’ perceived value: every dollar the plaintiff loses in the transaction goes into the defendant’s pocket. The owners of a corporation that is selling (or buying) securities for its own account similarly benefit; thus, a corporate agent loyal to shareholder interests might be inclined to mislead when the company is engaged in a primary issuance or share buyback. In FOTM cases, however, privity of dealing is missing; moreover, corporate defendants are typically not involved in any contemporaneous trading. Thus, the corporation’s shareholders as a class have no obvious motive to support the fraud.19 As for the corporate agents responsible, their most probable motive is a self-serving one: to hide poor performance, thus allowing them to game incentive compensation programs and avoid other forms of shareholder discipline. Indeed, most scholars today conceive of fraud-onthe-market as a form of agency cost.20 Nevertheless, the corporate agents responsible for fraud-on-the-market are still treated as having acted within “the scope of employment” and thus their corporate employer remains liable for their actions under the doctrine of respondeat superior. The absence of privity in FOTM suits also operates to sever the connection that existed in early Rule 10b-5 cases between the plaintiffs’ loss and the defendant’s gain. In a FOTM suit, the class members’ losses are other secondary market traders’ gains, and the defendants’ gains—to the extent there are any—are something altogether different. Disgorgement and compensatory damages, while roughly interchangeable in early Rule 10b-5 cases, are therefore dramatically different remedies in the FOTM context, with the latter dwarfing the former in magnitude. The courts have endorsed the compensatory measure in FOTM suits, such that plaintiffs stand to recover their full out-of-pocket losses attributable to the fraud, with no offset for the gains to their innocent trading counterparties (Langevoort 2010). This, when combined with Basic’s extension of the right to sue under Rule 10b-5 to nonreliers and the availability of class treatment, results in enormous and unprecedented potential liability.21 This expanded liability in turn creates a very strong incentive for entrepreneurial attorneys to bring FOTM class actions on investors’ behalf, given that attorneys’ fees

19   Only the subset of shareholders intending to sell their shares at the time of the fraud would clearly benefit. Of course, scenarios could be imagined wherein a nontrading corporation and its shareholders would benefit from FOTM; my point is simply that the strong motive to commit fraud that is present in every privity of dealing case is lacking in the FOTM context. 20   Examples include Arlen & Carney 1992; Pritchard 1999; Macey 1991. A competing behavioral account has also been advanced (Langevoort 1997). 21   It has been observed that FOTM damages “can be staggeringly large, usually far in excess of any benefit the defendants hoped to gain from the misrepresentations or concealment”; “multibillion-dollar cases are not infrequent, and hundred-million-dollar cases are ordinary” (Langevoort 2010).

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The Rule 10b-5 private right of action  47 are driven, to a significant extent, by recovery size. It also affects the quality of cases: the larger the potential payout, the more willing a rational plaintiffs’ lawyer is to pursue a case with a smaller likelihood of success. Conversely, the enormous liability threatened creates a very strong incentive for defendants to settle FOTM class actions—even cases they believe are weak, given the uncertainty that surrounds some of Rule 10b-5’s elements and the unpredictability of juries (Rose 2017).22 Indeed, gambling with such enormous potential liability at trial is something that corporations almost never do; empirical studies confirm that FOTM class actions that are not dismissed pretrial settle in all but the very rarest circumstance.23 This has the potential to fuel an unvirtuous cycle, as the settlements prevent judicial clarification of Rule 10b-5’s uncertain elements and make the filing of borderline suits more attractive to plaintiffs’ counsel. Congressional concern that the “merits don’t matter” in FOTM settlements led to the enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA).24 Among other things, the PSLRA adopted reforms that make pretrial dismissal of FOTM class actions easier for defendants to achieve.25 When FOTM class actions result in settlement rather than dismissal, the corporation almost always pays the entire settlement amount, either directly or through insurance; contribution by individually named defendants—the corporate agents actually responsible for the alleged fraud—is extremely rare.26 The fact that corporate defendants tend to exclusively fund settlements is a very important characteristic of FOTM suits. It means, of course, that public company shareholders are the ones who ultimately pay, which has given rise to the familiar observation that there is a “circularity” involved in FOTM class actions. This circularity exists at the micro and macro level. In a particular case some portion of the class will be on both sides of the “v,” as some class members will continue to hold shares in the company who in turn pays the settlement. Some portion of the class, in other words, will effectively fund a portion of their own recovery (Cox 1997). On the macro level, over time diversified public company shareholders will likely find themselves on the paying end of FOTM suits as often—if not more often—as they find themselves on the receiving end, even if they do not stand on both sides in particular cases (Coffee 2006). 27

22   Other factors may also influence settlement, such as the personal interests and risk aversion of the agents who control the corporation’s litigation decisions and insurance coverage considerations. 23   Less than 1 percent of securities class action filings from 1997 to 2015 reached a trial verdict (Aganin 2015). 24   Pub. L. No 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C. and 18 U.S.C.). The quoted phrase is attributable to an influential—albeit controversial (Seligman 1994)—article by Professor Janet Cooper Alexander (Alexander 1991). 25   For an overview, see Rose 2008. 26   An empirical study of securities class actions filed between 2006 and 2010 found that outside directors contributed in none of the settled cases, and officers contributed in only 2 percent (Klausner et al. 2013). 27   As Professor Langevoort has explained, inactive investors who pursue “buy and hold strategies make it somewhat more likely that they will be non-trading shareholders of an issuer defendant (and suffer their share of the resulting loss) than members of the plaintiff class who stand to gain from the settlement or judgment” (Langevoort 1996).

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48  Research handbook on representative shareholder litigation Thus, diversified investors may not, in the grand scheme, benefit from FOTM settlements on a net basis, particularly once litigation costs are taken into account. A related macro point focuses not on the circularity of settlement payments at the back end of litigation but on the out-of-pocket losses passive shareholders can be expected to incur from secondary market fraud on the front end. As Daniel Fischel and Frank Easterbrook first observed, secondary market traders lose when they purchase securities at an artificially inflated price, but they profit when they sell at an artificially inflated price (Easterbrook & Fischel 1985); therefore, well-diversified investors’ out-of-pocket gains and losses from secondary market fraud may likewise tend toward zero over time (Mahoney 1992; Alexander 1996; Grundfest 2014). The circularly related claims described above are sometimes overstated.28 A perfect netting of settlement payouts, or of fraud gains and losses, will not occur vis-à-vis individual diversified investors, even if it occurs vis-à-vis diversified investors as a class (Evans 2015). Nor will it occur to the extent that there is insider trading. Moreover, not all public company shareholders are diversified.29 Stated more modestly, however, the circularity claims are unassailable. It is clear that: (1) the net out-of-pocket losses suffered by a diversified investor over time due to FOTM will likely be far less than the investor’s total out-of-pocket losses; and (2) over the long haul, a diversified investor will likely pay out, as an owner of settling corporate defendants, a significant percentage of what it recovers in FOTM litigation.

3. THE SOCIAL FUNCTION OF THE MODERN RULE 10B-5 CLASS ACTION: AN INTRODUCTION TO THE SCHOLARLY DEBATE With the foregoing characteristics of modern Rule 10b-5 litigation in mind, let us return to the topic of social purpose. Whereas the early version of the private right under Rule 10b-5 found support in corrective justice and deterrence theory, can the same be said of private Rule 10b-5 enforcement today? This section takes up that question, using it as a vehicle for understanding the main scholarly debates surrounding the social worth of FOTM class actions. 3.1  Corrective Justice As explained in section 1, the essence of corrective justice theory is that a wrongdoer is made to make whole their victim. Early Rule 10b-5 cases involving individual defendants could persuasively be defended on this ground. Those involving corporate defendants could also be reconciled with corrective justice theory, but only if the corporation could properly be characterized as the “doer” of the agent’s act of fraud—a plausible leap when,

28   For scholarly critiques of the circularity arguments, see Evans 2007; Park 2009; Dubbs 2009; Spindler 2016. 29   For a discussion of the function of corporate liability for securities fraud in firms with concentrated ownership structures, see Gelter 2013.

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The Rule 10b-5 private right of action  49 as was typical in the early cases, the corporation itself stood in privity with the plaintiff and thus benefited directly from its agent’s fraudulent communications. As explained in the last part, FOTM class actions result in corporate rather than individual liability in all but the rarest cases. Moreover, corporate defendants in FOTM suits typically do not stand in privity with the plaintiffs and typically have not engaged in any trading in their own shares contemporaneous with the fraud. Most scholars therefore believe that FOTM is typically motivated by the selfish desires of disloyal corporate agents, who wish to hide their poor performance from shareholders. In light of this, it is hard to view the corporation and ultimately its shareholders as “doers” of the fraud—they are more plausibly characterized as among its victims. Thus, the corrective justice case for FOTM class actions is difficult to make, and there are few scholars today who seek to defend FOTM class actions on this basis (Burch 2007).30 If compensation is being paid to injured parties by someone other than the wrongdoer—or other than someone who should properly be held accountable for the wrongdoer’s conduct—then it needs to find support under some theory other than corrective justice. The usual candidate is deterrence theory, which is taken up below. 3.2 Deterrence As explained in section 1.2, holding a corporation strictly liable for its agent’s delicts under the doctrine of respondeat superior is potentially consistent with deterrence theory to the extent that it forces cost internalization, discourages victim precautions, and/or reduces riskbearing costs through loss shifting. In a deterrence framework, these benefits must be weighed against the costs of the system, including overdeterrence costs. As discussed later in the chapter, whether FOTM class actions in fact produce these benefits or, assuming they do, whether the costs of the liability system outweigh the benefits created, are the meta questions that expressly or implicitly animate much of the scholarly literature focused on Rule 10b-5. 3.2.1  Forced cost internalization If the threat of respondeat superior liability is to promote socially efficient corporate investments in fraud prevention, the expected sanction must approximate the expected social costs of the harm sought to be prevented. Only then will the specter of liability prompt the desired level of firm investment. In the FOTM context, many scholars believe that this precondition is not satisfied. Whereas in the early Rule 10b-5 cases the out-of-pocket damages measure may have been a good proxy for the social costs of the harm—or at least coextensive with the defendants’ gain from engaging in the fraudulent transaction—the same cannot be said in the FOTM class action context. Many scholars believe that awarding out-of-pocket damages to all secondary market purchasers vastly overstates the social costs of FOTM, even when discounted to reflect the probability of nondetection; moreover, it likely vastly overstates the gain (if any) to the corporation resulting from the fraud (Easterbrook & Fischel 1985; Langevoort 1996; Alexander

30   For a challenge to the widespread view of passive investors as “innocent” when it comes to FOTM, see Mitchell 2009.

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50  Research handbook on representative shareholder litigation 1996). This has led to a variety of academic proposals aimed at correcting the problem by replacing the out-of-pocket measure with better tailored substitutes. For example, Donald Langevoort and Janet Cooper Alexander have argued for a system of civil fines (Langevoort 1996; Alexander 1996), and Adam Pritchard has argued for the adoption of a disgorgement measure of damages (Pritchard 2008).31 A more fundamental challenge to this rationale for FOTM class actions flows from the fact that forced cost internalization may simply be unnecessary. To the extent that the characterization of FOTM as an agency cost is correct, shareholders have natural incentives to use the tools of corporate governance available to them to try to prod managers to invest firm resources in its prevention (Rose 2014). This has led to a recharacterization of the purpose of FOTM class actions—rather than serving to force the corporation to internalize costs, FOTM class actions might be thought of as a tool in shareholders’ corporate governance toolkit.32 For example, this author has argued that FOTM suits might be thought of as a way for shareholders to outsource the monitoring of corporate agents (Rose 2014). Under this conception, the class action bar—lured by the prospect of large attorneys’ fees—is delegated the job of detecting FOTM; once the discovered fraud is revealed through the filing of a class action complaint, shareholders may in turn impose punishment as appropriate on the responsible individuals (with the assistance of market forces and perhaps public enforcement authorities). The threat of this might in turn deter corporate agents from committing FOTM in the first place and encourage boards to put in place good internal controls to prevent it. Viewed this way, it is not troubling that FOTM class actions are ultimately funded by innocent shareholders, as this is a feature of corporate governance generally. Nor is it troubling that FOTM class actions do not directly impose punishment on corporate officers—their function is mainly informational. What is troubling under this view, however, is the inability of shareholders to vote to shield a company from the reach of FOTM class actions if they so choose, a right that some scholars have advocated should be afforded them (Bratton & Wachter 2011; Pritchard 2008). Similarly troubling are statistics suggesting that FOTM class actions do a poor job of discovering frauds not previously made public through other means (Dyck et al. 2010) and, as discussed infra, generate significant deadweight costs. Thus, the efficiency of using FOTM class actions as an informational device is highly questionable (Rose 2014; Bratton & Wachter 2011; Rose & Squire 2011). Assuming that there are externalities from FOTM that public company shareholders do not naturally internalize,33 or do not otherwise internalize via the threat of public enforcement or market sanction,34 at least two further challenges to the forced costinternalization rationale for FOTM class actions have been raised. The first flows from

31   Easterbrook & Fischel have also suggested a rule of the wrongdoer’s profits for secondary market fraud (Easterbrook & Fischel 1985). A related concern noted in the literature is that it is difficult for corporate defendants to predict expected damages (Alexander 1996). 32   For a critical assessment of some variants of this argument, see Bratton & Wachter 2011. 33   For a description of the costs securities fraud can impose on parties other than investors, see Velikonja 2013. 34   One empirical study found that a firm’s reputation losses as a result of financial fraud “exceeded the legal penalty by over 7.5 times, and . . . the amount by which firm value was artificially inflated by more than 2.5 times” (Karpoff et al. 2008).

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The Rule 10b-5 private right of action  51 the circularity claims discussed in the last part. To the extent that shareholders expect to be on the receiving end of FOTM class action settlements as often as the paying end, the threat of those settlements will do little to incentivize them to encourage corporate investments in fraud prevention measures (Rose & Squire 2011). In this scenario, they will only truly be forced to internalize the deadweight litigation costs associated with FOTM class actions. It would be fortuitous indeed if those costs happened to approximate the externalities generated by FOTM. The second flows from the reality that litigation costs, as well as the actual settlement payments in FOTM suits, are mostly paid through insurance, such that the costs shareholders are forced to bear as a result of FOTM class actions are largely transformed into the ex ante payment of insurance premiums. Empirical studies by Tom Baker and Sean Griffith find that insurers attempt to price policies on the basis of risk (Baker & Griffith 2007a), but that “there is not a large marginal difference between the . . . premiums paid by a well-governed firm relative to a poorly governed firm” (Baker & Griffith 2007b). Moreover, insurance companies do little to monitor or otherwise influence a corporation’s fraud prevention efforts to manage litigation risk over the life of the policy (Baker & Griffith 2007b). Thus, the prevalence of insurance may dampen the deterrence potential of FOTM litigation. 3.2.2  Discouragement of victim precautions As explained in the previous section, the promise of compensation that corporate liability offers potential plaintiffs might also promote efficient outcomes to the extent that it discourages investors from taking socially inefficient steps to protect themselves from fraud, including, in the extreme, dropping out of the capital markets altogether. Several challenges have been raised to this rationale for FOTM class actions, as well. The most fundamental challenge is premised on Fischel & Easterbrook’s observation about the circularity of secondary market fraud gains and losses. The claim is that, to the extent that diversified investors’ losses from secondary market fraud are largely offset by gains, those investors have little incentive to incur costs to avoid it in the first place. Thus, promising them compensation is unnecessary (or at least unwarranted in light of the transaction costs associated with litigation) (Pritchard 2015). James Spindler has recently questioned the logic of this argument, emphasizing that everyone would prefer to win more than they lose from secondary market fraud (Spindler 2016). In the absence of compensatory FOTM class actions, his argument proceeds, more passive investors would choose to adopt active investment styles in an effort to be a net winner from FOTM.35 An independent challenge to this rationale is presented by studies suggesting that investors recover only a small percentage of their out-of-pocket losses in FOTM class actions.36 If expected recoveries are negligible, then the specter of FOTM class actions will do little to dampen investors’ incentives (whatever those incentives might otherwise be) to protect themselves from FOTM. Solutions to this problem are provided in the literature,

35   Information traders should be compensated for fraud losses (Fisch 2009), but FOTM class actions are a poor device for delivering compensation to this subset of investors. For a fuller discussion of this point, see Rose 2014 at 1244 n.38, and references cited therein. 36   For a discussion of these studies, see Evans 2007.

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52  Research handbook on representative shareholder litigation and vary depending on its presumed source. One explanation for inadequate recoveries is lawyer–client agency costs; thus we might understand the voluminous literature on how to better align the interests of class counsel with those of the class as responsive to this critique.37 Another possible explanation is that Congress and the courts have made it too difficult for plaintiffs to prevail in Rule 10b-5 cases, with the obvious solution being a rollback of the barriers that have been erected (Sale 1998). A final challenge to this rational for FOTM class actions points to alternative sources, real or hypothetical, for FOTM victim compensation. For example, scholars have pointed to the Fair Funds provision in the Sarbanes–Oxley Act of 2002 (Rose 2008). This provision permits the SEC to itself deliver compensation to injured investors in cases where it has obtained relief. Whether one views this as a sufficient source of victim compensation depends on one’s views about not only the need for compensation in the first instance, but also the efficacy of public versus private enforcement. As another example, Alicia Davis Evans has argued for the creation of an investor compensation fund, to be paid for by a tax on securities transactions, which she argues would be a better alternative to FOTM class actions as a source of victim compensation (Evans 2007). 3.2.3  Reduction of riskbearing costs Corporate liability also has the potential to increase social welfare to the extent that it operates to shift the risk of loss to parties who are better able to bear it. Many scholars disregard this rationale for FOTM class actions, arguing that shareholders can more cheaply reduce their FOTM riskbearing costs through diversification: by investing only a small amount in many firms, diversified investors avoid the risk of suffering a large outof-pocket fraud loss and they also set themselves up to experience offsetting gains from FOTM (Arlen & Carney 1992; Fox 2009b). Not every scholar agrees that diversification moots the insurance case for FOTM class actions. For example, James Park has argued that FOTM suits might serve a useful insurance function due to the limits of diversification (Park 2009). Like Park, Alicia Davis Evans argues that diversification is inadequate to protect against the risk of significant losses attributable to FOTM, although as noted above, she believes that an investor compensation fund could more efficiently compensate investors for FOTM losses than FOTM class actions do (Evans 2007). The costs of FOTM class actions are considered next. 3.2.4  Costs of FOTM class actions Even if FOTM class actions produce social benefits in some or all of the manners described above, the matter of cost must be considered before a conclusion can be reached about their efficiency. Indeed, most critics of FOTM class actions concede that they may produce some deterrence benefits—or at least concede the impossibility of disproving otherwise—but nevertheless argue that the costs of FOTM class actions likely dwarf these benefits.38 A proper deterrence accounting would factor in the costs which FOTM class

  Examples include Coffee 1983; Coffee 1986; Macey & Miller 1991.   For example, Professor Langevoort has remarked that “[e]ven if we concede some residually desirable, insurance-like, compensatory element to the current regime, it is dwarfed by the transaction costs involved” (Langevoort 1996). 37 38

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The Rule 10b-5 private right of action  53 actions impose on the judiciary and litigants, including time and distraction on the part of corporate personnel. It would also include an estimate of overdeterrence costs, which are likely far greater than in the early years of private Rule 10b-5 enforcement. Recall that in a regime of vicarious liability, overdeterrence costs can result if corporate sanctions are set too high—leading to a potential overinvestment of firm resources in fraud prevention—or if legal error is feared. As already noted, many scholars have argued that the damages threatened in FOTM class actions likely vastly exceed the true social costs of FOTM, something that was likely not true in the early years and which has prompted scholarly reform proposals. Moreover, the enormous damages threatened by FOTM class actions may encourage the filing of borderline suits and, in a vicious cycle, their settlement (assuming survival past a motion to dismiss). An ostensible desire to reduce overdeterrence costs has led to both Congressional and judicial efforts to increase defendants’s ability to secure early dismissal of low-merit suits. The scholarly literature examining the merits of FOTM suits, as well as the effect of these reform efforts, is abundant.39 A final, additional factor that must be considered in a deterrence analysis is whether alternative enforcement mechanisms could generate a greater net savings in social costs than the existing FOTM class action regime. Scholars have argued that a variety of such mechanisms exist or could be created. For example, many have argued that a system focused more on individual liability would produce greater social welfare gains (Arlen & Carney 1992; Fox 2009a; Booth 2007), and have offered suggestions for how the current FOTM class action regime might be reformed to achieve this result (Langevoort 2007; Coffee 2006; Pritchard 2008). Other scholars have pointed to enhanced public enforcement efforts as a better alternative to FOTM class actions (Rose 2010; Bratton & Wachter 2011). A variety of other proposals in this spirit exist (Fox 2009a; Rose 2008; Pritchard 1999; Evans 2007).

4. CONCLUSION The Rule 10b-5 private right of action has changed considerably since first implied in 1946. While the early version of the right could find an easy defense under traditional corrective justice and deterrence rationales for liability, its modern incarnation—the FOTM class action—cannot. This chapter has offered a historical and theoretical context for understanding the voluminous body of scholarship examining the contemporary social function of private Rule 10b-5 enforcement.

BIBLIOGRAPHY Aganin, Alexander (2015), “Securities Class Action Filings: 2016 Midyear Assessment,” Cornerstone Research Consulting. Alexander, Janet Cooper (1991), “Do the Merits Matter? A Study of Settlements in Securities Class Actions,” Stanford Law Review, 43, 497–598.

  Examples include Johnson et al. 2007; Choi 2006; and Choi 2004.

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54  Research handbook on representative shareholder litigation Alexander, Janet Cooper (1996), “Rethinking Damages in Securities Class Actions,” Stanford Law Review, 48, 1487–1538. Arlen, Jennifer (1994), “The Potentially Perverse Effects of Corporate Criminal Liability,”  Journal of Legal Studies, 23, 833–68. Arlen, Jennifer and William Carney (1992), “Vicarious Liability for Fraud on the Securities Markets: Theory and Evidence,” University of Illinois Law Review, 691–740. Arlen, Jennifer and Reinier Kraakman (1997), “Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes,” New York University Law Review, 72, 687–779. Baker, Tom and Sean J. Griffith (2007a), “Predicting Corporate Governance Risk: Evidence from the Directors’ & Officers’ Liability Insurance Market,” University of Chicago Law Review, 74, 487–544. Baker, Tom and Sean Griffith (2007b), “The Missing Monitor in Corporate Governance: The Directors’ & Officers’ Liability Insurer,” Georgetown Law Journal, 95, 1795–1842. Booth, Richard A. (2007), “The End of the Securities Fraud Class Action as We Know It,” Berkeley Business Law Journal, 4, 1–36. Bratton, William W. and Michael L. Wachter (2011), “The Political Economy of Fraud on the Market,” University of Pennsylvania Law Review, 160, 69–168. Bulan, Laarni T., Ellen M. Ryan and Laura E. Simmons (2015), “Securities Class Action Settlements: 2015 Review and Analysis,” Cornerstone Research Consulting. Burch, Elizabeth Chamblee (2007), “Reassessing Damages in Securities Fraud Class Actions,” Maryland Law Review, 66, 348–97. Calabresi, Guido (1970), The Costs of Accidents: A Legal and Economic Analysis. Yale University Press. Choi, Stephen J. (2004), “The Evidence on Securities Class Actions,” Vanderbilt Law Review, 57, 1465–1526. Choi, Stephen J. (2006), “Do the Merits Matter Less after the Private Securities Litigation Reform Act?” Journal of Law, Economics & Organization, 23, 598–626. Coase, R.H. (1960), “The Problem of Social Cost,” Journal of Law and Economics, 3, 1–44. Coffee, Jr, John C. (1983), “Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working,” Maryland Law Review, 42, 215–88. Coffee, Jr, John C. (1986), “Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions,” Columbia Law Review, 86, 669-727. Coffee, Jr, John C. (2006), “Reforming the Securities Class Action: An Essay on Deterrence and its Implementation,” Columbia Law Review, 106, 1534–86. Cox, James D. (1997), “Making Securities Fraud Class Actions Virtuous,” Arizona Law Review, 39, 497–524. Dubbs, Thomas A. (2009), “A Scotch Verdict on ‘Circularity’ and Other Issuers,” Wisconsin Law Review, 455–64. Dyck, Alexander, Adair Morse,  and  Luigi Zingales (2010), “Who Blows the Whistle on Corporate Fraud?” Journal of Finance, 65, 2213–53. Easterbrook, Frank and Daniel Fischel (1985), “Optimal Damages in Securities Cases,” University of Chicago Law Review, 52, 611–52. Evans, Alicia Davis (2007), “The Investor Compensation Fund,” Journal of Corporation Law, 33, 223–96. Evans, Alicia Davis (2015), “Do Investors’ Gains and Losses from Fraud on the Market Even Out?” Available at https://ssrn.com/abstract=1121198. Fitzpatrick, Brian T. (2010), “An Empirical Study of Class Action Settlements and Their Fee Awards,” Journal of Empirical Legal Studies, 7, 811–46. Fisch, Jill E. (2009), “Confronting the Circularity Problem in Private Securities Litigation,” Wisconsin Law Review, 333–50. Fox, Merritt B. (2005), “Demystifying Causation in Fraud-on-the-Market Actions,” Business Lawyer, 60, 507–32. Fox, Merritt B. (2009a), “Civil Liability and Mandatory Disclosure,” Columbia Law Review, 109, 237–308. Fox, Merritt B. (2009b), “Why Civil Liability for Disclosure Violations When Issuers Do Not Trade?” Wisconsin Law Review, 297–332. Freeman, Milton (1967), “Administrative Procedures,” Business Lawyer, 22, 891–926. Gelter, Martin (2013), “Risk-Shifting through Issuer Liability and Corporate Monitoring,” European Business Organization Law Review, 14, 497–533. Grundfest, Joseph A. (1994), “Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission’s Authority,” Harvard Law Review, 107, 961–1024. Grundfest, Joseph A. (2014), “Damages and Reliance Under Section 10(b) of the Exchange Act,” Business Lawyer, 69, 307–92. Johnson, Marilyn F., Karen K. Nelson, and A. C. Pritchard (2007), “Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act,” Journal of Law, Economics & Organization, 23, 627–52. Karpoff, Jonathan M., D. Scott Lee, and Gerald S. Martin (2008), “The Cost to Firms of Cooking the Books,” Journal of Financial & Quantitative Analysis, 43, 581–612.

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The Rule 10b-5 private right of action  55 Klausner, Michael, Jason Hegland, and Matthew Goforth (2013),  “How Protective is D&O Insurance in Securities Class Actions? An Update,” Professional Liability Underwriting Society Journal, 26, 1–4. Kornhauser, Lewis (1981), “An Efficiency Analysis of Vicarious Liability under the Law of Agency,” Yale Law Journal, 91, 168–206. Kornhauser, Lewis (1982), “An Economic Analysis of the Choice Between Enterprise and Personal Liability for Accidents,” California Law Review, 70, 1345–92. Landes, William M. and Richard A. Posner (1987), The Economic Structure of Tort Law. Harvard University Press. Langevoort, Donald C. (1996), “Capping Damages for Open-Market Securities Fraud,” Arizona Law Review, 38, 639–64. Langevoort, Donald C. (1997), “Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Harms),” University of Pennsylvania Law Review, 146, 101–72. Langevoort, Donald C. (2007), “On Leaving Corporate Executives ‘Naked, Homeless and Without Wheels’: Corporate Fraud, Equitable Remedies, and the Debate over Entity Versus Individual Liability,” Wake Forest Law Review, 42, 627–62. Langevoort, Donald C. (2010), “Reading Stoneridge Carefully: A Duty-Based Approach to Reliance and ThirdParty Liability under Rule 10b-5,” University of Pennsylvania Law Review, 158, 2125–72. Macey, Jonathan R. (1991), “Agency Theory and the Criminal Liability of Organizations,” Boston University Law Review, 71, 315–40. Macey, Jonathan R. and Geoffrey P.  Miller (1991), “The Plaintiffs’ Attorney’s Role in  Class Action  and Derivative Litigation: Economic Analysis and Recommendations for Reform,” University of Chicago Law Review, 58, 1–118. Mahoney, Paul G.  (1992), “Precaution Costs and the Law of Fraud in Impersonal Markets,”  Virginia Law Review, 78, 623–70. Mitchell, Lawrence E. (2009), “The ‘Innocent’ Shareholder: An Essay on Compensation and Deterrence in Securities Class Action Lawsuits,” Wisconsin Law Review, 243–96. Park, James J. (2009), “Shareholder Compensation as Dividend,” Michigan Law Review, 108, 323–72. Posner, Richard A. (1981), “The Concept of Corrective Justice in Recent Theories of Tort Law,” Journal of Legal Studies, 10, 187–206. Prentice, Robert A. (1997), “Conceiving the Inconceivable and Judicially Implementing the Preposterous: The Premature Demise of Respondent Superior Liability Under Section 10(b)”, Ohio State Law Journal, 58, 1325–1420. Pritchard, A.C. (1999), “Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers,” Virginia Law Review, 85, 925–1020. Pritchard, A.C. (2008), “Stoneridge Investment Partners v. Scientific Atlanta: The Political Economy of Securities Class Action Reform,” Cato Supreme Court Review, 217–55. Pritchard, A.C. (2015), “Halliburton II: A Loser’s History,” Duke Journal of Constitutional Law & Public Policy, 10, 27–55. Rose, Amanda M. (2008), “Reforming Securities Litigation Reform: Restructuring the Relationship between Public and Private Enforcement of Rule 10b-5,” Columbia Law Review, 108, 1301–64. Rose, Amanda M. (2010), “The Multienforcer Approach to Securities Fraud Deterrence: A Critical Analysis,” University of Pennsylvania Law Review, 158, 2173–2232. Rose, Amanda M. (2014), “Better Bounty Hunting: How the SEC’s New Whistleblower Program Changes the Securities Fraud Class Action Debate,” Northwestern University Law Review, 108, 1235–1300. Rose, Amanda M. (2015), “Form vs. Function in Rule 10b-5 Class Actions,” Duke Journal of Constitutional Law & Public Policy, 10, 57–69. Rose, Amanda M. (2017), “The ‘Reasonable Investor’ of Federal Securities Law: Insights from Tort Law’s ‘Reasonable Person’ & Suggested Reforms,” available at https://ssrn.com/abstract=2840993. Rose, Amanda M. and Richard Squire (2011), “Intraportfolio Litigation,” Northwestern University Law Review, 105, 1679–1706. Sale, Hillary A. (1998), “Heightened Pleading and Discovery Stays: An Analysis of the Effect of the PSLRA’s Internal-Information Standard on ’33 and ’34 Act Claims,” Washington University Law Quarterly, 76, 537–96. Seligman, Joel (1994), “The Merits Do Matter: A Comment on Professor Grundfest’s Disimplying Private Rights of Action under the Federal Securities Laws: The Commission’s Authority,” Harvard Law Review, 108, 438–57. Shavell, Steven (2004), Foundations of Economic Analysis of Law. Harvard University Press. Spindler, James C. (2016), “We Have A Consensus on Fraud on the Market—and It’s Wrong,” available at https://ssrn.com/abstract=2811318. Stewart, Richard B. and Cass R. Sunstein (1982), “Public Programs and Private Rights,” Harvard Law Review, 95, 1193–1322. Sykes, Alan O. (1984), “The Economics of Vicarious Liability,” Yale Law Journal, 93, 1231–82.

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56  Research handbook on representative shareholder litigation Sykes, Alan O. (1988), “The Boundaries of Vicarious Liability: An Economic Analysis of the Scope of Employment Rule and Related Legal Doctrines,” Harvard Law Review, 101, 563–609. Thel, Steven (2014), “Taking Section 10(b) Seriously: Criminal Enforcement of SEC Rules,” Columbia Business Law Review, 1–46. Velikonja, Urska (2013), “The Cost of Securities Fraud,” William & Mary Law Review, 54, 1887–1958. Weinrib, Ernest J. (1995), The Idea of Private Law. Oxford University Press. Weinrib, Ernest J. (2011), “Civil Recourse and Corrective Justice,” Florida State University Law Review, 39, 273–98.

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PART II SHAREHOLDER DERIVATIVE SUITS

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4.  The (un)changing derivative suit Jessica Erickson*

1. INTRODUCTION The past 25 years brought great upheaval in shareholder litigation. The Private Securities Litigation Reform Act of 1995 (“PSLRA”) upended securities class actions.1 As a result of this legislation, institutional investors now play a far more prominent role in these cases (Choi, et al. 2005), but also face procedural hurdles nearly unprecedented in our legal system (Erickson 2016). More recently, the number of merger class actions skyrocketed, as shareholders began to challenge nearly every significant merger or acquisition, often in multiple jurisdictions across the country (Sinha 2016). To curb these suits, courts announced increased scrutiny of settlements and invited companies to limit these suits in their governing documents.2 These legal innovations are fundamentally changing the way that shareholders litigate these types of claims. During this same time period, however, a third category of shareholder litigation­— shareholder derivative suits—has largely flown under the radar. There has been no major federal or state legislation targeting derivative suits. Courts have not announced any special scrutiny of settlements in these suits. And corporations have not rushed to include new procedures for these suits in their charters or bylaws.3 The upheaval in other types of shareholder lawsuits has largely missed derivative suits. One might surmise that derivative suits have escaped scrutiny because they do not raise the same problems as securities class actions and merger class actions. Yet empirical evidence shows the opposite. More than 70 years of studies have consistently found that derivative suits face deep and systematic problems (Wood 1944; Romano 1991; Erickson 2016). Few derivative suits end with monetary settlement. Instead, most derivative suits end with the plaintiff corporation agreeing to make fairly insignificant changes to its corporate governance practices (Romano 1991; Erickson 2016). Despite their modest benefits, these suits remain profitable for plaintiffs’ attorneys, with the median fee award close to a million dollars (Erickson 2016). Derivative suits have stayed under the radar, but not because they are working well. Instead, derivative suits have failed to attract attention for far more banal reasons. Unlike securities class actions, derivative suits are primarily filed under state law, so

*  I would like to thank Verity Winship and participants at the Fourth Annual Workshop for Corporate & Securities Litigation for helpful comments on an earlier draft of this chapter. 1   15 U.S.C. § 78u-4 (2016). 2   See In re Trulia, Inc. S’holder Litig., 129 A.3d 884 (Del. Ch. 2016). 3   As explained below, litigation-limiting provisions are sometimes worded broadly enough to include derivative suits, but the impetus behind the provisions is the problems in merger class actions. Derivative suits are just swept into broadly worded provisions aimed at another set of problems.

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The (un)changing derivative suit  59 Congress alone cannot fix the problems. Unlike merger cases, these problems have also been fairly consistent, so there has not been a sudden change to draw lawmakers’ attention. And unlike both of the previous types of suit, they have been subject to relatively minor reforms over the years, creating a sense that the problems have been addressed. And yet they haven’t. Franklin Wood conducted the first empirical examination of derivative suits in 1944, focusing his review on suits filed in New York state courts (Wood 1944). Since then, a number of other studies have examined derivative suits from different angles.4 Conducted over more than 70 years, these studies reached the same basic conclusions. There were differences at the margins—derivative suits in Delaware, for example, look better than derivative suits filed elsewhere (Thompson & Thomas 2004)—but overall, the story is one of high costs and low rewards for plaintiff corporations and their shareholders. This chapter argues that the time has come for the legal system to reexamine its approach to derivative suits. There are at least three ways that the legal system can bring more scrutiny to these suits. First, judges can examine settlements in derivative suits more closely, using the same heightened scrutiny many judges are now using in merger litigation. Second, corporations and their shareholders can engage in self-help by including litigation-limiting provisions in their charters and bylaws. Third, legislatures can adopt new statutes or rules implementing new heightened procedures in these suits, such as heightened pleading or fee shifting. The chapter proceeds as follows. Section 2 explores the empirical history of derivative suits, exploring the longstanding problems in these suits. Section 3 explains why these problems have been so persistent, contrasting the legislative and judicial inaction in derivative suits with the significant reform efforts in securities class actions and merger cases. Section 4 concludes by describing a new approach to derivative suits, one that envisions a new approach for judges, corporations, and legislatures. When it comes to derivative suits, seventy years of problems is enough.

2.  THE MORE THINGS CHANGE. . . A lawyer who picked up Franklin Wood’s 1944 study of derivative suits would be forgiven for thinking that the study described the current state of affairs. Just as in 1944, derivative suits today seldom end with meaningful financial recoveries for the plaintiff corporation. Instead, in many instances, the primary beneficiaries of these suits are the lawyers who file them. This section describes the empirical research regarding derivative suits over the past

4   Among the major study of derivative suits are Franklin Wood’s study of derivative suits in New York state court in the 1940s (Wood 1944), Thomas Jones’ examination of derivative suits filed in the 1970s (Jones 1980), Roberta Romano’s 1991 study of derivative suits filed against public companies (Romano 1991), Randall Thomas and Robert Thompson’s 2004 study of derivative suits filed in Delaware (Thomas & Thompson 2004), my 2010 study of derivative suits filed in federal court (Erickson 2010), and my coauthored study with Stephen Choi and Adam Pritchard of the interplay between securities class actions and derivative suits (Choi et al., 2018). Other studies examine particular aspects of derivative litigation, most notably Minor Myers’ review of SLC decisions (Myers 2009).

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60  Research handbook on representative shareholder litigation 70 years, explaining how little things have changed over this time period. It then explores the bright spots where derivative suits have brought value despite the empirical criticism. 2.1  Seventy Years of Problems 2.1.1  Few financial recoveries Most lawsuits boil down to money—the plaintiffs want to recover money, the defendants do not want to pay money, and the judge ultimately allocates the money. Derivative suits do not fit this mold. For more than 70 years, researchers have repeatedly found that a surprisingly small percentage of derivative suits end with cash payments to plaintiff corporations or their shareholders. The first major study of shareholder derivative suits was conducted in 1940 by Franklin Wood, who was hired by the Chamber of Commerce of the State of New York (Wood 1944). Mr Wood examined derivative suits filed in New York state and federal court between 1932 and 1942. He found recoveries for the plaintiff in only 46 of the 573 suits involving public companies. He also found that the typical settlement was worth less than 3 percent of the damages alleged in the complaint. He concluded that “[t]he outstanding fact derived from this survey is the large preponderance of unsuccessful and unfounded stockholder derivative actions” (p.112). Professor Roberta Romano reached a similar conclusion approximately forty-five years later, stating that “[s]hareholder-plaintiffs . . . have abysmal success in court [and] the proportion of derivative suits with a cash payout to shareholders is significantly lower than that of class actions.” (Romano 1991, 60). Examining shareholder suits filed from the late 1960s through 1987, she found that only 12 derivative suits out of a total of 128 resolved suits ended with the corporations or its shareholders receiving any monetary recovery.5 On average, these settlements averaged $0.18 a share ($0.15 net of attorneys’ fees), representing only 2 percent of the stock price on the day prior to filing. Moreover, the average recovery in the derivative suits was approximately half of the recovery in the class actions in her study and represented a far smaller percentage of firm assets. I conducted the most recent study of derivative suits, focusing on suits filed in federal court in the mid-2000s (Erickson 2010). Of the 141 suits filed on behalf of public companies in this study, only 22 (16 percent) ended with the corporation or its shareholder receiving a meaningful financial benefit. Only 13 of these cases involved the typical cash payment often seen in other types of lawsuits. In other cases, the defendants agreed to reprice their stock options or otherwise alter their financial relationship with the corporation. Moreover, nearly all of the cases with monetary settlements involved allegations that the defendants had backdated stock options. These cases dominated the business press

5   It is difficult to determine an exact percentage of the derivative suits in this study that ended with a monetary recovery. Professor Romano states that only 12 derivative suits in the study ended with a monetary recovery, but she does not break out the total number of derivative suits in the study. A study of shareholder suits filed in the 1970s found a larger percentage of suits ending with a monetary recovery (Jones 1980). This study, however, was not based on a random sample of suits. His original data set included a random sample of 190 companies, but he then added 15 companies to the sample that he knew had been named in major shareholder lawsuits, skewing the results of the study.

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The (un)changing derivative suit  61 during the relevant time period, but they were not representative of more classic derivative suits. In the more typical suits that did not involve allegations of backdating, only one ended with the plaintiff corporation receiving a cash payment. In short, this study found relatively few monetary settlements, and the cases that did end with monetary settlements tended to involve very different allegations than the more typical derivative suits. Although these studies stretch over nearly 70 years, they reach the same conclusion. Derivative suits, unlike most lawsuits, rarely end with the plaintiff receiving money.6 2.1.2  Many nonmonetary settlements The far more common outcome in these suits is a nonmonetary settlement in which the plaintiff corporation agrees to change its own corporate governance practices, often in fairly minor ways. These settlements seem to be a recent invention because they are not mentioned in Franklin Wood’s 1944 study. By the 1990s, however, these settlements had become standard practice. In her study, Professor Romano found that nonmonetary settlements were more than twice as common as monetary settlements (Romano 1991). She stated: “while it is impossible to value the benefits from structural settlements with any precision, the gains seem inconsequential.” For example, several of the settlements involved changes to the composition of the board, which Professor Romano notes is a “potentially important reform,” yet she found the specific changes in the settlements at issue “cosmetic.” She stated that the other reforms involved “even more cosmetic organizational change” (p.63). She hypothesized that the nonmonetary settlements were used primarily to justify the award of attorneys’ fees to plaintiffs’ counsel. The findings in my study two decades later were largely consistent (Erickson 2010). Approximately 24 percent (34 of the 141) of the derivative suits filed on behalf of public companies ended with nonmonetary relief. And, as in the Romano study, these settlements rarely appeared significant. A close examination of the settlements revealed several common problems. First, many of the reforms had little to do with the alleged problems that led to the litigation. Second, the reforms were fairly uniform from case to case, regardless of the underlying allegations in the suit. Third, these common reforms had questionable value, with empirical studies showing many of them to be ineffective in promoting shareholder value. Taken together, this data suggests that corporate governance reforms are often window dressing, allowing defendants to settle derivative suits cheaply while giving plaintiffs’ attorneys a basis to recover fees. 2.1.3  High fees and low stakes Scholars have long noted that derivative suits involve significant agency costs (Macey & Miller 1991; Coffee 1986). The plaintiff corporation is the real party in interest, and any recovery goes to the corporation.7 In practice, however, the corporation does not control 6   Ironically, one other type of lawsuit in which nonmonetary settlements are common is merger cases, where for many years it has been common for the corporation to agree to make relatively insignificant supplemental disclosures in exchange for dismissal of the suit. Just as with shareholder derivative suits, these nonmonetary settlements have been roundly criticized. 7   See In re Wal-Mart Stores, Inc. Del. Derivative Litig., Case No 7455-CB, 2016 WL 2908344, at 16 (May 13, 2016).

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62  Research handbook on representative shareholder litigation the litigation because the board of directors, which normally makes litigation decisions for the corporation, is often implicated in the alleged misconduct and therefore cannot make unbiased decisions about the litigation.8 As a result, derivative suits are typically controlled by a representative shareholder and his or her attorney. This relationship has long been subject to criticism. Franklin Wood, for example, colorfully claimed that “[t]his shoddy burlesque of a professional relationship to clients makes the ambulance-chaser by comparison a paragon of propriety” (Wood 1944, 49). He based this critique on the low ownership of many representative shareholders in the plaintiff corporation. It is difficult to collect empirical data regarding average ownership stakes because representative plaintiffs are typically not required to disclose this information to courts. Anecdotal evidence, however, suggests that many plaintiffs own relatively few shares in the plaintiff corporation. As an example, Wood describes the briefs from one case, which made clear that “in the event of success the five plaintiffs stood to gain, by theoretical appreciation of the value of their stock, the respective amounts of $3.57, $.41, $2.41, $.17, and $.65” (Wood 1944). My study similarly found that “although derivative plaintiffs rarely disclosed their precise ownership interest in the plaintiff corporations, few shareholders appeared to own a significant stake in these corporations” (Erickson 2010, 1765). This state of affairs may slowly be changing. More recent empirical evidence suggests that institutional investors are participating in a greater percentage of derivative suits. Approximately one third of the derivative suits filed on behalf of public companies in my study were filed by institutional investors (Erickson 2010). These financial institutions were almost all public pension or labor funds, rather than more traditional financial institutions. These institutional investors were far more common in the cases involving the alleged backdating of stock options, suggesting that they are drawn to the bigger, higher quality cases. Perhaps over time, the rise of institutional investors will change the state of play in derivative litigation. For the time being, however, attorneys control most derivative suits, and these suits remain quite profitable for them. Professor Romano found that plaintiffs’ attorneys received an average of $1.45 million in cases ending with monetary settlements and $287,000 in cases ending with nonmonetary settlements (Romano 1991). This disparity had increased twenty years later. My study found that the median fee in cases ending with monetary settlements was $6.65 million, while the median fee in cases ending with nonmonetary settlements was only $460,000 (Erickson 2010). These figures reflect courts’ recognition that nonmonetary settlements are less valuable to plaintiff corporations than traditional monetary settlements, but they also demonstrate that both types of settlements are profitable for attorneys. 2.1.4  Tagalong to other suits Derivative suits may not fare well when examined on their own, but they fare even worse when examined within the broader context of corporate litigation. No form of corporate litigation, including shareholder derivative suits, exists in a vacuum. In the wake of corporate wrongdoing, shareholders and the government have an array of litigation 8

  See Ryan v. Gifford, 918 A.2d 341, 352 (Del. 2007).

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The (un)changing derivative suit  63 options available to them, including shareholder derivative suits, securities class actions, SEC enforcement actions, criminal investigations, and ERISA class actions (Erickson 2011). When compared to these other litigation options, shareholder derivative suits look even worse. This comparison is fairly new. The older research on derivative suits did not examine them in relation to other types of litigation. In my study examining derivative suits filed in the mid-2000s, however, I also examined the other lawsuits that arose out of the underlying allegations (Erickson 2011). I found that nearly 95 percent of the shareholder derivative suits filed on behalf of public companies were accompanied by at least one parallel lawsuit or government investigation. More than 80 percent of the public company derivative suits were accompanied by two or more parallel lawsuits or government investigations. Overall, these companies faced a median of four different types of litigation arising out of the same underlying event. Corporate law, it seems, leaves few stones unturned when it comes to litigating corporate misconduct. Moreover, the study found that shareholder derivative suits were typically less effective than these other options. The median settlement amount in the parallel securities class actions was $18 million. Not one of the shareholder derivative suits in my study settled for anything close to this number (Erickson 2011).9 It might be that shareholder derivative suits earn their keep by focusing more on individuals, given that securities class actions are typically aimed at the corporation itself. Yet it is hard to argue that derivative suits are accomplishing much on that front either. In the relatively few derivative suits that ended with financial settlements, the individuals named as defendants rarely contributed any money (Erickson 2010). Moreover, shareholder derivative suits are not the only suits that target individuals. The Securities & Exchange Commission and the Department of Justice also target the specific individuals who committed the wrongdoing at issue, often with more success. In short, in the hierarchy of corporate lawsuits, shareholder derivative suits may well be at the bottom. A recent and more extensive study confirms this conclusion (Choi, et al. 2017). This study started with a sample of 582 securities class actions filed against public companies between July 1, 2005 and December 31, 2008 and then examined all derivative and class action lawsuits arising out the same underlying allegations. This study made three important findings. First, nearly half (45.4 percent) of the securities class actions had a parallel derivative suit or class action, with most of these parallel suits filed in the federal courts. Second, the evidence suggests that attorneys in parallel suits cherry pick the most promising securities class actions when deciding which suits to file. Third, attorneys who frequently file parallel suits are more likely to obtain lower monetary recoveries for their clients. They are also more likely to agree to settlements involving corporate governance reforms. At the same time, however, these attorneys receive higher attorneys’ fees and expenses, at least as a ratio of the attorneys’ fees and expenses awarded in the

9   This is not to say that derivative suits never settle for substantial sums of money. Indeed, Part II(B) describes a few of the sizable settlements that have occurred in derivative suits over the past several years. The point here, however, is that large financial settlements are relatively uncommon in derivative suits, whereas they occur relatively frequently in the other types of suit that arise out of the same underlying events.

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64  Research handbook on representative shareholder litigation a­ ccompanying securities class action. In short, these attorneys deliver less to shareholders, but get more for themselves. These studies reinforce the longstanding concerns about derivative suits. Although these suits typically challenge the same underlying allegations as securities class actions or other types of litigation, they return much less value to corporations or their shareholders. The empirical evidence suggests that attorneys are often using derivative suits not to uncover new types of misconduct or to advance new theories of liability, but rather to obtain a share of the attorneys’ fees.10 2.2  Bright Spots among the Criticism Despite this criticism, there are some bright spots in the empirical record. First, the problem itself is fairly limited. Unlike the recent spike of merger cases, there has never been a similar explosion of derivative litigation. In my survey of derivative suits in the federal courts, I found that only 126 public companies had been named as plaintiffs in derivative suits during the one-year period covered in the study (Erickson 2010). This number is not insignificant—at the time of this study, derivative suits were likely the most common type of shareholder lawsuit, outpacing both securities class actions and acquisition class actions.11 Even still, however, only a small percentage of the 4,700 public companies listed on US stock exchanges at the time faced such a suit—a conclusion reached by other studies as well (Romano 1991). Along similar lines, Randall Thomas and Robert Thompson found that approximately 30 shareholder derivative suits are filed per year in the Delaware Court of Chancery (Thompson & Thomas 2004). In other words, shareholder derivative suits may not offer many benefits, but their costs are relatively minor. Another bright spot concerns geography. Even within the relatively small world of shareholder derivative suits, some jurisdictions seem to attract better suits. Randall Thomas and Robert Thompson examined shareholder derivative suits filed in the Delaware Court of Chancery in 1999 and 2000 (Thompson & Thomas 2004). Although most of the settlements in these suits were nonmonetary, the authors found that these settlements often returned “very real gains” to the plaintiff corporations (p.1779), challenging the “traditional story” that derivative suits “almost never produce real recovery for shareholders” (p.1774). Even this study, however, did not paint shareholder derivative suits in a completely positive light. Of the cases that ended before the study closed, approximately two thirds were dismissed without the plaintiff corporation receiving any relief. In short, Delaware has a better track record than other jurisdictions when it comes to shareholder derivative suits, although even this court still experiences many of the same problems that plague derivative suits more widely. In addition, shareholder derivative suits have shone in addressing particular types of corporate misconduct, most recently the backdating of stock options. In the mid-2000s, it was revealed that many companies had backdated their stock options, allowing them to

10   Randall Thomas and Robert Thompson have developed a similar theory in connection with multijurisdictional litigation (Thomas & Thompson 2012). 11   As most readers know, this soon changed as shareholders started to file an increasing number of merger class actions (Sinha 2016).

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The (un)changing derivative suit  65 manipulate their value. The derivative suits filed in the wake of these revelations ended far more favorably for plaintiff corporations than more traditional derivative suits. My study, for example, found that 40 percent of stock option suits ended with the plaintiff corporation obtaining a meaningful financial benefit, compared to only 2 percent of the other suits in the study (Erickson 2010). Other studies have found that shareholder derivative suits were a better vehicle to address these allegations than securities class actions, a head to head comparison that derivative suits rarely win (Fuerman 2016). Finally, sprinkled among the more negative news about derivative suits are cases in which the plaintiff corporation unquestionably received real value. In 2013, for example, News Corporation received a $139 million settlement for claims related to the company’s use and attempted coverup of illegal reporting tactics.12 In 2014, Activision Blizzard received $275 million in connection with a derivative suit challenging the company’s purchase of 50 percent of its outstanding shares from its controlling shareholder.13 And in 2015, Freeport-McMoRan Copper & Gold Inc. agreed to a $137.5 million settlement to resolve claims that the company overpaid in its purchase of two companies as a result of conflicts of interest among the board.14 These settlements, and others like them, reveal that the derivative suits can bring real value to corporations. As this discussion illustrates, derivative suits have a silver lining. The empirical record overall is largely negative, but even the most ardent critics of derivative suits would likely concede that these suits have some value. This concession complicates the reform agenda. If derivative suits had no silver lining, states could eliminate them without a second glance, leaving the enforcement of corporate law to other vehicles. By acknowledging that these suits have value, however, the legal system must go down the trickier path of sorting the good cases from the bad. Section 3 explores why the system has not embraced this challenge so far.

3.  WHY DERIVATIVE SUITS HAVE ESCAPED SCRUTINY If the problems in derivative suits have been obvious for so long, why has the legal system not tried harder to solve them? This section argues that there are at least four reasons. First, unlike merger litigation, there have not been any dramatic changes that have drawn lawmakers’ attention to these suits. Second, because these suits are not concentrated in any single court, there is no one legislature or set of judges that is uniquely motivated to take on the problem. Third, most of the parties in these suits are happy with the status quo and therefore are not pressing for reform. Finally, many states adopted a number of procedural reforms several decades ago, and although these reforms have been largely ineffective, they make lawmakers wary about piling on additional procedural hurdles. 12   See, e.g., News Corporation Form 8-K (May 6, 2013) (announcing settlement of derivative claims). 13   See, e.g., Tom Hals, Judge Oks Activision $275 million shareholder settlement, $72 million for lawyers, Reuters (May 20, 2015). 14   See, e.g., Jonathan Stempel, Freeport-McMoRan in $137.5 million settlement over purchases, Reuters (Jan. 15, 2015).

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66  Research handbook on representative shareholder litigation 3.1  No Perceived Crisis One possible reason that shareholder derivative suits have not come under greater scrutiny is that these suits have presented more or less the same problem for the past 70 years. The problems have not been identical for this time period, of course. There are likely more derivative suits that serve as tagalong suits to securities class actions and other types of lawsuits today than there were in Franklin Wood’s time. And, in the plus column, there were not $275 million settlements in 1944 either. But the more fundamental problem of derivative suits ending with low-value settlements that do not benefit corporations or their shareholders has been a persistent problem for many decades. This fact distinguishes shareholder derivative suits from the other common form of shareholder litigation brought under state law—merger litigation. For a long time, merger litigation, like derivative suits, largely flew under the radar. To the extent that these cases got any attention at all, the attention was largely positive. For example, a 2004 study concluded that, although merger cases were more common than previously recognized, these suits did not bear the same hallmarks of litigation agency costs as other types of shareholder litigation (Thompson & Thomas 2004). Specifically, this study found that merger cases often resulted in larger settlements and lower attorneys’ fees as a percentage of the amount recovered than these other suits. As a result, the authors recommended caution when lawmakers considered reforms that might impact these suits. All of this changed in the late 2000s, as other chapters in this book discuss in greater detail. Whereas shareholders challenged only 44 percent of larger mergers and acquisitions in 2007, this number grew to 93 percent by 2014 (Sinha 2016). As these suits became nearly ubiquitous, the criticism grew as well. Lawyers and scholars pilloried the rise in litigation as a “deal tax” plaguing corporate America.15 And Delaware courts agreed, issuing a series of decisions that rejected “peppercorn” settlements that offered little value to shareholders.16 In justifying this new approach, the Delaware Court of Chancery held that “far too often such litigation serves no useful purpose for stockholders. Instead, it serves only to generate fees for certain lawyers who are regular players in the enterprise of routinely filing hastily drafted complaints on behalf of stockholders . . . settling quickly on terms that yield no monetary compensation to the stockholders they represent.”17 Judges in many other jurisdictions soon followed Delaware’s lead.18 In the wake of these decisions, the number of merger cases has fallen, although perhaps not as much as Delaware judges had hoped (Griffith 2016). In hindsight, this backlash seems inevitable. And maybe it was, given the extreme 15   See Emily V. Burton et al., Reducing the “Deal Tax”: Delaware’s Recent Scrutiny of Nonmonetary Settlements, 2015 BUS. L. TODAY 1 (2015). 16   See, e.g., In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 894 (Del. Ch. 2016); In re Riverbed Technology, Inc. Stockholders Litig., C.A. No 10484–VCG, 2015 WL 5458041, at *2 n.6 (Sept. 17, 2015); In re TPC Group Inc. S’holders Litig., C.A. No 7865–VCN, 2014 WL 5500000, at 3 n.19 (Oct. 29, 2014). 17   See, e.g., In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 891–92 (Del. Ch. 2016). 18   See In Re: Walgreen Co. S’holder Litig., 832 F.3d 718 (2016); Corwin v. British Am. Tobacco PLC, No 14 CVS 8130, 2016 WL 635191 (N.C. Super. Ct. 2016); Vergiev v. Aguero, et al., No L-2776-15 (N.J. Super. Ct. 2016). But see Gordon v. Verizon Communications, Inc., Case No 653084/13, N.Y. App. Div. (Feb. 2, 2007).

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The (un)changing derivative suit  67 nature of the problem. But the problem still had to reach an almost comical level—93 percent of large mergers and acquisitions challenged in court, most of them in multiple jurisdictions—before there was any systematic response from courts. Judges in Delaware and elsewhere had always policed these lawsuits on a case-by-case basis, but it took a true crisis for judges to mobilize in a coordinated fashion.19 Derivative suits have never faced such a crisis. Sometimes derivative suits look particularly bad, and sometimes they look particularly good, but they never experienced the extreme change that merger litigation did. As a result, it has been easier for them to fly under the radar of meaningful reform. 3.2  No Judicial or Legislative Champion This lack of meaningful reform has been exacerbated by the fact that derivative suits do not have a natural judicial or legislative champion. Derivative suits are scattered across the country in both state and federal courts, making it difficult for a single jurisdiction to adopt effective reform. Again, derivative suits are different in this respect than merger litigation. It is important not to overstate this point, as merger cases became infamous over the past decade for their multijurisdictional nature. A 2013 study, for example, found that 62 percent of deals were challenged in more than one court, and these cases were litigated in courts across the country, from New York City to Harris County, Texas and Santa Clara, California (Koumrian 2014). But, despite this geographical diversity, Delaware remained a key battleground for these suits. The vast majority of deals were still challenged in Delaware, even if they were also filed elsewhere, giving Delaware at least some consistent authority over these suits (Koumrian 2014). In the high water years of merger litigation, Delaware found a way to increase this authority. In a now famous decision, the Delaware Court of Chancery invited companies to include forum selection provisions in their governing documents.20 A significant number of companies accepted this invitation; by 2014 nearly half of merger cases were filed only in Delaware and approximately 90 percent either only in Delaware or in Delaware and another jurisdiction (Sinha 2016). The fact that so many merger cases are filed in Delaware is significant for two reasons. First, Delaware judges see enough of these cases to understand the more systemic issues associated with them. If a given judge handles only a few merger cases a year, it is difficult for that judge to know if the cases before them are representative of merger cases more generally. In contrast, a judge who sees these cases day in and day out will have a more nuanced understanding of the broader issues. Second, Delaware judges are in a better position to address these issues. These judges can announce general rules, as the Delaware Court of Chancery did in Trulia, without worrying that these rules will impact only a small fraction of the cases. The same is true for lawmakers—a state’s legislature will only

19   As discussed below, a similar argument can be made about securities class actions in the mid-1990s. With respect to these cases, the crisis may have been more manufactured than real, but it still took a perceived crisis to get the legislature to act. 20   See In re Revlon, Inc. S’holders Litig., 990 A.2d, 940, 960 (Del. Ch. 2010).

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68  Research handbook on representative shareholder litigation feel the pressure to address a given type of lawsuit if the state sees enough of these cases to make reform worth the legislature’s time. Derivative suits are far more dispersed geographically, which makes it more difficult for individual judges to both understand and address the issues with these cases. The traditional view was that most derivative suits, like most merger class actions, were filed in Delaware. More recent research, however, suggests that a significant percentage of these cases are filed in federal court (Erickson 2010). Within the federal system, these cases are relatively dispersed (Erickson 2010). Researchers also have no idea how many derivative suits are filed in state courts other than Delaware. Most state dockets are not online, making it difficult both to know how many cases are filed in state court and to understand how these cases may be different from those filed in Delaware or in federal court. For example, it is likely that state courts see more derivative suits filed on behalf of private companies or smaller public companies, and these suits may differ from derivative suits filed on behalf of large public companies. The fact that scholars cannot study these cases means that it is difficult to understand these differences. And regardless of how these suits might vary, the fact that there is no single jurisdiction or court in which individual judges preside over a significant number of derivative suits makes it tough for judges to understand or address problems. Moreover, Delaware is unlikely to be a savior in this area because, as discussed above, the cases that are filed in Delaware look different than the cases filed elsewhere. The most recent empirical study focusing on derivative suits in Delaware suggests that these cases are less likely to end in nonmonetary settlements, and the nonmonetary settlements that Delaware does see are more likely to include meaningful reforms (Thompson & Thomas 2004). As a result, Delaware judges have less incentive to adopt systematic rules for these suits. 3.3  No Advocate around the Settlement Table An additional reason why derivative suits have long managed to fly under the radar is that no one is motivated to press for reform. Again, a comparison with other types of shareholder litigation helps illustrate this point. In securities class actions, companies had a strong financial incentive to lobby Congress because typical settlements in these cases were in the millions of dollars. In merger cases, as discussed, there were rarely multimillion-dollar settlements, but these suits became so ubiquitous that they nonetheless got business groups’ attention. These examples suggest that judges and lawmakers take action when the amounts at stake cause defendants to press for reform or the sheer number of suits becomes impossible to ignore. Derivative suits do not fit either criteria. First, the amount at stake in these suits is rarely significant enough to cause corporations or their executives to lobby for reform. As detailed above, these suits typically end with plaintiff corporations agreeing to make fairly trivial changes to their corporate governance practices. These changes impose little cost on corporations, who often would have adopted the same reforms anyway (Erickson 2010). Additionally, these suits generally impose no costs whatsoever on the individual defendants in the suits, even though they are the ones who allegedly engaged in the wrongdoing. Individual defendants can get out of the suits by letting their insurance company pay their legal fees and the corporation make the necessary governance reforms. The suits may be a nuisance, but they are not an expensive nuisance.

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The (un)changing derivative suit  69 Second, although derivative suits are relatively common, they never saw the same spike in filings that prompted reform of merger cases. Moreover, derivative suits are frequently filed at the same time as other, potentially more costly litigation related to the same events. Given the higher stakes in these other lawsuits, corporations and their executives are typically focused more on those lawsuits than the tagalong derivative claims. As a result, even after the suits are over, neither plaintiff corporations nor their executives are motivated to press for reform. In theory, shareholders might have an incentive to press for reforms to protect their investment in the plaintiff corporations. Yet the shareholders who serve as representative plaintiffs in these suits usually own too little stock in the plaintiff corporation to ensure that settlements are in the best interests of these corporations. And institutional investors who may own more stock in the plaintiff corporation rarely file these suits. As a result, they likely do not see a financial or institutional reason to devote their own time to reforming this corner of the law. The final set of participants in these suits—attorneys—similarly has little incentive to press for reform because attorneys benefit from these suits, even if their clients do not. Plaintiffs’ attorneys are entitled to compensation in derivative suits as long as the settlement provided “substantial benefit” to the plaintiff corporation,21 a point which the parties typically stipulate in the settlement agreement and that is rarely questioned by the court. Similarly, these suits can be lucrative for defense attorneys, given the number of parties who need separate representation and the possibility of representing corporate boards or committees of these boards in related internal investigations. Legal reform occurs when someone advocates for it. With securities class actions, corporate America put tremendous pressure on Congress to adopt new restrictions on these suits.22 With merger class actions, the problem became so obvious that judges and other commentators could not help but take steps to address it.23 With derivative suits, however, the problems have never reached the level where those impacted by the suits felt moved to advocate for comprehensive reforms. As we shall see, however, this does not mean that states have been completely passive in responding to these suits. 3.4  Ineffective Procedural Reforms The prior section argues that derivative suits have escaped major legislative and judicial scrutiny. That does not mean, however, that these suits have escaped all reform efforts over the past 70 years. Derivative suits are subject to a host of procedural requirements that 21   See In re Johnson & Johnson Derivative Litig., 900 F. Supp. 2d 467, 488 (D.N.J. 2012) (“Case law makes clear that corporate governance reforms, unaccompanied by monetary damages, may form the basis for an attorney’s fee award where the reforms confer a ‘substantial benefit’ on the plaintiff corporation”). 22   See, e.g., H.R. Rep. No 104-369, at 31 (1995) (“Congress has been prompted by significant evidence of abuse in private securities lawsuits to enact reforms to protect investors and maintain confidence in our capital markets”). 23   See In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 887 (Del. Ch. 2016) (discussing “concerns that scholars, practitioners and members of the judiciary have expressed that these settlements rarely yield genuine benefits for stockholders and threaten the loss of potentially valuable claims that have not been investigated with rigor”).

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70  Research handbook on representative shareholder litigation do not apply to other types of civil lawsuits. This section explores these requirements and explains why they are unlikely to solve the problems. Before getting into the specific procedural requirements, however, it is worth discussing what these requirements should aim to do. All procedural rules are designed to sort the good cases from the bad, allowing meritorious claims to go forward while barring meritless ones (Erickson 2016). In general, procedural rules are transsubstantive, with the same procedures applying in all civil cases,24 and the legal system generally believes that transsubstantive rules do a decent job of sorting meritorious cases, at least in most areas of the law. Yet, although transsubstantive rules may work as a general matter, they sometimes cannot address the challenges associated with specific types of claims.25 As a result, lawmakers often adopt heightened procedural rules that apply only in these cases.26 The goals of these heightened procedures, however, are the same as the goals of other procedural rules—to accurately sort cases with merit from those without. Accordingly, in assessing the heightened procedural rules applicable in shareholder derivative suits, it is appropriate to ask if they are accomplishing this goal. These rules tend to fall into two categories. The first category includes rules that make it more difficult for all shareholders to file derivative suits, while the second gives power to corporate boards and committees to control these suits. As discussed presently, neither type is likely to sort the meritorious derivative suits from the meritless ones, at least in a way that would prevent many of the meritless suits from being filed in the first place. The first type of procedural rules—those that make it more difficult for all shareholders to file derivative suits—have been common since at least the publication of the Wood Report. Following publication of this report in 1944, many states adopted bond requirements, which require plaintiffs (or permitted courts to require plaintiffs) to post a bond with the court to indemnify the corporation against any expenses, including attorneys’ fees, incurred in successfully opposing a derivative suit. The primary objective of these statutes was to discourage actions by shareholders with only a small stake in the corporation, an aim that was furthered by a common exemption if the plaintiffs held more than five percent of the corporation’s stock. These statutes were initially viewed as the “death knell” for derivative suits (Ferrera, et al. 2013). As commentators have noted, however, these statutes had little impact on

24   See Fed. R. Civ. P. 1 (“These rules govern the procedure in all civil actions and proceedings in the United States district courts, except as stated in Rule 81”). 25   Derivative suits are an appropriate area for heightened procedural reforms because they suffer from greater cost asymmetries than other types of civil litigation. Plaintiffs will typically not file lawsuits that they do not expect to win because their expected costs to litigate the suit will exceed their likely monetary gains from the suit. In derivative suits, as well as other types of cost asymmetric cases, however, the defendant’s costs to litigate the case far exceed the plaintiff’s costs. In these cases, the plaintiff may well file a case they do not expect to win simply because they know it will be cheaper for the defendant to enter into a settlement rather than defend against the claims. As a result, the normal procedural reforms may not be enough to solve the problems. 26   See, e.g., Private Securities Litigation Reform Act of 1995, 15 U.S.C.A. § 78u-4 (2015) (imposing heightened pleading, discovery stays, and mandatory Rule 11 reviews on securities class actions); Prison Litigation Reform Act, 42 U.S.C. § 1997e(a) (2015) (adopting heightened procedures for prisoner claims); N.C. R. Civ. P. 9(j) (adopting heightened procedural rules in medical malpractice cases).

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The (un)changing derivative suit  71 the filing of meritless derivative suits. Shareholders were able to easily avoid them by pleading a federal cause of action or getting a judicial waiver (Cary & Eisenberg 1980). Moreover, at a more fundamental level, these statutes are likely a poor sorting mechanism of meritless and meritorious claims. Plaintiffs who are able to plead a federal claim or get a waiver from a sympathetic judge can evade the requirement. Other plaintiffs, even those with meritorious claims, may be reluctant to file suit either because they cannot come up with the money to post the bond or they fear the ever present risk that a judge or jury will not agree with their assessment of the claims and thus they will be forced to surrender their bond. Oklahoma recently adopted a similar requirement that is styled as a feeshifting statute rather than a bond requirement. Under section 18-1126 of the Oklahoma Code, losing parties in derivative suits are now required to pay their opponents’ expenses, including attorneys’ fees.27 This new rule applies to both losing plaintiffs and defendants, but it is still a striking departure from the American rule, which requires both sides to pay their own expenses. Representative shareholders receive only their pro rata share in the recovery if they win,28 but under the Oklahoma statute would be forced to pay all of the defendants’ costs if they lose. This imbalance of risk and reward will likely deter most shareholders of Oklahoma corporations from filing a derivative suit, regardless of the merits of the suit. In short, therefore, whether styled as a bond requirement or a feeshifting statute, rules that discourage all derivative plaintiffs from filing suit do little to sort the good cases from the bad. The second type of procedural hurdle common in derivative suits gives more power to plaintiff corporations to control these suits. In most jurisdictions, before filing a derivative suit, the derivative plaintiff must make a demand on the corporation’s board of directors, requesting that the board itself file the suit.29 Some states allow the plaintiff to avoid this requirement if the derivative plaintiff alleges with particularity that demand would have been futile.30 Alleging futility is no easy task, however, and courts are required to dismiss claims that do not comply with the demand requirement or adequately allege futility. Even if the plaintiffs survive the demand requirement, they quickly face another hurdle. The corporation can then appoint a committee of independent directors, called a 27   See Okla. Stat. tit. 18, § 1126 (“In any derivative action instituted by a shareholder of a domestic or foreign corporation, the court having jurisdiction, upon final judgment, shall require the nonprevailing party or parties to pay the prevailing party or parties the reasonable expenses, including attorney fees, taxable as costs, incurred as a result of such action”). 28   And even then, shareholders only benefit indirectly from derivative suits, because the recovery goes to the plaintiff corporations. Shareholders benefit to the extent that the value of their stock increases as a result of the litigation. 29   See, e.g., Del. Ct. Ch. R. 23.1(a) (“The complaint shall also 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 the reasons for the plaintiff’s failure to obtain the action or for not making the effort”); Fed. R. Civ. P. 23.1 (“The complaint must . . . state with particularity . . . any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; and the reasons for not obtaining the action or not making the effort”). 30   See, e.g., In re Citigroup Inc. S’holder Derivative Litig., 964 A.2d 106, 120 (2009) (“Where, as here, a plaintiff does not make a pre-suit demand on the board of directors, the complaint must plead with particularity facts showing that a demand on the board would have been futile”).

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72  Research handbook on representative shareholder litigation special litigation committee or SLC, to review the allegations in the derivative complaint and determine whether the suit is in the best interests of the corporation.31 If the SLC determines that the suit is not in the plaintiff corporation’s best interests, it will recommend that the court stay or dismiss the suit. In theory, these requirements seem better equipped than the other procedural rules described above to sort cases with merit from those without. If the case has merit and thus will lead to a recovery for the corporation, the corporation should want the case to proceed. If, on the other hand, the case does not have merit and thus will not lead the corporation to recover money, the corporation should move to dismiss it. In practice, however, these rules have not solved the problems associated with derivative suits. Empirical studies have found that shareholders rarely make demands on the corporation, routinely claiming instead that such demands would be futile (Erickson 2010). Although corporations often contest this claim, it is rarely dispositive in the litigation.  The same goes for special litigation committees. Corporations often form an SLC, but the SLC’s report does not necessarily end the litigation (Erickson 2010; Myers 2009). Why haven’t these procedural hurdles done more to corral derivative suits? One possibility is that it is more costly for plaintiff corporations to comply with and/or fight over these procedures than to simply settle the cases. SLC investigations are expensive and incredibly time-consuming for corporate directors, who have to conduct an in-depth investigation into the allegations made in the suit as well as the suit’s costs and benefits for the corporation. Briefing battles over the demand requirement are less costly, but still require lawyers to fight over whether the plaintiffs can survive this hurdle. Settlements, on the other hand, are relatively inexpensive, especially nonmonetary settlements that require corporations to make modest changes to their corporate governance practices. As a result, corporations may rationally decide that it is cheaper to settle these cases than fight to enforce the procedural requirements. As this discussion illustrates, derivative suits have long had their problems, and courts and lawmakers have long tried to fix these problems, albeit with procedural reforms that are ill equipped to address the specific challenges that these suits present. The next question is whether the legal system can better address the challenges in these suits.

4.  TOWARD A NEW APPROACH TO DERIVATIVE SUITS After 70 years of documented problems with derivative suits, the time has come to address these issues. This section outlines three possible approaches to overhauling these suits. First, judges can use greater scrutiny in reviewing proposed settlements in these suits. Second, corporations and their shareholders can engage in self-help by including litigation-limiting provisions in their governing documents. Finally, legislatures can take matters into their own hands by adopting heightened procedures to apply in these cases.

31

  See Zapata Corp. v. Maldonado, 430 A.2d 779,788 (Del. 1981).

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The (un)changing derivative suit  73 4.1  Judicial Oversight Judges play a crucial role in improving the effectiveness of derivative suits. Under Rule 23.1 of the Federal Rules of Civil Procedure, judges must approve all settlements of derivative suits. This rule is intended to “discourage the private settlement of a derivative claim under which a shareholder-plaintiff and attorney personally profit to the exclusion of the corporation and the other shareholder.”32 This concern is reflected in the current data on derivative suits. As discussed previously, these suits frequently end with nonmonetary settlements in which the corporation receives little of value, but the plaintiffs’ attorney receives a six-figure fee. Despite the problems with these settlements, judges routinely rubberstamp them. In short, these are exactly the types of settlements that judges should review more closely, and yet they don’t. Judges could improve the functioning of derivative suits by rejecting meritless settlements. This enhanced scrutiny could take different forms. For example, judges could simply scrutinize all proposed settlements in derivative suits more closely, asking hard questions about the merits of the claims and the benefits of the relief. Alternatively, courts could adopt more standardized rules or presumptions to help standardize their review. One such change could be a rebuttable presumption against nonmonetary settlements, forcing litigants to explain precisely how the settlement benefits plaintiff corporations and their shareholders to overcome this presumption. Along similar lines, judges could insist on closer links between the “ask” and the “get,” comparing the nonmonetary reforms in the settlements to those requested in the complaint. Such review would force plaintiffs’ attorneys to decide up front what types of reforms will address the alleged wrongs, rather than coming up with a list of reforms on a more ad hoc basis at the settlement table. This judicial oversight is increasingly common in other types of shareholder lawsuits. As discussed previously, shareholders used to challenge nearly all large mergers and acquisitions (Sinha 2016). As with derivative suits, these merger class actions typically ended with nonmonetary settlements and usually additional and arguably unnecessary disclosures about the transaction. Anxious to eliminate what was seen as a “deal tax” on mergers and acquisitions, the Delaware Court of Chancery announced that it would start to scrutinize nonmonetary settlements far more closely.33 The Court promised that it would “disfavor” disclosure-only settlements that did not involve “plainly material” information.34 Courts reviewing derivative suit settlements could follow the Delaware Court of Chancery’s lead, rejecting corporate governance settlements in derivative suits unless they involve “plainly beneficial” corporate governance reforms. Increased judicial scrutiny is unlikely to be an easy fix. First, it will be difficult to get judges to change their normal practice of rubberstamping settlements. Judges have busy dockets, and they are not looking for additional work. Most judges also do not handle a significant number of derivative suits, so they may not be familiar with the problems in these suits or the need for greater judicial oversight. Unlike merger class actions, which

  Fed. R. Civ. P. 23.1(c).   See In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 898 (Del. Ch. 2016). 34  Ibid. 32 33

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74  Research handbook on representative shareholder litigation were always relatively concentrated in Delaware, there is no single state or federal court that has primary jurisdiction over derivative suits. Second, even if a few judges start to crack down on these suits, there is little to stop plaintiffs’ attorneys from filing elsewhere. Most derivative suits can be filed in multiple forums, so attorneys can choose forums where they think their suits will receive less scrutiny. Delaware has seen this backlash in the wake of its increased scrutiny of merger cases, with more cases being filed outside of Delaware (Myers 2014). Yet the strategies being used in merger class actions may help here as well. The Delaware Court of Chancery invited corporations concerned about forum shopping in merger cases to include forum selection provisions in their charters or bylaws, giving corporations more control about where they are sued and what type of oversight these cases will receive.35 Many of these provisions are written broadly to sweep in all fiduciary duty suits, including derivative suits. Moreover, even if not all judges bring greater scrutiny to these cases, even a few judges can still have a significant impact. Right now, derivative suits fly almost entirely under the judicial radar. As a result, attorneys do not fear that a judge will reject their settlement, even if the settlement does not benefit the plaintiff corporation. If a few judges who routinely handle these cases started to scrutinize these settlements more closely, it could have a ripple effect in other jurisdictions. This strategy on its own is unlikely to solve all of the problems in derivative suits, but it would be a helpful start. 4.2  Corporate Self-Help Corporations themselves also have the ability to reform derivative suits. In recent years, corporations have started to experiment with litigation-limiting provisions in their corporate charters and bylaws. As discussed previously, many corporations have adopted provisions specifying Delaware or another jurisdiction as the exclusive forum for litigating internal corporate claims. A smaller number of corporations have experimented with other procedural provisions, including feeshifting bylaws (Bainbridge 2016), which were later banned by the Delaware General Assembly.36 To date, most of the discussion concerning these bylaws and charter provisions has related to their impact on merger class actions. But these provisions also have the ability to reshape derivative litigation. A provision, for example, that bars a company from agreeing to a nonmonetary settlement in any shareholder suit, including a derivative suit, could eliminate the incentive to file many of these suits. This point recognizes the parties’ incentives at different points in time. Ex post, nonmonetary settlements make sense. After a case has been filed, both parties have an incentive to agree to a nonmonetary settlement. Even if the corporation does not think the claims have merit, it is often cheaper for the 35   As discussed in the next section, forum selection clauses are also not a panacea because corporations can simply waive them when they think that a different forum will bless a settlement that their prechosen forum would not. 36   See Del. Code, tit. 8, § 109(b) (“The bylaws may not contain any provision that would impose liability on a stockholder for the attorneys fees or expenses of the corporation or any other party in connection with an internal corporate claim, as defined in § 115 of this title.”); Del. Code, tit. 8, § 102(f) (same in charters).

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The (un)changing derivative suit  75 company to pay a small amount of money to settle the suit rather than pay to take the case to trial. Ex ante, however, companies may be willing to tie their own hands. Doing so will constrain their options if they are sued, but it should also reduce the likelihood that they will be sued in the first place. Similarly, companies may be able to adopt provisions that will subject derivative suits to more scrutiny (Winship 2016). For example, companies could adopt minimum ownership requirements, barring shareholders from filing derivative suits if they have only a miniscule stake in the company. Alternatively, companies could adopt heightened pleading requirements, prohibiting claims that do not include particularized allegations of wrongdoing. Potentially, companies could also experiment with mandatory cost sharing in discovery, requirements that companies first use Section 220 to review books and records, and enhanced standing requirements. This strategy does raise concerns because directors have their own conflicts of interest in adopting these provisions. As discussed previously, directors are common defendants in derivative suits. As a result, although they are supposed to be unbiased guardians of the corporate interest, they will inevitably be influenced by concerns about their own selfinterest. Accordingly, they have an interest in barring all shareholder litigation, regardless of its merit. If the goal of procedure is to sort the cases with merit from those without, there is reason to doubt that directors will act solely with this goal in mind. So far, courts have been relatively unconcerned about these potential conflicts of interest. In ATP Tour, Inc. v. Deutscher Tennis Bund,37 the Delaware Supreme Court held that litigation-limiting charter and bylaw provisions are generally valid. The Court did retain the right to review these provisions on an as applied basis to determine whether they are “adopted by the appropriate corporate procedures and for a proper corporate purpose.”38 Although this standard might prohibit a board from adopting protective procedures after its members have been sued, it does not account for the more pervasive structural biases that exist when boards adopt procedures that will govern claims that may later be filed against them. As a result of this structural bias, courts may be warranted in using a stricter standard of review to evaluate litigation-limiting bylaw provisions.39 Courts typically use the deferential business judgment rule to review board decisions.40 When the independence of the board is in question, however, courts use an enhanced standard of review, subjecting the decision to greater scrutiny.41 Some scholars have suggested that courts should recognize the structural bias inherent in the adoption of these provisions and therefore use such an enhanced standard in reviewing litigation-limiting bylaw and charter provisions (Kaufman & Wunderlich 2015). Rather than simply asking whether these provisions reflect directors’

  ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 559 (Del. 2014).   See ibid. 39   Shareholders must approve litigation-limiting provisions in the charter, while directors alone can amend the bylaws. As a result, bylaw provisions deserve greater scrutiny than charter provisions. 40   Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457 (2011) (“Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness. The business judgment rule is the default standard of review”). 41   See ibid. 37 38

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76  Research handbook on representative shareholder litigation business judgments, courts could probe more deeply, examining the likely impact of the provision. Specifically, courts should ask whether the provision is likely to reduce the number of frivolous claims while preserving meritorious claims. A provision that simply reduces the number of lawsuits, meritless and otherwise, should not pass muster. 4.3  Legislative Intervention Legislatures could also use targeted procedural rules to improve the functioning of derivative suits. This approach would not be without controversy. One of the guiding rules of the American judicial system is that procedural rules should be transsubstantive—that is, the same rules should apply in all civil cases. As a result, the federal courts as well as most state courts have a uniform set of procedural rules that apply regardless of the nature of the claim.42 Derivative suits, however, already fall outside the transsubstantive model. Rule 23.1 of the Federal Rules of Civil Procedure includes specialized procedures for derivative suits, and many states have similar rules for derivative suits filed in their courts.43 Settlements in civil cases typically do not require judicial approval, but settlements in derivative suits do.44 The complaints in most civil cases do not have to be signed by the plaintiff, but complaints in derivative suits do.45 And plaintiffs in most civil cases do not need to make a prefiling demand, but derivative plaintiffs do.46 In other words, there is already a long tradition of specialized procedural rules for derivative suits. These specialized rules reflect the fact that derivative suits face different challenges than other types of civil cases. These suits are not controlled by the real party in interest. Additionally, the option for nonmonetary settlement in these suits makes it relatively easy for plaintiffs’ attorneys to structure settlements that benefit themselves at the expense of the plaintiff corporation. As a result, these cases require enough special oversight to justify a departure from the transsubstantive norm. Yet perhaps legislatures have not gone far enough in adopting heightened procedural rules. Existing rules do require judicial approval of settlements, but as discussed previously, most judges are not subjecting these settlements to significant scrutiny. The demand requirement mandates that plaintiffs present their claims to the plaintiff corporation before filing them, unless such presentment would be futile, but the evidence suggests that this requirement is not doing enough to sort the good claims from the bad. It may be time for legislatures to take a fresh look at the heightened procedures in their legislative toolbox and explore how they might better crack down on the abuses in these suits.

42   See, e.g., Fed. R. Civ. P. 1 (“These rules govern the procedure in all civil actions and proceedings in the United States district courts, except as stated in Rule 81”); Rules of the S. Ct. of Va. 3.1 (“These Rules apply to all civil actions, in the circuit courts, whether the claims involved arise under legal or equitable causes of action, unless otherwise provided by law”). 43   See, e.g., N.Y. Business Corp. Law § 626 (setting out special procedures for derivative suits under New York law); Cal. Corp. Code § 800 (same). 44   Fed. R. Civ. P. 23.1(c) (“A derivative action may be settled, voluntarily dismissed, or compromised only with the court’s approval”). 45   Fed. R. Civ. P. 23.1(b) (stating that derivative complaints must be “verified”). 46   Fed. R. Civ. P. 23.1(b)(3).

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The (un)changing derivative suit  77 For example, legislatures might subject derivative suits to heightened pleading standards. These pleading standards could require shareholders to include particularized allegations supporting an inference that the named defendants breached their fiduciary duties to the corporation. Such provisions would not be without controversy. Yet the normal objection to heightened pleading standards is that plaintiffs lack access to the relevant facts. In most cases, this is a valid concern because plaintiffs are typically not entitled to discovery until after they have survived a motion to dismiss. In derivative suits, however, shareholders can request access to the corporation’s books and records before filing suit. Under Section 220 of the General Corporation Law of Delaware, for example, as long as shareholders have a credible reason to suspect misconduct, they can get sweeping access to emails, memoranda, and other internal documents that they can then use to support their claims.47 Additionally, legislatures could explore limited feeshifting and cost sharing proposals. The Delaware legislature recently prohibited feeshifting provisions in corporate charters or bylaws because these provisions were inherently onesided.48 They made representative shareholders liable for 100 percent of the defendants’ fees if the suit was unsuccessful, even though these shareholders would only receive their pro rata share of the recovery if the suit was successful. This situation threatened to make it financially perilous for shareholders to file these claims (Lebovitch & van Kwawegen 2016). Given that these provisions were drafted by corporate directors (that is, the likely defendants in any derivative suit), it is not surprising that they were so onesided. Yet feeshifting proposals need not be so extreme. For example, instead of making representative shareholders liable if the suit is unsuccessful, lawmakers could require their attorneys to pay the defendant’s legal fees if the suit is unsuccessful (Erickson 2016). These potential losses could be offset by higher fees awarded to plaintiffs’ attorneys in successful suits. This more moderate proposal could make it more costly for attorneys to file frivolous claims, but also more lucrative to file meritorious claims. Legislative action along these lines is more promising than corporate self-help in at least three ways. First, legislators do not have the same structural biases as corporate directors because legislators, unlike directors, are unlikely to be defendants in derivative suits. Second, legislative action covers all companies incorporated in a given jurisdiction, so any new procedures adopted by the legislature will apply to a wide range of companies. In contrast, a corporate board can only adopt procedures for their particular company, forcing each company to reinvent the procedural wheel. Finally, rulemaking is within the legislative wheelhouse. The federal government has an existing structure in the Federal Civil Rules Advisory Committee to evaluate and craft procedural rules. Although many

47   Del. Code, tit. 8, § 220(b); see also Melzer v. CNet Networks, Inc., 934 A.2d 912, 917 (2007) (“Before shareholders may inspect books and records, they must . . . a proper purpose for seeking inspection”). 48   See Del. Code, tit. 8, § 109(b) (“The bylaws may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim, as defined in § 115 of this title”); Del. Code, tit. 8, § 102(f) (“The certificate of incorporation may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim, as defined in § 115 of this title”).

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78  Research handbook on representative shareholder litigation states do not have standing committees devoted to procedure, state legislatures are still used to drafting and assessing laws that impact the legal system. This is not to say that legislatures are a procedural panacea. They are subject to capture and lobbying by the lawyers on either side who may be impacted by these proposals. Moreover, as the experience of the PSLRA demonstrates, there is a risk that they will not take the time to do the type of nuanced reflection and consultation that good procedural rules require. And legislatures may not be interested in taking on this issue. As discussed in section 3, derivative suits have long flown under the radar, so they are not likely to be high on many lawmakers’ list of priorities. In the end, it seems likely that there is not a single solution to the problems posed by derivative suits. These suits need comprehensive reform, ideally through a combined effort of courts, corporate boards, shareholders, and legislatures. Through this combined effort, the legal system might finally solve the problems that have long plagued these suits.

5. CONCLUSION More than 70 years ago, Franklin Wood declared that “the great preponderance” of derivative suits are “unfounded and speculative” (Wood 1944, 9). Scholars today make the same claim. Yet despite longstanding concerns about these suits, little action has been taken. Derivative suits are still filed by shareholders with little stake in the company. Most derivative suits still end with nonmonetary settlements that offer little benefit to the plaintiff corporation. And an increasing number of derivative suits serve as tagalong cases to larger securities class actions, offering little additional value to shareholders. This chapter argues that the legal system should conduct a wholesale reexamination of its approach to derivative suits. The current approach of leaving derivative suits in the hands of plaintiffs’ attorneys and corporate boards is not working. Instead, judges, shareholders, and legislatures should all play an increased role in these suits, rejecting meritless settlements and developing better ex ante procedural rules to sort the good cases from the bad. If the legal system embraces this approach, perhaps we will not still be lamenting the problems with derivative suits in another 70 years.

BIBLIOGRAPHY Bainbridge, S., Fee-Shifting: Delaware’s Self-Inflicted Wound, Delaware Journal of Corporation Law 40 (2016), 851–76. Cary, W. & Eisenberg, M., Cases and Materials on Corporations (5th ed. 1980). Choi, S., Fisch, J., & Pritchard, A., Do Institutions Matter? The Impact of the Lead Plaintiff Provision of the Private Securities Litigation Reform Act, Washington University Law Quarterly 83 (2005) 869–904. Choi, S., Erickson, J., & Pritchard, A., Piling On: An Empirical Study of Parallel Derivative Suits, Journal of Empirical Legal Studies 14 (2017) 653–82. Coffee, Jr, J., Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law through Class and Derivative Actions, Columbia Law Review 86 (1986), 669–727. Erickson, J., Corporate Governance in the Courtroom: An Empirical Analysis, William & Mary Law Review 51 (2010), 1749–1831. Erickson, J., Overlitigating Corporate Fraud: An Empirical Analysis, Iowa Law Review, 97 (2011), 49–99. Erickson, J., The Market for Leadership in Corporate Litigation, University of Illinois Law Review [2015], 1479–1528.

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The (un)changing derivative suit  79 Erickson, J., Heightened Procedure, Iowa Law Review 102 (2016), 61–120. Fisch, J., Griffith, S., & Solomon, S., Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform, Texas Law Review 93 (2015), 557–624. Ferrera, R., Abikoff, K., & Gansler, L., Shareholder Derivative Litigation: Besieging the Board (Law Journal Seminars-Press 2013). Fuerman, R., Securities Class Actions Compared to Derivative Lawsuits: Evidence from the Stock Option Backdating Litigation on Their Relative Disciplining of Fraudster Executives, Journal of Forensic and Investigative Accounting 8 (2016), 198–217. Griffith, S., Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, Boston College Law Review 56 (2015), 1–59. Griffith, S., Private Ordering Post-Trulia: Why No Pay Provisions Can Fix the Deal Tax and Forum Selection Provisions Can’t, in The Corporate Contract in Changing Times, Steven Davidoff Solomon and Randall S. Thomas, eds (2017). Jones, T., An Empirical Examination of the Incidence of Shareholder Derivative and Class Action Lawsuits, 1971–1978, Boston University Law Review 60 (1980), 306–30. Kaufman, M. & Wunderlich, J., Paving the Delaware Way: Legislative and Equitable Limits on Bylaws after ATP, Washington University Law Review 93 (2015), 335–77. Koumrian, O., Settlements of Shareholder Litigation Involving Mergers and Acquisitions—Review of 2013 M&A Litigation, Cornerstone Research (2014). Lebovitch, M. & van Kwawegen, J., Of Babies and Bathwater: Deterring Frivolous Stockholder Claims Without Closing the Courthouse Door to Legitimate Claims, Delaware Journal of Corporation Law 40 (2016), 491–540. Macey, J. & Miller, G., The Plaintiffs’ Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform, University of Chicago Law Review, 58 (1991), 1–117. Myers, M., The Decisions of Corporate Special Litigation Committees: An Empirical Investigation, Indiana Law Journal 84 (2009) 1309–36. Myers, M., Fixing Multi-Forum Shareholder Litigation, University of Illinois Law Review [2014] 467–551. Romano, R., The Shareholder Suit: Litigation Without Foundation?, Journal of Law, Economics, and Organization 7 (1991), 55–87. Sinha, R., Shareholder Litigation Involving Acquisition of Public Companies: Review of 2015 and 1H 2016 M&A Litigation, Cornerstone Research (2016). Thompson, R. & Thomas, R., The New Look of Shareholder Litigation: Acquisition-Oriented Class Actions, Vanderbilt Law Review 57 (2004) 131. Thompson, R. & Thomas, R., The Public and Private Faces of Derivative Lawsuits, Vanderbilt Law Review 57 (2004), 1747–793. Thompson, R. & Thomas, R., A Theory of Representative Shareholder Suits and Its Application to Multijurisdic­ tional Litigation, Northwestern Law Review 106 (2012) 1753–1819. Winship, V., Shareholder Litigation by Contract, 96 Boston University Law Review 481 (2016), 485–542. Wood, F., Survey and Report Regarding Stockholders’ Derivative Suits (1944).

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5.  Claim character and class conflict in securities litigation Richard A. Booth*

1. INTRODUCTION In a typical securities fraud class action (SFCA) arising under SEC Rule 10b-5—where the plaintiff class comprises investors who bought during the fraud period—the measure of damages is the difference between the price paid by a given investor and the corrected price after the truth comes out (Booth 2004).1 But the price of a stock may fall for many reasons, some of which are not actionable. For example, if the price of a stock falls solely in tandem with a marketwide or industrywide decrease in equity prices, buyers have no claim. On the other hand, there are several different company-specific reasons why the price of a stock may fall that may be actionable. For example, expected return may be revised downward; or the perceived risk associated therewith may increase, thus entailing an increase in the cost of equity capital—the applicable discount rate; or it could be that *  Thanks to the participants in the 2016 Corporate & Securities Litigation Workshop: Eric Chiappinelli, Stephen Choi, James Cox, Jessica Erickson, Jake Fedechko, Hon. James Gale, Matteo Gargantini, Martin Gelter, Sean Griffith, Lawrence Hamermesh, Charles Korsmo, Hon. Travis Laster, Ann Lipton, Minor Myers, James Park, Poonam Puri, Hon. Ruth Ronen, Amanda Rose, Megan Shaner, Charles Silver, Eric Talley, Urska Velikonja, David Webber, Verity Winship, Chao Xi. 1   To be precise, the law provides that damages are limited to the difference between the price paid or received by the plaintiff investor and the average closing price over the 90 days following corrective disclosure. Securities Exchange Act of 1934 (Exchange Act) § 21D(e). See also In re Cendant Corporation Litigation, 264 F.3d 201, 241–42 (and note 24) (3d Cir. 2001) (discussing calculation of damages and estimation of aggregate). Although this provision (added to the Exchange Act by the Private Securities Litigation Reform Act (PSLRA) of 1995) states that it applies to cases in which the plaintiff seeks to establish damages by reference to the market price of a security, it implicitly approves the standard measure of damages. The discussion herein assumes that the fraud involves the cover-up of bad news and thus that the plaintiff class comprises buyers. It is quite possible for fraud to involve the coverup of good news and for the class to comprise sellers. But bad news fraud is much more common. Indeed, my own research indicates that fewer than 1 in 50 cases is a good news case. Thus, it is odd that some of the most important judicial decisions have involved good news fraud. See Basic, Inc. v. Levinson, 485 U.S. 224 (1988); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968). To be clear, the focus here is on claims involving outstanding stock and arising under SEC Rule 10b-5. For the most part, the discussion herein does not apply to claims arising under the 1933 Act in which the defendant company has issued stock and the remedy is essentially one of disgorgement (even though a parallel claim under Rule 10b-5 may be asserted in such cases). See Herman & MacLean v. Huddleston, 459 U.S. 375 (1983). As discussed further later in the chapter, claims relating to already outstanding stock (such as where the company has issued a false press release) are ultimately based on the timing of disclosure. The claim is that if accurate information had been disclosed in a timely fashion, buyers (or sellers) would not have suffered a loss (or missed a gain).

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Claim character and class conflict  81 the company suffers a significant onetime cash outflow. These causes of loss may or may not be actionable under Rule 10b-5, depending on whether management has misrepresented the relevant facts. In addressing the need to plead and prove loss causation, the Supreme Court has quite clearly stated that the loss suffered by a buyer must have resulted from the misrepresentation giving rise to the SFCA: When the purchaser subsequently resells such shares, even at a lower price, that lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price . . . Other things being equal, the longer the time between purchase and sale, the more likely that this is so, i.e., the more likely that other factors caused the loss.2

Thus, it matters what causes stock price to change. Moreover, in the wake of Halliburton II, defendant companies may oppose class certification by showing lack of price impact.3 As a result, the question of why stock price fell now arises very early in a SFCA. So a court may need to parse the elements of price decrease. Until now, the courts (and litigants) have generally failed to notice that the cause of a loss may result in a claim that is properly seen as belonging to the corporation—a derivative claim—rather than a direct claim belonging to individual buyers. For example, a onetime cash outflow may be the result of bad luck, such as a freak accident, which is not actionable standing alone. But if management covers up the event, resulting in an eventual SEC fine and substantial attendant legal expenses, the decrease in stock price will reflect not only the cost of the accident itself but also the SEC fine and legal expenses. It is well settled that stockholders who bought after the accident but before its disclosure would have a (direct) claim based on the entire decrease in stock price.4 But it also seems quite clear that the corporation would have a (derivative) claim to the extent of its loss from the fine and the legal expenses although not the cost of the accident itself (Booth 2009; Strine, et al. 2010).5   See, e.g., Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 342–3 (2005).   Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398, 2404 (2014) (Halliburton II). 4   See, e.g., Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011) (company made public statements predicting growth in revenues knowing that several consumers claimed to have suffered injuries from using product); Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) (company made public statements that demand remained strong for product when demand was in fact waning); Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) (company made public statements predicting approval of medical device despite knowledge to the contrary). 5   Although the business judgment rule precludes director and officer liability in many situations, it does not extend to legally prohibited actions. See, e.g., Joy v. North, 692 F.2d 880 (2d Cir. 1982) (derivative action to recover losses based in part on violation of lending limits); Miller v. American Telephone & Telegraph Co., 507 F.2d 759 (3d Cir.1974) (derivative action based illegal campaign contribution in form of forgiven debt). It is not necessary to assume that management misconduct rises to the level of a prohibited act in order to overcome the business judgment rule even if the corporation has adopted an exculpatory charter provision under DGCL 102(b)(7). The law is quite clear that if the corporation suffers harm as the result of management misconduct accompanied by scienter, the business judgment rule does not apply. See In re Goldman Sachs 2 3

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82  Research handbook on representative shareholder litigation To be clear, the market reacts quickly—especially to bad news—and market price will adjust to reflect the possibility and probability of loss even though the cash outflow will come later (Alexander 1994; Cornell & Rutten 2006; Lev & de Villiers 1994; DeBondt & Thaler 1985, 1987).6 In other words, upon disclosure of the freak accident and its coverup, market price can be expected to adjust not only for the direct loss from the event but also for the fines and legal expenses that are likely to follow. In short, the loss happens all at once (although it may vary in magnitude over time as the market learns more about the merits). The key point for present purposes is that part of the loss suffered by buyers is in fact a loss suffered by the corporation and thus all of its stockholders. In other words, there is a derivative claim imbedded in the larger decrease in stock price. The obvious question is: How should we handle the competing direct claims of buyers (under Rule 10b-5) and the derivative claims of the corporation (under state law)? The prevailing practice is to give priority to the direct claims of buyers (and often to settle the derivative claim for non-monetary governance reforms of dubious value). But this approach makes no sense and indeed may do more harm than good. First (and foremost), by settling the corporate claim first, stockholders in the aggregate would be restored to the same position as if there had been no fraud. Moreover, recovery by the corporation would reduce the remaining claim of buyers (if any) based on the happenstance of buying just before disclosure of the loss. In contrast, to settle the buyer claims first out of corporate funds (as under Rule 10b-5) is both to deny recovery on the corporate claim to nonbuyer holders and to magnify the loss they suffer by further reducing stock price. In other words, nonbuyer holders pay twice. To confuse matters still further, if the corporation does later recover on its claim, buyerholders also benefit. In effect, buyer-holders enjoy a double dip if the corporation later recovers again for the portion of the loss it suffered in the first place. Moreover, since the corporation will also have a claim based on the further loss it suffers from the payout to settle buyer claims, the double dip becomes in effect a quadruple dip. All of these problems disappear if we handle the corporate claim first. Indeed, the law is quite clear that derivative claims should give rise to recovery by the corporation rather than by individual stockholders and should take precedence over direct claims in cases

Group Shareholder Litigation, 2011 Del. Ch. LEXIS 151, aff’d, sub nom. SEPTA v. Blankefein, 44 A.3d 922 (Del., 2012); In re American International Group, Inc., Consolidated Derivative Litigation, 965 A.2d 763, 799 (Del. Ch. 2009). Moreover, it is also clear that deception constitutes actionable misconduct even in the absence of a stockholder vote (assuming the corporation suffers quantifiable harm). See Malone v. Brincat, 722 A.2d 5 (Del. 1998) (stockholder plaintiff can demonstrate a breach of fiduciary duty by showing that the directors deliberately misinform[ed] stockholders about the business of the corporation either directly or by a public statement); In re infoUSA, Inc. Shareholders Litigation, 953 A.2d 963, 990 (Del. Ch. 2007) (directors violate fiduciary duty where it can be shown that they issued communication with the knowledge that it was deceptive or incomplete since stockholders are entitled to honest communication from directors given with complete candor and in good faith even in the absence of a request for stockholder action). 6   Needless to say, this assertion presupposes basic market efficiency (at least informational, if not fundamental). But if anything the market seems to overreact to bad news.

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Claim character and class conflict  83 of conflict.7 So it is all the more curious that the law has evolved as it has to emphasize a class action remedy rather than a derivative remedy. The one issue that remains is the claim by buyers that they would not have suffered the loss directly attributable to the freak accident itself if the news thereof had not been covered up by management. Clearly, the corporation itself has no claim for this loss. So the claim (if any) must be direct if only by process of elimination. But if this is the only loss suffered by investors, there is a serious question whether the law should provide any remedy at all. As in musical chairs, this loss is a loss that someone will suffer. Investors in the aggregate will lose what they will lose. Que sera sera. Moreover, a diversified investor is just as likely to sell an overpriced stock as to buy one. Over time, gains (from losses avoided) and losses (from untimely purchases) wash out. In other words, investors can protect themselves against this risk—and can do so for free—by holding an index fund (for example). In contrast, the loss that gives rise to a derivative claim cannot be diversified away. There is no windfall gain from the opposite of fraud or other management misconduct—which always gives rise to a loss.8 So the only real loss for most investors is the derivative loss that cannot be diversified away (Booth 1998). The foregoing analysis applies ceteris paribus to the other sources of loss noted above— a reduction in expected return or an increase in the discount rate. Some such events just happen, while others can be traced to fraud or other management misconduct. The losses that just happen or those that can be traced to management decisions protected by the business judgment rule are losses that someone must suffer. And the risk of such losses can always be diversified away because they will be offset by unexpected gains under the law of large numbers.9 But the avoidable losses that happen only because of fraud or management misconduct cannot be diversified away because they are never offset by gains from the absence thereof. Coincidentally, these losses all give rise to derivative claims. Thus, the only claims that really matter are claims that belong to the corporation, which suggests that SFCAs should properly be litigated as derivative actions. Finally, and perhaps needless to say, the aggregate price decrease in any given case may comprise changes in several of these factors, giving rise to a combination of direct and derivative claims that may be difficult to sort out. Under federal law, all of these losses are glommed together into one big cause of action as long as management has deceived investors (with scienter) as to any one factor of loss, and buyers can recover the entire difference between purchase price and corrected price (at least in theory). 7   FRCP 23(b)(3) states that a class action for damages may be certified only if the trial court finds “that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.” If a derivative action is an equally good (or better) way to resolve the matter, FRCP 23 itself requires that the matter be tried as a derivative action. 8   There is no potential for gain from nonfraud as there is from good luck. In other words, a diversified investor may enjoy a gain on the stock of a company whose sales are more robust than expected—a gain that offsets the loss from a company whose results are disappointing. But there is no potential for offsetting gain just because a company avoids fraud claims and unexpected outflows of cash or an increase in its cost of capital from a loss of trust in management. 9   Admittedly, a freak accident cannot be offset by the absence thereof. But a windfall is always possible. Although the two are not exactly symmetrical, the more important point is that fraud and misconduct are avoidable and always operate to reduce return.

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84  Research handbook on representative shareholder litigation But because the only claims that really matter derive from losses suffered by the corporation, it is ultimately quite simple to fix the problem by recasting SFCAs as derivative actions—a solution that (again) turns out to be dictated by settled rules of civil procedure anyway.10

2.  VALUATION FACTORS Since a share of stock represents a fractional ownership interest in the issuing corporation, share price depends on three factors as reflected in the basic formula for going concern value (GCV): VALUE = (RETURN / DISCOUNT RATE) + CASH To restate the formula in terms of share price: SHARE PRICE = (RETURN PER SHARE / DISCOUNT RATE) + CASH PER SHARE Note that the term discount rate goes by many different names, including cost of equity (COE) or sometimes capitalization rate. But whatever the name used, it is equal to the rate of return required by investors (the market) in light of the risk inherent in the subject company. Thus, I use the term required rate of return (RRR) herein.11 Needless to say, it can be difficult to determine what each of these inputs should be in any real world case. But for present purposes we need not worry about how to measure these factors. All that matters is the relationship. It is helpful to consider a simple example: Suppose that Acme Blasting Cap Corporation (ABC) trades for $25 per share based on expected return of $2.00 per share with RRR equal to 10% and excess cash of $5.00 per share. Plugging these numbers into the formula: SHARE PRICE = 2.00 / (0.10) + 5.00 = 20.00 + 5.00 = 25.00 With this formula in mind, we can isolate three distinct types of events that might cause a decrease in the stock price of ABC: (1) a decrease in expected return, (2) an increase in RRR, or (3) a decrease in cash. It is entirely possible for any one of these causes to occur alone or for two or all three to occur together. For example, suppose that ABC loses a major customer and that as a result expected return decreases from $2.00 per share to $1.50 per share. Other things equal, stock price should fall: SHARE PRICE = 1.50 / (0.10) + 5.00 = 15.00 + 5.00 = 20.00

  See note 7 supra.   RRR is my own invention (as far as I know), but it is closely akin to internal rate of return (IRR), which is widely used in the world of finance. 10 11

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Claim character and class conflict  85 Or suppose that ATF announces that it is conducting a major study focusing on the possibility of adopting new regulations with the result that investors now demand a 12 percent return from ABC: SHARE PRICE = 2.00 / (0.12) + 5.00 = 16.67 + 5.00 = 21.67 Or suppose that an ABC delivery truck explodes in a freak accident that results in a lawsuit that is settled for an amount equal to $3.00 per share (but that the circumstances of the accident are so bizarre that it does not affect expected return or RRR): SHARE PRICE = 2.00 / (0.10) + 2.00 = 20.00 + 2.00 = 22.00 None of the above events would give rise to a claim by investors under federal law in the absence of some sort of misrepresentation (plus scienter). But suppose the CEO of ABC states during a quarterly conference call that he expects earnings to remain stable for the foreseeable future even though he knows that a major customer has cancelled a contract (as in the first example above). When the truth comes out, the price of ABC stock drops dramatically: SHARE PRICE = 1.50 / (0.12) + (5.00 – 3.00) = 12.50 + 2.00 = 14.50 Note that the total price decrease of $10.50 per share is attributable to changes in all three of the valuation factors: expected return, discount rate, and cash. Of the aggregate loss, $5.00 is attributable to a decrease in expected return, $3.00 is attributable to a decrease in cash (from the prospect of fines and legal expenses), and the remaining $2.50 is attributable to an increase in RRR (from a loss of trust in management).12 Under federal law, a buyer can recover individually—in a direct class action—for the entire loss, even though the parts of the loss attributable to a decrease in cash and an increase in RRR are derivative losses suffered by the corporation.

3.  LOSS CAUSATION Although a loss can always be traced to a change in one of the three valuation factors described above, the precise cause of the loss as to a given factor may vary. Considered in isolation, some causes may be actionable, while others may not. Or the loss from a given factor may be a mixture of the two. 3.1  Cash Outflow As for cash, the price decrease may be attributable to a freak event and thus not actionable. Or the cash loss may come from the prospect of a fine by the SEC, expenses of defense, or 12   Specifically, the new EPS of $1.50 at a discount rate of 10 percent would have given a GCV of $15.00. But at the new 12 percent discount rate, $1.50 gives a GCV of $12.50 thus accounting for $2.50 of the total decrease.

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86  Research handbook on representative shareholder litigation the likelihood of a SFCA and settlement thereof. Presumably, these losses are actionable since they arise from management malfeasance. In the absence of scienter there would be no fine or settlement. So the central point for present purposes is that if the cash loss is actionable it is almost certainly derivative. Note that the last form of loss—from a SFCA settlement—is peculiar in that it results from an effective transfer of funds from the corporation (and thus holders) to buyers, with the effect that the market price of the subject stocks falls more than it otherwise would depending on the number of damaged shares represented in the plaintiff class. One might say that the cure is worse than the disease—or at least that it is part of the disease. Many scholars refer to this problem as circularity—thus focusing on the fact that holders pay buyers. But that appellation fails to capture the price effect—which I call feedback. Again, the market reacts immediately to the prospect of these outflows. Even if the payout will come months (or years) in the future, informed investors will reckon that the value of a share is net of the present value of such items (Alessi 2001; Booth 2007).13 3.2  Discount Rate As for discount rate, the increase may be attributable to an increase in risk perceived by the market, for example, because customer relationships in the industry seem to be less stable than previously thought or because investors have lost trust or confidence in ABC management. If the former, the increase in discount rate will likely affect other companies in the industry (though possibly to varying degrees) and thus is probably not actionable. (Moreover, investors can hedge away such risks with diversification.) If the latter, the change is likely to be a company-specific one that affects only ABC. While it is possible that a company-specific increase in the cost of capital may occur because of some peculiar risk factor applicable only to one company, it seems unlikely that there are many such business risks (other than in an industry with only one company). Thus, it seems likely 13   As I have shown elsewhere, the feedback effect depends on the number of damaged shares (absolute turnover during the fraud period) (Booth 2007). To be specific, the effect in bad news cases—where the plaintiff class comprises buyers—is to magnify the damage claim according to the following formula:

damage claim (%) = simple loss (%) / (1.00 minus absolute turnover (%)) Thus, where stock price would have fallen by (say) 10 percent as a matter of fundamentals, the loss will be magnified to 20 percent if the plaintiff class comprises 50 percent of the shares. The problem is that it is impossible to determine the percentage of damaged shares before claims are filed (although there are numerous quack theories that claim to do so). Needless to say, this complicates settlement negotiations. On the other hand, there is every reason to think that the market is pretty good at estimating this number. See generally James Suroweicki, The Wisdom of Crowds (2004). It is important to emphasize that in relatively uncommon good news cases, the calculus of loss is different. First, feedback operates negatively to reduce the loss suffered by sellers. See Richard A. Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L.J. 1 (2007). The same is true for other cash outflows (such as from fines and legal expenses) as well as the cost of capital. Thus, it is little wonder that there are so few good news cases since all of the forces that militate to magnify the loss in a good news case operate in the opposite way in good news cases. Indeed, it is conceivable that good news fraud could result in a stock price decrease under perfect storm conditions.

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Claim character and class conflict  87 that a company-specific increase in the cost of capital almost always flows from a loss of trust.14 If so, the loss is quite clearly derivative. But in the unlikely case that management has covered up a peculiar business risk, clearly the company itself has no claim. So the claim (if any) must be direct.15 Again, multiple forces may be at work. 3.3  Expected Return As for return, the loss attributable thereto is almost always a loss that will happen irrespective of any misrepresentation.16 In the example, it stems from the ordinary business risk that a customer may cancel a contract. Thus, it is a risk that investors freely assume when they invest. (And again, it is a risk that can be diversified away.) On the other hand, lower return may sometimes be caused by management misconduct. For example, management might fail to perform as agreed on a contract or may misrepresent product quality, thus prompting customers to cancel otherwise binding commitments that have been booked as sales. If so, the loss should give rise to a derivative action. But in the more likely case that the loss stems from bad business luck, clearly the company has no claim. Thus, if buyers have a claim because the facts have been covered up, the claim must be direct. Again, under Rule 10b-5, a defrauded buyer may recover the entire difference between purchase price and corrected price (at least as a matter of law) if the loss from any one factor can be traced to a misrepresentation. But note that losses from cash outflows and increases in cost of capital are almost always derivative, while the portion of any loss that is not derivative is attributable to a risk that can be diversified away—the revelation of previously unknown business risks or a reduction in expected return from bad business luck. Moreover, in any meritorious case—one that can withstand a motion to dismiss—some of the loss is almost certainly derivative. Since such a case will always have settlement value, some of the loss will always be attributable to the prospect of cash outflow. Thus, buyers

14   Presumably, a corporation’s reputation for candor may have an effect on its cost of capital. There has been a good deal of scholarship about the importance of trust in corporation law (Akerloff 1970; Blair & Stout 2001; Ribstein 2001; Rock & Wachter 2001). 15   See In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106, 2009 Del. Ch. LEXIS 25  (distinguishing business risk and the duty to manage it from the risk of illegal conduct and the duty to monitor compliance). Compare American International Group, Inc. Consolidated Derivative Litigation, 965 A.2d 763 (Del. Ch. 2009) (finding in contrast to Citigroup that a complaint alleging a pervasive fraudulent scheme was sufficient to withstand a motion to dismiss). Although the phrase business risk may seem internally redundant, I use it here as distinct from reputational risk to distinguish between losses that may flow from new information about the risk inherent in a line of business (and a concomitant increase in the cost of capital) from increases in the cost of capital attributable to a loss of trust in management because of misconduct. I suspect that the Citigroup court was struggling to make the same distinction. 16   Many courts characterize such loss as resulting from price inflation. See, e.g., Ludlow v. BP, PLC, 800 F.3d 674 (5th Cir. 2015). But the word inflation connotes that management has done something to cause a positive increase in stock price. It is much more common for management merely to have covered up the truth so as to delay the inevitable. See, e.g., In re Time Warner Securities Litigation, 9 F.3d 259 (2d Cir. 1993). Cf. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) (rejecting idea that buyer can recover upon proof of price inflation without price impact upon corrective disclosure).

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88  Research handbook on representative shareholder litigation can have no claim unless the company has at least one claim. So it is difficult to see how the courts can avoid analyzing claims as outlined here.17

4.  ACTIONABLE LOSSES Legal scholars differ as to whether all of these elements of loss should be recoverable  consistent with the loss causation requirement in an action arising under Rule 10b-5.18 On the one hand, Allen Ferrell and Atanu Saha have argued that the loss from fines, defense costs, and presumably feedback cannot be recovered because such losses are not caused by the offending misrepresentation. Rather, such losses should be seen as collateral damage (or ancillary damages, in the words of others). According to Ferrell and Saha, the only actionable loss comes from a decrease in return or an increase in the discount rate stemming from misrepresented risk factors—what one might call fundamental losses (Ferrell & Saha 2007). Similarly, other scholars have noted that stock prices tend to overreact to corrective disclosure (Alexander 1994; Cornell & Rutten 2006; Lev & de Villiers 1994; DeBondt & Thaler 1985, 1987). In other words, stock price tends to fall more than it should based on the specific content of new (negative) information. Thus, these scholars have argued that the excess loss—dubbed crash damages—should not be recoverable. To be sure, studies show that stock price tends to recover from such overreaction. Accordingly, under Section 21D of the Exchange Act (added by PSLRA in 1995), damages are calculated based a 90-day average of closing prices following corrective disclosure (Booth 2004). But it is also possible that some (or much) of crash loss is attributable to other factors (such as feedback) from which there is no reason to expect any bounceback. On the other hand, Barbara Black has argued that excess price decreases attributable to a loss of trust or confidence in management should be recoverable as reputational damages. In essence, her argument is that such damages are proximately caused by the fraud even though the offending misrepresentation may have related to projected earnings (for example) rather than management integrity (Black 2009). As a matter of tort law, these other forms of loss are usually called consequential damages—as they have been by several courts in SFCAs.19 It is blackletter law that consequential damages may be recovered if the underlying tort is intentional. Since fraud under Rule 10b-5 requires scienter, it would seem to follow that consequential damages should be part of the award.20

17   Incidentally, the requirement that all misrepresentations be pleaded with particularity (as added by PSLRA) should facilitate distinguishing among various sources of loss. 18   In contrast, all losses can be recovered under Securities Act §11. There is no loss causation requirement. Indeed, there is no adjustment for market losses. 19   The classic example (in contract law) is Hadley v. Baxendale, 156 Eng. Rep. 145 (Ex. Ch. 1854). A closely related question is whether losses from the materialization of an undisclosed or misrepresented risk can be recovered. This issue is discussed in detail in section 6. 20   See W. Page Keeton, et al., Prosser and Keeton on Torts §110 (5E 1984).

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Claim character and class conflict  89 In the end, this controversy is about proximate cause. Ferrell and Saha (and others) think consequential damages are too remote. They also argue that reputational damages should be seen as resulting from a separate misrepresentation as to management integrity or internal controls. But as Black points out, Congress (in PSLRA) apparently endorsed a damages formula based on total price decline (albeit as measured by a 90-day average of closing prices following corrective disclosure). She also points out that the fraud on the market (FOTM) doctrine is based on the notion that investors should be able to rely on the integrity of the market price (and presumably management). Moreover, the Supreme Court has held on at least two occasions that false statements of opinion by management may be actionable.21 And Congress has reinforced these ideas in the Sarbanes–Oxley Act (SARBOX) by requiring management regularly to certify the internal controls that assure accurate reporting, together with the financial statements themselves.22 Thus, there is ample reason to think that both Congress and the courts see consequential damages as recoverable. Although Black seems to have the better argument (at least as to reputational damages), she acknowledges that such damages affect all stockholders—both buyers and holders— and thus might be precluded from being recovered because only buyers (or sellers) may recover under the Blue Chip Stamps rule.23 In response, Black argues that this judgemade standing rule is intended to thwart fabricated claims such as by nontraders who claim they would have bought or sold but for a misrepresentation—and not to limit recovery by traders with standing to sue.24

5.  DIRECT AND DERIVATIVE CLAIMS Although the argument from standing is twisted at best, it reveals a fatal flaw in the arguments of both sides of this debate, to wit, that reputational damages affect all stockholders in the same way: Whereas only buyers usually have standing to complain about the substance of a false projection of earnings (since holders are already holders and cannot claim reliance), reputational damages affect all stockholders in the same way and to the same extent. The implication is that any recovery for reputational damages should come from a derivative action by which the corporation recovers—presumably

21   See Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 111 S.Ct. 2749 (1991); Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318, 191 L. Ed. 2d 253 (2015). 22   These latter points also answer the argument that management is under no general obligation to disclose its own failings. See Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977). Thus, there can be no entitlement to underlying facts. See In re Time Warner, Inc. Securities Litigation, 9 F.3d 259 (2d Cir. 1993). 23   See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). 24   See Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71 (2006). Moreover, the argument that buyers cannot recover for reputational damages because holders have no standing to sue seems disingenuous at best. Indeed, Black concludes that arguments seeking to limit the measure of damages for securities fraud stem from a persistent distrust of SFCAs and the danger of open-ended damages for claims of dubious merit—problems that Black (and others) see as having been addressed by Congress in PSLRA.

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90  Research handbook on representative shareholder litigation from the individual wrongdoers. Moreover, the same goes for the other forms of collateral damage described by Ferrell and Saha, particularly consequential losses from fees, fines, and feedback. Thus, the debate over proximate cause turns out to be a red herring—albeit one that provides an important clue about how to resolve the controversy. The problem of what elements of consequential damages are properly within the scope of damages in a SFCA is a problem because the answer is NONE. All such damages are suffered by the corporation and should be recoverable (if at all) by the corporation in a derivative action. In other words, both sides are wrong in the debate over consequential damages.25 Perhaps the best way to see this distinction is to ask what the price decrease would be in the absence of any fraud—if the truth had been disclosed in a timely manner. The answer is that the price would have fallen by just the amount that Ferrell and Saha describe as the recoverable amount. In other words, stock price will fall by this amount simply because of the new information. If this is the only loss suffered by investors, there is a serious question whether the law should provide any remedy at all. Investors in the aggregate will lose what they will lose. Thus, in a world with SFCAs, buyers may end up better off than they would have been in the absence of fraud since they can recover for their entire loss (at least as a matter of law) including those portions thereof that would have happened one way or the other. Indeed, this is the essence of the overdeterrence that many legal scholars cite as the biggest problem with SFCAs.26 Moreover, investors in the aggregate are worse off than they would be without a remedy because the settlement payment by the defendant company reduces company value dollar for dollar, while a significant portion thereof goes to the plaintiff lawyers. And the value of the defendant company is further reduced by its own costs of defense. Thus, the plaintiff class is never made whole, while holders suffer additional loss to the extent of the settlement and the costs of defense. If we assume that most investors are diversified (as they are), it seems clear that they would forgo any such remedy if they could vote to change the law. In effect, SFCAs provide a form of insurance that nobody wants or needs—like an extended warranty on a toaster.27 25   Note that the debate is not entirely symmetrical. Black focuses only on reputational damages, which she thinks flow directly (enough) from the fraud to be recoverable. Black does not discuss nonreputational consequential damages. But Ferrell and Saha argue that other losses baked into the total price decrease—such as from the prospect of fines—are also off limits. As they see it, the only recoverable losses are those that flow from a decrease in return or a company-specific increase in discount rate (because of misrepresented company-specific risk) since these are the losses that are traceable to misrepresentation of such facts. 26   Although often made, the overdeterrence argument is it is not always well explained. Indeed, one might argue that fraud cannot be overdeterred. But aside from the fact that fraud may be too strong a word for the offense, one problem with overdeterrence is that it makes management too reluctant to share information that might turn out to be incorrect and results in a circle-the-wagons mentality when controversies arise. 27   To extend the metaphor, the premiums on this insurance are paid by a tax on returns. Assuming aggregate annual SFCA settlements of about $5B and total market capitalization of about $25T, SFCAs are equivalent to a tax on returns of 2 BP. But if we include expenses of defense and forgone derivative recovery the total swing is probably about $10B and equivalent to a tax on returns of 4 BP. And that does not include the cost of business failures. By comparison, the annual

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Claim character and class conflict  91 To be sure, a buyer who pays a too-high price for a stock during the fraud period will be better off if she has a remedy—and will profess to favor the extant system ex post. But if she is diversified, she is just as likely to sell an overpriced stock as to buy one. Over time, gains and losses wash out. Thus, from an ex ante perspective, even undiversified stock-pickers may oppose SFCAs because even they may pay more often as holders than they recover as buyers.28 The bottom line is that SFCAs are nothing more than a system for redistributing stockholder wealth. As Joseph Grundfest has said, securities fraud class actions move money around for the benefit of those who move the money around.29 So Ferrell and Saha are correct that buyers should be precluded from recovering collateral damages. But they are correct for the wrong reason. Proximate cause is not the problem. Rather, the problem is that all of the other sources of nonfundamental loss give rise to claims that belong to the corporation—claims that should be the subject of a derivative action. Moreover, such claims will arise in every case in which the market thinks there is a meritorious claim that will survive the motion phase of litigation (or that will give rise to an enforcement action by the SEC or criminal action by the DOJ).30 Since all such claims will have settlement value, the stock price of the defendant company can be expected to decrease by some amount in excess of fundamental damages. If not, it must mean that the market thinks the claim (if any) will fail. Thus, the market provides a reliable signal as to whether there is actionable fraud. Market price—or, more precisely, changes in market price—should indicate whether or not a supposed misrepresentation was material and made with scienter.31 There should be no claim unless stock price falls by more than it should based on new information about company-specific factors.32 In other words, there should be no claim if there is no collateral damage. For example, if the market thinks the CEO simply made a mistake—got it wrong as a matter of business judgment—the market may conclude that no action is

expense ratio on SPDRs—one of the most popular ETFs tracking the S&P 500—is just under 10BP. Given that many investors subscribe to the idea that the best way to maximize return is to minimize expenses, SFCAs thus represent a significant drain on returns. 28   Note that the average fraud period is about 300 days whereas the average holding period for a stock is about two years (as measured by mutual fund turnover), suggesting that most investors are more likely to be holders rather than buyers in most cases. 29   See Kevin LaCroix, Private Securities Litigation: Important Deterrent or Wasteful Churn? The D&O Diary (Regulatory Reform, Securities Litigation), October 26, 2008. www.dando​diary. com/2008/​10/articles/securities-litigation/private-securities-litigation-important-deterrent-or-​was​ teful-churn/. 30   Compare with Amanda M. Rose’s suggestion that SEC should act as a gatekeeper for private securities litigation (Rose 2008). 31   To be sure, stock price may decrease to a degree because the market believes that a frivolous action will be filed. But there is little reason under PSLRA to think that plaintiffs often file actions that are utterly without merit. 32   Several scholars have suggested that we should rely on market prices to determine ­materiality—if only because lack of a statistically significant price change would seem to indicate that that a particular item of information simply did not matter to the market. But I am not aware of anyone else who has suggested that scienter can be determined in the same way.

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92  Research handbook on representative shareholder litigation warranted or that an action if filed will be dismissed for failure to state a claim.33 If the market does not punish the company, why should the law do so?34

6. BUSINESS RISK, REPUTATIONAL LOSS, AND MATERIALIZATION OF RISK Although the market should tell us whether a company is likely to suffer litigation or enforcement costs in the form of an excess decrease in cash value, it is less clear whether the market will send an unambiguous signal about company-specific changes in discount rate. Ferrell and Saha argue that changes from concealed company-specific risks and the additional decreases in stock price attributable thereto are appropriately recoverable in a Rule 10b-5 action. But they disagree with Black that changes from a loss of trust or confidence in management should also be recoverable. The problem is that such a loss may result from bad news regardless of whether or not management has misrepresented business risks. If the bad news reveals a risk that was known to the market all along but underappreciated and underpriced (such as from the loss of a major customer or even a freak accident), presumably no one should recover. But if management somehow concealed this business risk, its revelation would give rise to a fundamental loss of the sort Ferrell and Saha see as properly within the scope of recoverable damages in a direct action by buyers. On the other hand, if the loss comes from an increase in the discount rate because the market has loss trust in management simply because it covered up the fact of lower expected earnings, the loss should properly be seen as derivative—a loss that would not have happened but for management misconduct. And of course, the loss may come from a mixture of the two. So how can we tell the difference between these two sources of loss? The answer is that an increase in discount rate attributable to previously unknown risks inherent in the business is likely also to affect other companies in the same industry. So it seems unlikely that a company-specific increase in discount rate will obtain except where attributable to a loss of trust or confidence, because increases from other sources are 33   Cf. Lev & de Villiers 1994, at 30–33 (suggesting that business judgment rule would preclude award of consequential damages in many cases). Incidentally, the possibility that we might rely on the market to signal scienter (or materiality) suggests that the PSLRA provision precluding discovery during the pendency of a motion to dismiss makes a good deal of sense. Since (prospective) decreases in cash from fees, fines, and feedback may be a significant factor in aggregate loss, it is important to minimize the upfront expenses of defense in order to get the clearest possible signal from the market. In the absence of such a rule we would expect the market to react simply because a defendant company has been sued, because every defendant company would be put to the considerable expense of preparing a defense and responding to plaintiff demands for discovery. 34   One obvious response to this idea is that the law and the market are two different things. The fact that the market fails to react is no reason to conclude that there is no fraud. So why should we trust the market? The answer is that securities laws are intended to protect the market. If the market does not care, the law should not care. It does not follow that we should look to the market to tell us if we should worry about product liability claims or environmental harms. Although the market may well be a good indicator of likely success, it tells us nothing about the merits of such claims. The signal is all the more reliable in the context of SFCAs only because some investors stand to recover ultimately from other investors.

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Claim character and class conflict  93 likely to affect the entire industry and thus to be netted out in any event study.35 Again we can trust the market. If market prices for similar companies fall by a similar amount, the claim should be dismissed. Only if the defendant company suffers a loss that is greater than other comparable companies should the claim proceed.36 In addition, some of the loss may come from materialization of risk. For example, in the securities litigation that followed the Deepwater Horizon explosion, plaintiffs argued that BP had misrepresented its policies and practices related to offshore drilling.37 Although market price reflected known risks, it did not reflect concealed risks (the known unknown, as Donald Rumsfeld would have called it). When the explosion occurred, the market allegedly discovered that BP had covered up some of this risk. But of course, much of the price decline also came from the prospect of cash outflows in connection with cleanup, repairs, fines, settlements, and so forth—expenses that are likely to be suffered by any oil company at some point. As BP argued (among other things), buyers of BP stock should recover at most the difference in preexplosion price that would have obtained if the market had known that the risk was greater, but should not be able to recover the much greater loss attributable to the explosion itself. Needless to say, plaintiffs argued that they should recover their entire loss, including the consequential damages from materialization. In the end, the court avoided the question by declining to certify the class on the dubious theory that class membership could not be ascertained because some class members might have bought the stock even at higher risk levels and would thus be precluded from recovering for materialization while other class members would not have bought even at a lower price and thus should be able to recover their entire loss. Needless to say, this theory is at odds with the rationale for FOTM. And never mind that all buyers suffered the lesser loss (Booth 2015). More pertinent for present purposes, the case illustrates the central point here that the courts must consider the component factors of loss in order to craft the appropriate remedy. In the case of BP, it might be possible to calculate the actionable loss by netting out the projected cash outflows from the explosion as well as changes in discount rates experienced by comparable companies. While these calculations may be difficult to do with any precision, at least the approach is principled. Finally (but perhaps needless to say), the calculation serves to emphasize the differing character of the component factors 35   This also addresses a potential shoot-the-messenger problem—the possibility that the first company to disclose a previously unknown industry-specific risk will be held liable for any loss net of changes in the market as whole. For example, in Pfeiffer v. Toll, 989 A.2d 683 (Del. Ch. 2010), defendants misrepresented the number of visitors to model homes built by Toll Brothers in the months leading up to the 2008 crash of the housing market and sold about $615 million of their own stock before corrective disclosure—upon which the stock price fell by 42 percent from its high during the fraud period. A comparable homebuilder stock (Horton) fell by about 15 percent during the same period (from July to December 2005) while the S&P 500 rose by 2 percent during the same period. While it is possible that the decrease in Horton shares was triggered in part by Toll disclosures, the plaintiffs in the Toll SFCA should have a claim at most for the 27 percent difference between the Toll loss and the loss suffered by Horton (assuming it is a comparable company and unaffected by its own company-specific news) plus the 2 percent difference in marketwide prices (as adjusted for risk (beta)). 36   This is precisely what event studies should reveal: Only such losses as exceed market and industry losses can be recovered. To be sure, this approach may not work in a single-company industry and may be difficult to apply to a company involved in several lines of business. 37   See Ludlow v. BP, PLC, 800 F.3d 674 (5th Cir. 2015).

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94  Research handbook on representative shareholder litigation of loss. While the loss from materialization and industrywide increases in the cost of capital should be seen as ordinary business risks, the remaining loss from a company-specific increase in the cost of capital should be seen as derivative. To be sure, it is possible that some of the cash outflow from materialization can be traced to actionable management misconduct (such as knowing failure to monitor compliance with the company’s own rules). But if so, the action would remain derivative in character.

7.  FUNDAMENTAL DAMAGES REVISITED Aside from the fact that much of the claim in any meritorious SFCA is derivative and should be so handled (as a matter of law), litigating such claims as derivative actions would solve the circularity and feedback problems. Again, since the corporation pays in a successful SFCA, stock price declines more than it otherwise would. So holder losses are magnified by the remedy itself—adding insult to injury. In effect, holders pay buyers and lose twice—once from the payout to buyers and once again from the loss of a derivative recovery. Needless to say, this magnification of the loss exacerbates the overdeterrence problem. Again, in the absence of fraud, no one has a claim just because stock price falls. The fundamental loss is a loss that will happen to someone. Everyone understands that it is the risk you take as an investor. So to permit buyers to recover their entire loss is to make them better off than they would have been in the absence of fraud. In contrast, the prospect of a derivative action against individual wrongdoers should be plenty of deterrence. Indeed, if the analysis here is correct, derivative actions should provide optimum deterrence. The question remains: What should be done about the fundamental loss suffered by buyers? If they do recover in a direct action against the corporation—albeit after resolution of derivative claims—such recovery will reintroduce feedback, undoing at least some of the benefit of proceeding by derivative action in the first place. There are several solutions. One possibility is individual recovery.38 Some portion of the derivative award (or settlement) may be paid to buyers. To be sure, some courts have been reluctant to permit individual recovery seemingly out of an overriding sense of propriety or cosmic order. But there is nothing to prevent a corporation from agreeing (say) to buy back the shares of class members.39 On the other hand, one could also argue that if the corporation is not made whole, individuals should not recover. Another possibility is that the law should decline to provide a remedy for such

38   See Perlman v. Feldmann, 219 F.2d 173 (2d Cir.1955); ALI, Principles of Corporate Governance 7.18 (court may order pro rata recovery in a derivative action if equitable and adequate provision made for creditors of the corporation). But Delaware case law strictly forbids direct stockholder recovery in a derivative action. See Bokat v. Getty Oil Co., 262 A.2d 246 (Del.1970); Keenan v. Eshleman, 2 A.2d 904 (Del. Ch. 1938). See also Bangor Punta Operations, Inc. v. Bangor & Aroostook Railroad Co., 417 U.S. 703 (1974) (same). On the other hand, a court may order rescission or inclusion of minority stockholders. See, e.g., Jones v. H. F. Ahmanson & Co., 460 P.2d 464 (1969). 39   A useful comparison is to James Park’s argument that payout by a corporation to settle a SFCA is akin to non pro rata repurchase of shares (Park 2009).

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Claim character and class conflict  95 fundamental losses. Again, as in musical chairs, the loss is one that someone will suffer. Investors in the aggregate will lose what they will lose. They are no better off because they have a remedy. Indeed, they are worse off since the settlement payment by the defendant company reduces company value dollar for dollar, but a significant portion thereof goes to the plaintiff lawyers. And the value of the defendant company is further reduced by its own costs of defense. Thus, the plaintiff class is never made whole, while holders suffer additional loss to the extent of the settlement and the costs of defense. If we assume that most investors are diversified (as they are), it seems clear that they would forgo any remedy in such circumstances if they could somehow vote to change the law. For diversified investors, losses from untimely purchases are offset by gains from lucky sales. So there is no real need for individual recovery (Booth 2012; Cox & Thomas 2006; Rubenstein 2001). To be sure, buyers in the example above would have bought at $20 rather than $25 if the truth had been known to the market (focusing on return alone). So there is an argument to be made that buyers should recover.40 But the fraud (so-called) consists only in shifting the loss from one set of investors to another because of a delay in disclosure. Indeed, to the extent that claims arise from voluntary misstatements of fact (as opposed to appearing in a filed document), it is often difficult to say when any given item of bad news should have been disclosed. The fraud period depends on the happenstance of a misrepresentation without which the truth may have remained undisclosed indefinitely. So it is often not clear that buyers during the fraud period would have paid a lower price but for the fraud. In any event, the only real loss for most investors is the loss that cannot be diversified away. As it happens, the losses that will happen anyway can be diversified away because they will be offset by unexpected gains under the law of large numbers. But the avoidable losses that happen only because of management misconduct cannot be diversified away because they are never offset by gains from good behavior. These losses all give rise to derivative claims (if any).

8. CONCLUSION The loss suffered by buyers in a typical securities fraud class action may come from several distinct sources, including lower expected return, or a higher cost of capital, or onetime outflows of cash, or a combination thereof, all of which are quickly impounded in market price even though prospective. Under federal securities law (Rule 10b-5), a buyer may recover the entire difference between purchase price and market price after correction. But some of this loss should properly give rise to a derivative claim on behalf of the corporation (and all stockholders) rather than a direct claim on behalf of a buyer class. In addition, some sources of stock price decrease are losses that would happen even in the 40   It could also be argued that buyers would not have bought if they had known the truth. See Ludlow v. BP, PLC, 800 F.3d 674 (5th Cir. 2015). If so, they would have suffered no loss at all and thus should be able to recover the entire difference between purchase price and corrected price. On the other hand, this argument is somewhat inconsistent with the fraud on the market doctrine, which effectively presumes that buyers are pricetakers who would have bought when they did in reliance on the integrity of market prices.

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96  Research handbook on representative shareholder litigation absence of fraud. Thus, for buyers to recover for such a loss is to restore them to a better position than if there had been no fraud, resulting in overdeterrence. Moreover, investors can protect themselves against such losses through diversification. In contrast, the extra loss that derives from fraud or misconduct—loss over and above the loss from bad business luck—cannot be diversified away, because such losses can result only in a decrease in stock price. Although stock price may sometimes increase because of good business luck, there is no potential for gain from the absence of fraud or misconduct. The bottom line is that the only losses that really matter are those that are nondiversifiable—which losses also happen to be derivative. The question is why the courts have failed to characterize investor claims properly. The answer is a combination of historical factors, conflicts of interest, and market failures. The most promising solution seems to be for index funds acting on behalf of investors to intervene to oppose certification. Index investors who trade infrequently—and only for purposes of portfolio balancing—lose more as holders (because the corporation pays) than they recover as buyers. They should oppose a direct class action remedy in favor of a derivative remedy by which the corporation recovers to the extent of actionable losses that give rise to a decrease in stock price. The same is true for diversified investors in general, who comprise a large majority of investors. And because it is impossible to sort investors who would thus oppose a direct buyer remedy from those who may favor such a remedy, the courts should decline to certify securities fraud class actions on grounds of class conflict. Rather, such actions should be recast as derivative actions, which constitute a superior form of class remedy under established rules of civil procedure, because they benefit all stockholders proportionally and only for nondiversifiable losses.

BIBLIOGRAPHY Akerloff, George, The Market for “Lemons”: Quality Uncertainty and the Market Mechanism, 84 Q. J. Econ 488 (1970). Alessi, Robert A., The Emerging Judicial Hostility to the Typical Damages Model Employed by Plaintiffs in Securities Class Action Lawsuits, 56 Bus. Law. 483 (2001). Alexander, Janet Cooper, The Value of Bad News in Securities Class Actions, 41 UCLA L. Rev. 1421 (1994). Black, Barbara, Reputational Damages in Securities Litigation, 35 J. Corp. L. 169 (2009). Blair, Margaret M., & Stout, Lynn A., Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law, 149 U. Pa. L. Rev. 1735 (2001). Booth, Richard A., Stockholders, Stakeholders, and Bagholders (Or How Investor Diversification Affects Fiduciary Duty), 53 Bus. Law. 429 (1998). Booth, Richard A., Windfall Awards under PSLRA, 59 Bus. Law. 1043 (2004). Booth, Richard A., The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L.J. 1 (2007). Booth, Richard A., Five Decades of Corporation Law—From Conglomeration to Equity Compensation, 53 Villanova L. Rev. 459 (2008). Booth, Richard A., Direct and Derivative Claims in Securities Fraud Litigation, 4 Va. L. & Bus. Rev. 277 (2009). Booth, Richard A., Class Conflict and Securities Fraud Litigation, 14 U. Penn. J. Bus. L. 701 (2012). Booth, Richard A., Who Owns a Class Action? 58 Villanova L. Rev. Online: Tolle Lege 21 (2013). Booth, Richard A., What Counts as Price Impact for Securities Fraud Purposes? 9 Virginia L. & Bus. Rev. 37 (2015). Casey, Lisa L., Reforming Securities Class Actions from the Bench: Judging Fiduciaries and Fiduciary Judging, 2003 B.Y.U.L. Rev. 1239. Cox, James D., & Thomas, Randall S., Private Securities Litigation Reform Act: Does the Plaintiff Matter? An Empirical Analysis of Lead Plaintiffs in Securities Class Actions, 106 Colum. L. Rev. 1587 (2006). Cornell, Bradford, & Rutten, James C., Market Efficiency, Crashes, and Securities Litigation, 81 Tulane L. Rev. 443 (2006).

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Claim character and class conflict  97 DeBondt, Werner F.M., & Thaler, Richard, Does the Stock Market Overreact? 40 J. Fin. 793 (1985). DeBondt, Werner F.M., & Thaler, Richard H., Further Evidence on Investor Overreaction and Stock Market Sensationality, 42 J. Fin. 557, 579 (1987). Ferrell, Allen, & Saha, Atanu, The Loss Causation Requirement for Rule 10b-5 Causes of Action: The Implications of Dura Pharmaceuticals v. Broudo, 63 Bus. Law. 163 (2007). Lev, Baruch, & de Villiers, Meiring, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7 (1994). Park, James J., Shareholder Compensation as Dividend, 108 Mich. L. Rev. 323 (2009). Ribstein, Larry, Law v. Trust, 81 B.U. L. Rev. 553 (2001). Rock, Edward B., & Wachter, Michael L., Islands of Conscious Power: Law, Norms, and the Self-Governing Corporation, 149 U. Pa. L. Rev. 1619 (2001). Rose, Amanda M., Reforming Securities Litigation Reform: Restructuring the Relationship between Public and Private Enforcement of Rule 10b-5, 108 Colum. L. Rev. 1301 (2008). Rubenstein, William B., A Transactional Model of Adjudication, 89 Geo. L.J. 371, 406–07 (2001). Strine, Jr., Leo E., et al., Loyalty’s Core Demand: The Defining Role of Good Faith in Corporation Law, 98 Geo. L.J. 629, 649 (2010).

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6.  Illegality and the business judgment rule Charles R. Korsmo

This chapter argues that corporate officers and directors should not, as a matter of corporate law, face greater judicial scrutiny in stockholder suits simply because they have caused the company to violate the criminal or civil law. The treatment of stockholder suits seeking to hold directors liable for causing the company to commit illegal acts is a matter of longstanding controversy. The topic has rarely been the focus of sustained scholarly attention, and has been marked by a general failure to articulate compelling policy grounds for allowing stockholders to sue directors for illegal actions and for applying a more stringent standard of review than for other stockholder suits. Technological, economic, and legal developments, however, make it increasingly likely the issue will take on increased salience in the near future, and that, without a change in legal doctrine, stockholder suits challenging illegal actions could become a significant obstacle to many socially beneficial advances.

1. INTRODUCTION Corporate lawbreaking can take an enormous variety of forms, ranging from environmental and labor law violations, to antitrust, to bribery, to fraud, to regulatory violations of bewildering diversity. It is altogether unsurprising that, at some level, illegal corporate actions are disfavored by the law. Corporations that violate the law are subject to criminal and civil liability, including fines and even the “death penalty” of losing their corporate charter. Individuals within the corporation—including directors and officers—who are personally involved in illegal activity can themselves face personal sanctions, including imprisonment (Beveridge 1996). None of this is particularly startling or controversial. Once one moves out of the realm of criminal and civil law, however, and into the realm of corporate law proper, easy certainties melt away. It remains reasonably clear, as a matter of positive law, that illegal activity is also disfavored as a matter of corporate law. As a result, business decisions involving illegal actions are, in theory, subject to greater judicial scrutiny. In Delaware, for example, illegal acts are nonexculpable and fall outside of the protection of the Business Judgment Rule. Beyond these bare doctrinal bones, however, it is unclear exactly what obligations directors have to stockholders to obey the law, where those obligations originate, and when and how stockholders can block illegal actions or hold directors personally liable for undertaking them. Scholars have proposed a number of theories of director liability, with varying degrees of descriptive plausibility. But a compelling prescriptive argument for using stockholder suits as a mechanism of substantive law enforcement has been elusive. At the same time, influential expositors of the otherwise ascendant contractarian view of corporate law have long argued—apparently unsuccessfully—that law enforcement concerns should, in most situations, play no role at all in corporate law (Easterbrook & Fischel 1982). If 98

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Illegality and the business judgment rule  99 illegal actions harm the company, the argument goes, any duty to obey the law should be subsumed under a more general duty to maximize the firm’s value. If illegal actions benefit the company, whatever duties were breached could not have been duties owed to the stockholders. In the absence of consensus on the appropriate role of corporate law in policing illegality, the doctrine has unavoidably remained muddy. While not ideal, this has long been a tolerable state of affairs. In a world where corporate lawbreaking is a reliably bad thing, stockholder litigation is simply one more arrow in the quiver of deterrence, though perhaps a bent one. Indeed, the bulk of the commentary on the topic appears to consist of proposals for making stockholder litigation a more effective deterrent against corporate illegality. New developments, however, threaten to make untenable the uncertainty surrounding corporate directors’ obligation to obey the law. Chief among these developments are new technologies—autonomous vehicles, for example—that could well render existing regulatory regimes grossly inefficient. At the same time, over the past several decades, an increasing number of laws and regulations have had a revenue-raising or protectionist component in addition to any traditional health or safety function. Such laws are especially likely to be socially inefficient. In a related development, many startups have begun to make violating, and ultimately changing, socially inefficient regulations a central part of their business model—a practice recently dubbed “regulatory entrepreneurialism” (Barry & Pollman 2017). We stand on the brink of a new world, where corporate lawbreaking may be both hugely profitable and, more importantly, often socially beneficial. In such a world, stockholder litigation seeking director liability for illegal actions threatens to be a formidable obstacle to progress, with few if any countervailing benefits. This chapter has three aims, and proceeds in three parts. Section 2 summarizes the law—such as it is—surrounding director liability for corporate illegality, and argues that this law is an undertheorized muddle. Section 3 argues that leaving the law in such a state will soon become untenable, as important instances of profitable, and often socially desirable, corporate lawbreaking are set to proliferate in the immediate future. Section 4 considers stockholder suits as a check on illegal activity. Section 5, in closing, offers tentative thoughts on how relevant legal doctrine should be reformed, and argues that stockholder suits are unlikely to play any beneficial role in policing corporate compliance with external legal obligations. This chapter will not exclusively focus on Delaware law. In fact, much of the relevant case law originates in New York, though Delaware of course looms large, as home to the majority of economically significant companies.

2.  DIRECTORS’ DUTY TO OBEY THE LAW Over the past century, the nature of corporate law regarding illegal activity has progressed from simple and misguided to convoluted and misguided. In the early years of corporate law, the treatment of illegal activities was straightforward. Corporations were considered public entities, and the right to incorporate was considered a dispensation from the state, granted in order to achieve public purposes that were specified at the time of incorporation. As a result, a corporation’s legal authority was limited to those powers specifically

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100  Research handbook on representative shareholder litigation enumerated in the corporate charter. Because illegal actions fell outside of the powers that could be enumerated, they were simply treated as “a subset of the larger category of ultra vires activities” (Greenfield 2001, 127). Not only were ultra vires activities void and subject to injunction, but individual directors could be “compelled to make good on the loss” occasioned by acting beyond their legal powers (Clark & Marshall 1901). As the famous 1909 case Roth v. Robertson demonstrated, a director could originally be held personally liable even where the illegal activity benefited the company, and even where stockholders had consented to the illegal actions. The company in Roth operated an amusement park that violated New York’s Blue Laws by operating on Sundays. The company’s directors—after consulting with the stockholders—caused $800 to be paid as hush money to a blackmailer who threatened to report the Blue Law violation. This illegality was clearly intended to, and probably did, benefit the company, as it made a substantial portion of its profits on Sundays. Nonetheless, a minority stockholder brought a derivative suit. The court found the blackmail payments illegal and therefore ultra vires, and forced the controlling director to reimburse the company the $800. While this regime may have functioned to deter illegality, the incentive structure it created was bizarre: the stockholders first profited from the illegal activity and then were also able to recover the costs associated with the illegal activity. The ultra vires doctrine slowly eroded in the early decades of the twentieth century. It was largely replaced—at least in terms of its internal governance function—by the fiduciary duties of care and loyalty with which we are familiar today, coupled with a norm of stockholder wealth maximization. As traditional ultra vires doctrine ebbed, however, limits on corporate lawbreaking were left in an awkward limbo. The prevailing consensus appears to have been that illegality remained off-limits to corporations. Midcentury treatises frequently referenced a “duty of obedience” in addition to care and loyalty, which apparently included a requirement of obedience to the law (Ballantine 1946; Knepper 1973). The contours of this duty, though, remained decidedly fuzzy, with no clear answer to the many questions surrounding who could enforce the duty, the proper standard of review, and the appropriate remedies. Today, as one scholar recently noted, “corporate law treatises no longer mention the duty of obedience” (Palmiter 2010, 463). Modern courts have retained the traditional antipathy toward illegality, but have struggled to fit it into the framework of fiduciary duty and stockholder wealth maximization. One of the earlier modifications is the so-called net loss rule, which bars director liability unless the plaintiff can demonstrate that the illegal activity caused a net harm to the company (Rapp 2001). The rule first arose in New York around midcentury, and was later adopted by Delaware as well. On its face, the net loss rule is logical for at least two reasons. First, it eliminates the anomalous result from Roth, where the stockholders were able to benefit from the illegal activity and also recover any losses. Second, it brings illegal activity within the broader mandate to maximize stockholder wealth and only allows stockholders to recover where a duty owed to them was arguably breached. Indeed, the net loss rule, taken to its logical conclusion, can be seen as subsuming the old duty of obedience within the duty of care. And, in fact, contractarian scholars have reached this logical conclusion, arguing that “[m]anagers have no general obligation to avoid violating regulatory laws, when violations are profitable to the firm” and “not only may but also should violate the rules when it is profitable to do so” (Easterbrook & Fischel 1982, 1177, n.57). Easterbrook and Fischel would exclude laws that are malum in se (evil

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Illegality and the business judgment rule  101 in itself, as distinguished from evil only because it is prohibited), though it is not readily apparent why the distinction should matter in this context. In any event, the law has not taken up the contractarians on this point. The ALI’s Principles of Corporate Governance explicitly “rejects any cost-benefit justification for lawbreaking and, by way of illustration, forbids a trucking corporation to instruct its drivers to exceed the speed limit to improve corporate profits” (Beveridge 1996, 731). The Third Circuit, applying New York law in Miller v. AT&T, held that even when “committed to benefit the corporation, illegal acts may amount to a breach of fiduciary duty,” without specifying which duty it might breach. In 2003, in Guttmann v. Huang, 823 A.2d 492, 506 n.34 (Del. Ch. 2013), Vice Chancellor Strine—now Chief Justice of the Delaware Supreme Court—wrote that “one cannot act loyally as a corporate director by causing the corporation to violate the positive laws it is obliged to obey,” suggesting that illegal actions should be treated as a breach of the duty of loyalty. In Stone v. Ritter and the Disney cases, the Delaware courts treated intentional illegal acts as a species of bad faith, which Stone made clear was also to be treated as a subset of the duty of loyalty. Yet duty of loyalty is an awkward fit where directors make a decision to break the law in order to benefit the corporation, rather than to benefit themselves personally. Neither Delaware’s courts nor those of any other jurisdiction have had occasion in recent decades to clarify the source of directors’ duty to obey the law, or to specify how exactly personal liability can be established (Uebler 2008; Coffee 1977). A few things, however, are relatively clear. First, the business judgment rule does not protect decisions involving illegality. This has been clear at least since the famous case of Shlensky v. Wrigley in the 1960s, and also follows from treating illegality as a species of duty of loyalty violation. Second, greater judicial scrutiny will be applied to special litigation committee recommendations to dismiss a derivative action involving illegal activity. In particular, under the standard that has grown out of Zapata v. Maldonado, Delaware courts are permitted to exercise their own business judgment in deciding whether to accept the SLC’s recommendation. Again, illegal activity is subject to greater scrutiny, as Zapata instructs the Court of Chancery to consider whether “public” considerations—such as a desire to punish and deter illegal actions—weigh against agreeing to dismiss the suit. The actual substance of the greater scrutiny for illegality remains fuzzy. In a typical duty of loyalty case where the business judgment rule does not apply, the burden is on the defendants to demonstrate entire fairness to the corporation. This standard does not map cleanly onto claims involving illegal activity, where the defendants may have been acting perfectly selflessly in attempting to maximize profits. What would fairness mean in this context? That the illegality did not actually harm the company? That it was not really illegal? That it was not clearly illegal at the time the directors acted? That the directors behaved reasonably, either in thinking that what they were doing was not illegal, or in thinking that what they were doing would benefit the stockholders? Two things are reasonably clear. First, even disinterested board decisions involving illegality are potentially subject to greater judicial scrutiny—and judicial secondguessing—than other disinterested board decisions. Second, because derivative actions alleging illegality are not blocked by the business judgment rule and are more difficult for an SLC to dispose of, such actions are more likely to survive past the motion to dismiss and summary judgment stages, thus creating enormous settlement leverage. That such suits have hitherto been rare may stem from the scarcity of situations where corporate

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102  Research handbook on representative shareholder litigation lawbreaking is both out in the open and profitable. Section 3, however, suggests that such situations are set to become much more common.

3. THE COMING WAVE OF (BENEFICIAL?) CORPORATE LAWBREAKING Most laws are not profitable to break. Where there is a general consensus that a certain activity—say, dumping garbage in a river—is socially harmful, legislators and regulators attempt to set the penalties for the activity at such a level as to make the activity unprofitable. This is not to say that corporations will never break the law, but corporate criminality is unlikely to be pervasive, and unlikely to be profitable in the long run. As a result, in most situations, both stockholders within the firm and society at large historically had an interest in deterring boards from making illegal decisions. That may be beginning to change. The change is driven by at least three interrelated developments. First, the number of crimes that would traditionally be considered malum prohibitum, rather than malum in se, has increased dramatically in recent decades. In addition to any traditional public welfare rationale, many of these laws also serve as government revenue generating measures, or protectionist measures for politically influential groups, or both. Second, an increasing number of companies—particularly startups—are making breaking the law, or “regulatory entrepreneurialism,” an explicit part of their business model. Finally, and relatedly, technological advances are rendering some old laws grossly inefficient. The explosion of criminal and regulatory law over the past 50 years is no secret. There is no shortage of commentary decrying the runaway proliferation of criminal statutes and regulations, and the tendency of these new laws to be malum prohibitum (Reynolds 2013; Cottone 2014). Much of this regulatory activity has come to function—whether it was intentionally designed to or not—as a revenue source for governmental agencies. To take a single well-known example, ticket revenue for traffic and parking violations has come to be an important source of revenue for local governments in recent years, with some estimates showing that nationwide revenues exceed $300,000 per traffic enforcement officer. Similarly, municipalities generate large revenues from automated red light and speed cameras, despite mixed evidence on whether the cameras improve traffic safety. Protectionist measures such as restrictive zoning and occupational licensing have also multiplied. More than 30 percent of American workers are now subject to occupational licensing, up from less than 5 percent in the 1950s. While some zoning and licensing restrictions can easily be justified by traditional health and safety concerns, some cannot—occupational licensing for hairbraiders is one common example. One characteristic that all of these laws have in common is that they are unusually likely to be socially inefficient. Rather than being designed to be efficient, they are designed—at least in part—to transfer wealth to influential political constituencies: existing property owners in the case of restrictive zoning; existing businesses in the case of occupational licensing; the government itself in the case of traffic laws. Again, traffic laws serve as a simple example. Studies consistently find that virtually nobody follows the speed limit, and that as many as 85 percent of drivers routinely exceed it. One plausible explanation is that speed limits are kept artificially low precisely in order to generate greater ticket revenue.

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Illegality and the business judgment rule  103 As anyone familiar with the nation’s experience with Prohibition can attest, inefficient laws create a wealth of profit opportunities. And, indeed, a number of businesses have emerged to take advantage of these profit opportunities. A few well-known examples will suffice as illustrations. Ridesharing services such as Uber and Lyft seek to profit largely by circumventing inefficient, protectionist taxi licensing laws. Short-term rental networks such as Airbnb seek to profit, in part, by circumventing restrictive zoning rules and regulation of the hotel and rental industries. Online fantasy sports sites such as DraftKings profit by circumventing gambling laws intended, at least in part, to protect existing casino operators. In some cases, intentionally breaking the law is a core part of the business model. While these businesses may or may not ultimately seek to gain legal acceptance, in the meantime they frequently operate in open defiance of the law. Uber, for example, has reportedly ignored cease and desist demands from transit regulators and even reimbursed drivers who have been fined by authorities (Barry & Pollman 2017). Professors Barry and Pollman have labeled these businesses “regulatory entrepreneurs,” and suggest that their actions have the “potential to combat socially efficient laws.” As they point out, “the political economy literature has long observed that some laws and regulations provide concentrated benefits to particular interest groups, while imposing diffuse costs on the public” (p.391). Regulatory entrepreneurs can potentially combat this dynamic both by becoming a counterbalancing interest group themselves, and by rallying and organizing their customers into a cohesive political force. Advancing technology is the third factor that is making profitable—and even beneficial—corporate lawbreaking more likely. The networking technology behind the companies mentioned above is an obvious example, and readers can undoubtedly come up with others on their own. I wish to focus on a slightly different example, involving autonomous vehicles, or self-driving cars. Though this is only a single example, it is an enormously important one, as such technology promises to be revolutionary and to confer radical improvements in safety and quality of life. The National Highway Traffic Safety Administration estimated that the economic toll from traffic accidents was $871 billion in 2010 alone. Even small improvements in safety would have enormous real-world impact, and with an estimated 90 percent of accidents caused by human error, the potential savings are vast, even leaving aside expected reductions in traffic congestion. An interesting problem has emerged, however, in early road-testing of autonomous vehicles by companies such as Google, Audi, and Delphi. While the self-driving cars themselves have almost never been directly at fault in causing an accident, they have thus far been involved in roughly twice as many accidents per mile driven as human-driven vehicles. Almost all of these accidents occur when a human driver rearends the autonomous vehicle. The problem is that the autonomous vehicles are programmed to slavishly follow the traffic laws. They never speed. They never do a rolling stop at a stop sign. They never accelerate through a yellow light. And it turns out that slavishly following the traffic laws—at least in a world where nobody else does—is not such a safe choice. Indeed, trying to merge at 55 mph with highway traffic going 65 mph, or slamming on the brakes at a yellow light, is quite hazardous. At least until autonomous vehicles have the roads to themselves—with none of those pesky human drivers—safety could be significantly improved by programming the cars to violate the traffic laws in much the way most human drivers do.

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104  Research handbook on representative shareholder litigation Apart from the engineering problems involved, the legal difficulty is this: What risk of personal liability should a director of a company which manufactures autonomous vehicles face if she decides to improve safety by programming the vehicles to break the law? The question is bound up with the question of how liability will be assigned for accidents involving autonomous vehicles. The present system—largely relying on driver-purchased no-fault insurance—makes little sense where the “driver” is increasingly irrelevant. Instead, a growing consensus suggests that manufacturers of autonomous vehicles should face something approaching strict liability for accidents involving their vehicles. Indeed, a number of leading manufacturers, including Volvo, Google, and Mercedes Benz, have already proposed offering warranties, voluntarily accepting liability for any accidents caused by their self-driving systems. Such a system makes a great deal of sense, in that it places liability on the party in the best position to take measures to reduce accidents, and also the party best placed to spread the costs of accidents by including them in the price of the vehicle or taking out insurance, or both. Consider, however, the following scenario. Google programs its self-driving cars to violate the speed limit, and also indemnifies drivers against loss. These measures are intended to improve safety and increase sales of the car, maximizing stockholder wealth. Later, one of Google’s cars causes an accident while speeding, causing $100,000 in damages. Google indemnifies the owner of the car, and pays the $100,000 in damages. A Google stockholder, owning 100 shares, sues to recover the $100,000 by holding the directors personally liable. The plaintiffs’ attorney argues that the loss to the corporation was caused by illegal activity—speeding—that was deliberately authorized by the board, and thus that the board’s decision is not protected by the business judgment rule. What result? This question is addressed in section 4.

4. RECONSIDERING STOCKHOLDER SUITS AS A CHECK ON ILLEGAL ACTIVITY The problem at this point should be reasonably clear. When, if ever, would a court considering a stockholder suit be justified in applying greater judicial scrutiny to a board’s decision to break the law? For simplicity of expression, I will focus in this section on the lack of business judgment rule protection for board decisions involving illegality. But the arguments made will apply also to the myriad other ways the law applies greater scrutiny to illegality. At least two potential rationales for greater scrutiny exist. First, we might think that illegal actions are unusually likely to harm stockholders, in which case greater scrutiny may be justified in order to better enforce the board’s internal duty to maximize stockholder wealth. Second, we might think that even illegal actions that benefit stockholders are likely to be socially harmful, and that stockholders can function as private attorneys general, supplementing what would otherwise be underenforcement of the board’s duty to satisfy its external duty to follow the law. Even if either of these rationales were once persuasive, they are both severely undercut by the changes described in the last section. A number of articles have attempted to clarify and locate the duty of directors to obey the law (Beveridge 1996; Rapp 2001; Uebler 2008; Palmiter 2010). Probably the most successful conception of the duty to obey the law is as a holdover from the old ultra

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Illegality and the business judgment rule  105 vires doctrine. This conception finds textual support in corporate codes that empower corporations to engage in any “lawful activity,” which carries with it the implication that unlawful activities are beyond the power of the corporation. In addition, most corporate charters, even where they do not limit the powers of the board to any specific purpose, include provisions restricting the corporation to “any lawful business” or some equivalent language. This internal restraint lends support to the idea that the duty to obey the law is also an internal duty—above and beyond the duties of care and loyalty. The logical conclusion is that unlawful decisions are a breach of duty owed to the corporation and the stockholders, and are a proper subject for derivative actions. Few scholars, however, have offered sustained analysis as to what beneficial role stockholder litigation can be expected to play in either enforcing the law or increasing stockholder wealth. An exception is Professor Greenfield, who in a 2001 article attempted to explain why various stakeholders—including stockholders—would want a rule against intentional lawbreaking by the board. Many of the reasons he offers—that managers’ and directors’ incentives, risk-preferences, and time-horizons may differ from those of the stockholders; that managers and directors may underestimate risks and overestimate benefits—prove too much, as they are hardly unique to illegal decisions. If taken seriously, these considerations would argue against judicial deference across a broad swath of corporate decisionmaking. Greenfield, however, makes two arguments for scrutiny that arguably apply with special force to illegal decisions. First, he argues that illegal decisionmaking will, by its very nature, be more difficult for stockholders to monitor, because illegal acts will generally have to be hidden. Second, he argues that “illegal acts will be of dubious benefits to the firm in most cases” (p.1342) and will “tend to harm the long-term interests of the firm” (p.1336). And, indeed, earlier research has suggested that illegality is rarely profitable and is often the result of an agency problem within the firm (Alexander & Cohen 1999). In essence, these arguments suggest that an easily applied brightline rule—no ­illegality—performs adequately, and that a more finegrained standard requiring case by case adjudication is unnecessary. These arguments are greatly weakened in the context of regulatory entrepreneurialism. First, the lawbreaking of regulatory entrepreneurs is hardly a secret, but rather is a central feature of the business plan. Similarly, for self-driving cars, the behavior of the autopilot algorithms and any resulting liability will be matters of intense public scrutiny. Second, it can no longer be blithely assumed—if it ever could—that breaking the law will harm the firm or the stockholders. Again, where breaking the law is central to the business plan—either in an effort to get the law changed, or because the law simply functions as a tax on profitable activity—it is entirely possible that illegal activity will benefit the firm. To be sure, directors could err, and end up breaking the law in ways that ultimately hurt stockholders. But that is always a possibility with any risky business decision, and no reason to allow courts to secondguess boards where they otherwise would not. A final possibility is that stockholder suits can serve as supplemental law enforcement, helping to deter illegal corporate conduct that may be profitable for the firm but detrimental to society as a whole. This intuition seems to tacitly underlie many discussions of judicial scrutiny of illegal board decisions, and is explicitly invoked by Professor Greenfield. By making an activity illegal in the first place, he argues, society has “determined that the costs of certain acts—whether speeding or fraud or murder—outweigh the

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106  Research handbook on representative shareholder litigation benefits of such acts from society’s perspective” (p.1325). As such, stockholder suits can serve as a possible corrective to underenforcement of criminal and civil law. Of course, given the dynamics of most stockholder litigation, the plaintiffs’ attorneys who actually control derivative litigation make for singularly unpromising agents of public welfare (Korsmo & Myers 2014). The lack of any significant derivative actions holding directors personally liable for illegal decisions suggests that such actions do not serve any valuable law enforcement function. More to the point, however, with the growth of protectionist and revenue-oriented regulation, and with the advent of disruptive technology such as self-driving cars, it is no longer safe to assume that corporate illegality will be harmful on the net level. Much corporate illegality is harmful, of course, but that can always be addressed more directly by increasing criminal and civil penalties to the point where it is no longer profitable. Given the potential for regulatory entrepreneurialism to reform socially inefficient laws, increased judicial scrutiny of illegal action is as likely to stymie beneficial reform as it is to stamp out destructive lawbreaking. Whatever justifications may once have existed for treating illegal decisions differently as a matter of corporate law, they are no longer compelling. The example of self-driving cars is once again instructive, and by itself an important instance of the broader problem. Again, consider a manufacturer of autonomous vehicles that has programmed its cars to violate inefficient traffic laws in order to increase safety, and has agreed to indemnify buyers for any accidents. These measures, though they include deliberate flouting of the law, are both socially beneficial and likely to be profitable to manufacturer’s stockholders. If, however, the board’s decisions were challenged in a derivative suit, they would not be entitled to the protection of the business judgment rule, and even an independent special litigation committee’s recommendation to dismiss would come under significant scrutiny. Without the protection of the business judgment rule, it is unclear what precisely the standard of review would be. At the very least, however, the board would presumably be required to demonstrate that the company suffered no net harm, and perhaps might need to persuade the court that no broader public policy concerns justified liability either. In any case, significant discovery would be required, with the attendant expense. At best, the outcome would be a settlement with plaintiffs’ attorneys for the nuisance value of their claim. At worst, fearing liability, the directors would—as manufacturers of autonomous vehicles have so far done—program their vehicles to follow the law even where doing so led to more accidents.

5. CONCLUSION The corporate law doctrines surrounding board decisions involving illegality have long been mostly wrongheaded, but mostly harmless. In the near future, they will grow even more wrongheaded, but will no longer be harmless. Instead they will threaten to throw up barriers to welfare-enhancing technological developments, and to economic and political developments that could otherwise lead to reform of inefficient laws. Increased judicial scrutiny of illegal decisions, as a matter of corporate law, was never likely to be a particularly useful tool of public policy. In today’s world, such scrutiny is more likely to

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Illegality and the business judgment rule  107 have perverse consequences than beneficial ones. Illegality, by itself, should not trigger liability or increased scrutiny as a matter of corporate law.

BIBLIOGRAPHY Alexander, Cindy R. & Cohen, Mark A. (1999). “Why Do Corporations Become Criminals? Ownership, Hidden Actions, and Crime as an Agency Cost,” Journal of Corporate Finance, 5: 1. Ballantine, Henry W. (Revised ed. 1946). Ballantine on Corporations. Barry, Jordan M. & Pollman, Elizabeth, “Regulatory Entrepreneurship,” 90 Southern California Law Review 383, 391 (2017). Beveridge, Norwood P. (1996). “Does the Corporate Director Have a Duty Always to Obey the Law?” DePaul Law Review, 45: 729–80. Clark, William L. & Marshall, William L. (1901). A Treatise on the Law of Private Corporations. Coffee, Jr, John C. (1977). “Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response,” Virginia Law Review, 63: 1099. Cottone, Michael (2014). “Rethinking Presumed Knowledge of the Law in the Regulatory Age,” Tennessee Law Review, 82: 137–66. Easterbrook, Frank H. & Fischel, Daniel R. (1982). “Antitrust Suits by Targets of Tender Offers,” Michigan Law Review, 80: 1155. Greenfield, Kent (2001). “Ultra Vires Lives! A Stakeholder Analysis of Corporate Illegality (with Notes on How Corporate Law Could Reinforce International Law Norms),” Virginia Law Review, 87: 1279–1379. Knepper, William E. (2d ed. 1973). Liability of Corporate Officers and Directors. Korsmo, Charles R. & Minor Myers (2014). “The Structure of Stockholder Litigation: When Do the Merits Matter?” Ohio State Law Journal, 75: 829–901. Palmiter, Alan R. (2010/2011). “Duty of Obedience: The Forgotten Duty,” New York Law School Law Review, 55: 457–78. Rapp, Geoffrey (2001). “On the Liability of Corporate Directors to Holders of Securities for Illegal Corporate Acts: Can the Tension between the ‘Net-Loss’ and ‘No-Duty-To-Disclose’ Rules Be Resolved,” Fordham Journal of Corporate and Financial Law, 7: 101–29. Reynolds, Glenn H. (2013). “Ham Sandwich Nation: Due Process When Everything Is a Crime,” Columbia Law Review Sidebar, 113: 102–8. Uebler, Thomas A. (2008). “Shareholder Police Power: Shareholders’ Ability to Hold Directors Accountable for Intentional Violations of Law,” Delaware Journal of Corporate Law, 33: 199–221.

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PART III MERGER LITIGATION

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Section A Managing Multijurisdictional Litigation

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7.  Fighting frivolous litigation in a multijurisdictional world Adam Badawi

1. INTRODUCTION Delaware courts have recently shown an increased resolve to limit what many view as frivolous litigation. This fortitude is most evident in the crackdown on disclosure-only settlements that the In re Trulia and In re Riverbed decisions have initiated.1 The justification for these approaches is easy to see, at least from an ex post perspective. When plaintiffs’ lawyers are only able to secure additional deal disclosures that are unlikely to affect how shareholders vote, it is hard to understand why they should get a fee for doing so and why defendants should get a global release for agreeing to pay that fee.2 Instead, it appears that these settlements allow class counsel to use the leverage they have to slow or imperil a deal to extract a rent while also providing defendants insulation from further scrutiny at a relatively cheap price. But looked at from the standpoint of competition among states for corporate charters, these issues become murkier. Part of Delaware’s comparative corporate advantage is its place at the forefront of corporate law production.3 Much of this production comes from its courts, which have been deciding cases on bleeding edge corporate issues for decades. This ability to innovate has depended on a constant stream of new cases. If plaintiffs do not file complaints in Delaware—or if a preclusive judgment has been issued in another state by the time a case makes it to Delaware—the resulting lack of corporate law production could pose a threat to Delaware’s standing as the preeminent jurisdiction for corporate law in the United States. This chapter asks whether Delaware’s recent attempts to limit frivolous cases are likely to be sustainable given its commitment to being at the vanguard of corporate law production. The question is a complicated one because it turns on a number of issues that are difficult to quantify. I focus here on two of those issues. The first, and perhaps the most important one, is how evident it is to plaintiffs’ lawyers that a case has substance at the time those lawyers file the case. If it is more or less apparent whether a case is meritless after a brief glance, the confident rejection of fees in Trulia and Riverbed-like cases is unlikely to imperil Delaware’s ability to stay at the forefront of corporate law. But if

1   In re Trulia, Inc. Stockholder Litigation, 129 A.3d 884 (2016); In re Riverbed Technology, Inc., Stockholders Litigation, 2015 WL 5458041. 2   As the court in Trulia explained: “Members of this Court also have voiced their concerns over the deal settlement process, expressing doubts about the value of relief obtained in disclosure settlements, and explaining their reservations over the breadth of the releases sought and the lack of any meaningful investigation of claims proposed to be released.” 129 A.3d at 895–96. 3   See, e.g. William J. Carney, The Production of Corporate Law, 71 S. Cal. L. Rev. 715 (1998).

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Fighting frivolous litigation  111 merit is difficult to ascertain until lawyers are able to learn more about the underlying facts, disallowing fees when the benefit produced by the case are questionable could lead to good cases leaving Delaware. Those cases will therefore not contribute to the future development of Delaware law. The issue of merit is inextricably intertwined with the role that multijurisdictional litigation plays as a potential threat to Delaware’s place in the corporate law world. If Delaware raises the threshold that is necessary to merit a fee award in merger cases, plaintiffs will naturally look elsewhere.4 If this means losing relatively uninteresting cases—such as high premium mergers negotiated at arm’s length—there should be little concern that Delaware will miss out on the difficult matters that can lead to innovative change. But the availability of other jurisdictions can compound the issues that come alongside increasing the threshold results that plaintiffs must show to have fees approved. The ongoing Walmart litigation provides an object lesson in these dangers. This dispute, which involved allegations that the Walmart board ignored reports that employees of Walmart’s Mexican subsidiary were bribing foreign officials, gives the Delaware courts the potential to make an important ruling on the scope and content of directors’ oversight duties. The Delaware plaintiffs heeded warnings by the Chancery that derivative cases like this one faced dismissal if plaintiffs did not use their books and records inspection rights to ensure that the case had merit.5 While the plaintiffs were litigating these Section 220 inspection rights, an alternative set of plaintiffs filed a related suit in Federal Court in Arkansas. When that suit got dismissed on demand excusal grounds, the defendants went to Delaware to get the Delaware case dismissed on the basis of issue preclusion. The Chancery Court agreed to do so.6 While the litigation remains ongoing, the mere fact that Delaware may lose the case shows the dangers of increasing legal thresholds: those cases can get resolved in other jurisdictions, thus depriving Delaware of important grist for the corporate law mill. A second, albeit less important, factor that can be affected by the Trulia-like cases is the financing of plaintiffs’ law firms. In order to bring cases—both good and bad—the 4   It is possible that forum selection clauses in a Delaware corporation’s charter would ostensibly require that litigation take place in Delaware. But these provisions provide no guarantees. Other states may refuse to enforce the provision—as has happened in at least one case (see Galaviz v. Berg, 763 F. Supp. 2d 1170 (N.D. Cal. 2011))—or, more perniciously, firms may waive the Delawareonly requirement. Firms are, of course, more likely to waive this requirement when a potentially ­meritorious case can be quickly resolved through unsearching litigation in a non-Delaware state. See Alison Frankel, How corporations can game their own forum selection clauses, http://blogs.reuters. com/alison-frankel/2015/11/17/how-corporations-can-game-their-own-forum-selection-clauses/ (November 17, 2015). 5   For an overview of the § 220 litigation see Wal-Mart Stores, Inc. v. Indiana Electrical Workers Pension Trust Fund IBEW, 95 A.3d 1264 (2014). The Chancery is not shy about encouraging this sort of diligence. One relatively well-known admonishment of plaintiffs to make use of their books and records rights is Chancellor Chander’s comment in Beam ex rel. Martha Stewart Living Omnimedia, Inc. v. Stewart, 833 A.2d 961, 981-82 (2003): “It is troubling to this Court that . . . litigants continue to bring derivative complaints pleading demand futility on the basis of precious little investigation beyond perusal of the morning newspapers . . . If the facts . . . could have been ascertained through more careful pre-litigation investigation, the failure to discover and plead those facts . . . results in a waste of resources of the litigants and the Court. 6   In re Wal-Mart Stores, Inc. Delaware Derivative Litigation 2016 WL 2908344 (2016).

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112  Research handbook on representative shareholder litigation economics of a given firm must be sustainable. It is a well-worn technique for plaintiffs’ firms to use smaller cases of questionable merit to help build a war chest to finance larger cases. This strategy, which may be a necessary evil, becomes more difficult when courts refuse settlements or otherwise place limits on what they view as potentially meritless litigation. Without the ability to build a war chest, these firms’ ability to litigate the better cases to completion becomes strained. Defendants surely know this and can use their leverage in these situations to produce lower settlements and earlier phases in litigation. Plaintiffs’ firms may be able to adapt by, for example, diversifying the types of cases that they litigate or, increasingly, by turning to litigation financing firms. Nevertheless, the possibility of long stretches of time with no income from Delaware cases may threaten the viability of some plaintiffs’ firms maintaining a robust Delaware practice. The remainder of this chapter works through how each of these two factors may affect the ability of Delaware courts to limit what they view as frivolous litigation. The chapter ends by placing this discussion in the context of the interest group analysis that has long been a leading framework for analyzing the development of Delaware corporate law.

2. MERIT THRESHOLDS AND MULTIJURISDICTIONAL LITIGATION While evidence is necessarily preliminary, it appears that Trulia and Riverbed have started to stem the tide of merger cases in Delaware. Plaintiffs now appear to be filing merger challenges elsewhere, or not at all. Cain et al. show that while the percentage of merger lawsuits that produced at least one Delaware case hovered between 51 and 61 percent between 2011 and 2015,7 for 2016 that number came in at 32 percent.8 While identifying causation is always difficult, it is not unreasonable to believe that some of this precipitous drop is due to the substantially diminished prospects of obtaining a legal fee in merger lawsuits.9 What is more difficult to know is what the net effect of this shift will be. As Cain et al. suggest, deterring plaintiffs from filing in Delaware means some meritless suits will be filed elsewhere.10 But it is also possible that some nonmeritless suits—and potentially the types of cases that allow the Chancery Court and the Delaware Supreme Court to provide guidance on emerging corporate governance practices—will also migrate to other jurisdictions. That possibility presents a danger to Delaware’s position as the leading jurisdiction for corporate law and, relatedly, as the top destination for incorporations.  7   Matthew D. Cain, Jill Fisch, Steven Davidoff Solomon, and Randall S. Thomas, The Shifting Tides of Merger Litigation 21–22, available at: papers.ssrn.com/sol3/papers.cfm?abstract_ id=2922121 (2017).  8   Ibid at 22.  9   Although the potential for obtaining an attorneys’ fee from a settlement that only produces additional merger disclosures has diminished, there is still a possibility that the plaintiffs’ lawyers can obtain a so-called mootness fee. This fee, which Trulia expressly authorizes, allows the defendant board and the plaintiffs to agree to a payment that compensates the plaintiffs for obtaining additional disclosures that moot the litigation. The primary difference between a nondisclosure settlement and a mootness fee is that mootness fees do not provide a global release for all mergerbased claims against the defendant directors. 10   Ibid at 43.

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Fighting frivolous litigation  113 This threat means it is quite important to get a sense of how Trulia and Riverbed will affect the thinking of lawyers who are contemplating bringing a lawsuit in Delaware.11 If a suit’s merit is evident from the outset, that suggests that Delaware may not lose too many important cases. The plaintiffs’ attorney who observes how meritorious a given case may be can then make a choice of jurisdiction based on that information. And there may be something to this account. Those who practice and comment on mergers and acquisitions litigation can identify the leading indicators of a strong case. For example, the presence of a controlling shareholder or of a management sponsored buyout means that the principals in the case may have been particularly motivated by their own self-interest. Likewise, the existence of a low premium in a deal may signal that the target’s board did not comply with their fiduciary duties when negotiating the deal.12 If these signals are strong ones, then the Trulia/Riverbed regime may accomplish the goal of deterring meritless litigation in Delaware.13 But there are some reasons for caution about the reliability of these signals in merger litigation. Lawyers typically need to decide whether to file merger challenges in short order, and this need to move quickly necessarily diminishes the time that plaintiffs have to investigate merit. That merit is not always apparent in short order.14 If Delaware refuses to authorize fees in cases that ultimately turn out to have little, or questionable, merit, lawyers may rationally decide to file cases where they have uncertain information outside of Delaware.15 And they are particularly likely to do so if they believe that the other jurisdictions will tend to approve settlements in these situations. There is a potential lesson in Delaware courts’ experience of trying to deter frivolous

11   The concerns about Delaware law and how it affects attorney strategy are not the only—or even the paramount—concerns with this development. As Dari-Mattiacci and Talley argue, there is a set of conditions under which the turn away from disclosure-only settlements can discourage the willingness of potential buyer’s to make bids. Insofar as the goal of Delaware merger law is to maximize the wealth of target shareholders, this is an obvious concern. See Dari-Mattiacci, G. and E. Talley. 2016. “Do Disclosure-Only Settlements in Merger Objection Lawsuits Harm Shareholders?” Working paper. Columbia Law School. 12   See Boris Feldman, Litigating Post-Close Mergers, available at: corpgov.law.harvard. edu/2012/11/09/litigating-post-close-merger-cases (describing “situations where objective factors suggest a lack of merit to the claims: e.g., high premium; no contesting bidders; overwhelming shareholder approval; customary deal terms”). 13   The conventional wisdom that third party mergers are highly unlikely to be problematic may very well be correct. But there is some evidence that high quality plaintiffs’ firms do sometimes file complaints in third-party cases. See Adam B. Badawi and David Webber, Does the Quality of the Plaintiffs’ Law Firm Matter in Deal Litigation?, 41 J. of Corp. L. 359 (2015) (showing that high quality firms file a substantial number of complaints in third-party cases). While one should not infer too much from this mere fact, one possible interpretation is that high quality lawyers believe that some third party mergers may be worth further investigation. 14   As then-Chancellor Strine explained in awarding a very large attorneys’ fee in the Southern Peru Copper case: “[The plaintiffs] advanced a theory of the case that [I] was reluctant to embrace. I denied their motion for summary judgment. I . . . gave [them] a good amount of grief that day about the theory. [The theory] faced some of the best lawyers I know . . . and won.” Americas Mining Corporation v. Theriault, 51 A.3d. 1213, 1256 (2012). 15   This decision may be rational because the expected value of bringing cases with high value signals in Delaware and low value signals elsewhere is higher than other approaches. It could be that the expected value of other strategies is not much different, but because of a combination of

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114  Research handbook on representative shareholder litigation derivative lawsuits. For some time, the judges of the Chancery Court have strongly encouraged shareholder plaintiffs to use their rights under Delaware General Corporate Law Section 220. That statute permits shareholders to initiate legal action to obtain documents and records that are “necessary and essential” to the shareholder’s purpose. While bringing a Section 220 action prior to filing a derivative lawsuit is not an ironclad necessity, plaintiffs who do not do so face a substantial risk that their lawsuit will be dismissed.16 This requirement played a key role in the litigation related to allegations that the board of Walmart failed to exercise oversight over one of the company’s Mexican subsidiaries that was alleged to have engaged in extensive bribery of government officials. These allegations resulted in 15 separate lawsuits being filed in Delaware and Arkansas. Some of the Delaware plaintiffs—informed by then-Chancellor Strine that a failure to do an adequate investigation would likely result in his granting a motion to dismiss—initiated a Section 220 action to obtain internal documents related to the allegations.17 That action took three years to resolve and included an appeal to the Delaware Supreme Court.18 In the interim, the federal Arkansas plaintiffs pressed forward without making a records request and without waiting for the outcome of the Delaware action. The Arkansas court determined that demand would not have been futile in the case and, accordingly, dismissed the lawsuit.19 With the Arkansas judgment in hand, the defendants then sought to have the Delaware action dismissed on the basis of issue preclusion. In a May 2016 opinion, Chancellor Bouchard agreed, finding that the Arkansas plaintiffs were adequate representatives for the shareholders.20 As a consequence of this process, Delaware faced the potential loss of an opportunity to determine whether these very serious allegations against the directors of one of the largest corporations in the United States implicated the oversight duties that the directors owe to the corporation and its shareholders. The Delaware Supreme Court may have revived this opportunity when it unanimously reversed Chancellor Bouchard’s opinion in January of 2017.21 The basis for the decision was that the Chancellor’s opinion paid insufficient attention to the potential federal due process rights of the Delaware plaintiffs. The Supreme Court’s opinion called on the Chancellor to address the argument used in an earlier Chancery Court opinion, In re EZCORP Inc. Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016).22 In that case, Vice Chancellor Laster held that a derivative plaintiff does not become a party to the litigation until that party gains the authority to represent the corporation by surviving a motion to dismiss. If Vice-Chancellor Laster’s view on this point solidifies as a matter of Delaware risk aversion and uncertainty in Delaware, plaintiffs’ attorneys prefer litigating cases with high uncertainty outside of Delaware. 16   See supra note 5. 17   California State Teachers’ Retirement System v. Alvarez, 2017 WL 239364 (2017) at *1. 18   See Wal-Mart Stores, Inc. v. Indiana Elec. Workers Pension Trust Fund IBEW, 95 A.3d 1264 (2014). 19   In re Wal-Mart Stores, Inc. S’holder Deriv. Litig., 2015 WL 1470184, at *1 (W.D. Ark, 2015). 20   In re Wal-Mart Stores, Inc. Delaware Derivative Litigation, 2016 WL 2908344 (Del Ch. 2016). 21   See Alvarez supra note 17 at *5–6. 22   Ibid at *7–8.

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Fighting frivolous litigation  115 corporate law, potentially impactful cases like the Walmart derivative litigation will be at substantially less risk of slipping from Delaware’s grasp. But retaining these cases this way will come with the potential for significant costs. Under this rule, Delaware corporations could be subject to successive waves of derivative lawsuits over the same matter. That would revive the threat of nuisance litigation that Delaware seems to want to snuff out through the Trulia line of cases. This suite of difficult choices can be traced, at least to some extent, to the insistence that derivative plaintiffs do more to investigate claims prior to filing. As the ongoing saga of the Walmart case shows, that demand may be too dear an ask in an environment of intense multijurisdictional litigation. Requiring more work prior to filing will naturally produce delays in litigation. During the interim created by that delay, cases in other jurisdictions might move along more rapidly. If these cases are important for development of corporate law, Delaware risks losing its edge as the leading jurisdiction for corporate law in the United States.23 My point here is not that this state of affairs is obviously worse than a world where Delaware does not press derivative plaintiffs to perform a decent amount of pre-suit investigation. Rather, the point is that this world is not obviously better than one that tolerates some amount of meritless litigation. To put it another way, even from Delaware’s perspective, the optimal amount of frivolous lawsuits is unlikely to be zero. There is a potential lesson in this account for Delaware’s newfound determination to clamp down on disclosure-only merger settlements. The available evidence suggests that Trulia and Riverbed have led to the predictable exodus of cases to other jurisdictions.24 There may be several dynamics leading to these choices. The rosy scenario is that potential plaintiffs know shortly after a deal announcement whether the case has merit or not and they can choose to not file the meritless cases in Delaware.25 But a more troubling account is possible. Plaintiffs may know relatively little about a case’s merit at the time of filing and file outside of Delaware because they are confident of at least some compensation if there turns out to be little to the case. In the latter scenario, those lawsuits filed elsewhere may become a problem for Delaware. Just as in the Walmart context, there is a risk that those cases will proceed quickly and a preclusive ruling or settlement will be entered into before the Delaware suits gets filed.26 In that situation, even if the investigation finds something meritorious, it may not matter.27 The lawsuit will not get filed in Delaware and the Delaware courts 23   While the risk is particularly acute when, as in the Walmart case, the alternative jurisdiction dismisses the case, this risk can also occur if the competing jurisdiction allows the case to move forward at a rapid clip. In that situation, a Delaware court needs to decide whether to stay the Delaware case or allow the competing cases to proceed. 24   See supra note 7. 25   Some of these cases are presumably being filed in other jurisdictions, but some of them may not be getting filed at all. 26   The same thing can happen, of course, even if a Delaware case gets filed sometime after the initial non-Delaware suit. Depending on the timing, the other case could be so far along that the Delaware case has little or no impact on the ultimate outcome. 27   One express justification that Chancellor Bourchard used in Trulia was the argument by a Delaware practitioner that good cases may get settled out before all the facts come to light. See Trulia at 895 (citing Joel Edan Friedlander, How Rural/Metro Exposes the Systemic Problem of

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116  Research handbook on representative shareholder litigation will not have a chance to say anything about the case. If Delaware loses cases in this way, there is a risk that Delaware will lose an opportunity to stay on the cutting edge of leading corporate law matters. That potential for ossification may pose a threat to Delaware’s place as a leader in corporate practice. As stated at the outset, the danger posed by this threat depends, in large measure, on when the merits of a case become evident. If readily observable factors such as deal premium and the presence of a controlling shareholder are highly reliable indicators of merit, this problem is unlikely to be large. Plaintiffs can bring meritorious cases in Delaware and Delaware will then get to pass judgment on the important corporate law issues of the day. But if investigations need some time to sort through complex disclosures or to conduct some discovery to determine if they are meritorious, the Trulia framework presents some risk. Plaintiffs may choose to forgo Delaware because if these investigations turn up only some minor disclosure problems, they will get nothing for the effort. That possibility is likely to drive those plaintiffs elsewhere.

3.  FUNDING LITIGATION Though boards and defense lawyers may sometimes lament the tactics of plaintiffs’ lawyers, a healthy plaintiffs’ bar is a necessary part of Delaware’s corporate ecosystem. Maintaining that health requires that the enterprise be financially viable, which can be challenging for plaintiffs’ firms. It can be a long time between judgments and settlements and those droughts can make it difficult to keep together the large teams of lawyers that are necessary to perform high caliber plaintiffs’ work. This fact is well known to the defense bar, which may sometimes drag cases on so that, among other reasons, plaintiffs’ attorneys begin to feel the squeeze between paychecks.28 While plaintiffs’ firms may have some financing options, the payouts that disclosureonly lawsuits provide some level of income smoothing for the lumpy earnings that are a fact of life for the plaintiffs’ bar. The lack of that income smoothing may pose a threat to the health of the plaintiffs’ bar. To be sure, there is some risk that overindulging plaintiffs will lead to a parasitic rather than healthy relationship between that bar and other

Disclosure Settlements, 40 Del. J. Corp. L. 877 (2016)). That piece argues that the Rural/Metro case almost did not produce an important decision because the initial plaintiffs’ counsel were willing to settle for increased disclosure. It was only because other plaintiffs objected that the court did not approve the settlement. It is hard to see why the Rural/Metro case justifies the Trulia standard. In Rural/Metro, the system worked. The concern is that there are other cases where the disclosure-only settlement prevented an important case from moving forward. It is, naturally, difficult to develop information on that point. Moreover, it is not clear that Trulia would even solve this problem because other jurisdictions may approve a disclosure-only settlement before the Delaware case can be developed. 28   See, for example, Peter A. Bell and Jeffrey O’Connell, Accidental Justice: The Dilemmas of Tort Law 113–14 (1997) (“Defense attorneys often proceed slowly, to stretch out litigation, in the knowledge that delays in the receipt of compensation put pressure on plaintiffs to accept lower settlements in order to get needed cash”).

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Fighting frivolous litigation  117 prominent Delaware players.29 But there is a potentially plausible set of conditions where setting the threshold for policing settlements somewhere below the line set by Trulia may better sustain the health of the Delaware corporate law ecosystem. The admittedly rosy scenario required for this approach to be correct would entail a group of plaintiffs’ firms who act in good faith and conduct diligent investigations both before and after filing a merger challenge. When investigations turn up potentially problematic behavior by firm fiduciaries, the subsequent cases may provide the raw material that Delaware courts need to stay on top of current corporate law issues. But these cases may be relatively rare. And that might mean that even plaintiffs’ firms acting in good faith—to the degree that they specialize in this type of litigation—will go a long time between paydays if these are the only merger cases that produce a return. That situation may threaten the viability of this practice area. An alternative would be to provide a modest return when the investigation does not yield a juicy case. As long as the awards in the better cases adjust downwards to account for providing a settlement in the modest cases, the ex ante expected value of a case can be maintained, with the added benefit of smoothing income in a way that provides more practice stability. Of course, this sort of income smoothing is not the only way a law firm might deal with these financing challenges. There are at least two other approaches that a firm could explore to address substantial droughts between awards. One is to diversify its practice. By branching out beyond merger litigation a plaintiff-focused firm may be able to obtain some level of internal income smoothing. There is some evidence that plaintiffs firms have the ability to react to legal changes in this way. For example, when the Private Securities Litigation Reform Act made it more difficult to bring securities lawsuits, plaintiffs firms reacted by branching out into corporate law litigation.30 One plausible rationale for this approach was that filing corporate lawsuits helped to smooth out income for firms that specialized in securities class actions because settlements and awards from that practice became more lumpy post-PLSRA. There are, of course, some natural limitations on the ability to diversify. If the practice areas of lawyers are not at least somewhat complementary, it is unlikely that there will be large gains from joining forces to create diversification. Partners in a law firm must do some monitoring of each other, if only to determine how to split the fruits of a partnership. If one partner does family law and another does criminal appellate work, it may be difficult to convince each other that it just happened to be a down year that produced low billings rather than a lack of effort. That problem may not be as pressing when one partner does criminal trial work and the other does criminal appellate work.31 29   An explicit concern in Trulia was the nonadversarial nature of many disclosure-only settlements. Trulia, 129 A.3d at 893–94. Once the parties have agreed to the additional disclosures, both the plaintiffs and the defendants have an interest in seeing the settlement approved (as is true in any settlement hearing). But this point is collateral to the one that I make here. If initial discovery indicates issues that go beyond disclosure matters, any settlement or judgment is likely to look much different than a disclosure-only case. 30   John Armour et al., Delaware’s Balancing Act, 87 Ind. L. J. 1345, 1380 (2012). 31   A leading academic rationale for law firm mergers is the potential it creates to leverage intraclient referral networks. See Forrest Briscoe and Wenpin Tsai, Overcoming Relational Inertia: How Organizational Members Respond to Acquisition Events in a Law Firm, 56 Adm. Sci. Quar. 408 (2011). While plaintiffs’ firms may merge for other reasons, given the traditionally disparate

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118  Research handbook on representative shareholder litigation In the context of merger litigation, these sorts of synergies are likely to come from other plaintiff-side firms working in the corporate and securities space. If the firms specializing in merger litigation need to find a way to smooth their income, a merger with a securities firm might accomplish that goal. But, of course, as mentioned above, some of these securities firms have already branched out into Delaware plaintiffs’ work. That history might mean that these opportunities are slim. Merging, however, may be an extreme solution to the problem of sporadic paydays becoming even more sporadic. A simpler way to smooth income would be to obtain financing from a bank, as many defense firms do. While it is difficult to obtain much information about this practice, it does appear that financial institutions tend to shy away from lending to plaintiffs’ firms. It is hard to know precisely why this is the case, but the speculative nature of plaintiffs’ work may create substantial information asymmetries that make traditional lending difficult. Whatever the reason, most lending to plaintiffs’ firms happens through specialty lenders that engage in litigation finance. These firms typically employ large numbers of lawyers, a fact that may help to minimize the information asymmetries that would otherwise exist. To the degree that profitable opportunities still exist in merger litigation, it may be possible that plaintiffs’ firms can use this method of financing to maintain a stable practice. But absent these opportunities, raising merit thresholds may pose a threat to the business model. Weakening this practice area may also mean a loss of some of the more meritorious cases to the potential detriment of the health of Delaware law.

4. INTEREST GROUPS, MULTIJURISDICTIONAL LITIGATION, AND SOME CONCLUDING THOUGHTS By now it is an old saw that corporations and the Delaware bar are the primary interest groups in the political economy of Delaware’s corporate law.32 While the passage of 102(b) (7) in the wake of Smith v. Van Gorkom is perhaps the most well-known example of this dynamic, these interests have played a role in the more recent battles over cost shifting and forum selection provisions. A simplified version of this theory suggests that Delaware enjoys a significant competitive advantage in the provision of corporate charters. The Delaware bar is aware of this advantage and knows that it can extract some rents before corporations will seek to incorporate in another jurisdiction. The debate over merger litigation has been couched in these terms at times. The chief complaint of many critics was that the practice of suing on every deal created a “merger

nature of class action plaintiffs, intrafirm client referral networks are unlikely to generate a lot of new business for these firms. It is possible, however, that the need to develop relationships with institutional investors, in order to have a chance of becoming a lead plaintiff in federal securities and Delaware shareholder litigation, may create a situation where merging to expand these networks makes sense for plaintiffs’ lawyers. 32   See Jonathan R. Macey and Geoffrey P. Miller, Toward an Interest-Group Theory of Delaware Corporate Law, 65 Tex. L. Rev. 469 (1987).

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Fighting frivolous litigation  119 tax” that nearly all buyers had to pay.33 Putting aside that this tax was more or less a rounding error in deals of any significant size, this critique had some traction in the run-up to the Riverbed and Trulia decisions. Some of the complaints about this “tax” came from the corporate interests that are on one side of the interest group theory.34 The beneficiaries of this practice were the plaintiffs’ and defense lawyers who generated fees from the voluminous litigation produced by the sue-on-every-deal phenomenon. Though there is no indication in these opinions that the judges of the Chancery Court were thinking in these express terms, Riverbed and Trulia can be seen, at least in the short term, as a win for the corporate interests and a loss for the Delaware bar. It is worth wondering, however, about the potential losses to Delaware that may occur through its desire to increase the amount of presuit investigation that plaintiffs conduct. If, as the discussion above suggests, this tightening could send meritorious cases elsewhere, the potential impairment to the health of Delaware law that could adversely affect both sets of interests. But there is a problem insofar as the continuing vitality of Delaware law is in some sense a public good. Corporations and the Delaware bar both benefit from the continued development of Delaware corporate law and neither group can be readily excluded from the gains associated with that development. As one might expect, if these interests can receive the gains without paying for them they will be more than happy to do so. Any development that limits the possibility of shareholder class actions is likely to please the corporate side of the ledger. For that reason, Delaware firms almost certainly welcome the Trulia and Riverbed. Things are a bit more complex for the Delaware bar. Being involved in an innovative case can bring with it tremendous rewards (or not, if the lawyers wind up on the losing side).35 But even with significant internalization of the benefits, some of the positive effects will spillover. Moreover, some of these lawyers will have an opportunity to pursue both innovative and nuisance litigation outside of the state. That possibility will limit the fervor of their complaints about lost opportunities to sue in Delaware. All of these reasons contribute to the potential underproduction of corporate law innovation. And this, ultimately, is how raising the threshold of lawsuits could threaten 33   See, e.g., Joel C. Haims and James J. Beha, II, Recent Decisions Show Courts Closely Scrutinizing Fee Awards in M&A Litigation Settlements 1 (2013) (arguing that the existing disclosure-only settlement regime has essentially become a tax on every deal), available at www.mofo. com/files/Uploads/Images/130418-In-the-courts.pdf, archived at http://perma.cc/9NBW-VL2S. 34   See The Trial Lawyers’ New Merger Tax: Corporate Mergers and the Mega Million-Dollar Litigation Toll on Our Economy, U.S. Chamber Inst. for Legal Reform (Oct. 24, 2012), www. instituteforlegalreform.com/resource/the-trial-lawyers-new-merger-tax-corporate-mergers-and-the-​ mega-million-dollar-litigation-toll-on-our-economy. 35   For an example of these large rewards look no further than Southern Peru Copper, Americas Mining Corp. v. Theriault, 51 A.3d 1213 (2012) (approving an attorneys’ fee of more than $300 million). But in many of the boundary-pushing cases, the plaintiffs’ side receives nothing for their efforts. As an example, take the relatively recent MFW Case, where the Delaware Supreme Court determined that a controlling shareholder transaction would be subject to the business judgment rule if the board delegates decision making power to an independent and well functioning special committee and holds a majority of the minority vote. See Kahn v. M & F Worldwide Corp., 88 A.3d 635 (2014). That case marked a significant change, but it did not produce any gain for the plaintiffs or their attorneys.

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120  Research handbook on representative shareholder litigation the vitality of Delaware’s corporate law. The corporations will not miss the litigation that is necessary to keep Delaware law current and the Delaware bar has imperfect incentives to press to keep potentially strong cases in Delaware. This potential threat is, of course, speculative. But the overarching point is there is a set of conditions where doing what seems obviously correct—raising the threshold to recover fees in merger litigation—may have unanticipated consequences. And those consequences are adverse ones for Delaware. Whether they will come to pass is difficult to predict. As I argue above, the factors that will determine the impact of Trulia and Riverbed include some hard-to-observe variables. Should good cases begin to seep out of Delaware in a way that affects its ability to innovate, it is worth the reminder that doing what seems right and correct can produce outcomes that are hard to anticipate and not necessarily desirable.

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8.  Addressing the “baseless” shareholder suit: mechanisms and consequences James D. Cox

In the realm of public corporations, shareholder suits, whether in the form of a class action, in the form of a derivative suit, or simply maintained individually, are widely regarded as a menace. Furthermore, this view exists regardless whether the suit invokes state fiduciary duty claims or allegations of fraud under the federal securities laws. Representative suits are especially suspect, in large part because of the well-understood weak incentives of the suit’s litigants, particularly plaintiff’s counsel, to take full measure of the suit’s merits when deciding to prosecute, defend and settle the action (Coffee 1986). By far the greatest concern for shareholder suits is that they are lawyer driven. Invariably the suit is maintained on a contingency fee, so it is plaintiff’s counsel who has “skin in the game.” Thus, there are numerous accounts of how such a lawyer-driven process systematically enriches that profession, with scant evidence of complementary benefits to the corporation or shareholders whose benefits the norms invoked in such suits are intended to protect (Winter 1993). Whereas for securities class actions there is a formal mechanism to anoint as the lead plaintiff the claimant with the largest stake in the suit’s outcome, state law representative actions measure the plaintiff’s adequacy hardly at all, requiring little more than the plaintiff’s ability to make “mist on a mirror,” that is, be living and have some cognitive abilities but no sophistication whatever regarding the suit’s theories or claims. And even this low standard does not apply when the shareholder suit is maintained individually. A further consideration with shareholder suits is the nature and magnitude of potential externalities that accompany them. The externalities considered here are not the direct costs of litigation. Initiating suits and defending them are both inherently expensive regardless of whether the suit is a shareholder suit or otherwise. What is different with respect to litigation externalities in the case of a shareholder suit is the suit’s hydraulic pressure on the board of directors’ pursuit of what it believes is the best interests of the corporation. Indeed, it is not just the hydraulics of the suit, but also the nonproportional costs of the plaintiff and the corporation. To illustrate, assume the shareholder claims management’s proxy statement was materially misleading because it omitted certain information bearing on the transaction which the board received from its investment banker. The costs incident to the suit to this point are sunk costs from the plaintiff’s counsel’s perspective; the situation is quite to the contrary for defense counsel. Defending against the plaintiff’s request for discovery and a preliminary injunction entails cost X. There is the collateral cost, Y, to the defendants if either motion is lost, as the value of the claim inherently increases with each victory scored by the plaintiff; a similar consideration arises if the defense is not confronted with a request for preliminary relief, but the defendant is weighing whether to make a motion to dismiss. Losing that motion adds value to the plaintiff’s claim. Moreover, uncertainty related to the suit’s outcome may well create 121

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122  Research handbook on representative shareholder litigation uncertainty for the transaction itself. This risk is greater when the suit challenges not disclosure, but rather the board’s procedures for approving the transaction, such as whether the board should have “shopped the firm” before inking the deal. Even a slight chance that the board will have to renegotiate the transaction imposes costs on the corporation and its shareholders. These costs are disproportionately large given their consequential effects on the plaintiff shareholder. The path forward is to locate steps which the plaintiff’s counsel can support that yield Z, where Z is less than the combined value of X and Y. This indeed is the process that is played out with some regularity. This chapter examines several mechanisms—pretrial hearings, the derivative suit’s demand requirement, and settlements—that exist for screening shareholder suits.1 Screening serves a dual purpose: discarding meritless suits and enabling, indeed strengthening, meritorious suits so that injuries can be prevented or compensated. The review reflects that the picture is not complete, as many shareholder suits fall within screening mechanisms that elicit the least trust: approval of termination through settlement.

1. THE DEMISE AND RESURRECTION OF SCREENING IN SECURITIES FRAUD SUITS One mechanism to screen litigation for suits unworthy of further scrutiny by the court is for the presiding court to conduct a minitrial of the suit. This section describes the various substantive doctrines that have developed in the securities law areas that embrace just such an approach. Early in the life of the FRCP 23, the fount of the modern class action, the Supreme Court in Eisen v. Carlisle & Jacquelin2 addressed whether a court can assess the merits of a suit as part of its administration of the class action. The issue was how to handle notice of the case to approximately six million class members. The district court certified the suit as a class action, permitting notice through publication to most class members, but holding that the cost of notice could be shifted to the defendant if, following a preliminary hearing, the court believed there was a strong likelihood of success.3 The circuit court reversed the ruling,4 and the Supreme Court affirmed the circuit’s decision, reasoning as follows: We find nothing in the language or history of Rule 23 that gives a court any authority to conduct a preliminary inquiry into the merits of a suit in order to determine whether it may be maintained as a class action. Indeed, such a procedure contravenes the Rule by allowing a representative plaintiff to secure the benefits of a class without first satisfying the requirements for it. He is

1   This chapter does not weigh, and therefore takes no position, regarding the benefits of existing judicial screening mechanisms against reform measures such as introducing some form of fee-shifting as a prophylaxis against baseless suits (Choi 2016). 2   417 U.S. 156 (1974). 3   Eisen v. Carlisle & Jacquelin, 52 F.R.D. 253 (S.D.N.Y. 1971). Following a mini-trial, the court assigned 90 percent of the cost of notice to the defendants based on its finding after a hearing that more likely than not the class would prevail on the merits. Eisen v. Carlisle & Jacquelin, 54 F.R.D. 565 (S.D.N.Y. 1972). 4   Eisen v. Carlisle & Jacquelin, 479 F.2d 1020 (2nd Cir. 1973).

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Addressing the “baseless” shareholder suit  123 thereby allowed to obtain a determination on the merits of the claim on behalf of the class without any assurance that a class action may be maintained.5

The reference to “whether it may be maintained as a class action” appears to be more sweeping than the issue before the court: whether the court could delve into the merits to determine who should bear the cost of imparting notice to class members. Nonetheless, Rule 23 itself makes no reference to the merits being a factor in considering whether a suit can be brought on behalf of a class. A key consideration in the Court’s reasoning was concern that a preliminary hearing on the merits could prejudice the case against the defendant; among its concerns was that the hearing could occur without the rules of evidence and procedure applying.6 Five decades later, Eisen cannot be seen as barring pretrial involvement of the court on the merits in ways that heavily bias the case’s outcome. In the case of securities fraud litigation, courts regularly engage in pretrial evaluations of the facts that clearly enter the realm of assessing key components of the plaintiff’s suit. In the area of suits under the antifraud provision, this regularly occurs with respect to the several substantive questions: the materiality of the misrepresentation, whether the misrepresentation was committed with scienter, and causation. The sine qua non of any securities misrepresentation action is that the defendant made an alleged omission or misstatement that is material. While materiality is understood as a mixed question of law and fact,7 the courts over the past 30 years have developed a number of doctrines that render materiality more a question of law than one of fact. These developments have allowed the central element, materiality, to be addressed in pretrial motions. Doctrines that enable courts to handle materiality as a legal rather than a factual question are the truth on the market defense,8 the doctrine of puffery,9 and exculpation of forward-looking statements if accompanied by meaningful cautionary language.10 Thus, in deciding whether the truth on the market defense has been established, courts consider a range of external facts, such as public analysis on the same topic by independent analysts,11 to reach a conclusion as to whether the independent reports correct the defendant’s announcement that the plaintiff alleges to be materially misleading. With the puffery defense, courts assess whether the misrepresentation, although incorrect, would not be considered important by the reasonable investor who knows that generalized statements of optimism are customarily made in such transactions even though the optimism is not factually based.12 In deciding whether a statement was qualified by meaningful cautionary   Eisen v. Carlisle & Jacquelin, 417 U.S. 156, 177–78 (1974).  Ibid at 178.  7   TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438 (1976).  8   See e.g., Wielgos v. Commonwealth Edison Co., 892 F.2d 509 (7th Cir. 1989).  9   See e.g., ECA v. J.P. Morgan Chase, 553 F.3d 187, 196 (2d Cir. 2009). 10   See e.g., Kaufman v. Trump’s Castle Funding, 7 F.3d 357 (3d Cir. 1993); see also Securities Exchange Act Section 21E(c)(1)(A)(i), 15 U.S.C. § 78u-5(c)(1)(A)(i). 11   See e.g., In re Apple Computer Sec. Litig., 886 F.3d 1109 (9th Cir. 1989) (company’s claims of performance of a new computer product were offset by numerous industry reports the computers underperformed the manufacturer’s claims). 12   See Eisenstadt v. Centel Corp., 113 F.3d 738 (7th Cir. 1997) (statement that efforts to sell the firm were going well not misleading when there were no significant third party buyers  5  6

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124  Research handbook on representative shareholder litigation language, courts by necessity probe deeply into all of the case’s facts, because what is meaningful entails an understanding of the company’s operations when the challenged forward statement was made.13 In each of these dimensions of the materiality inquiry, courts are deeply entwined with the case’s merits. A further platform for trial courts to assess the overall strengths of a case is provided by the Supreme Court’s recent decision in Omnicare, Inc. v. Laborers District Council Construction Industries Pension Fund.14 The case focused on what the plaintiff must allege regarding the defendant’s awareness when pursuing an opinion statement made in a registration statement for a public offering; the issue in Omnicare, Inc. was a difficult one because under the securities laws the security’s issuer has absolute liability for material misrepresentations contained in its registration statement. In the registration statement for its public offering, Omnicare stated that it believed its business practices and customer contracts complied with the law. They did not; the shares covered by the registration statement lost their value when Omnicare ultimately disclosed extensive illegal conduct in the promotion and operation of its business; and a class action ensued by investors in the registered shares. Omnicare Inc. resolved the dispute of whether the expression of an opinion could be a materially misleading fact by focusing on whether the opinion statement was defective because it omitted facts needed to render the opinion of compliance from itself being materially misleading.15 Evaluating whether this occurred necessarily involved a sweeping inquiry into what Omnicare’s officers knew and when they had such knowledge. The allegations in the complaint were the principal basis for the inquiry but, most importantly, it is an inquiry that invites the court to draw inferences from the facts set forth in the complaint. Courts applying Omnicare have done so by evaluating the overall strength of the central allegation: was the defendant’s professed opinion materially misleading because of what was known and not disclosed? Thus, judicial doctrine has once again evolved to define an element of the case that necessarily provides a pretrial mechanism by which the court gains perspective on the suit’s merits. The heightened pleading requirement introduced by the Private Securities Litigation Reform Act requires that, in addition to pleading scienter with particularity, the complaint’s facts establish a strong inference that the defendant’s alleged misrepresentation was committed with knowledge or recklessness.16 This requires that the facts more likely than not establish a reasonable or permissible inference that the defendant acted with scienter; the Supreme Court defined the requisite strength of the inference to be that which is “cogent and compelling, thus strong in light of other explanations.”17 The Supreme Court’s reasoning reflects awareness that the approach will necessarily involve courts in making judgments about the case. For example, the Court defended its approach against the claim it would usurp the jury’s role; it reasoned that when applying the heightened as court reasoned such statements are understood to mean only that efforts to sell the firm are proceeding). 13   See Asher v. Baxter Int’l, Inc., 377 F.3d 727 (7th Cir. 2004). 14   135 S. Ct. 1318 (2015). 15  Ibid at 1327–29. 16   See Securities Exchange Act Section 21D(b)(2), 15 U.S.C. §78u-4(b)(2). 17   Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308. 324 (2007).

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Addressing the “baseless” shareholder suit  125 pleading requirement the court is bound to accept the truthfulness of the facts alleged, whereas when the jury considers their truthfulness, so much remains for the jury (assuming the pleadings withstand the motion to dismiss).18 Nonetheless, a court’s consideration whether alleged facts establish an inference that the defendant acted with scienter, and its evaluation of the strength of that inference, necessarily draws the presiding judge into assessing the case’s strengths, even though factual allegations are not being questioned. Courts are drawn even more deeply into the suit’s merits when addressing causation questions. In securities class actions, causation arises with respect to two distinct moments: the class certification stage and the motion to dismiss stage. Reliance is an element in private securities suits under the antifraud provision. When the suit alleges a public company committed a material misrepresentation, however, reliance by investors is addressed through the fraud on the market approach, which requires evidence supporting the claim that the class’ investors were justified in relying on the security’s price being impacted by a material misrepresentation.19 Because the fraud on the market presumption of reliance can only arise when the security trades in a market that bears qualities consistent with an efficient market, a good deal of the litigants’ effort in such cases is devoted to establishing that such conditions exist so that the class can be certified. Courts resolve this question through a hearing where evidence from both sides is presented,20 generally in the form of detailed reports and testimony from the forensic economists retained by both sides of the dispute. Ultimately, findings on this question are reached21—findings that invariably shed a good deal of light on, if not resolve, the central claim that the misrepresentation had a material impact on the security’s price during the class action period. The presiding court is further drawn into the securities fraud case by the need for the plaintiff to allege that the misrepresentation caused the plaintiff to incur an economic loss. Thus, even if the plaintiff successfully alleges that a material misrepresentation affected the security’s price, the suit is dismissed absent factual allegations that the security’s price corrected upon disclosure of the truth.22 Courts therefore inquire into whether there was an economic loss as a consequence of the misrepresentation; this inquiry invariably pulls the court into facets of the misrepresentation and into whether there was a corrective statement. These assessments are deeply factual inquiries and entail the court assessing the overall strength of the case. Thus, the Supreme Court’s post-Eisen holdings on how to approach the heightened pleading requirement and causation in securities suits very much embrace the trial court’s deep involvement in the suit’s facts at the pretrial stage. Depending on the individual case, this involves varying perspectives for the presiding court to assess the suit’s qualities,

 Ibid at 328.   Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014). 20   Most courts at least begin with factors set forth in Cammer v. Bloom, 711 F. Supp. 1264 (D. N.J. 1989) (setting out several factors, including percentage of market shares traded weekly, analyst following, presence of market makers, whether company is eligible to use SEC Form S-3 when undertaking a public offering, and responsiveness of security’s price new information). The last consideration invariably is the most important focus, and where the litigants depend on their forensic economists. 21   See e.g., In re Initial Public Offering Sec. Litig., 471 F.3d 24 (2d Cir. 2006). 22   Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005). 18 19

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126  Research handbook on representative shareholder litigation indeed overall merits. What is different from Eisen is that today’s foci are substantive elements that are central to the case, whereas Eisen’s focus was on resolving an administrative question: Who should bear the cost of notice to class members. Nonetheless, the merits of federal securities fraud suits are today regularly evaluated by the court.

2.  RAISING THE COST TO LITIGATE Economics 101 teaches us that one way to dampen demand for something is to raise its cost. The question is whether this works for discouraging the consumption of securities litigation as it did for reducing the consumption of fountain drinks. We can see several of the initiatives introduced by the Private Securities Litigation Reform Act of 1995 as significantly raising the cost to maintain securities fraud suits. Most prominent among these developments is the Act’s introduction of a heightened pleading requirement whereby allegations involving scienter must not only be pled with particularity but the alleged facts must establish a strong inference that more likely than not the defendant committed the misrepresentation with the requisite scienter.23 Greatly complicating the plaintiff’s establishment of a strong inference of fraud is the PSLRA’s discovery bar until pretrial motions have been resolved.24 In combination, the suit’s counsel frequently must engage in costly pre-suit investigative efforts to discover what the actors in the fraud knew and when they knew it.25 As seen in the preceding section, not all the burdens faced by plaintiff’s counsel can be attributed to the PSLRA; courts have been busy raising the costs to maintain suits against public companies for materially misleading reports and announcements. Recall that for such open-market fraud cases the plaintiff must set forth affirmative allegations that the alleged misrepresentation caused an economic loss,26 and when the transaction occurs in a public market the plaintiff must establish that the market in which the security trades has features consistent with the security’s price likely being impacted by a material misrepresentation.27 Each substantive requirement increases the costs of litigating for plaintiff’s counsel, who must retain a forensic economist to meet these requirements—a very expensive undertaking. Even though these procedural and substantive developments have increased the cost

  See Exchange Act Section 21D(b)(2), 78 U.S.C. §78u-4(b)(2).   See Exchange Act Section 21D(b)(3)(B), 15 U.S.C. §78u-4(b)(3)(B). 25   Another consequence of costs, and procedures, introduced by the PSLRA is increased concentration among plaintiff law firms that handle securities matters. This concentration reflects the necessity of a plaintiff law firm developing and sustaining relationships with labor and pension funds to be able to earn the opportunity to be lead counsel in securities class actions. The PSLRA introduced a process for selecting the “lead plaintiff ” whereby the court entertains petitions from purported class members to serve as the lead plaintiff of the class; the PSLRA provides a strong presumption that the most adequate plaintiff is the petitioner with the largest loss. Once selected, the lead plaintiff then selects the class’ counsel. Plaintiff firms therefore must engage in substantial efforts to win the confidence of large numbers of such institutional investors if the firm wishes to participate in securities class actions involving significant losses. These dynamics have essentially driven smaller plaintiff firms from this area of practice (Thomas & Thompson 2012). 26   See Dura Pharms. Inc. v. Broudo, 544 U.S. 336 (2005). 27   See Halliburton Co. v. Erica P. John Fund, Inc., 124 S. Ct. 2398 (2014). 23 24

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Addressing the “baseless” shareholder suit  127 to maintain securities fraud actions, and particularly those alleging open-market frauds that are prosecuted as a class action, the data is not convincing that it has reduced the number of securities class action suits. During the most recent five-year period (2011–15), an average of 221 such actions were filed each year (NERA 2015, fig. 1); this compares with an average of 200 yearly filings in the five years (1991–5) preceding the PSLRA being enacted and the 220 filings in the first five years of the act’s existence (1996–2000) (NERA 2007, 2). Moreover, in the most recent five-year period average settlements have increased to $42.6 million,28 over average settlements of $6.6 million in 1996–2000 (NERA 2015, fig. 24), while the median settlements increased from $7.14 million to $8.7 million—up about 22 percent (NERA 2015, fig. 26). The data does show that the PSLRA and other developments have adversely impacted the success of filed securities class actions. Evidence of the impact of the heightened pleading requirement, and no doubt how its satisfaction is hobbled by the discovery bar, is the significant increase in dismissal rates for securities suits following the PSLRA. In 1996, a year after Congress introduced a variety of procedural changes intended to reduce the frequency of securities suit, 43 securities class actions were dismissed; in 2013, in an era when about 10 percent fewer securities class actions were being filed, eighty suits were dismissed (NERA 2015, at 28). Overall, approximately 42 percent of filed securities class actions are dismissed in response to defendant’s motion to dismiss or motion for summary judgment (NERA 2015, at 28). Because suits are maintained on a contingency fee basis, the increase in dismissal rates following the PSLRA means that firms are today encountering much higher sums of unreimbursed costs than was the case when the pleading standard was lower and there was a bar to discovery during the pretrial motion period. Overall, the number of dismissals reflects a drift upward for each year since 1995, now constituting about 100 dismissals a year, whereas the five-year average for 1996–2000 was 59 cases per year (NERA 2015, fig. 19; Cornerstone 2016, at 13).29 Recall that the number of filings during this five-year period was nearly identical to that for the most recent fiveyear period. This observation is further documented by studies of the dramatic increase in dismissal rates following enactment of the PSLRA (NERA 2014, 28). The process of counting filings and evaluating dismissal rates is a very noisy one by which to discern the impact of legislative and doctrinal developments, even though there is a good deal of intuitive appeal for having raised the cost to initiate securities fraud actions. The data does tell us that the risk of a public company being the target of a securities class action continues to rise each year, driven by the sharp decline in the number of listed companies while the number of filed suits, as seen above, has remained fairly constant (Cornerstone 2015, 9). The number of filings, dismissal rates, and settlements is impacted by clustering of types of misconduct that underlie the suit, such as the financial reporting abuses of 1999–2001, the tsunami of option backdating cases, or various suits involving financial products that became worthless in the financial crisis. Even regulatory developments, such as at first strengthening the auditor’s attestation of internal controls then weakening those obligations, can be seen as changing management conduct, with

  Each comparative dollar figure reference in this chapter is inflation-adjusted to 2014 dollars.   The Cornerstone report observes that the dismissal rate for suits within three years of their filing was 47 percent in 2012, but was a staggering 56 percent in 2006. 28 29

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128  Research handbook on representative shareholder litigation consequential effects on the quality of financial reporting and ultimately the instances of suits for alleged abuses in reporting. Also, the infrequent recovery of large sums on behalf of the class may suggest the presence of a lottery effect that attracts the risk-preferring plaintiff’s counsel. These, and likely many other considerations, should qualify the economic thesis that raising the cost to maintain such suits will reduce the suits to the optimal level. At the same time, the initiatives can be seen as introducing significant additional costs to maintain such actions, with the consequential effect that the real question is not how many suits have been filed or how many were dismissed under the current legal regime, but rather what those numbers would have been had the PSLRA and doctrinal developments related to class certification and loss causation not existed. It is in this area that evidence of rising dismissal rates and relatively flat filings support our intuition that raising the cost of the activity most likely does reduce its frequency. A final review of the data offers a positive view of the impact of various legal developments. To be sure, we find that the overall number of securities class action filings has remained constant, despite a marked decline in the number of listed companies and an increase in dismissal rates. While this may suggest unresponsiveness to rising costs of prosecuting the suits, it may be qualified by considering that the concentrated plaintiff law firms operate on a portfolio basis. Thus, while they have certainly experienced greater costs and more dismissals in the past three decades, their median recoveries are higher than they were in the five-year period before the PSLRA. Thus, we may surmise that, on a portfolio basis, firms have improved in terms of selecting suits likely to generate returns to justify the risks that exist in today’s securities class action environment. Overall, the above data does not appear to make a convincing case that screening of cases has necessarily occurred in connection with changing the cost to engage in shareholder suits.

3.  SCREENING VIA THE DEMAND REQUIREMENT The line of first defense for the derivative suit has long been the demand requirement (Cox & Hazen 2010, at § 15.7). Unless excused, the derivative suit plaintiff must direct to the corporation’s board of directors a formal request that the corporation initiate suit against the proposed defendants for misconduct allegedly committed that harmed the corporation. Three decades ago derivative suits existed only in those limited instances in which a demand was excused on grounds of futility, which was variously defined by the states (Cox & Hazen 2010, at 152–58); to make a demand was to admit that the board of directors enjoyed the presumption of independence to determine whether pursuit of the suit was in the corporation’s interest. As such, the board’s predictable response—rejecting the necessity of a suit—enjoyed the substantial presumptions accorded board decisions by the Business Judgment Rule. Moreover, in the unlikely event that the board believed misconduct had occurred, the corporation would pursue the matter, most likely via a settlement with the malefactor. Either case, an excused demand meant there was no vitality to the matter being pursued derivatively.30

30   See e.g., Sohland v. Baker, 15 Del. Ch. 431. 443 (Del. Ch. 1927) (reasons for directors’ refusal to pursue the suit need not be considered).

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Addressing the “baseless” shareholder suit  129 In the ensuing decades, the demand requirement has been cast differently, so that it is no longer an impregnable bulwark. It is with some irony that weakening of the demand requirement can be linked to efforts that began in the 1980s to expand its reach to demand-excused cases. Delaware and New York were early jurisdictions to embrace the view that a board that itself lacked independence to assess the corporate interest served by a derivative suit could nonetheless bestow that power on a committee of independent directors, even a committee whose members were recruited to the board and appointed to the committee by the interested directors.31 However, neither jurisdiction accorded unwavering deference to the anointed committee’s perspective, recognizing that standards of good faith and independence were required.32 The basis for only qualified deference being accorded the committee directors’ judgment is best captured in the famous observation in Delaware’s leading decision, “there but for the grace of God go I.”33 Scholars, as well as the then ongoing American Law Institute “corporate governance project,” raised concerns regarding the structural bias that could likely impact the outcome of a director’s decision when asked to stand in judgment of claims asserted against a colleague by a faceless outsider.34 As scholars considered this dynamic, they also reasoned that the multiple considerations that support the great deference accorded director decisions regarding the firm’s business under the Business Judgment Rule do not apply when the directors’ decision is whether a suit should proceed against a colleague. Directors’ toolkit includes skills in finance, marketing, and management; the derivative suit judge lacks comparable training or experience in these areas. Hence, deference to the directors on such matters is not just understandable but a desideratum. Moreover, second guessing by courts on business matters is believed to be inconsistent with nurturing risk taking, a quality believed necessary in the commercial world. Were courts not guided by the strong presumption of the Business Judgment Rule, there would be a great fear of hindsight bias; in the world of business bad things can happen, but not necessarily because of ineptitude or negligence on the part of the decision maker. The high presumption of propriety insulates boards from the ill-effects of hindsight bias (Eisenberg & Cox 2014, at 625). And a consequence of a court substituting its judgment for a business decision is that the directors would be held liable for the decision if the court later determines that the decision was unwise. Thus we see there are multiple considerations that support the high presumption of propriety embodied in the Business Judgment Rule. Courts came to understand that these considerations are absent when reviewing the board or committee’s assessment of charges against a colleague. If the court disagrees with the dismissal recommendation of directors, the consequence is that the derivative suit is not dismissed, it continues; most importantly, the court’s disagreement with the directors on the question whether the suit should proceed does not impose liability on the directors whose decision the court supplanted. Thus, a non-deferential court’s review and reversal of a board decision not to 31   See e.g., Zapata Corp. v. Maldonado, 430 A.2d 779, 787 (Del. 1981); Auerbach v. Bennett, 393 N.E.2d 994 (N.Y. 1979). 32   430 A.2d at 788–89; 393 N.E.2d at 996. 33   430 A.2d at 787. 34   See ALI, 2 Principles of Corporate Governance; Analysis and Recommendations § 7.03(a) (1994).

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130  Research handbook on representative shareholder litigation embrace the derivative suit cannot be expected to chill director risk taking in business matters or discourage individuals from their willingness to serve. The impact of not accepting a board or committee’s dismissal recommendation is on the suit’s defendant and not the deciding directors. Moreover, in reviewing the dismissal recommendation, the court is drawing on its own toolbox—the likely merits of a case and also whether the facts have been sufficiently investigated—not the more foreign questions of finance, marketing, or management. The issues posed in considering the board or committee’s dismissal recommendation are those that are fairly steady fare in the trial court. For these reasons, nearly half of the states have embraced a universal demand approach whereby the derivative suit plaintiff must make a demand in all cases. But also, even in demand-futility jurisdictions, the demand made and rejected no longer elicits unquestioning deference. Treatment of the demand requirement today reflects a process that invites a fulsome analysis of the corporate interest likely to be served by the suit, an analysis that is fed by the adversarial nature of the proceeding. The case law is now replete with decisions probing, albeit mostly around the edges, the derivative suit’s merits. The states are divided between universal demand (where, with rare exceptions, the derivative suit plaintiff must lodge a demand with the corporation and await a response before commencing the suit) and demand-futility jurisdictions. Delaware is a leader among the latter, so that to escape making a demand, the plaintiff must set forth with particularity facts that create a reasonable doubt of the directors’ independence. The plaintiff has the burden of persuasion in establishing demand futility, and reviewing courts, as is typical with reviews of dismissals, draw all reasonable inferences from the pled facts in determining whether the plaintiff has met its burden. The distinction between universal demand and demand-futility jurisdictions may be that the latter entails greater inefficiency. This at least is the position taken by the American Law Institute, whose earlier work provided the momentum for universal demand. The ALI reasoned that universal demand is efficient because it avoids litigation occurring within litigation. Delaware requires more than evidence of a longstanding business and personal relationship between the director and the suit’s defendant to establish a lack of independence. This standard was applied recently in Delaware County Employees Retirement Fund v. Sanchez,35 where the Delaware Supreme Court emphasized that a friendship extending five decades should be seen differently than one that was not so long, and also that much of the director’s income was dependent on the suit’s defendant.36 However, reflecting on the degree of scrutiny that occurs, the Delaware Supreme Court concluded that absent substantial economic dependence, longtime personal relationships will not alone rob directors of their independence when considering the corporation’s interest served by a pending derivative suit.37 In Rosenbloom v. Pyott the Ninth Circuit, applying Delaware law, also believed the plaintiff had created a reasonable doubt that the directors of Allergan lacked independence to assess a derivative suit, and thus held it was error to dismiss the suit for the plaintiff’s failure to make a demand on the company’s board of directors.38 Allergan

  124 A.3d 1017 (Del, 2015).  Ibid at 1022–23. 37   Beam v. Martha Stewart, 845 A.2d 1040 (Del. 2004). 38   765 F.3d 1137 (9th Cir. 2014). 35 36

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Addressing the “baseless” shareholder suit  131 produced the well-known drug Botox. For years, Allergan, Inc.’s board of directors pursued a number of initiatives designed to promote off-label sales of Botox, its main product, even though such off-label sales were illegal; indeed, the board had received several warnings from the Food and Drug Administration that Allergan’s practices violated the law. As a consequence of allegations first lodged in qui tam suits that ultimately attracted government actions, Allergan paid a total of $600 million to settle the civil and criminal actions. Shortly after these settlements, derivative actions were filed alleging that Allergan’s directors were liable for violations of various state and federal laws, as well as for breaches of their fiduciary duties to Allergan, in connection with the firm’s pursuit of off-label sales of Botox. The suit’s plaintiffs, however, did not make a demand, so the issue was whether demand was excused on the basis that the plaintiff had successfully alleged facts with particularity that created a “reasonable doubt” that the directors were “disinterested or independent.”39 The Ninth Circuit held that such a doubt was created by allegations showing a substantial likelihood the directors were liable in failing to act when they had a duty to act.40 The Ninth Circuit closely considered numerous facts set forth by the plaintiff and concluded that the allegations at least established a reasonable doubt regarding the director’s independence. In considering whether the board lacked independence, the court dove deeply into facts bearing not only on whether they were independent but more particularly on when they lacked independence because they breached their duty to Allergan. Pyott reviewed an array of facts the panel believed supported claims of probable board misbehavior by its members’ purposeful inaction where action was required. The facts also supported the view that the directors had pursued a business strategy premised on illegal conduct. Among the facts evaluated for competing inferences were: the board had adopted a four-year plan that gave top priority to maximizing off-label uses known to be prohibited for its dominant product, Botox; the company continued funding of organizations Allergan controlled that promoted off-label uses of Botox and reviewed their promotional materials; the board regularly received reports linking rising sales of Botox with off-label sales; the board received one FDA warning against its practice of off-label sales and several other warnings with parallel warnings; the board made off-label sales of Botox a priority and engaged in these practices for more than a decade.41 Based on these facts, the court concluded: Plaintiffs’ particularized factual allegations . . . suffice to show that the Board either did nothing despite actual or constructive knowledge of wrongdoing at Allergan, or knowingly adopted a business plan premised on illegal conduct. In either case, Allergan’s directors violated their duty of loyalty and would face a substantial likelihood of liability; in the latter case, they would also have forfeited the protection of the business judgment rule.42

Left unsaid in both Sanchez and Pyott is whether the plaintiff’s victory in each case may be shortlived; conflicted directors who are not successful in scuttling the derivative

  See Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984).   765 F.3d at 1151. 41  Ibid at 1151–59. 42   Ibid at 1159. 39 40

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132  Research handbook on representative shareholder litigation suit through the demand requirement may, as has happened in the celebrated Delaware decision Zapata Corp. v. Maldonado,43 resurrect the demand requirement by empaneling a special litigation committee. When this occurs, the good faith and independence of the committee, including the process for the committee’s formation, is closely scrutinized. Boland v. Boland Trane Assoc., Inc.44 is an excellent recent illustration of scrutiny of a dismissal recommendation of a special litigation committee; it is especially illuminating because it applies not the more scrutinizing review standard in Zapata Corp. but a standard that requires the business judgment rule to be extended to reasoning and conclusions reached by the committee.45 In Boland, Maryland’s high court reviewed a recommendation of a committee that a derivative suit be dismissed. It held it was incumbent on the corporation to explain why it had appointed the individuals appointed to the committee.46 This inquiry was part of the overall requirement that the committee must be independent and have acted in good faith. In making this inquiry, the committee members were not accorded a presumption of independence. Independence required “that no substantial business or personal relationships impugned the SLC’s independence or good faith.”47 If this information is set forth, the plaintiff is accorded an opportunity to challenge the assertions and the rebuttal tested by standards applied in motions for summary judgment. Moreover, the committee has the burden of establishing that it reached its decision by employing methodologies and reasoning that were reasonable under the circumstances. Of significance, the court held that the committee enjoyed no presumption of propriety with respect to the methodologies it employed to carry out its investigation of the facts it relied on to support its conclusion. On the other hand, substantive conclusions the committee drew from the facts were held to be within the protective reach of the business judgment rule. The court proceeded to review its investigation and concluded there were serious deficiencies in the committee’s investigation and, thus, concluded it was an error for the trial court to have granted summary judgment to the defendant. Consider that a recent Delaware decision involving a demand made and rejected follows the same line of inquiry as Boland regarding the director’s good faith as that followed in universal demand jurisdictions. Ironworkers District Council of Philadelphia and Vicinity Retirement & Pension Plan v. Andreotti,48 while not evaluating either the substance of the suit’s allegations or the board’s conclusions for rejecting the presuit demand, nonetheless closely evaluated the board’s process of investigating to determine if the board’s rejection was “taken in good faith and absent gross negligence.”49 The court’s focus was on   430 A.2d 779 (Del. 1981).   423 Md. 296, 31 A.3d 529 (2011). 45   As a technical matter, Zapata’s approach is assumed to be more probing than the Auerbach standard because under Auerbach there is still space for the business judgment rule’s presumption to support the committee’s recommendation. However, the distinction between Zapata and Auerbach, as illustrated in Boland, is at best razor thin since challenges to methodology via the committee’s good faith is sufficiently openended to allow conclusions drawn from the facts to be recast as a matter of incompleteness of the inquiry rather than a suspected error in judgment. 46   Boland v. Boland Trane Assoc., Inc., 423 Md. 296, 31 A.3d 529 (2011). 47   423 Md. at 341; 31 A.3d at 556. 48   2015 Del. Ch. LEXIS 135 (2015), aff’d without opinion, 132 A.3d 748 (2016). 49  Ibid at *27. 43 44

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Addressing the “baseless” shareholder suit  133 the detailed process the board employed that followed the well-paved path of internal investigations: a nearly 200-page report prepared by independent counsel that was not shown to be less than inclusive. The report was prepared by outside counsel and was relied upon by the board. The court observed that, had there been gaps in the report that supported an inference of gross negligence in its preparation, dismissal of the derivative suit would not be appropriate. The most vulnerable point of Andreotti’s analysis was not whether the report was sufficiently detailed and comprehensive, but whether the report’s facts supported the substantive judgment made by the board in reliance on the report. Andreotti arose from DuPont Corporation being adjudged liable to Monsanto for $1.2 billion in a jury trial for violating its patent licensing agreement with Monsanto. The trial court further sanctioned DuPont by requiring it to pay Monsanto’s litigation costs, reasoning that the defense to the suit was not in good faith. The verdict was upheld on appeal and the appellate court also observed that DuPont had litigated in bad faith. Several derivative suits ensued, demanding that the corporation investigate and pursue claims against responsible officers and directors. The extensive investigation process that supported the report appears beyond question. The report, however, was only part of the inquiry; the court also weighed the conclusion reached by the board in reliance on the  report, particularly the key conclusion there was no breach of fiduciary duty (despite the imposition of substantial damages on DuPont for the conduct carried out on its behalf). Vice-Chancellor Glasscock examined the dissonance between the report’s findings and the damages awarded by the district court. The jury returned an enormous verdict—more than $1 billion—for Monsanto’s patent claims, which verdict was pending appeal at the time of settlement. It is not possible, on the facts pled in the Complaint, to determine the ultimate cost to DuPont of this verdict, subsumed as it was in the Settlement, which obviated an appeal, surrendered the antitrust allegations, settled the litigation, and gave the company new rights to use Monsanto technology, in return for $1.75 billion over ten years. The Committee found the detriment of the jury verdict, in light of the appeal and the Settlement, to be virtually zero. One can take exception with the opinion without doubting the good faith of the Board’s decision to rely on the Committee’s recommendation that it was not worthwhile to proceed with fiduciary duty litigation against “at least some” employee or board member, for the reasons discussed above.50 From the perspective of evaluating the suit’s merits prior to full trial, it is hard to envision how scrutiny of the complaint could be closer than that undertaken in Andreotti, a demand-required case.

4.  SCREENING VIA APPROVAL OF SETTLEMENT As seen above, securities fraud suits and derivative suits provide their own mechanisms for pretrial scrutiny that naturally draw the court into assessing the suit’s merits. What is missing from the spheres of the above described mechanisms is direct nonsecurities fraud actions. A principal illustration of such a claim is a class action alleging an injury  Ibid at *39–40.

50

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134  Research handbook on representative shareholder litigation suffered by shareholders because of alleged director and officer misconduct in connection with a merger whereby shareholders receive too little for their shares. Just such a case is Trulia Inc., discussed presently. Another example is a challenge to defensive maneuvers employed by a corporation that allegedly prevented an above market takeover bid for the firm. For such suits, the traditional pretrial opportunities for review are the motions for summary judgment, motion to dismiss, and requests for a preliminary injunction. Over the years, the Delaware courts have greatly intensified their pretrial scrutiny of the suit’s merits when considering the defendant’s motion to dismiss. A recent study by Professors Lawrence Hamermesh and Michael Wachter reflects the importance of this screening process in shareholder suits: [T]he Delaware Court of Chancery’s increasingly muscular reliance on extrinsic facts in resolving motions to dismiss demonstrates that the motion to dismiss is being increasingly relied upon as an efficiency-promoting substitute for a trial, in which, despite the absence or paucity of formal discovery, the court is able to rely on a reasonably substantial factual record, at least where (1) there is no indication or assertion by the plaintiff that information presented from outside the four corners of the complaint is disputable in a relevant way, and (2) substantial relevant information is available through publicly available sources, stockholder inspection rights, or voluntary production by the corporation. (Hamermesh & Wachter 2017)51

Outside of Delaware, the motion to dismiss continues to be a weak medium for screening self-dealing matters, such as those that arise in the acquisitions litigation. And, when in a particular case the central facts are disputable, the motion to dismiss even in Delaware proves to be a porous mechanism for pretrial screening. Consider the challenges the defense faces in addressing a claim that management has undertaken a defensive maneuver or there is a sale of control transaction; in Delaware, when such a claim is made the burden of proof shifts to management to demonstrate it acted reasonably. This does provide an opportunity for the defense to detail the steps taken by the management; however, the plaintiff can survive the motion upon a bare showing of fairly neutral facts—the engagement of a defensive maneuver or a change of control transaction when the defendant is unable to introduce indisputable facts supporting the reasonableness of management’s actions. Thus in a leading defensive maneuver case, the issue was whether the board, in the face of a hostile bid, had met its fiduciary obligations when it placed approximately 16 percent ownership in the hands of a friendly party, adopted a poison pill, applied the pill in a discriminatory manner to prefer one bidder over another, and engaged in a repurchase program. In denying the defendant’s motion to dismiss, the court reasoned: 51   In Delaware the complaint can be dismissed only where the court determines with “reasonable certainty” that the plaintiff could prevail on no set of facts that may be inferred from the complaint. Delaware Rule 12(b)(6). See, e.g., Malpiede v. Townson, 780 A.2d 1075, 1082–83 (Del. 2001) (plaintiff is entitled to all reasonable inferences that logically flow from the face of the complaint). The complaint must, however, set forth “well-pleaded allegations” which requires specific allegations of fact and conclusions supported by the alleged facts. See, e.g., Solomon v. Pathe Communications Corp., 672 A.2d 35, 38 (1996) (locating this standard as being inherent notice pleading). However, in the close analysis of Delaware cases, Professors Hamermesh and Wachter show that the Delaware judiciary increasingly considers a wide range of information before the court in determining whether the complaint sets forth a “reasonable conceivable” claim.

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Addressing the “baseless” shareholder suit  135 [A]s the terminology of enhanced judicial scrutiny implies, boards can expect to be required to justify their decision making, within a range of reasonableness, when they adopt defensive measures with implications for control. This scrutiny will usually not be satisfied by resting on a defense motion merely attacking the pleadings.52

Thus, in the heightened scrutiny realm, where the burden of explanation is placed on management, bright-line legal rules, such as whether the acts taken by the defendant were defensive maneuvers53 or that the transaction’s structure triggered Revlon considerations,54 a premium should be placed on the defendant’s setting forth detailed facts supporting the reasonableness of management’s actions. The reasonable probability of ultimate success requirement for a preliminary injunction can provide a better platform for screening suits than ruling on motions to dismiss.55 For example, in instances of an alleged disclosure violation, the reasonable probability standard calls on courts to determine a variety of questions such as what was disclosed and the types of disclosures companies need not make generally,56 or in a specific context.57 There are considerations of the collateral consequences of such an order, however, that regularly weigh against such relief. For example, in cases where material misrepresentations are alleged, while as a policy matter there is a preference toward ordering disclosure ex ante rather than determining damages ex post,58 this preference is substantially qualified by

52   In re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 72 (Del. 1995) (reversal of lower court’s grant of defendant’s motion to dismiss); see also, In re Ebix, Inc. S’holder Litig., No CV 8526-VCN, 2016 WL 208402, at 18 (Del. Ch. Jan. 15, 2016) (“The activation of heightened scrutiny poses a systematic difficulty for defendants seeking dismissal under Court of Chancery Rule 12(b) (6), given the limited record from which they might draw to demonstrate reasonableness”). 53   See, e.g., Gantler v. Stephens, 965 A.2d 695, 705 (Del. 2009) (affirming grant of motion to dismiss on ground the board had not engaged in acts that were defensive). 54   See e.g., In re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 71 (Del. 1995) (no facts pleaded indicating transaction posed a change of control so that Revlon should apply). 55   See La. Mun. Police Employees’ Ret. Sys. v. Crawford, 918 A.2d 1172, 1185 (Del. Ch. 2007) (to obtain preliminary injunction plaintiff must demonstrate (1) a reasonable probability of ultimate success on the merits at trial, (2) that failure to issue an injunction will result in immediate and irreparable injury before final hearing, and (3) that the balance of the hardships weighs in the plaintiff’s favor). These factors, however, are greatly impacted by the court’s concern for the collateral consequences of granting a preliminary injunction that stops or retards the transaction’s occurrence. For example, in cases where material misrepresentations are alleged, there is a theoretical preference toward ordering disclosure ex ante rather than determining damages ex post. See In re Staples, Inc. S’holder Litig., 792 A.2d 934, 960 (Del. Ch. 2001). However, this preference is substantially qualified by concern that the admittedly value-increasing transaction may disappear in the face of the resulting delay of or uncertainty regarding approval. See McMillan v. Intercargo Corp., C.A. No 16963, 1999 WL 288128 at 4 (Del. Ch. May 3, 1999) (“The threat of Intercargo losing its only offer if the court issues an injunction is real, and it far outweighs the risks created by denying injunctive relief ”). 56   See Arnold v. Soc’y for Savings Bancorp, 650 A.2d 1270, 1280 (Del. 1994) (Delaware does not require disclosure of unreliable or speculative information). 57   See e.g., In re Netsmart Techs., Inc. Shareholder Litig., 924 A.2d 171, 203-04 (Del. Ch. 2007). Hence, when a transaction is stated to have been adjudged fair by an investment bank, the Delaware court lists a range of collateral disclosures that must be made such as the valuation methods used, the key inputs into the determination as well as the range of ultimate values. 58   See In re Staples, Inc. Shareholder Litig., 792 A.2d 934, 960 (Del. Ch. 2001).

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136  Research handbook on representative shareholder litigation concern that the admittedly value-increasing transaction may disappear in the face of the resulting delay or uncertainty of approval.59 Professors Hamermesh and Wachter find that in Delaware, when a preliminary injunction is sought, the pretrial screening process occurs not in considering that motion but earlier, in addressing the plaintiff’s motion to expedite discovery. In these proceedings, they report, the Delaware courts engage in scrutiny of the allegations and a rich array of facts that is indistinguishable from the approach followed when considering the defendant’s motion to dismiss (Hamermesh & Wachter 2017). The settlement process is by far the weakest of all the screens. This is because it has long been understood that the court is greatly disabled by the proceeding not being adversarial; as Judge Henry Friendly wisely observed, “[o]nce a settlement is agreed, the attorneys for the plaintiff stockholders link arms with their former adversaries to defend the joint handiwork.”60 Just such an absence of the adversarial process is illustrated by In re Trulia, Inc. Stockholder Litigation.61 The complaint alleged that the directors breached their fiduciary duties in approving a merger with a single bidder that allegedly failed to obtain the highest exchange ratio for the shareholders.62 Opposing counsel reached an agreement in time for several supplemental disclosures to be added to the proxy statement circulated among the shareholders; the merger was ultimately approved by 79.52 percent of the shares entitled to vote (99.15 percent of the votes cast).63 In addition to agreeing to the supplemental disclosures, the defendants agreed not to oppose a fee request not in excess of $375,000.64 The parties then sought approval of the settlement that released any other claims that could be brought against the company’s directors. Chancellor Bouchard closely examined each of the supplementary disclosures regarding distinct features of the valuation process used by the investment bank in its fairness opinion to the board. He found the supplementary disclosures were not meaningful in light of all the other ­information the company disclosed regarding the valuation process,65 and he therefore rejected the settlement, thereby leaving the suit where it had started—a bald accusation of breach of fiduciary obligation. In reaching this conclusion, he offered the following approach: [P]ractitioners should expect that disclosure settlements are likely to be met with continued disfavor in the future unless the supplemental disclosure addresses a plainly material misrepresentation or omission, and the subject matter of the proposed release [from further liability] is 59   See McMillan v. Intercargo Corp., C.A. No 16963, 1999 WL 288128, at *4 (Del. Ch. May 3, 1999) (“The threat of Intercargo losing its only offer if the court issues an injunction is real, and it far outweighs the risks created by denying injunctive relief ”). A very different problem confronts the plaintiff and the court when disclosure violations are alleged that the defendant subsequently mooted by making supplementary disclosures. In this instance, lacking an opinion, a norm was not generated by the court, but clearly there is the basis for inviting an inquiry into causal connection to the suit as well as the probable benefits of the resulting benefit. See Tandycrafts, Inc. v. Initio Partners, 562 A.2d 1162 (Del. 1989) (upholding award of fees in such a case). 60   Allegheny Corp. v. Kirby, 333 F.2d 327, 347 (2d Cir. 1972). 61   129 A.3d 884 (Del. Ch. 2016). 62   Ibid at 889. 63  Ibid. 64  Ibid. 65  Ibid at 899–907.

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Addressing the “baseless” shareholder suit  137 narrowly circumscribed to encompass nothing more than disclosure claims and fiduciary duty claims concerning the sale process, if the record shows that such claims have been investigated sufficiently.66

The weakness of the settlement proposed in Trulia Inc. is how the settlement terms varied remarkably from the misconduct alleged in the complaint. Such dissonance between the gravamen of the complaint and settlement are inconsistent with the settlement being remedial. This lack of connection, however, was not explored in Trulia, Inc. Had the court linked the settlement to the complaint that established its jurisdiction, it could have considered how the remedy of disclosure of facts surrounding a fiduciary’s breach of duty, as was proposed in Trulia, Inc., sits poorly with corporate fiduciary duty principles.67 To be sure, a universal feature of fiduciary obligations is the duty of candor. The director’s obligations, however, compel more than disclosure and include the affirmative obligation to act in the interests of the corporation and its shareholders. To this end, the misconduct alleged in Trulia, Inc. was not any want of disclosure—this was not alleged in the ­complaint—but rather that the directors failed to take steps to secure a higher exchange ratio.68 Because nondisclosure was not a part of the claimed breach by the defendants, settlement in which only disclosure is obtained naturally invites skepticism. Further irrelevance between the disclosure provided in the proposed settlement and the misconduct alleged in the complaint arises from Delaware’s approach to ratification of misconduct. A fiduciary’s breach can be approved by shareholders following full disclosure; however, under the strict equitable ratification approach followed in Delaware, any such shareholder approval must occur in a vote distinct from the one in which they approve the transaction, such as the merger in Trulia, Inc.69 Because the parties did not agree to the shareholders voting separately to ratify the directors’ conduct, the disclosures to which they agreed were not a step toward excusing the alleged breach by the directors. Independent of the court’s rejection of the proposed settlement, because the disclosures provided no additional information that was meaningful to shareholders, the court should have raised another basis to reject the settlement: the terms of the settlement were nonresponsive to the alleged misconduct alleged in the suit. It is a matter of speculation what the Chancellor’s approach would have been had the accord reached between the attorneys required, instead of disclosure, a slightly greater percentage than otherwise necessary to approve the transaction. This remedy entails more than disclosure, but with no other suitor in the wings and an above-market offer

 Ibid at 898.   Further disquiet with disclosure being the relief sought in the settlement is that there does not appear to ever have been a request for a preliminary injunction seeking disclosure before the shareholders voted. The record recounts how the parties reached an agreement on supplementary disclosures without such a motion and, for that matter, without the defense raising a motion to dismiss. Thus, the defense sought the plaintiff’s cooperation in settling the matter before the transaction was closed and proceeded to court only after the transaction had been approved (with the supplementary disclosures the court considered not meaningful). 68   This point is emphasized by Chancellor Bouchard in his careful qualification of the scope of the case’s holding. He states that the review standard embraced in Trulia, Inc. is limited to instances in which the complaint does not raise a “plainly material” misrepresentation. Ibid at 898. 69   See Gantler v. Stephens, 965 A.2d 695 (Del. 2009). 66 67

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138  Research handbook on representative shareholder litigation before the shareholders, a modest increase in the vote needed would have been akin to a peppercorn settlement. Clearly the court’s cynicism for settlements should not be isolated to disclosure-only settlements. Nonetheless, because in Trulia Inc. there was no earlier opportunity for the court to evaluate the suit’s merits with the intensity that we see with the demand requirement or the dominant elements in securities fraud actions, settlements without these presuit evaluations result in shareholder disputes being resolved without adversaries. When this happens, the court finds itself in the awkward position of not knowing whether it is participating in an error, be that error approving the end of a potentially valuable suit or awarding counsel for maintaining a valueless suit.

5. CONCLUSION The PSLRA and judicial doctrines have provided means for federal courts to evaluate the likely strengths of private securities lawsuits. The modern applications of the derivative suit demand requirement, even in demand-futility jurisdictions, also provide the presiding court with an intense development of the case’s pivotal facts as a result of an adversarial process. Orphaned in this process are settlements that occur outside these spheres of these screening mechanisms. Trulia Inc. reflects angst, albeit only partially, over this lacunae. Chancellor Bouchard’s opinion nonetheless shines a bright light, joining that of others, on the perniciousness of disclosure-only settlements. This concern is likely too narrow. The focus would better be with the entire process of settlement. Left in Trulia Inc.’s wake will be inventive attorneys, plaintiffs’ and defendants’ attorneys, who can be expected to substitute for disclosure-only settlements other forms of milquetoast remedies, most likely tweaks to governance procedures. Where this occurs, the court will again be faced with considering what mechanisms allow it to determine whether the proposed settlement is fair and adequate. It may well be that the court’s earlier engagement through considering the demand requirement—if the suit is a derivative—or its consideration of the motion to dismiss or motion to expedite discovery provide background to consider the settlement, and particularly the likelihood that the suit has been adequately represented. When this does not occur, as was very much the case in Trulia Inc., because of the unqualified dependence of the presiding court on an adversarial process, the court should not distinguish between disclosure-only settlements and settlements that do not produce tangible rewards to the corporation or the class when asked to approve a settlement. Absent meaningful benefits to the corporation, the court should resort to a prophylaxis: it should deny the award of any fees. The same lack of adequacy of representation should also cause the court to withhold its approval of the settlement; certainly this is the desired result if the court is aware that litigation involving similar claims is proceeding in other forums. Leaving the parties where the court found them is justified when the court has a basis to believe the interests of the corporation or shareholders have not been adequately represented.

BIBLIOGRAPHY Choi, A., 2016, “Optimal Fee-Shifting Bylaws,” working paper, available at https://ssrn.com/so13/papers. cfm?abstract_id=2840947.

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Addressing the “baseless” shareholder suit  139 Coffee, Jr, J., 1986, “Understanding the Plaintiff’s Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions,” 86 Columbia Law Review 669. Comoli, R. & Starykh, S., NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2013 Full-Year Review (Jan. 14, 2014). Comoli, R. & Starykh, S., NERA Economic Consulting, Recent Trends in Securities Class Action Litigation: 2014 Full-Year Review (Jan. 20, 2015). Cornerstone Research, Securities Class Action Filings 2015 Year in Review (2016). Cox, J. & Hazen, T., Treatise on the Law of Corporations § 2:4 (3d ed. 2010). Eisenberg, M. & Cox, J., 2014, Business Organizations Cases and Materials (11th Unabrd. ed.). Hamermesh, L. & Wachter, M., 2017, “The Importance of Being Dismissive: The Efficiency Role of Pleading Stage Evaluation of Shareholder Litigation,” 42 Journal of Corporate Law 597. Plancich, S., Saxton, B., & Starykh, S., NERA Economic Consulting, 2007 Year End Update: Recent Trends in Shareholder Class Actions (Dec. 2007). Thomas, R. & Thompson, R., 2012, “A Theory of Representative Shareholder Suits and Its Application to Multijurisdictional Litigation,” 106 Northwestern Law Review 1753. Winter, R., 1993, “Paying Lawyers, Empowering Prosecutors, and Protecting Managers: Raising the Cost of Capital in America,” 42 Duke Law Journal 945.

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9.  Who collects the deal tax, where, and what Delaware can do about it Sean J. Griffith and Anthony Rickey*

1. INTRODUCTION At some point during the past decade, US merger litigation came to be dominated by nuisance claims. By 2009, 85 per cent of all public deals over $100 million had attracted at least one lawsuit, up from a historical average of 30–40 percent (Cain & Solomon, 2015). For the five years that followed, the percentage of such deals attracting litigation hovered between 90 and 95 percent (Cain & Solomon, 2016). The cases were standard nuisance fare (Rosenberg & Shavell, 1985, 2006): most plaintiffs settled before a judicial review of the merits, and the stockholder class received no monetary relief. Instead, the cases settled for supplemental disclosures in a proxy statement (Daines & Koumrian, 2013; Cain & Solomon, 2016). These ‘disclosure settlements’ resulted in court-approved awards of fees to plaintiffs’ attorneys, but there is no evidence that they altered voting patterns or benefited stockholders in any way (Fisch, Griffith, & Solomon, 2015). With the expectation that they could extract settlement value from virtually every suit, plaintiffs’ lawyers brought suit in essentially every deal. By 2015, criticism of this system had become widespread, and a few cases in New York and Delaware hinted that change was coming. Finally, in January 2016, the Delaware Court of Chancery issued its opinion in In re Trulia, holding that disclosure settlements in Delaware would be subject to exacting scrutiny and likely rejected unless class plaintiffs were able to extract disclosures that were “plainly material” in nature.1 The decision included a sharp critique of standard practices in merger litigation and an expression of continued disfavor for such settlements in Delaware. The response to Trulia has been swift. In the wake of the decision, several tentative settlements were scuttled in favor of voluntary dismissal.2 Moreover, plaintiffs brought fewer lawsuits. In the first half of 2016, only 64 percent of all deals over $100 million attracted claims (Cornerstone, 2016a). Although this is a decline of one third from the high point of nuisance litigation, it is still roughly double the historical average. *  This chapter reflects legal developments through mid-2017. The authors wish to thank participants at the 2016 Conference on Corporate & Securities Litigation, University of Illinois College of Law, for valuable comments on an earlier draft of this chapter. Thanks also to Miranda Lievsay (FLS’17) for invaluable research assistance. 1   In re Trulia, Inc. S’holder Litig., 129 A.3d 884 (Del. Ch. 2016). Sean Griffith filed an amicus curiae brief in the Trulia case. 2   See, e.g., In re Health Net, Inc. Stockholders Litigation, C.A. No 11349-VCL (consol.) (Dismissal Order 1/25/16); Cohen v. Christopher [Mueller Industries], C.A. No 11189-CB (Dismissal Order 1/25/16); Widlewski v. Carson et al. [GrafTech], C.A. No 11086-VCL (Dismissal Order 1/27/16).

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Who collects the deal tax  141 The most striking change since Trulia, however, has been the tendency for merger litigation to be brought outside of Delaware. In the fourth quarter of 2015 and the first half of 2016, the percentage of litigated deals with claims filed in Delaware fell by more than half—to 26 percent from 61 percent over the prior three months (Cornerstone, 2016a). Similarly, in the first half of 2016, complaints involving Delaware-incorporated targets were filed in Delaware just 36 percent of the time, down from 74 percent of the time in 2015 (Cornerstone, 2016a). However, merger lawsuits filed in federal court began increasing in the second half of 2015 (Cornerstone, 2016b), and by all accounts continued to grow robustly in 2016 (Boettrich & Starykh, 2017; Cain et al, 2017; Cornerstone, 2017). These patterns hint at a sorting of merger claims in the wake of Trulia. It may be that nuisance claims, defined here as claims brought with an expectation that they will settle for supplemental disclosures and attorneys’ fees, are brought in an alternative jurisdiction while claims with the potential for significant damages awards continue to be brought in Delaware. But how does this sorting occur? Commentators have suggested a “two-tier” plaintiff’s bar, consisting of nuisance filers on the one hand, and firms seeking significant damages awards on the other (Friedlander, 2016). Other studies of the merger litigation bar find evidence that higher quality firms litigate more aggressively and produce better outcomes (Krishnan, Solomon, & Thomas, 2015) and link law firm quality to case selection (Badawi & Webber, 2015). What these studies have in common is a tendency to divide the plaintiffs’ bar into white hats (firms seeking real relief) and black hats (firms content with nuisance settlements). The post-Trulia pattern of much (but not all) merger litigation being filed outside of Delaware suggests a sorting mechanism in which the black hats seek alternative jurisdictions while the white hats stay put. But is this really the case? Does the division of the plaintiffs’ bar into white hats and black hats match reality? Do white hats typically file inside Delaware while black hats typically file elsewhere? And have these patterns really changed since Trulia? This chapter attempts to answer these questions empirically by observing whether ‘white hat’ firms adopt different strategies within and outside of Delaware. To do so, we develop a handcollected data set of merger litigation resulting in nonmonetary recoveries from 2009 through 2016. Using disclosure settlements as our proxy for nuisance litigation, we look to see whether there are differences in how and where white hats and black hats engaged in nuisance litigation. We examine where these firms tend to bring and settle merger claims and look for changes in these patterns since Trulia. Despite assertions to the contrary, we find no pure “white hat” firms, although the “top tier” of the plaintiffs’ bar does appear to seek disclosure settlements with less regularity. Moreover, these firms tend to bring disclosure settlements at least as often, and in some cases dramatically more often, outside of Delaware. As nuisance lawsuits migrate away from Delaware, this suggests that even the “white hat” firms may be tempted to pursue disclosure settlements in other jurisdictions, particularly where fees in the high six or low seven figures remain available. This is a problem for Delaware. The state’s attempt to solve the nuisance litigation problem through a combination of Trulia and forum selection bylaws has produced, at best, limited results.3 Delaware’s corporations remain subject to merger-related lawsuits,   See generally Sean J. Griffith, Private Ordering Post-Trulia: Why No Pay Provisions Can Fix

3

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142  Research handbook on representative shareholder litigation but with less oversight from Delaware courts. We argue, however, that Delaware courts can do something about black hat firms masquerading as white hat firms simply by asking tough questions in appointing leadership and in reviewing settlements. They should also take into account the shades of gray when the adequacy of plaintiff’s counsel is made an issue.

2.  DELAWARE, DISCLOSURE SETTLEMENTS, AND TRULIA In spite of being one of the smallest US states, both by size and population, Delaware is the leading jurisdiction of incorporation of the largest companies in America.4 More than half of all public companies and an even larger share (65.6 percent) of all Fortune 500 companies are incorporated in Delaware (Bebchuck & Hamdani, 2002; Bullock, 2014). The comparative advantage of Delaware has long been thought to be the quality of its corporate law, especially its judiciary (Black, 1990). The Delaware statute is, in general, enabling rather than mandatory (Romano, 1989). As a result, the limits of what corporations may do are set by judicial interpretations of fiduciary duty (Fisch, 2000; Rock, 1997). The result is a body of precedent that is both deep and flexible (Kamar, 1998). Additionally, because Delaware has retained the distinction between its equity and law courts, it can ensure that most corporate governance matters are reviewed by a small number of judges—the five members of the Court of Chancery. Contrast this with the approach of New York State, which abolished its chancery court in 1846, transferring equity jurisdiction to its trial court of general jurisdiction, the New York Supreme Court.5 As a result of this choice, corporate disputes litigated in New York State can be heard by any one of literally hundreds of different trial court judges.6 Because Delaware maintained a small equity court, its judges became repeat players in corporate law disputes, developed expertise in complex corporate matters, and, because they were few in number, retained the ability to coordinate. The small scale of Delaware’s corporate bar also means that lawyers become repeat players, developing lasting reputations based on the quality of their work. A significant portion of the claims that come before the Delaware judiciary are class action complaints involving mergers and acquisition transactions. Because these claims are brought in the form of class actions, they cannot settle without a judicial hearing on the fairness of the settlement (Rubenstein; Court of Chancery Rule 23(e)). At the fairness hearing, the Delaware Court of Chancery reviews the proposed settlement with a view toward protecting the interests of absent class members. As part of this process, the court

the Deal Tax and Forum Selection Provisions Can’t, in The Corporate Contract in Changing Times, Solomon & Thomas, eds (2017); William B. Chandler III & Anthony A. Rickey, The Trouble with Trulia: Re-evaluating the Case for Fee-Shifting Bylaws as a Solution to the Overlitigation of Corporate Claims, in Can Delaware Be Dethroned? Evaluating Delaware’s Dominance of Corporate Law, Anabtawi, Bainbridge, Kim & Park, eds (2017). 4   Delaware ranks 45th out of 50 for population and 49th for size (total area). See United States Census Bureau, www.census.gov. 5   New York State Constitutional Convention of 1846. 6   See New York State Unified Court System, www.nycourts.gov.

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Who collects the deal tax  143 reviews both what the plaintiff class has given up in the settlement (the “give”) as well as the relief the plaintiff class has received in settlement (the “get”).7 As already noted, at least until Trulia, the most common form of consideration to stockholders in merger settlements was supplemental disclosures in the proxy statement. In exchange for this, the stockholder class released the right to litigate any and all claims, “known and unknown, ripe and unripe,” relating to the facts underlying the merger (Griffith & Lahav, 2013). The breadth of this release encompassed not only state law fiduciary duty claims but also federal securities claims and antitrust claims—in other words, “blanket protection against any type of recovery.”8 For a time, Delaware courts accepted such disclosure settlements as a routine means of concluding merger litigation (Friedlander, 2016). For example, in 1996 the Court of Chancery approved a disclosure settlement over a strong stockholder objection, holding that “two or three possibly material facts” in the supplemental disclosures provided “some benefit” to the plaintiffs’ class.9 By the mid-1990s, such settlements had become routine.10 It had not always been so. An earlier line of authority, never challenged or overruled, had conditioned settlement approval on a stringent review of the underlying merits of the claim. In the mid-1960s, the Court of Chancery approved a derivative suit settlement involving the Chrysler Corporation only after an exhaustive process, including extensive presettlement discovery and elaborate confirmatory discovery, a stockholder vote in favor of settlement, the appointment of an amicus curiae to analyze the settlement and the underlying claims, and a fairness hearing at which witnesses were called.11 On appeal of the Court of Chancery’s approval of the settlement, the Delaware Supreme Court

 7   In re Activision, 2015 WL 2438067, at *12–13 (Del. Ch. May 21, 2015) (quoting In re Resorts Int’l S’holders Litig. Appeals, 570 A.2d 259, 266 (Del. 1990)).  8   Acevedo v. Aeroflex Hldg. Corp., C.A. No 9730–VCL, at 66 (Del. Ch. July 8, 2015) (Transcript).  9   In re Dr. Pepper/ Seven Up. Cos., Inc. S’holders Litig. 1996 WL 74214, at *4–*5 (Del. Ch. Feb. 27, 1996), aff’d 683 A.2d 58 (Del. 1996) (table) (emphasis added). 10   Solomon v. Pathe Communications Corp., 1995 WL 250374, at *4 (Del. Ch. Apr. 21, 1995), aff’d, 672 A.2d 35 (Del. 1996) (“It is a fact evident to all of those who are familiar with shareholder litigation that surviving a motion to dismiss means, as a practical matter, that economically rational defendants . . . will settle such claims, often for a peppercorn and a fee”). Although in context the “peppercorn” idea reflected Chancellor Allen’s concern with advancing claims too easily beyond the motion to dismiss, thereby creating pressure on defendants to settle nonmeritorious claims, the idea was turned on its head and used as a theory to justify approving the settlement of nonmeritorious claims. See, e.g., Riverbed, 2015 WL 5458041, at *5 (“To use the expression first made in this context by Chancellor Allen, the Plaintiffs have achieved for the Class a peppercorn, a positive result of small therapeutic value to the Class which can support, in my view, a settlement, but only where what is given up is of minimal value”); In re Amylin Pharm., Inc. S’holders Litig., C.A. No 7673-CS, at 28, 30 (Del. Ch. Feb. 5, 2013) (Transcript) (“I remember [Chancellor Allen] once approving a settlement that basically he approved it because virtually any peppercorn of value to the class would support the release because the claims were so insubstantial. . ..This settlement is skating through on the barest of margins”); In re Talbots, Inc. S’holder Litig., C.A. No 7513-CS, at 11, 15 (Del. Ch. Dec. 16, 2013) (Transcript) (“I’ll approve this settlement on the Chancellor Allen peppercorn theory . . . This is also, to be honest, the kind of case where I could have simply not approved the settlement . . . because the social utility of cases like this continuing to be resolved in this way is dubious”). 11   Dann v. Chrysler, 198 A.2d 185, 193 (Del. Ch. 1963).

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144  Research handbook on representative shareholder litigation s­ eparated the issues of settlement approval and attorneys’ fees into two different opinions. The first, Hoffman v. Dann (“Hoffman”), dealt only with the conduct of the fairness hearing and the standard for settlement approval.12 The second, Chrysler v. Dann (“Chrysler”), concerned only the question of attorneys’ fees.13 In Hoffman, the central question was the merits of the settlement. Several objectors had argued that the settlement could not be approved because there was no merit to any of the underlying claims. The parties argued in response that one claim had sufficient merit to support the settlement. The Supreme Court held that in order for the settlement to be approved, there had to be at least one meritorious claim. Otherwise, the Court wrote, settlement would amount to “nothing more than a buying-off of the plaintiffs for the dismissal of worthless claims . . . an undesirable [practice that] Rule 23(c) . . . was . . . specifically designed to end.”14 The court underscored the importance of a meritorious underlying claim in Chrysler, holding that “[a] claim is meritorious within the meaning of the rule if it can withstand a motion to dismiss on the pleadings [and] if, at the same time, the plaintiff possesses knowledge of provable facts which hold out some reasonable likelihood of ultimate success.”15 Although the Delaware courts went through a period of approving settlements without applying stringent scrutiny to the materiality of disclosures,16 the principles propounded in Hoffman and Chrysler were never overruled.17 Moreover, the willingness of Delaware courts to accept disclosure settlements came at a time when the form and frequency of merger litigation was materially different from what it has since come to be. Recognizing Delaware’s role in the proliferation of nuisance claims, the Delaware Court of Chancery in 2015 began to apply greater scrutiny to disclosure settlements and require a stronger showing of materiality.18 These decisions culminated in the court’s definitive statement on disclosure settlements in Trulia.   205 A.2d 343, 345 (Del. 1964), cert. denied 380 U.S. 973 (1965).   223 A.2d 384 (Del. 1966). 14   Hoffman, 205 A.2d at 352 (upholding the Court of Chancery’s opinion finding of a single meritorious claim). Accord Allied Artists Picture Corp. v. Baron, 413 A.2d 876, 879 (Del. 1980) (“[T]his Court has been concerned with discouraging baseless litigation (see [Chrysler]) and has adhered to the merit requirement”). 15   Chrysler at 387. 16   See supra note 9 and accompanying text. 17   The Court of Chancery may seem to suggest in Cox Communications that the court need make no finding of merit in order to approve a settlement. 879 A.2d 604 (Del. Ch. 2005) (“Cox”). However, Cox, like the Dann litigation, had bifurcated settlement approval and attorneys’ fees, and, because the objector previously conceded that “the settlement was favorable,” the only live issue in Cox was fees. Ibid, at 639. See also C.A. No 613-N, Letter from Kevin G. Abrams to VC Strine (May 16, 2005) (citing Hoffman in service of the argument that Chrysler did not require a merits filter at settlement because Chrysler only addressed fees). Cox thus can be seen as holding merely that the “pleading-stage viability’ of the claim should have been raised at the settlement approval stage, not in awarding attorneys’ fees. Cox at 639 (“To have an objector come forward and concede that the settlement was favorable but contest the fee under [Chrysler] would be inequitable and serve no proper purpose”). 18   The 2015 Court of Chancery cases include: Acevedo v. Aeroflex Hldg. Corp., C.A. No 9730–VCL, at 73 (Del. Ch. July 8, 2015) (Transcript) (refusing to approve a disclosure settlement with “precisely the type of nonsubstantive disclosures that routinely show up in these types of settlements”); In re Aruba Networks, Inc. Stockholder Litigation, Consol. C. A. No 10765-VCL, 12 13

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Who collects the deal tax  145 Like most disclosure settlements, the plaintiffs in Trulia initially challenged process and price but shifted to challenging the adequacy of disclosure once the preliminary proxy statement was filed, and as in most such cases, the plaintiffs ultimately resolved all claims for supplemental disclosures and no payment to the plaintiff class.19 After critiquing the incentive system that generates such claims as a matter of course, Chancellor Bouchard announced that henceforth the Delaware Court of Chancery would no longer rubberstamp disclosure settlements. Instead, [P]ractitioners should expect that disclosure settlements are likely to be met with continued disfavor in the future unless the supplemental disclosures address a plainly material misrepresentation or omission . . . In using the term ‘plainly material,’ I mean that it should not be a close call that the supplemental information is material as that term is defined under Delaware law.20

In reaffirming a high standard of materiality as the basis for scrutinizing and ultimately rejecting disclosure settlements, Trulia announced that such routine settlements are no longer welcome in Delaware.21

at 73 (Del. Ch. Oct. 9, 2015) (Transcript) (refusing to approve settlement and finding inadequate representation as a result of filing litigation when “there wasn’t a basis to file in the first place” and then failing to aggressively litigate when discovery turned up potentially valuable information); In re Riverbed Technology, Inc. Stockholders Litigation, 2015 Del. Ch. LEXIS 241, at **20 (Del. Ch. Sept. 17, 2015) (approving settlement but noting that “If it were not for the reasonable reliance of the parties on formerly settled practice in this Court . . . the interests of the Class might merit rejection of a settlement encompassing a release that goes far beyond the claims asserted and the results achieved”). Prior Delaware cases expressing scrutiny concerning settlement practices include: In re Transatlantic Holdings S’holders Litig., No 6574-CS (transcript) (Del. Ch. Mar. 8, 2013) (refusing to approve settlement for lack of “any real investigation,” disclosure of additional background information, and overwhelming vote in favor of the transaction); In re Medicis Pharmaceutical Corp. Shareholder Litigation, CA No 7857-CS, transcript at 24 (Del. Ch. Feb. 26, 2014) (refusing to approve settlement and noting that “giving out releases lightly is something we’ve got to be careful about”); Rubin v. Obagi Medical Products, Inc., C.A. No 8433-VCL transcript at 8 (Del. Ch. Apr. 30, 2014) (refusing to approve settlement and noting that “there are unknown unknowns in the world, and the type of global release . . . in this case and [similar] disclosure settlements provides expansive protection for the defendants against a broad range of claims, virtually all of which have been completely unexplored by plaintiffs”); In re Theragenics Corp. Stockholders Litigation, C.A. No 8790-VCL, transcript at 69 (Del. Ch. May 5, 2014) (refusing to approve settlement and noting that “when a fiduciary action settles, I have to have some confidence that the issues in the case were adequately explored, particularly when there is going to be a global, expansive, all-encompassing release given”). 19   Trulia, 129 A.3d at 887 (describing the case as one wherein “[t]he only money that would change hands is the payment of a fee to plaintiffs’ counsel”). 20   Ibid at 898–99 (emphasis added, citations omitted). 21  Since Trulia, the Court of Chancery has approved a number of disclosure settlements, but only where the Court found that at least one of the disclosures offered as settlement consideration was plainly material. See In re BTU Int’l, Inc. S’holders Litig., C.A. No 10310-CB (Del. Ch. Feb. 18, 2016) (Transcript); In re NPS Pharm. S’holders Litig., C.A. No 10553-VCN (Del. Ch. Feb. 18, 2016) (Transcript); In re Regado Biosciences, Inc. S’holder Litig., C.A. No 10606-CB (Del. Ch. July 27, 2016) (Transcript).

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3. WHY WHAT HAPPENS OUTSIDE OF DELAWARE SHOULD MATTER TO DELAWARE Disclosures settlements may, however, still be welcome elsewhere. Merger claims can typically be brought and settled in any one of three places: the state of incorporation, the headquarters state, or federal court. Trulia announced a new Delaware procedure for addressing disclosure settlements, and the dynamics of the Court of Chancery suggest that it will be applied consistently inside Delaware. There is no assurance, however, that Trulia will be applied consistently or at all in alternative jurisdictions. The flight of filings from Delaware in the wake of Trulia suggests that litigants are actively seeking alternative jurisdictions. The Delaware judiciary now disfavors disclosure settlements because routinely approving nuisance settlements “undercuts Delaware’s credibility as an honest broker in the legal realm.”22 But now that Trulia has set forth a standard in Delaware, should the state be concerned about the conduct of merger litigation outside of Delaware? Should Delaware be bothered if litigants—wearing white, black, or gray hats—take disclosure settlements to other courts for approval? We suggest that the answer is yes. Delaware should be concerned, because litigants’ ability to take settlements elsewhere, even where companies have adopted forum selection provisions, means that the state may be unable to protect either its corporations from nuisance litigation or the stockholders of those corporations from losing potentially valuable rights in exchange for meaningless relief (Griffith, 2017). Moreover, such tactics provide a vehicle, at least in theory, for other states to challenge Delaware’s franchise if another state can provide a similar degree of certainty in corporate law while removing the threat of nuisance lawsuits.23 Whether the migration of post-Trulia merger cases threatens Delaware’s dominance in corporate law may depend on whether only weak claims are filed elsewhere. Although prior commentators have warned that alternative fora threaten “the viability of Delaware’s Court of Chancery’s current status as ‘the Mother Court of corporate law’” (Armour, Black, & Cheffins, 2012) and risk making Delaware corporate law ‘less developed’ and ‘less coherent’ and its judges less expert (Kahan & Rock, 2009), there is little danger of these consequences if only nuisance claims exit the state. Because nuisance claims tend to settle before courts make any merits determinations, they make little, if any, law. Moreover, it seems likely that the quality and coherence of Delaware corporate law would be improved if the Court of Chancery’s caseload held a greater proportion of seriously litigated cases, rather than rote settlement approvals. Once freed from the time and distraction of nuisance litigation, Delaware judges would have more time and opportunity to focus on complex issues of law. This assumes, however, that plaintiffs’ attorneys are consistently able to identify, ex 22   Aeroflex at 66. See also Trulia, 129 A.3d at 894 (suggesting that Delaware has played a role, through the approval of disclosure settlements and with broad releases, in causing “deal litigation to explode in the United States beyond the realm of reason”). 23   See Dan Awrey, Blanaid Clarke, & Sean J. Griffith, Resolving the Crisis in U.S. Merger Regulation: A Transatlantic Alternative to the Perpetual Litigation Machine, 35 Yale Journal on Regulation 1 (2018).

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Who collects the deal tax  147 ante, which cases will become nuisance lawsuits and which will not. So long as cases brought outside Delaware continue to follow the pattern described in Trulia—quick settlements reached after cursory discovery—the pattern above may hold true. If plaintiffs begin to identify potentially meritorious claims during expedited discovery, however, and those in turn are litigated in postclosing actions, Delaware may stand to lose “good” cases as well as bad. At least in the short run, the flight of nuisance litigation to alternative fora does not seem to imperil Delaware’s status as the preeminent state of incorporation. For another state to challenge Delaware’s dominance, it would almost certainly need to offer a substantive law that appeals to either managers or stockholders sufficiently to induce them to relocate the firm to the other state. But the creation of a substantive alternative to Delaware would be difficult to craft from a judicial policy of approving disclosure settlements or ruling on predominantly nuisance claims. Moreover, any opinion rendered by the alternative jurisdiction can only have the effect of improving Delaware law, since desirable innovation would become a part of Delaware law, while misapplications or misinterpretations could be swiftly disavowed (Griffith & Lahav, 2013). Nor does Delaware have much to fear from cases brought in federal court. Although the federal government poses a real threat to Delaware when it comes to legislation and preemptive rulemaking (Roe, 2003), as long as there is no federal incorporation option, Delaware retains its primacy as a jurisdiction of incorporation. Indeed, considering the savings of judicial resources and administrative costs, it seems Delaware only gains if the nuisance claims go away while the damages cases remain. But this account also depends on it being predominantly nuisance claims that settle in the alternative jurisdiction, while legitimate damages claims remain in or are brought back to Delaware. Although Delaware courts retain some procedural controls to direct this sorting of cases—such as the use of the forum non-conveniens doctrine, expedited discovery, and formal or informal communications with the judge in the alternative jurisdiction (Griffith & Lahav, 2013)—much of the sorting depends on the parties themselves. Some have suggested that exclusive forum provisions are a useful tool in this regard, allowing defendants to avoid meritless claims altogether by requiring class plaintiffs to bring claims in Delaware. Nevertheless, forum selection provisions remain largely untested, particularly with regard to federal claims.24 Moreover, while it is reasonable to suppose that defendants will use exclusive forum provisions to move meritorious cases back to Delaware, there are also good reasons to suspect that they will use the provisions strategically to funnel claims to jurisdictions where they can still achieve a broad release in exchange for a disclosure settlement (Griffith, 2017). The risk, in other words, is not that strong claims will be litigated elsewhere, but that strong claims will be settled elsewhere as though they were nuisance claims.

24   In the wake of Trulia, several class plaintiffs have challenged mergers by forgoing traditional state law fiduciary claims in favor of federal securities causes of action, particularly where the target corporation has adopted a forum selection bylaw. See, e.g., Complaint, Paprakis v. Skullcandy, Inc., et al., Case No 2:16-cv-00810-BCW (D. Utah July 19, 2016).

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4. AN EMPIRICAL INVESTIGATION OF THE “TWO-TIER” PLAINTIFFS’ BAR While it is clear why defense counsel would be happy to settle potentially serious damages claims for meaningless disclosures, it is less clear why plaintiffs’ counsel would ever seek a nuisance settlement if they had a potentially valuable damages claim. One thesis, put forward by a prominent member of the plaintiffs’ bar, is that there are two business models pursued by plaintiffs’ firms before the Court of Chancery (Friedlander, 2016). According to this theory, “[o]ne tier of law firms pursued disclosure settlements as a business model. Another tier of law firms never presented disclosure settlements to the Court of Chancery, and instead brought Revlon cases with the objective of seeking significant monetary recovery and/or significant non-monetary relief ” (Friedlander, 2016: 905). Friedlander (ibid) suggests that the first business model “puts a premium on maximizing the number of disclosure settlements and minimizing the costs associated with each settlement,” while the second requires a law firm to “devote significant resources to each case.” In theory, “[a] law firm representing stockholder plaintiffs in the Court of Chancery generally employs one model of litigation or the other.” Friedlander suggests that appointment of lead counsel in class litigation in the Court of Chancery should be guided by these tiers, with preference given to the top tier (ibid at 909). However, Friedlander’s evidence in support of a “two-tier” plaintiff’s bar is more qualitative than quantitative. He does not specifically identify the universe of “top tier” firms or present systematic data regarding firms’ involvement in disclosure settlements. Moreover, he limits his consideration to the Delaware Court of Chancery, without considering how the national law firms in his tiers might operate outside the First State. There is another possibility, consistent with a two-tier plaintiff’s bar but without the black hat/white hat dichotomy. Delaware’s preeminence in corporate law and litigation ensures that the Court of Chancery addresses a broad portfolio of cases annually, with potential for significant payouts. Certain types of merger litigation—for instance, where there is a controlling shareholder—may have a greater fee potential than others. Combined with the small size of the plaintiff’s bar and frequency of repeat players, a reputation as a “white hat” or “top tier” firm in Delaware may be potentially lucrative, because it allows a “white hat” firm to succeed in leadership contests for more valuable cases. “Black hat” or “second tier” firms would then be left to choose among cases with a small chance of a significant monetary settlement, but a large chance that a firm would earn back its lodestar (at least prior to Trulia). If Delaware’s “two-tier” bar is a result of this reputational dynamic, one might expect to see “top tier” law firms more willing to pursue disclosure settlements outside of Delaware, while eschewing them in the Court of Chancery. In other words, while “black hats” would wear black hats everywhere, “white hats” in Delaware might change their colors when settling cases outside the state.25 If correct, this dynamic would have implications for how 25   Indeed, some have suggested that firms may switch hats depending upon whom their client is—driving harder bargains for institutional lead plaintiffs, but accepting disclosure settlements for non-institutional class representatives. See David H. Webber, “Private Policing of Mergers and Acquisitions: An Empirical Assessment of Institutional Lead Plaintiffs in Transactional Class and Derivative Actions,” 38 Del. J. Corp. L. 907 (2014).

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Who collects the deal tax  149 Delaware courts should consider leadership contests, providing courts with a tool to affect the litigation of disclosure settlements outside their own jurisdiction. 4.1 Methodology To test this theory, we compiled a set of more than 150 cases in which plaintiffs presented disclosure settlements in state and federal courts.26 The data was collected primarily by conducting searches of trial court documents available on Bloomberg Law, Westlaw and Lexis between 2009 and 2016. These results were crosschecked and supplemented by searching for disclosure-only settlements listed in LexisNexis’s Class Action Settlement database as well as by running a search based on the 35 most common law firms produced in the original search results. Only disclosure settlements where a final court order was electronically available were included in the data set. We have included cases where disclosure settlements were presented by a plaintiff, even if those settlements were not ultimately approved by the reviewing court. This methodology likely understates the participation of law firms in disclosure settlements. Many states do not make trial court documents available online, so many jurisdictions may not be included in our data set. Moreover, the frequency of multiforum litigation will contribute to an undercount of law firm participation. For instance, if Firm A sues in Delaware and Firm B sues in Kansas, and the case settles in Delaware, Firm B may not be mentioned on the Delaware papers (where the settlement is presented), even though they may share in the attorneys’ fees. 4.2 Results With regard to Friedlander’s lower tier firms (“black hats”), our data largely supports his thesis. There are a number of firms which frequently present disclosure settlements inside and outside of Delaware. Following the Trulia opinion, these firms have predominantly migrated their disclosure cases outside of Delaware (Cain et al. 2017). Collectively, these firms were involved in a majority of the disclosure settlements captured in our database. The results for the top tier or “white hat” firms, however, are not fully consistent with Friedlander’s thesis. Instead, we found that several “white hat” national firms pursued disclosure settlements outside of Delaware. Indeed, one such firm pursued three times as many disclosure settlements in other jurisdictions as they did in Delaware during the period of our study, although most other “white hat” firms that pursued disclosure settlements outside of Delaware participated in three or fewer such settlements. Collectively we found seven instances in which top tier national plaintiffs’ firms participated in disclosure settlements in Delaware between 2009 and 2015, but 18 instances of the same firms presenting disclosure settlements to courts outside the First State over the same period.27 Given the fact that many state courts may be underrepresented in our data set, the difference may be even starker than these data suggest.

26   For purposes of this chapter, a “disclosure settlement” is a settlement in which class members receive supplemental disclosures before a deal closes, and may receive other nonmonetary consideration (such as reduced breakup fees or other deal terms), but no additional cash distribution. 27   Because firms often present settlements jointly, in compiling this figure, we include each

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150  Research handbook on representative shareholder litigation However, disclosure settlements pursued by the “top tier” law firms did tend to differ qualitatively. Several of these firms eschewed disclosure-only settlements in favor of settlements for disclosures plus other “therapeutic” relief. Nevertheless, none of these therapeutic settlements appear to have won any additional money for the shareholder class (such as, for example, an increase in the deal price). This data demonstrates that the dividing line between “white hat” and “black hat” firms is not as clear as Friedlander suggests. Even “white hat” plaintiffs firms may negotiate, agree to, and seek fees for disclosure settlements in M&A litigation. Moreover, they do so more often when their cases are not before the Court of Chancery. If we are correct, and firms seek a “white hat” perception in the Court of Chancery because there is a value to reputational capital that does not accrue in other courts, this provides Delaware courts with an unusual opportunity to discourage meritless claims and affect the course of litigation outside of their ordinary jurisdiction. As explained presently, Delaware courts can, and should, consider the behavior of supposedly “white hat” firms when they pursue Delaware cases in other forums—and refuse to give the sheriff’s badge to firms that switch hats when they go out west.

5.  WHAT DELAWARE CAN DO As the Court of Chancery recognized in Trulia, disapproval of nuisance suits could simply cause plaintiffs (and defendants seeking a swift end to litigation) to seek other jurisdictions. Although Chancellor Bouchard voiced the hope that other jurisdictions would follow Trulia, few courts outside Delaware have addressed the case, especially in the absence of an objector (Chandler & Rickey, 2017). In one notable exception, the United States Court of Appeals for the Seventh Circuit, in an opinion by Judge Posner, adopted the Trulia standard for review of disclosure settlements in a case involving both state law and federal securities claims.28 As discussed above, the flight of disclosure cases from Delaware poses potential risks to its franchise and its status as the dominant jurisdiction in corporate law. Yet Trulia appears to be encouraging plaintiffs to seek other jurisdictions, and to challenge corporate mergers in securities cases rather than traditional corporate governance class actions. Delaware’s dominance as a venue for incorporation, however, gives its courts a number of means of influencing plaintiff behavior far beyond its own borders. Based on the data above, we suggest two. 5.1  Consider Actions Taken outside of Delaware when Awarding Lead Counsel Roles Although the number of cases filed in Delaware has declined since Trulia, so long as the cases that remain hold significant settlement or judgment value for plaintiff’s counsel,

plaintiff’s firm appearance as a separate instance, such that a settlement involving Firm A and Firm B would count twice. 28   See In re Walgreen Co. S’holder Litig., 832 F.3d 718 (7th Cir. 2016).

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Who collects the deal tax  151 then the court’s ability to designate lead plaintiffs provides a considerable carrot. Indeed, even in the absence of nuisance suits likely to lead to disclosure settlements, Delaware courts retain a set of corporate governance cases that can be lucrative for plaintiff’s counsel despite the absence of a monetary return to class members.29 There are signs that the Delaware courts are already using these cases to influence the behavior of plaintiff’s counsel. Delaware courts have asked plaintiffs to submit affidavits summarizing their litigation track records, and appointed counsel at least in part on the basis of counsel to litigate cases to money judgments or monetary settlements.30 These leadership contests, to the extent that they award leadership to firms with a track record for money judgments, can be seen as a method of rewarding “white hats” and disincentivizing “black hats.” Our data suggests that Delaware courts could use a similar technique to influence the behavior of class counsel when they litigate in other jurisdictions by more closely examining litigation strategy in non-Delaware cases when the Court awards leadership positions. Plaintiffs’ counsel who do not bring nuisance litigation, or disclosure settlements, outside of Delaware could be given preference in leadership contests over those who do—­ensuring that counsel do not change hats when litigating elsewhere. In particular, we suggest that the Court should ask counsel seeking leadership positions in class or derivative actions questions such as: ●

How many settlements has a firm settled for nonmonetary recoveries in Delaware? Outside of Delaware? ● Since 2016, has the firm presented disclosure settlements for approval outside of Delaware, particularly in cases involving Delaware corporations? If so, has it cited Delaware authority to a non-Delaware court? Did that authority include Trulia? ● How many of the firm’s non-Delaware settlements have drawn objections during the settlement process? Did any of those objections rely on Trulia? Have they been sustained? Such questions would cause purportedly “white hat” firms to expect to lose lucrative lead plaintiff positions if they did not fairly present Delaware authority to non-Delaware courts. Similar inquiries could be employed to deter “black hat” firms from seeking either settlement approval or class certification. In both cases, approval requires a finding that the representative parties will adequately represent the interest of the class.31 Class certification or a settlement may be rejected where plaintiff’s counsel do not provide adequate representation to the class.32 Based on the answers to the questions above, the Court of

29   See, e.g., Order and Final Judgment, Espinoza v. Zuckerberg, C.A. No 9745-CB (Del. Ch. Mar. 30, 2016) (awarding $525,000 fees to plaintiffs’ counsel in derivative action). 30   See, e.g., Order of Consolidation, In re Compellent Techs., Inc. S’holder Litig., C.A. No 6084VCL at 6 (Del. Ch. Jan 10, 2011) (requiring submission of cases in which firms obtained monetary recovery or other relief solely as a result of representative litigation). 31   See Ct. Ch. R. 23(a)(4). 32   See, e.g., In re Aruba Networks, Inc. Stockholder Litigation, Consol. C. A. No 10765-VCL, at 73 (Del. Ch. Oct. 9, 2015) (TRANSCRIPT).

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152  Research handbook on representative shareholder litigation Chancery could refuse to find counsel adequate where a firm has sought approval of, and an award of fees for, a disclosure settlement in a non-Delaware court while failing to provide that court with relevant authority, including Trulia.33 5.2  Place Greater Emphasis on the Role of Delaware Decisions in non-Delaware Courts The migration of nuisance settlements outside of Delaware poses a particular risk to the consistency of Delaware law. The evolutionary nature of Delaware jurisprudence embraces fine distinctions and eschews brightline rules. For example, decisions of the Delaware Court of Chancery vary as to the materiality of unlevered free cash flows: ●

Disclosures of unlevered free cash flows are important and may well be material (Maric, Netsmart);34 but ● It is not necessary for a target to disclose information sufficient for a plaintiff to run its own DCF analysis (Checkfree);35 but ● If the summary of financial data provided to bankers by management has been disclosed, unlevered free cash flows are not per se material if they were calculated from that summary data by bankers rather than management (Nguyen);36 and ● Management projections (including unlevered free cash flows) may be of greater importance (and thus material) in a going-private transaction than in a stock-forstock merger, but may be less material where the newly disclosed projections are “all directionally consistent with the information that was already disclosed.”37

33   One California court has twice refused to preliminarily approve disclosure settlements where plaintiffs failed to address Walgreen or Trulia. See Order After Hearing, Anderson v. Alexza Pharms., Case No 16-CV-295357 (Cal. Super. Ct.—Santa Clara Cty. Apr. 3, 2017) (rejecting settlement and noting that preliminary approval initially denied for failure to address relevant authority); Order after Hearing, Drulias v. 1st Century Bancshares, Inc., Case No 16-CV-294673 (Cal. Super. Ct.—Santa Clara Cty. Nov. 18, 2016) (rejecting preliminary approval of settlement and finding it “very troubling” that plaintiffs failed to cite Trulia). 34   Maric Capital Master Fund, Ltd. v. PLATO Learning, Inc., 11 A.3d 1175 (Del. Ch. 2010); In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171 (Del. Ch. 2007). 35   In re Checkfree Corp. S’holders Litig., 2007 WL 3262188 (Del. Ch. Nov. 1, 2007) (rejecting claim that failure to include cash flow projections constituted material omission because “[a] disclosure that does not include all financial data needed to make an independent determination of fair value is not . . . per se misleading or omitting a material fact. The fact that the financial advisors may have considered certain non-disclosed information does not alter this analysis,” quoting In re Gen. Motors (Hughes) S’holder Litig., C.A. No 20269, 2005 WL 1089021, at *16 (Del. Ch. May 4, 2005), aff’d, 897 A.2d 162 (Del. 2006)). 36   See Nguyen v. Barrett, 2016 WL 5404095, at *4 (Del. Ch. Sept. 28, 2016) (“Plaintiff acknowledged that our case law indicates that banker-derived financial projections need not be disclosed”); see also Nguyen v. Barrett, 2015 WL 5882709, at *4 (Del. Ch. Oct. 8, 2015), aff’d 2015 WL 5924668 (Del. Oct. 9, 2015) (“Our case law provides that, where the bankers derive unlevered, after-tax free cash flows rather than relying on management projections, the inputs on which they rely are not per se subject to disclosure”); 2016 WL 5404095, at *4 (“With respect to the argument that all inputs provided by management on which the financial advisor relied in its DCF valuation must, as a matter of law, be disclosed to stockholders, I found such a per se rule inconsistent with our case law”). 37   See In re Baker Hughes Inc. S’holders Litig., Consol. C.A. No 10390-CB at 70-71 (Del. Ch. Nov. 30, 2016).

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Who collects the deal tax  153 In any given proxy statement, the question of the materiality of unlevered free cash flows is, thus, a multifaceted analysis. The Court of Chancery’s caseload ensures that Delaware judges recognize that, in spite of strong language in Maric and Netsmart, unlevered free cash flow disclosures are not per se material.38 But judges in other jurisdictions may not, and litigants may safely wager that those judges will not be familiar with the full line of Delaware jurisprudence on unlevered free cash flow disclosures. Moreover, the lack of adversarial process at settlement suggests that complicating factors in this analysis will not be mentioned at all if left out of the plaintiffs’ brief in support of settlement. And this indeed is what we found. Maric and Netsmart were cited in the vast majority of the settlement briefs in our dataset, and plaintiffs’ assertions regarding the meaning of those cases was rarely questioned.39 Non-Delaware judges will be further hindered by the fact that much of the more detailed authority resides in transcript opinions that are not available in Lexis or Westlaw. Given the complexity of the legal analysis and the lack of adversarial guidance, it would be remarkable if judges in other jurisdictions did not reach different conclusions as to the materiality of different classes of disclosure. But a multiplicity of authority weakens Delaware law in two ways. First, the predictability of Delaware disclosure law is diminished if a corporation cannot predict whether a given disclosure is necessary until a lawsuit is filed in a given jurisdiction. Second, class plaintiffs can be expected to cite as persuasive authority whichever jurisdiction provides rules most favorable to settlement— and that may not be Delaware. On the other hand, so long as class plaintiffs bring nuisance suits outside of Delaware, there are limited means by which the Court of Chancery can contain the damage caused by inconsistent interpretation of Delaware law. As an initial step, Delaware courts could consider making transcript opinions available in a searchable online format, so that nonDelaware judges may access this authority. However, this solution may not be sufficient. Non-Delaware jurists lack the Court of Chancery’s incentives to maintain a consistent body of Delaware law. It may be that the migration of litigation out of Delaware forces a tradeoff, wherein the Court of Chancery must choose between brightline rules that may be readily applied by nonspecialist judges, or a complex and finegrained legal regime that is inconsistently applied outside the First State.

6. CONCLUSION This chapter has examined the sorting of merger claims in the wake of Trulia. In particular, we have tested the claim that “white hat” firms always litigate in Delaware, while

38   See Maric Capital Master Fund, Ltd. v. PLATO Learning, Inc., 11 A.3d 1175 at 1178 (Del. Ch. 2010) (“management’s best estimate of the future cash flow of a corporation that is proposed to be sold in a cash merger is clearly material information”); see also In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171 at 203 (Del. Ch. 2007) (“The conclusion that this omission [of the company’s expected future cash flows] is material should not be surprising. Once a board broaches a topic in its disclosures, a duty attaches to provide information that is “materially complete and unbiased by the omission of material facts”). 39   Many of the exceptions in our dataset involved cases with well-represented objectors.

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154  Research handbook on representative shareholder litigation “black hat” firms always settle, and now settle outside Delaware in the wake of Trulia. While we have found evidence that “black hat” firms are increasingly avoiding Delaware, we have also found evidence that at least some firms with a reputation for wearing “white hats” in fact wear hats of a different shade—gray—outside of Delaware. Moreover, these firms tend to bring disclosure settlements at least as often, and in some cases dramatically more often, outside of Delaware. The presence of six- or seven-figure fees for nuisance suit settlements, in other words, tempts “white hat” firms as well as “black hats.” Our results suggest the sorting mechanism for good and bad claims is not working as expected. Even good firms sometimes file and settle nuisance claims. If this is so, can we really trust these firms to sort good claims from bad? Furthermore, what can Delaware do to encourage plaintiffs’ lawyers to pursue good claims, but only good claims? In addition to demonstrating the problem, this chapter has suggested several possible solutions. Courts could ask hard questions of plaintiffs’ counsel in awarding the lead plaintiff role. They could ask similarly hard questions at settlement and when reviewing adequacy of representation. In addition to greater scrutiny, Delaware could consider reforming its practices with regard to transcript opinions to make them more easily accessible to non-Delaware jurists, perhaps by creating an online searchable database.

BIBLIOGRAPHY Armour, John, Bernard Black and Brian Cheffins, 2012. “Is Delaware Losing Its Cases?” Journal of Empirical Legal Studies 9:605–56. Awrey, Dan, Blanaid Clarke, and Sean J. Griffith, 2018. “Resolving the Crisis in U.S. Merger Regulation: A Transatlantic Alternative to the Perpetual Litigation Machine,” Yale Journal on Regulation 35:1 (forthcoming). Badawi, Adam B. and David H. Webber, 2015. “Does the Quality of the Plaintiffs’ Law Firm Matter in Deal Litigation,” available at . Bebchuck, Lucian A. and Assaf Hamdani (2002). “Vigorous Race or Leisurely Walk: Reconsidering the Competition over Corporate Charters,” Yale Law Journal 112:553–615. Black, Bernard S., 1990. “Is Corporate Law Trivial? A Political and Economic Analysis,” Northwestern University Law Review 84:542–97. Boettrich, Stefan and Svetlana Starykh, 2017. “Recent Trends in Securities Class Action Litigation: 2016 Full-Year Review,” NERA Economic Consulting, available at www.nera.com/publications/archive/2017/ recent-trends-in-securities-class-action-litigation--2016-full-y.html. Bullock, Jeffrey W., 2014. “Delaware Division of Corporations 2014 Annual Report,” available at http://corp. delaware.gov/Corporations_2014%20Annual%20Report.pdf. Cain, Matthew D., Jill E. Fisch, Steven Davidoff Solomon, and Randall S. Thomas, 2017. “The Shifting Tides of Merger Litigation,” available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2922121 (working paper). Cain, Matthew D. and Steven M. Davidoff Solomon, 2015. “A Great Game: The Dynamics of State Competition and Litigation,” Iowa Law Review 100:465–500. Cain, Matthew and Steven Davidoff Solomon, January 16, 2016. “Takeover Litigation in 2015,” available at (working paper). Chandler, William B. and Anthony A. Rickey, 2018. “The Trouble with Trulia: Re-evaluating the Case for Fee-Shifting Bylaws as a Solution to the Overlitigation of Corporate Claims” in Can Delaware Be Dethroned? Evaluating Delaware’s Dominance of Corporate Law (Anabtawi, Bainbridge, Kim, and Park, eds.). Cornerstone Research, 2013. “Shareholder Litigation Involving Mergers and Acquisitions,” available at http://cornerstone.com/Publications/Reports/Stockholder-Litigation-Involving-Mergers-and-Acqui, archived at http:// perma.cc/TRL8-QNTK?type=pdf. Cornerstone Research, 2016A. “Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2015 1H 2016 M&A Litigation,” available at www.cornerstone.com. Cornerstone Research, 2016B. “Securities Class Action Filings: 2016 Midyear Assessment,” available at www. cornerstone.com. Cornerstone Research, 2017. “Securities Class Action Filings: 2016 Year in Review,” available at www.corner​ stone.com.

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Who collects the deal tax  155 Fisch, Jill E., 2000. “The Peculiar Role of the Delaware Courts in the Competition for Corporate Charters,” University of Cincinnati Law Review 68:1061. Fisch, Jill E., Sean J. Griffith, and Steven Davidoff Solomon, 2015. “Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform,” Texas Law Review 93:557–624. Friedlander, Joel Edan, 2016. “How Rural/Metro Exposed the Systemic Problem of Disclosure Settlements,” Delaware Journal 40:877–919. Griffith, Sean J., 2017. “Private Ordering Post-Trulia: Why No Pay Provisions Can Fix the Deal Tax and Forum Selection Provisions Can’t,” in The Corporate Contract in Changing Times (Steven D. Solomon and Randall S. Thomas, eds). Griffith, Sean J. and Alexandra D. Lahav, 2013. “The Market for Preclusion in Merger Litigation,” Vanderbilt Law Review 66:1053–1138. Kahan, Marcel and Edward B. Rock, 2009. “Hedge Fund Activities in the Enforcement of Bondholder Rights,” 103 Northwestern University Law Review 103:281–322. Kamar, Ehud, 1998. “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” Columbia Law Review 98:1908–59. Krishnan, C.N.V., Steven D. Solomon and Randall S. Thomas, July 20, 2015. “Who Are the Top Law Firms? Assessing the Value of Plaintiffs’ Law Firms in Merger Litigation,” European Corporate Governance Institute (ECGI)—Law Working Paper No. 265/2014; Vanderbilt Law and Economics Research Paper No. 14-25, available at http://ssrn.com/abstract=2490098. Rickey, Anthony and Keola R. Whittaker, April 29, 2016. “Will Trulia Drive ‘Merger Tax’ Suits Out of Delaware,” Washington Legal Foundation Legal Backgrounder 31:10. Rock, Edward B., 1997. “Saints and Sinners: How Does Delaware Corporate Law Work?” UCLA Law Review 44:1009–1107. Roe, Mark J., 2003. “Delaware’s Competition,” Harvard Law Review 117:588–646. Romano, Roberta, 1989. “Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws,” Columbia Law Review 89:1599–1617. Rosenberg, David and Steven Shavell, 1985. “A Model in Which Suits Are Brought for Their Nuisance Value,” International Review of Law and Economics 5:3–13. Rosenberg, David and Steven Shavell, 2006. “A Solution to the Problem of Nuisance Suits: The Option to Have the Court Bar Settlement,” International Review of Law and Economics 26:42–51.

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10.  Forum shopping in the bargain aisle: Wal-Mart and the role of adequacy of representation in shareholder litigation

Lawrence A. Hamermesh and Jacob J. Fedechko*

In determining whether a shareholder class or derivative action is barred by res judicata,1 on one hand, or collateral estoppel,2 on the other, courts may be called upon to evaluate whether the representation of the interests of the class or the corporation in the prior litigation was adequate. Doctrinal standards guiding that evaluation are loose and relatively undeveloped. With the rise of multiforum shareholder class and derivative litigation, however, there has been increased occasion for judicial review of adequacy of representation. This chapter reviews the applicable existing doctrine and proposes refinements to that doctrine that may better vindicate the competing policy concerns associated with judicial evaluation of adequacy of representation: namely, that courts must apply doctrines of repose robustly enough to minimize or avoid unproductive relitigation of claims but, on the other hand, must avoid claim preclusion where it would unfairly deprive the corporation or its stockholders of the opportunity to litigate meritorious claims. This chapter first explores the reasons for requiring adequate representation, and how multiforum litigation compels the courts to apply that requirement meaningfully. It then considers the current doctrinal framework and uses the decision of the Delaware Court of Chancery in In re Wal-Mart Delaware Derivative Litigation to illustrate how the doctrine has been applied.3 The chapter then sets forth an alternative approach to the current interpretation of the Restatement framework.4 Specifically, the chapter proposes a totality of the circumstances approach that requires consideration of several “badges of inadequacy.” The chapter also suggests how the Restatement framework can be interpreted to accommodate consideration of such “badges of inadequacy,” and thereby more fully implement the policies mentioned above.

*  We would like to acknowledge the contributions of Hon. J. Travis Laster, Sean Griffith, and other participants in the Corporate & Securities Litigation Workshop in Chicago. Inaccuracies, oversimplifications, and other shortcomings of this chapter, however, are the exclusive responsibility of the authors. 1   Also known as “claim preclusion.” 2   Also known as “issue preclusion.” 3   2016 WL 2908344 (Del. Ch. May 13, 2016) (“Wal-Mart I”). 4   See Restatement (Second) Judgments §§ 41–42.

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1.  THE REQUIREMENT OF ADEQUATE REPRESENTATION5 Shareholder class actions and derivative litigation can provide substantial private and public benefits. Ideally, class actions enable shareholders to obtain relief for breaches of duties owed to them where such relief would be impracticable for shareholders to pursue individually.6 Supplementing regulatory schemes, derivative litigation provides a mechanism for private enforcement of corporate management responsibilities to the corporation.7 By providing incentives to plaintiffs’ lawyers in the form of fee awards in successful cases, both class actions and derivative litigation enable widely dispersed groups of stockholders to hold management accountable for breaches of duty that isolated stockholders acting individually might not be able to challenge.8 And representative shareholder litigation serves the further purpose of conserving judicial and litigant resources by allowing for the adjudication of claims common to many shareholders in a single case, rather than in piecemeal fashion.9 These litigation mechanisms do not work efficiently, however, if stockholders could bring the same claims successively; to work efficiently, adjudication of a suit by a stockholder to vindicate the rights of other stockholders or the corporation must have preclusive effect. By some doctrine of repose—collateral estoppel or res judicata—shareholders who are not parties in litigation brought on their behalf must be prevented from bringing the same claims that were resolved on their behalf in the original suit.10 For those doctrines of repose to be applied fairly, however, there must be some ­assurance that the original shareholder plaintiff has done a reasonably effective job of prosecuting

 5   In this chapter, we discuss concurrently two distinct contexts—dismissal on motion and settlement—in which the issue of preclusion implicates the question of the adequacy of counsel in the original litigation. We do, however, recognize that the two contexts implicate different considerations and should not necessarily be treated identically.  6   See, e.g., Blank and Zacks 2005, p.11 (“Class actions also enable claims that may be economically and socially insignificant as individual claims, but that are far more significant as a whole, to be heard”); Kraakman et al. 1994, p.1733 (“Shareholder suits are the primary mechanism for enforcing the fiduciary duties of corporate managers”).  7   See, e.g., Davis 2008, p.411 (discussing the derivative suit’s historical role as the “chief regulator of corporate management” and “the most important procedure the law has yet developed to police the internal affairs of corporations” (citations omitted)).  8   See, e.g., Bird v. Lida, Inc., 681 A.2d 399, 403 (Del. Ch. 1996) (“[I]t is likely that in a public corporation there will be less shareholder monitoring expenditures than would be optimum from the point of the shareholders as a collectivity. One way the corporation law deals with this conundrum is through the derivative lawsuit and the recognized practice of awarding to successful shareholder champions and their attorney’s [sic] risk-adjusted reimbursement payments (i.e., contingency based attorneys fees). The derivative suit offers to risk-accepting shareholders and lawyers a method and incentives to pursue monitoring activities that are wealth increasing for the collectivity (the corporation or the body of its shareholders)” (citation omitted)).  9   See, e.g., King v. VeriFone Holdings, Inc., 12 A.3d 1140, 1150 (Del. 2011) (“We agree with the Vice Chancellor that it is wasteful of the court’s and the litigants’ resources to have a regime that could require a corporation to litigate repeatedly the issue of demand futility”). 10   See King v. VeriFone Holdings, Inc., 994 A.2d 354, 362 (Del. Ch. 2010) (“King I”) (discussing how res judicata prevents inefficiencies), rev’d on other grounds, 12 A.3d 354 (Del. 2011) (“King II”); Ficken v. Golden, 696 F. Supp. 2d 21, 31-32 (D.D.C. 2010) (discussing the benefits of res judicata and collateral estoppel); see also Clopton 2015, pp.1387–1428 (discussing preclusion in the context of transnational class actions).

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158  Research handbook on representative shareholder litigation the claims that absent shareholders are to be precluded from pursuing. Otherwise, absent class members or stockholders who may have been much better representatives, or who may have been able to achieve better results by bringing claims on their own, may be precluded from bringing those claims. This possibility has led some courts—notably the Delaware Court of Chancery—to call attention to a “specter of unfairness” as a result of adjudications against “feckless fast filers”—that is, shareholder plaintiffs whose litigation efforts are substandard and result in dismissals or settlements that fail to achieve the benefits that the claims being precluded might otherwise warrant.11 Not surprisingly, then, courts have insisted in one way or another that a class or derivative plaintiff must “fairly” or “adequately” represent non-party class members or shareholders who would be bound by the disposition of the original case. Since the 1800s, long before the Federal Rules of Civil Procedure were adopted, and when rules of equity guided the courts in this area of the law, the federal courts required that the named plaintiff fairly and adequately represent others who shared in the interests at stake.12 Eventually, this adequacy-of-representation requirement evolved from an equitable rule into an element of due process,13 and it is now codified in Federal Rules of Civil Procedure Rules 23 and 23.1 and in many of their state law counterparts.14 Thus, in order for anyone to benefit from representative litigation, the class or derivative plaintiff must prosecute the common claims “vigorously.”15 So when the representative shareholder plaintiff’s litigation efforts are inadequate, a final adjudication in a case will not have preclusive effect, and multiple lawsuits over the same claims may follow.

11   See, e.g., Asbestos Workers Local 42 Pension Fund v. Baamann, 2015 WL 2455469, at *18 n.147 (Del. Ch. May 21, 2015) (revised May 22, 2015) (“A specter of unfairness appears, however, in the derivative context, where a derivative plaintiff with a viable claim may be estopped from proceeding based on the inadequate efforts of a fellow stockholder in privity, a feckless fast filer”), aff’d, 132 A.3d 749 (Del. 2016) (Table). 12   Supreme Tribe of Ben Hur v. Cauble, 255 U.S. 356, 367 (1921) (holding that decree bound unnamed class members in part because “[t]he parties bringing the suit truly represented the interested class”); Smith v. Swormstedt, 57 U.S. 288, 303 (1853) (“In all cases where exceptions to the general rule are allowed, and a few are permitted to sue and defend on behalf of the many, by representation, care must be taken that persons are brought on the record fairly representing the interest or right involved, so that it may be fully and honestly tried”). 13   See, e.g., Wright et al. 2016, § 4455; Taylor v. Sturgell, 553 U.S. 880, 897 (2008) (“[O]ur holding that the . . . application of res judicata to nonparties violated due process turned on the lack of either special procedures to protect the nonparties’ interests or an understanding by the concerned parties that the first suit was brought in a representative capacity. [This Court] thus established that representation is ‘adequate’ for purposes of nonparty preclusion only if (at a minimum) one of these two circumstances is present”); Hansberry v. Lee, 311 U.S. 32, 42 (1940) (“[T]his Court is justified in saying that there has been a failure of due process only in those cases where it cannot be said that the procedure adopted, fairly insures the protection of the interests of absent parties who are to be bound by it”). 14   See, e.g., Del. Ch. Ct. R. 23, 23.1, 24. Notably, the Delaware Court of Chancery’s counterpart to Federal Rule 23 lacks a separate provision that addresses the adequacy of class counsel specifically. 15   See, e.g., Arduini v. Hart, 774 F.3d 622, 635 (9th Cir. 2014) (“Indeed, we have noted that an ‘adequate [shareholder] representative must have the capacity to vigorously and conscientiously prosecute a derivative suit and be free from economic interests that are antagonistic to the interests of the class.’” (citation omitted)).

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Forum shopping in the bargain aisle  159 It is well known that the effectiveness of representation in shareholder class and derivative litigation rarely depends at all on the nature or efforts of the named plaintiff shareholder or shareholders; whether representation in such litigation is effective depends almost entirely on the ability and efforts of plaintiffs’ counsel.16 Therefore, this chapter focuses on the role of counsel in the adequacy-of-representation analysis.17 We explore what it means for an attorney to adequately represent a class or corporation, and the mechanisms available to the courts to evaluate such adequacy.

2.  FORUM SHOPPING IN THE BARGAIN AISLE: A “RACE TO THE BOTTOM” PROBLEM The phenomenon of parallel shareholder class and derivative litigation in multiple forums has sharply highlighted the issue of adequate representation as a condition to precluding duplicative litigation of similar claims.18 The common scenario is that an event occurs—such as the announcement of a merger or acquisition, or the reporting of a corporate catastrophe—and plaintiffs’ attorneys file complaints in multiple jurisdictions alleging class, derivative, or hybrid claims,19 despite good reasons why such litigation should be concentrated in the state in which the subject corporation is incorporated.20 This phenomenon creates a classic “race to the bottom” problem: [R]ational judges, defendants, and plaintiffs’ counsel have incentives to engage in behaviors that result in deadweight costs: unnecessarily expediting litigation, accepting inadequate settlements and awarding inappropriate attorneys’ fees, prematurely filing derivative suits that unnecessarily engender dismissal motion practice, and inadequately supervising selection of class representatives and lead counsel.21

It has been suggested that multiforum shareholder litigation is at least in part a response to rulings by the Delaware Court of Chancery that took a tougher stance on approving fees for settled or mooted disclosure claims.22 Regardless of the motivation, however, 16   See Strine et al. 2013, p.9 (“The choice of forum in shareholder representative actions is driven almost entirely by tactical considerations of plaintiffs’ counsel”); Rubenstein 2001, p.408 (“In fact, as critics have noted for decades, class counsel is conventionally considered the real party in interest in securities class actions; because plaintiffs are thought to have scant damage claims, the attorney’s fee far exceeds any interest of the class members. Opportunities for class counsel to compromise the class’s interests are obvious and abundant. Though these particular concerns have long been the subject of scholarly criticism, they rarely led courts to deny certification in securities classes”); see also In re Revlon, Inc. S’holders Litig., 990 A.2d 940, 959 (Del. Ch. 2010). 17   Professor Cox has also alluded to adequacy issues involving counsel (Cox 2017/2018). 18   See, e.g., Wal-Mart I, 2016 WL 2908344, at *18–23 (Del. Ch. May 13, 2016); Asbestos Workers Local 42 Pension Fund v. Baamann, 2015 WL 2455469, at *18 n.147 (Del. Ch. May 21, 2015) (revised May 22, 2015), aff’d, 132 A.3d 749 (Del. 2016) (Table); La. Mun. Police Emps.’ Ret. Sys. v. Pyott, 46 A.3d 313, 335-51 (Del. Ch. 2012) (“Pyott I”), rev’d, 74 A.3d 612 (Del. 2013) (“Pyott II”). 19   Myers 2014, pp.483–84; Strine et al. 2013, pp.8–23; Micheletti & Parker 2012, pp.6–14. 20   Strine et al. 2013, p.61 (recommending a presumption that representative shareholder litigation should proceed in the state of incorporation). 21   Ibid at 54. 22   See Micheletti & Parker 2012, pp.8–9 (citing In re Cox Commc’ns, Inc. S’holder Litig., 879

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160  Research handbook on representative shareholder litigation a ­pernicious aspect of multiforum litigation is the temptation it creates for a race to settlement in which the first plaintiffs’ attorney to obtain a preclusive settlement “wins” because it is he or she who will receive a fee award to the exclusion of all the other attorneys in the parallel cases. Related to the race to settlement is the race to the courthouse generally, which is commonly thought to be the result of courts conferring lead counsel status on attorneys who file their complaints first.23 Defendants also have an incentive to cheer on that race, to the extent that it gives priority to a weaker complaint or promotes an early and relatively inexpensive settlement, or both. This incentive has even manifested in defendants waiving exclusive forum selection bylaws in order to secure a preclusive settlement or judgment that is less costly than one which may occur in a case brought by more effective counsel.24 Whether through dismissal or settlement, defendants benefit if similar claims are subsequently precluded. Thus, the incentive to file quickly and settle quickly—forum shopping in the bargain aisle—inevitably raises the concern that plaintiffs’ counsel may inadequately represent the stockholders or corporation, and that similar claims in other forums should not be precluded.25

A.2d 604 (Del. Ch. 2005)). Others have discussed more recently whether this trend will intensify post-Trulia (Griffith & Rickey 2017/2018). 23   See Pyott I, 46 A.3d 313, 337–38 nn.18–19 (Del. Ch. 2012) (quoting Elliot J. Weiss & John S. Beckerman, Let the Money Do the Monitoring: How Institutional Investors Can Reduce Agency Costs in Securities Class Actions, 104 Yale L.J. 2053, 2062 (1995); Welch, Edward P. et al. Mergers & Acquisitions Deal Litigation Under Delaware Corporation Law § 2.01[B][3][a], at 2–16 to 17), rev’d on other grounds, 74 A.3d 612 (Del. 2013); King I, 994 A.2d 354, 355, 357–58 (Del. Ch. 2010), rev’d on other grounds, 12 A.3d 1140 (Del. 2011). 24   See Lipton 2016 (“[D]efendants have the freedom to ignore a forum selection bylaw if their interests are served by dealing with a weaker set of plaintiffs in a foreign forum”); Frankel 2015. But see In re CytRx Corp. S’holder Derivative Litig., C.A. No. 14-6414-GHK-PJW, at 6–9 (C.D. Cal. Aug. 17, 2016) (scrutinizing parties’ motives for pursuing settlement in California in contravention of forum selection bylaw that identifies the Delaware Court of Chancery as the exclusive forum). 25   The Delaware courts have, with increasing urgency, called attention to this problem. See e.g., in chronological order, Biondi v. Scrushy, 820 A.2d 1148, 1159 (Del. Ch. 2003) (“The mere fact that a lawyer filed first for a representative client is scant evidence of his adequacy and may, in fact, support the contrary inference”); W. Coast Mgmt. & Capital, LLC v. Carrier Access Corp., 914 A.2d 636, 643 n.22 (Del. Ch. 2006) (“[I]f [a] second plaintiff makes substantially different allegations of demand futility based on additional information [obtained from a Section 220 demand], issue preclusion, from both a logic and fairness standpoint, would not apply”); King I, 994 A.2d 354, 357 (Del. Ch. 2010) (a derivative plaintiff waives its inspection rights if it files a complaint before seeking books and records); Pyott I, 46 A.3d 313, 336–51 (Del. Ch. 2012) (detailing the fast filer problem and applying a fast filer presumption of inadequacy); South v. Baker, 62 A.3d 1, 20-26 (Del. Ch. 2012) (describing and applying a “rebuttable” fast filer presumption of inadequacy). Suggesting a presumption against fast-filing plaintiffs’ attorneys’ being adequate to serve as lead counsel, the court observed: “When a derivative plaintiff files a damages action hastily in the wake of a public announcement, there is no basis for expediting the case to further the interests of the corporation and its stockholders, and, when the derivative plaintiff forewent a books and records investigation and a period of deep reflection on the publicly available documents and the law, should not the presumption be that the plaintiff is not fit to serve as the lead fiduciary for the corporation and its stockholders? What rational argument is there that it advances the legitimate interests of investors to give a leg up to the first to get to court in a situation when being first to court is likely to compromise the ability of the filing plaintiff to sustain his derivative complaint?”

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3.  WHEN IS COUNSEL INADEQUATE? In light of that concern, it has become important for courts to evaluate whether to give preclusive effect to a settlement or dismissal in a multiforum litigation situation. In making that evaluation, the courts have been called upon to balance two competing policies noted earlier: minimizing or avoiding unproductive relitigation of claims, and avoiding claim preclusion where it would unfairly deprive the corporation or its stockholders of the opportunity to litigate meritorious claims.26 As illustrated in In re Wal-Mart (discussed below), the currently prevailing interpretation of the Restatement framework imposes a demanding test for establishing that counsel in the original suit was inadequate. That test may be too demanding—especially in derivative suits, in which pleading requirements are particularly strict,27 and special procedures to protect absentees are lacking at the pleading stage.28 A redefined doctrine—or a more flexible application of existing doctrine—could limit the pathologies of multiforum shareholder litigation that threaten to unfairly prevent stockholders from asserting meritorious claims. 3.1  Sources of Law Due process forms the foundation for the analysis, and state law provides the framework. It is essential as a matter of federal constitutional law that absent parties “are in fact adequately represented by parties who are present.”29 In determining whether an absent party is “in fact” adequately represented, the US Supreme Court has thus far required that: at a minimum: (1) The interests of the nonparty and her representative are aligned; and (2) either the party understood herself to be acting in a representative capacity or the original court took care to protect the interests of the nonparty. In addition, adequate representation sometimes requires (3) notice of the original suit to the persons alleged to have been represented.30

Aside from this guidance, each state is left to formulate its own approach to determining whether representation in the first suit was sufficiently adequate to bind the absent

King I, 994 A.2d at 364 n.34. The Supreme Court reversed the Court of Chancery, but nevertheless agreed that the fast filing approach is harmful to both the judiciary and litigants, King II, 12 A.3d 1140, 1150­–51 (Del. 2011), and suggested some less stringent approaches: denying a fast filing plaintiff “lead plaintiff ” status; “dismiss[ing] the complaint with prejudice and without leave to amend as to the named plaintiff ”; or allowing the plaintiff to amend its complaint one time only if it pays the defendants’ fees associated with filing the motion to dismiss. Ibid at 1151–52. 26   See Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1283 (Del. 1989) (“The Court of Chancery plays a special role when asked to approve the settlement of a class or derivative action. It must balance the policy preference for settlement against the need to insure that the interests of the class have been fairly represented”). 27   Fed. R. Civ. P. 23.1(b) (requiring that demand futility be alleged with “particularity”); Del. Ch. R. 23.1(a) (same). 28   Fed. R. Civ. P. 23.1(c) (requiring court approval for settlement, voluntary dismissal, and compromise); Del. Ch. R. 23.1(c) (similar). 29   Hansberry v. Lee, 311 U.S. 32, 42–43 (1940). 30   Taylor v. Sturgell, 553 U.S. 880, 900–01 (2008) (internal citations omitted).

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162  Research handbook on representative shareholder litigation parties. The Restatement (Second) of Judgments has largely won the day as the favored framework for addressing preclusion in successive shareholder suits.31 3.2  Current Doctrinal Standards To date, there has been a general consensus that any determination of adequate representation involves a fact-intensive analysis.32 In light of that fact-specific approach to evaluating adequacy of representation, it is perhaps not surprising that doctrinal parameters are relatively loose and undeveloped. Under the Restatement test that several jurisdictions, including Delaware, have regularly used to determine whether to give preclusive effect to a prior judgment,33 “[a] person is not bound by a judgment for or against a party who purports to represent him if: . . . [t]he representative failed to prosecute or defend the action with due diligence and reasonable prudence, and the opposing party was on notice of facts making that failure apparent.”34 Despite the use of negligence-standard phraseology (“due diligence and reasonable prudence”) in the first part of the test,35 Comment f explains that “[t]actical mistakes or negligence on the part of the representative are not as such sufficient to render the judgment vulnerable.”36 The Comment goes on to identify two basic scenarios in which representation is inadequate: (1) counsel’s interests were antagonistic to those of the class (for example, where there was collusion between class counsel and the class adversary); and (2) counsel was grossly negligent in prosecuting the claim. This has been applied in a bifurcated manner, where courts analyze alleged conflicts of interest and then separately analyze whether counsel was grossly negligent.37 Comment f also makes more than one reference to inadequate representation involving the defendants’   §§ 41–42.   Ibid § 42(1)(e) cmt. (f); see also Matsushita Elec. Indus. Co., Ltd. v. Epstein, 516 U.S. 367, 397–98 (1996) (discussing Prezant v. De Angelis, 636 A.2d 915 (Del. 1994)); South v. Baker, 62 A.3d 1, 7, 20–26 (Del. Ch. 2012) (quoting Wolfe, Jr, Donald J. and Pittenger, Michael A. (2012) Corporate and Commercial Practice in the Delaware Court of Chancery § 9.02[b][1], at 9–31 to 32; Bakerman v. Sidney Frank Importing Co., 2006 WL 3927242, at *11 (Del. Ch. Oct. 10, 2006), reprinted in 32 Del. J. Corp. L. 551 (2007)). 33   See, e.g., Pyott II, 74 A.3d 612, 618 & n.21 (Del. 2013) (citing Restatement (Second) Judgments); Wal-Mart I, 2016 WL 2908344, at *18–20 & nn.99–100 (Del. Ch. May 13, 2016) (relying on the Restatement (Second) Judgments and citing cases from courts in other jurisdictions that have done the same). 34   Restatement (Second) Judgments § 42(1). 35   As drafted, the Restatement’s rule appears to be unduly (and perhaps unintentionally) restrictive. It appears to require, as a basis for a finding that a prior judgment is not preclusive due to inadequacy of representation, that the adverse party was on notice of facts making apparent the failure of counsel to act with due diligence and reasonable prudence. Thus, plaintiffs’ counsel could be entirely disloyal and intentionally undermine the interests of absent shareholders, but as long as that circumstance is not apparent to the opposing parties, a subsequent challenge to adequacy of representation must fail. Although defendants’ awareness of improper motivations or inadequate conduct on the part of plaintiffs’ counsel is surely important in the analysis, as discussed below, it may be inappropriate as an absolute requirement to a finding of representational inadequacy. 36   Restatement (Second) Judgments § 42(1) cmt. f. 37   See Wal-Mart I, 2016 WL 2908344, at *18–22. 31 32

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Forum shopping in the bargain aisle  163 being on notice of the inadequacy.38 The focus on the defendants’ awareness of the inadequacy sets the Restatement framework apart from the approach developed in the federal courts.39 As a practical matter, however, under both the Restatement framework and federal standards, courts will not find that counsel was inadequate for purposes of avoiding doctrines of repose unless the facts show that counsel had a direct conflict of interest or was grossly negligent.40 In other words, inadequacy must be obvious. As observed in one treatise, “the trend in the case law has been to sustain challenges to the representative only where a clear-cut conflict or other confidence-undermining problem exists and to reject challenges around the edges.”41 For example, recent decisions from the Court of Chancery, with notable exceptions, suggest that attorneys are generally entitled to deference when they decide to file suit without first seeking to exercise statutory inspection rights as a basis for strengthening their complaint.42 Like the duty of care in corporate law, which requires directors to become informed of all material information reasonably available and which is breached when they are grossly negligent, there appears to be an accountability gap. This area of the law parallels the duty of care in another way, in that some courts avoid hindsight bias by refraining from “second-guessing [counsel’s] decision-making based on information that was unavailable to them at the time” the challenged decision occurred.43 Thus, under the current legal regime counsel may fall well short of prosecuting a claim 38   Restatement (Second) Judgments § 42(1) cmt. f (“[A] fiduciary does not bind those for whom he acts as against third parties who are aware of the fiduciary’s failure to fulfill his responsibility. As applied to litigation, this principle implies that a judgment is not binding on the represented person where it is the product of collusion between the representative and the opposing party, or where, to the knowledge of the opposing party, the representative seeks to further his own interest at the expense of the represented person. Where the representative’s management of the litigation is so grossly deficient as to be apparent to the opposing party, it likewise creates no justifiable reliance interest in the adjudication on the part of the opposing party”). 39   One of the more popular standards in the federal courts provides that “the primary criterion for determining whether the class representative had adequately represented his class for purposes of res judicata is whether the representative, through qualified counsel, vigorously and tenaciously protected the interests of the class. A court must view the representative’s conduct of the entire litigation with this criterion as its guidepost.” Pelt v. Utah, 539 F.3d 1271, 1285 (10th Cir. 2008) (quoting Gonzales v. Cassidy, 474 F.2d 67, 75 (5th Cir. 1973)); see also Arduini v. Hart, 774 F.3d 622, 635 (9th Cir. 2014) (“[A]n adequate shareholder representative must have the capacity to vigorously and conscientiously prosecute a derivative suit and be free from economic interests that are antagonistic to the interests of the class” (internal quotations omitted)). 40   See, e.g., Wal-Mart I, 2016 WL 2908344, at *18–22 (Del. Ch. May 13, 2016); Pelt, 539 F.3d at 1286–89; In re Sonus Networks, Inc. S’holder Derivative Litig., 499 F.3d 47, 64–66 (1st Cir. 2007). But see Johnson v. Shreveport Garment Co., 422 F. Supp. 526, 534–36 (W.D. La. 1976) (demanding that class counsel perform at a higher standard than that expected of counsel who represents a single party). 41   McLaughlin on Class Actions vol. 1 § 4:29 (12th ed.) (discussing named plaintiffs and class counsel). 42   Wal-Mart I, 2016 WL 22908344, at *21–22 (Del. Ch. May 13, 2016) (expressing a reluctance to “second-guess[]” counsel’s decision-making); Laborers’ Dist. Council Constr. Indus. Pension Fund v. Bensoussan, 2016 WL 3407708, at *11–12 (Del. Ch. June 14, 2016). But see Krasner v. Third Avenue Tr., C.A. No. 12113-VCL (Del. Ch. July 28, 2016) (Order); Pyott I, 46 A.3d 313 (Del. Ch. 2012). 43   Wal-Mart I, 2016 WL 2908344, at *22.

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164  Research handbook on representative shareholder litigation vigorously—or even competently—and a court may nevertheless find that representation was adequate for purposes of applying doctrines of repose. The courts have also been sensitive to whether the original proceeding was adversarial or collusive in nature.44 This issue appears most often in the context of preclusive settlements, where the interests of class counsel and the class adversary may become aligned, as opposed to contested judgments. Of course, collusion remains an issue outside of the settlement context.45 One example of such collusion is when defendants waive a forum selection bylaw so as to favor a weaker complaint filed in a foreign forum and plaintiffs’ counsel in that forum fights off any attempts by interveners for a stay pending production and review of corporate books and records.46 The courts’ treatment of the stockholder derivative litigation in Arkansas and Delaware involving Wal-Mart illustrates the application of these principles.47 That litigation was triggered when the New York Times released an exposé, supported by hundreds of internal documents, on April 21, 2012 alleging that Wal-Mart had covered up a bribery scheme involving government officials in Mexico,48 thus violating US and Mexican law.49 Several lawsuits were filed in Arkansas and Delaware, some as quickly as four days after the Times exposé was released.50 While the Delaware plaintiffs vigorously pursued litigation for years in an effort to inspect corporate records to bolster a derivative complaint, the Arkansas plaintiffs pushed ahead without ever making a demand for inspection of relevant corporate records.51 Then, the consolidated Arkansas action was dismissed for failure to plead demand futility, enabling the defendants to invoke collateral estoppel as a basis for dismissing the Delaware litigation.52 The Court of Chancery, applying Arkansas law, held that collateral estoppel applied and that the Delaware plaintiffs failed to carry their burden of showing that the Arkansas attorneys were inadequate, because they failed to show that the attorneys’ interests were “directly opposed” to Wal-Mart’s or that their efforts were grossly negligent.53 Thus, because the Delaware plaintiffs could not establish inadequacy under either the loyalty or care prongs of the Restatement’s framework, their challenge failed.54 On appeal, the Delaware Supreme Court agreed,55 adding that “the Delaware Plaintiffs should have coordinated, intervened, or participated in some fashion in the Arkansas proceedings.”56 44   See, e.g., In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 887, 893 (Del. Ch. 2016); Radcliffe v. Experian Info. Solutions, Inc., 715 F.3d 1157, 1168 (9th Cir. 2013). 45   See supra note 24; see also Krasner v. Third Avenue Tr., C.A. No. 12113-VCL (Del. Ch. July 28, 2016) (Order). 46   See supra note 24. 47   Wal-Mart I, 2016 WL 2908344, at *17-23; In re Wal-Mart Stores, Inc. S’holder Derivative Litig., 2015 WL 1470184 (W.D. Ark. Mar. 31, 2015) (Order). 48   Barstow, 2012. 49   Wal-Mart I, 2016 WL 2908344, at *1. 50   Ibid at *7. 51   Ibid at *5–7. 52   Ibid at *7. 53   Ibid at *19, *19–23. 54   Ibid at *23. 55   Cal. State Teachers’ Ret. Sys. v. Alvarez, 2017 WL 239364, at *3–5 (Del. Jan. 18, 2017) (“WalMart II”), remanding Wal-Mart I, 2016 WL 2908344 (Del. Ch. May 13, 2016). 56   Ibid at *4. The Court found support in New York case law providing “an exception to claim

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Forum shopping in the bargain aisle  165 The Supreme Court remanded the case for the Court of Chancery to determine whether applying issue preclusion would violate federal due process requirements, and it reserved final judgment until after the lower court’s decision on remand. In light of the unique circumstances involved in Wal-Mart, we agree with the courts’ determination, under the current Restatement framework, that the Arkansas attorneys were not inadequate representatives. First, although the plaintiffs should have exercised their inspection rights, much of the information that was critical to making a demand futility argument was publicly available through the Times’ reporting, and the failure to pursue statutory inspection rights did not clearly disable the plaintiffs from presenting an effective complaint.57 And as the Supreme Court noted, “we cannot say that the Arkansas Plaintiffs, who made a tactical decision to base their complaint on the documents referenced in the New York Times article, coupled with their desire for a jury trial (which is unavailable in the Court of Chancery), and perhaps other strategic considerations, were ‘grossly deficient’ in their representation.”58 Notably, this was not a case where the defendants favored the weaker complaint so as to secure a preclusive judgment; the defendants sought to stay the Arkansas litigation so that the litigation could proceed in Delaware, where plaintiffs were pursuing efforts to exercise statutory inspection rights.59 Although the Court of Chancery reached a proper conclusion under the current doctrine, the outcome may have been different had the court applied the alternative framework discussed presently. First, this was a derivative case and preclusion was based on an early stage order dismissing the Arkansas complaint for failure to plead demand futility, and there were no special procedures to protect the absent shareholders. Second, the fact that the Arkansas plaintiffs failed to make a demand to inspect books and records is significant evidence of inadequacy, especially because the plaintiffs were asserting a Caremark claim and the directors’ awareness of the misconduct was not clear from the public record. The third (and related) factor that favors a finding of inadequacy is that the Arkansas plaintiffs resisted the defendants’ motion to stay, despite the recognition that the plaintiffs in the Delaware suit were attempting an action the Arkansas plaintiffs had bypassed, namely seeking to bolster their claims through exercise of statutory inspection rights. Although a rational judge may have found that the Arkansas plaintiffs’ counsel was inadequate under this alternative framework, it would have also been rational to find that the representation was adequate because of the thoroughness of the Times’ reporting and the Delaware plaintiffs’ failure to make any effort to intervene in the Arkansas litigation. The adequacy issue is indeed a close call. But the Restatement framework may not have given the court the latitude to sufficiently weigh the issue. That limitation demonstrates why a refined framework is desirable.

preclusion in derivative actions where a stockholder seeks to intervene in the prior action to protect its interests but is denied leave to participate.” Ibid at *4 n.23 (citing Parkoff v. Gen. Tel. & Elecs. Corp., 425 N.E.2d 820, 824 (N.Y. 1981)). Thus, if the Delaware plaintiffs had tried to intervene but were frustrated from doing so, the Court might well have sided with them on appeal. See ibid (quoting Parkoff, 425 N.E.2d at 824; Dana v. Morgan, 232 F. 85, 89 (2d. Cir. 1916)). 57   Wal-Mart I, 2016 WL 2908344, at *1. 58   Wal-Mart II, 2017 WL 239364, at *5. 59   Wal-Mart I, 2016 WL 2908344, at *6.

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166  Research handbook on representative shareholder litigation

4. A REFINED DOCTRINAL FRAMEWORK FOR EVALUATING ADEQUACY OF REPRESENTATION 4.1  Reconsidering a Rebuttable “Fast-Filer Presumption” As mentioned previously, the predominant framework used for evaluating the adequacy of counsel ex post may be more forgiving than is appropriate.60 By requiring the defendants to be aware of a direct conflict of interest or grossly deficient representation, the existing doctrine gives courts relatively little leverage to police the fast-filer problem. The most significant attempt thus far to modify applicable doctrine to address that problem was the fast-filer presumption of inadequacy developed over the course of several Court of Chancery decisions beginning with Biondi and culminating in Pyott I.61 It was a natural response to the threat posed by substandard pleadings to claims held by corporations and groups of stockholders, and it may have functioned well in limiting undesirable practices. The Delaware Supreme Court characterized the presumption as “irrebuttable,” however, and rejected it on that basis.62 Continuing to reject an irrebuttable fast-filer presumption is appropriate because it does not fully account for the highly fact-specific and nuanced nature of inquiries into adequacy of representation. For example, strict application of the presumption would have rendered counsel in Wal-Mart inadequate as a matter of course despite the fact that substantial information supporting arguments for demand futility was publicly available. The courts should be given greater latitude and discretion to evaluate this issue, not less. Notably, however, the presumption that the Court of Chancery announced in Pyott I was not necessarily irrebuttable, and courts in future cases could reconsider adopting a fast-filer presumption of inadequacy that operates as a conventional presumption— namely, by dictating a finding of inadequacy only if the parties seeking preclusion based on a prior judgment fail to produce evidence of adequacy.63 The Delaware Supreme Court’s ruling in Pyott II, however, makes the prospect that the courts will adopt an ordinary presumption of inadequacy uncertain at best. We believe, rather, that the courts are more likely to be open to a new approach that follows previously accepted principles underlying this area of the law—in particular, a “totality of the circumstances” approach, which is less sweeping than the fast-filer presumption but allows for more scrutiny than the Restatement approach. 4.2  The “Totality of Circumstances” Test Needs Elaboration A test that enables the courts to examine the totality of the circumstances has the virtue of acknowledging that a direct conflict of interest or grossly deficient prosecution are not   See supra note 35.   See supra note 25. 62   Pyott II, 74 A.3d 612, 618 (Del. 2013). 63   See Fed. R. Evid. 301 (“In a civil case, unless a federal statute or these rules provide otherwise, the party against whom a presumption is directed has the burden of producing evidence to rebut the presumption”); see also South v. Baker, 62 A.3d 1, 22–23 (Del. Ch. 2012) (describing a rebuttable presumption of disloyalty to be applied against fast filers). 60 61

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Forum shopping in the bargain aisle  167 the only possible grounds for finding that counsel was inadequate. Requiring one or the other of these circumstances as a basis for a finding of inadequate representation does not account for the reality that a range of human emotions may pull a fiduciary from the “path of propriety,” including greed, revenge, shame, or pride.64 Moreover, at least where preclusion arising from a settlement is concerned, there is (to borrow from other corporate doctrine) an “omnipresent specter”65 that counsel’s interest in an early fee award might compromise counsel’s motivation to act in the long-term best interests of absent shareholders. And if an improper motive causes counsel to make poor (although not grossly negligent) litigation decisions that contribute materially to a case being dismissed or settled too cheaply, then there may be a basis for finding that the absent parties in interest were deprived of their entitlement to adequate representation, either as a matter of state law or perhaps as a matter of due process.66 A rote adoption of a “totality of the circumstances test,” however, is not particularly helpful in guiding the courts’ evaluation of adequacy of representation. Merely reiterating that amorphous test would most likely continue to produce the same results as the current analytical framework, without enhancing the courts’ ability to determine when to give preclusive effect to a prior judgment in shareholder litigation. Accordingly, the following subsection examines a variety of procedural and substantive factors—or badges of inadequacy67—that the courts might consider to determine if a prior settlement or judgment deserves preclusive effect. 4.3 Proposed Doctrinal Refinements and Factors for Evaluating Adequacy of Representation Courts evaluating adequacy of representation for the purposes of determining the preclusive effect of a prior judgment in shareholder litigation should take account of the defendants’ reliance interest in the prior judgment, along with other considerations. The factors identified next might inform that account. In general, however, defendants’ reliance interest in a prior judgment in representative shareholder litigation should be viewed as less significant than in other forms of litigation where the plaintiff (the principal) has a closer relationship with and control over the attorney (the fiduciary agent), and agency problems are therefore likely to be less pronounced.68

64   Chen v. Howard-Anderson, 87 A.3d 648, 684 (Del. Ch. 2014) (quoting In re RJR Nabisco, Inc. S’holders Litig., 1989 WL 7036, at *15 (Del. Ch. Jan. 31, 1989)). 65   Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985). 66   The bar that absent shareholders must reach in claiming that counsel was inadequate as a matter of due process should perhaps be lower in derivative cases at the demand futility stage than in other contexts because of the attenuated relationship between shareholders. See In re EZCORP Inc. Consulting Agreement Derivative Litig., 130 A.3d 934, 947–49 (Del. Ch. 2016) (relying on Smith v. Bayer Corp., 564 U.S. 299 (2011)). 67   Cf. 37 Am. Jur. 2d Fraudulent Conveyances & Transfers § 12 (Westlaw database updated Summer 2016) (“Certain circumstances relating to defrauding creditors are characterized as ‘badges of fraud’ because they are circumstances tending to excite suspicion as to the conveyance, which, standing unexplained, may warrant an inference of fraud”). 68   Cf. Regan 1999, pp.61–83 (discussing the differences in “expectations arising from a­ greements

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168  Research handbook on representative shareholder litigation 4.3.1  Care in prosecuting the original litigation Existing doctrine already encourages the courts to examine the degree of care brought to bear in prosecuting the original litigation. That examination is appropriate; indeed, depending on other circumstances, it may not be appropriate to insist that a lack of care rise to the level of gross negligence before finding that representation in the original litigation was inadequate.69 It may be helpful, however, to identify in a more granular way how a lack of adequate care might be identified, as follows. 4.3.1.1  Quality of the pleadings    In determining if counsel in the original suit exercised adequate care, the court might consider the degree to which the complaint in the subsequent suit differs from the complaint in the previous suit. This is especially relevant in a derivative case subject to a heightened pleading standard that requires particularized facts. If there are appreciable differences between the two complaints regarding the factual allegations (that is, materially stronger allegations that could have been made in the original complaint), then this factor weighs against preclusion. But if the subsequent complaint sets forth essentially the same facts that were considered insufficient in the original proceeding, then the subsequent court may be able to infer that preclusion is appropriate.70 Similarly, if the pleadings and other submissions in the original proceeding exhibit sloppiness, then this factor may weigh against preclusion in varying degrees, depending on how egregious and material the errors were.71 4.3.1.2  Absence of meaningful discovery efforts   The presence or absence of meaningful discovery efforts indicates whether counsel adequately represented the class or ­corporation.72 This includes both presuit investigations, such as the employment of statutory inspection rights, and postsuit discovery through interrogatories, demands for production, and depositions. The failure to use the “tools at hand” (that is, statutory

negotiated by representatives” in various fiduciary relationships, including trustee/beneficiary and agent/principal relationships). 69   See supra note 66. 70   See Laborers’ Dist. Council Constr. Indus. Pension Fund v. Bensoussan, 2016 WL 3407708, at *12 (Del. Ch. June 14, 2016) (discussing plaintiffs’ claims that unsuccessful counsel in the prior litigation was inadequate, in part because they plagiarized in their complaint, and observing that the factual allegations raised in the subsequent complaint were essentially the same). 71   This factor is not intended to replace other established exceptions to res judicata and collateral estoppel recognizing that new facts that create new issues negate the preclusive effect of a prior judgment. See, e.g., 50 C.J.S. Judgments § 1061, at 423 (2009) (discussing “new facts” and suggesting that new facts will preclude collateral estoppel if they “alter the legal rights or relations of the litigants”); see also In re Duke Energy Corp. Derivative Litig., 2016 WL 4543788, at *11–13 (Del. Ch. Aug. 31, 2016) (giving prior dismissal preclusive effect under collateral estoppel to overlapping issues involving waste, but declining to do so as to bad faith claims not litigated or dismissed in the prior dismissal). 72   See, e.g., In re Revlon, Inc. S’holders Litig., 990 A.2d 940, 945 (Del. Ch. 2010) (finding that counsel was inadequate, in part, because they “did not even bother to serve discovery”); Johnson v. Shreveport Garment Co., 422 F. Supp. 526, 535 (W.D. La. 1976) (“[C]lass counsel owes a greater duty to absent clients than to those who are present. Counsel must undertake substantial discovery to preserve testimony in favor of the class, to rebut possible claims by the parties adverse to the class, and to impeach opposing witnesses”).

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Forum shopping in the bargain aisle  169 inspection rights) before filing suit may be an indication that counsel was inadequate. And in a case (such as a case asserting Caremark oversight claims) in which only damages are sought, there is rarely ever a need for haste in filing a derivative complaint, and a failure to pursue inspection rights to bolster the complaint is particularly forceful evidence that counsel was inadequate. In cases involving a preclusive settlement, the fact that counsel failed to make basic discovery demands (and amend the complaint if necessary, depending on what was uncovered in discovery) before entering into a settlement is something that should weigh against preclusion. 4.3.1.3  Failure to seek appellate review    The fact that counsel failed to seek appellate review of an assertedly preclusive judgment may indicate that representation was less than adequate. There may be legitimate reasons for not taking an appeal, but if the subsequent court cannot conceive of any downside associated with doing so, then this factor would weigh against preclusion. Moreover, this factor should be accorded greater weight where counsel may not have appealed because it “st[ood] to earn a substantial fee immediately by not appealing, [and had to] wait for payment and expend additional effort” to pursue an appeal.73 4.3.2  Other considerations in evaluating adequacy of representation Indicia of lack of care are not the only bases or “badges” for evaluating adequacy of representation. Other considerations might include the following. 4.3.2.1  Timing and investment   The importance of issue or claim preclusion ought to increase as the amount invested in the judgment increases, so that a judgment after discovery and trial ought to be given preclusive effect much more readily than where a defendant invests relatively little in securing a judgment, as on a motion to dismiss or through a settlement early in the proceedings.74 In contrast, if the complaint was filed and the case resolved (by settlement or dismissal) in an unusually rapid manner, a court could conclude that defendants’ claim of reliance on preclusion is less persuasive. The Delaware courts have all but acknowledged as much in the context of M&A litigation,75 and federal courts have done the same.76

  Macey & Miller 1991, p.43.   See Pelt v. Utah, 539 F.3d 1271, 1286 (10th Cir. 2008) (noting that res judicata was appropriate in an earlier case in part because “the fact that the prior litigation had gone on for seven years was evidence in itself that it was a hard fought contest”). Another way to look at this is to ask how many procedural “screens” the original litigation passed through before it was dismissed (Cox 2017/2018). 75   See, e.g., In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 887, 898 (Del. Ch. 2016) (declining to approve disclosure settlement where defendants were to receive a broad release of claims and plaintiffs’ counsel was to receive a fee, but the stockholders would not receive any material benefit, and recognizing “‘the risk of buy off’ of plaintiffs’ counsel”); In re Revlon, Inc. S’holders Litig., 990 A.2d 940, 945, 956 (Del. Ch. 2010) (discussing “the Cox Communications Kabuki dance” where fast filing plaintiffs file an inadequate complaint and defendants intentionally keep it alive to support a preclusive settlement). 76   See, e.g., In re Walgreen Co. S’holder Litig., 832 F.3d 718, 721 (7th Cir. 2016) (“[A]lmost all [disclosure strike] suits are designed to end—and very quickly too—in a settlement in which class 73 74

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170  Research handbook on representative shareholder litigation 4.3.2.2 The existence of a meaningful check on adequacy of representation in the original litigation   Assertedly preclusive judgments arise through a variety of procedures. Some of those procedures offer built-in checks and assurances of adequate representation. For example, where lead counsel is appointed through a competitive evaluation process, a court in subsequent litigation ought to be more inclined to afford preclusive effect to the judgment in the original litigation than where the lead counsel appointment is uncontested or not given significant judicial attention. Similarly, the court in subsequent class action litigation should consider the extent to which the court in the original litigation evaluated class certification and the adequacy of the class representative (and class counsel). And where the judgment is entered in connection with a settlement, the court in the subsequent litigation should take into account the significance of any opportunity to object to the settlement and question the adequacy of representation.77 In contrast, a dismissal arising solely upon defendants’ motion seems less likely to provide an opportunity for a contemporaneous check on adequacy of representation, and the court in the subsequent litigation should have greater room to inquire into that subject. A further check on adequacy of representation is the opportunity to intervene as a plaintiff. If that option is available but not exercised, a court in subsequent litigation may be less inclined to find the original representation inadequate.78 If the court, the other plaintiffs, or the defendants frustrate these efforts, then this factor weighs against preclusion. 4.3.2.3  Choice of forum    If defendants could have invoked an exclusive forum provision to dismiss the original litigation but chose to waive the provision, a court in subsequent litigation could infer, absent a showing of justification, that defendants’ departure from the forum choice provision was intended to achieve a litigation advantage at the expense of the class or the corporation.79 In certain cases, courts could expand this factor and find that not having a forum selection bylaw is equivalent to waiving one.80 counsel receive fees and the shareholders receive additional disclosures concerning the proposed transaction. The disclosures may be largely or even entirely worthless to the shareholders, in which event even a modest award of attorneys’ fees ($370,000 in this case) is excessive and the settlement should therefore be disapproved by the district judge”). 77   Forsythe v. ESC Fund Mgmt. Co. (U.S.), Inc., 2012 WL 1655538 (Del. Ch. May 9, 2012) (granting objectors an opportunity to “bond” the settlement and take over the case to pursue a larger recovery). Conversely, there may be evidence that absentee shareholders were satisfied with the original representatives, such as an “anti-objection” letter indicating that representatives were adequate. See Letter from Mark F. Turk to Delaware Court of Chancery, Chen v. HowardAnderson, C.A. No. 5878-VCL (Del. Ch. Aug. 8, 2016). 78   See Wal-Mart II, 2017 WL 239364, at *4 (Del. Jan. 18, 2017), remanding on other grounds Wal-Mart I, 2016 WL 2908344 (Del. Ch. May 13, 2016). 79   See sources cited in note 24, supra. 80   Sophisticated corporate boards and their advisors know how to, and do, create forum selection bylaws easily, and not doing so may be akin to deciding not to invoke such a provision that is already in place. It is possible that directors who fail to create such a bylaw are motivated by the possibility of obtaining cheap settlements and broad releases in jurisdictions outside Delaware. See Griffith 2017 (discussing this issue and how every Delaware corporation should be regarded as having a “shadow” exclusive forum bylaw).

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Forum shopping in the bargain aisle  171 4.3.2.4  Benefits conferred through settlement   Courts asked to give preclusive effect to a prior judgment in a settlement of shareholder litigation should review the terms of the settlement to compare the benefits conferred on the class or corporation with the benefits conferred on counsel, and to assess the benefits conferred on defendants. The fact that original counsel received a large fee for achieving a relatively modest benefit is an indication that counsel inadequately represented the class or corporation. Conversely, if the fee awarded is proportionate to the benefits conferred on those being represented, then this would weigh in favor of preclusion, so long as the claims released in the settlement were reasonably related to the claims presented.81 Similarly, a court in subsequent litigation should examine the scope of any release given in settlement of the original litigation: the more comprehensive the release and the less tailored it was to the claims actually presented, the greater the reason to infer awareness on the defendant side that plaintiffs’ counsel in the original litigation did not adequately represent the interests of absent shareholders.82

5.  INTERPRETING THE RESTATEMENT To the extent that a court must apply the Restatement framework in a particular case, it may interpret that framework in a way that incorporates aspects of the alternative framework set forth in this chapter. In derivative cases asserting Caremark claims where the only remedy sought is damages and there is therefore little or no time pressure (indeed, the harm complained of may have not even occurred at the time suit is filed), the failure to make a presuit demand for books and records should be considered gross negligence unless substantially all of the information that could have been obtained through the exercise of statutory inspection rights was obtained through some other method. This is consistent with Comment f, as it takes into account a variety of case-specific facts (such as nature of the claim, timing, discovery efforts), including the defendants’ reliance interests, and it avoids due process issues when they are at their most palpable.83 As to the defendants’ reliance interests specifically, the reviewing court may interpret the Restatement in a way that allows it to give greater weight to how and what stage the

81   Settlement Hearing Transcript, Acevedo v. Aeroflex Holding Corp., C.A. No. 7930-VCL, at 63 (Del. Ch. July 8, 2015); see also Friedlander 2016, p.910 (“So long as it is commonplace for stockholder plaintiff counsel to recommend the exchange of a global release for supplemental disclosures, regardless of whether the sale process was pristine or problematic, stockholder litigation loses its deterrent effect. Transactional lawyers in negotiated acquisitions have less clout over their clients and other deal participants to police the integrity of fiduciary decision-making”). 82   See In re Trulia, Inc. S’holder Litig., 129 A.3d 884, 898 (Del. Ch. 2016) (“[P]ractitioners should expect that disclosure settlements are likely to be met with continued disfavor in the future unless . . . the subject matter of the proposed release is narrowly circumscribed”); In re Revlon, Inc. S’holders Litig., 990 A.2d 940, 945, 956 (Del. Ch. 2010) (finding that counsel who negotiated “a broad, transaction-wide release” was inadequate); see also Hesse v. Sprint Corp., 598 F.3d 581, 589–92 (9th Cir. 2010) (holding on collateral review that overbroad release in consumer class action was not preclusive). 83   See supra note 66.

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172  Research handbook on representative shareholder litigation case was settled or dismissed. So if defendants secure a quick dismissal or cheap settlement by waiving an exclusive forum bylaw, the court may draw an inference of either collusion or awareness of grossly deficient prosecution if the record, viewed as whole, warrants such an inference.84 In such a situation, the court is taking into account the timing and investment, the existence of meaningful checks, the choice of forum, and the benefits conferred on the class or corporation.

6.  CONCLUSION As a result of “feckless fast filers,” whose substandard litigation strategies are encouraged in multiforum litigation, stockholders and corporations face a real threat of having legitimate claims precluded by cheap settlements and dismissals. To combat this threat, they are increasingly arguing that counsel in the original forum provided inadequate representation. Although courts have been open to these challenges, there has yet to emerge a doctrine that allows them to effectively police the fast-filer problem. We propose that the courts adopt a “totality of the circumstances” approach that is more flexible than a fast-filer presumption and allows for more scrutiny than the current Restatement framework. Moreover, by considering several specific “badges of inadequacy,” the courts have concrete guideposts to aid in working through adequacy challenges that arise. But if a court must apply the Restatement, the court may interpret it in a manner that incorporates aspects of the alternative framework set forth above.

7.  ADDENDUM Since this chapter was written, the Delaware Court of Chancery issued a second ­opinion85 and the Delaware Supreme Court issued its final decision.86 On remand, the Court of Chancery recommended that the Delaware Supreme Court adopt a new approach for analyzing collateral estoppel arguments in derivative litigation. The Delaware Supreme Court rejected that recommendation and affirmed the Court of Chancery’s original decision. After the plaintiffs appealed the first decision addressing preclusion (the one which this chapter examines), the Delaware Supreme Court remanded the case back to the Court of Chancery for it to answer this question:

84   For collusion see Restatement (Second) Judgments § 42(e) cmt. f (providing that preclusion is not proper when the representative “seeks to further his own interest at the expense of the represented person”). Of course, the fact that defendants have successfully argued that the case should be dismissed at the pleading stage is not, in and of itself, a sufficient basis for inferring inadequate representation. The party arguing that the prior representation was inadequate must point to facts in the record demonstrating that counsel’s shortcomings or improper motivations materially contributed to dismissal at the pleading stage. 85   In re Wal-Mart Stores, Inc. Del. Derivative Litig., 167 A.3d 513 (Del. Ch. 2017) (“Wal-Mart III”). 86   Cal. State Teachers’ Ret. Sys. v. Alvarez, 179 A.3d 824 (Del. Jan. 25, 2018) (“Wal-Mart IV”).

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Forum shopping in the bargain aisle  173 In a situation where dismissal by the federal court in Arkansas of a stockholder plaintiff’s derivative action for failure to plead demand futility is held by the Delaware Court of Chancery to preclude subsequent stockholders from pursuing derivative litigation, have the subsequent stockholders’ Due Process rights been violated? See Smith v. Bayer Corp., 564 U.S. 299 (2011).87

The motivation for the Supreme Court’s question was an earlier Court of Chancery Decision, In re EZCORP. In that decision, the court ruled on three separate bases that an order dismissing a derivative complaint for failure to allege demand futility could not preclude later derivative suits over the same claims—one of those bases was due process.88 The EZCORP court relied on Smith v. Bayer Corp., 564 U.S. 299 (2011), and analogized orders dismissing derivative complaints under Rule 23.1 to orders refusing to certify a class under Rule 23.89 In both situations, stockholders seek to represent others but are denied the opportunity to do so. Thus, any such preliminary dismissal will not bind absent stockholders because “the very ruling that [the defendant] argues ought to be given preclusive effect is the decision that a class could not be properly certified” or that a derivative plaintiff lacked standing.90 Contrary arguments face a paradox—that is, the preclusive order denied a stockholder the opportunity to represent the class or corporation, but absentees are bound because that stockholder represented the class or corporation. The Court of Chancery, in its most recent opinion, recommended that the Supreme Court adopt the rule in EZCORP, which provides that federal due process “prevents a judgment from binding the corporation or other stockholders in a derivative action until the action has survived a Rule 23.1 motion to dismiss, or the board of directors has given the plaintiff authority to proceed by declining to oppose the suit.”91 The Chancellor provided three reasons for his recommendation: “(1) the similarities between class actions and derivative actions, (2) some of the realities of derivative litigation, and (3) public policy considerations.”92 In essence, the court reasoned that a “purported derivative action” that does not survive a Rule 23.1 dismissal “is no more a representative action than the proposed class action in Bayer that was denied certification”93 and that the approach in EZCORP will better curb the ill effects of the fast-filer problem than the current system of reviewing for grossly negligent representation after the fact.94 If the Delaware Supreme Court adopted the EZCORP rule, stare decisis would have taken the place of claim or issue preclusion when deciding whether to dismiss derivative complaints filed after an initial dismissal for failure to allege demand futility or wrongful refusal.95 In other words, a dismissal pursuant to a Rule 23.1 motion would have persuasive as opposed to preclusive effect. After receiving the Court of Chancery’s recommendation, the Delaware Supreme

  Wal-Mart II, 2017 WL 239364, at *8 (Del. Jan. 18, 2017).   In re EZCORP Inc. Consulting Agreement Derivative Litig., 130 A.3d 934, 942–49 (Del. Ch. 2016). The other two bases were Court of Chancery Rule 15(aaa) and Delaware substantive law. Ibid at 942–46. 89   Ibid at 947–49. 90   See Bayer, 564 U.S. at 314. 91   Id. at 948. 92   Wal-Mart III, 167 A.3d 513, 525 (Del. Ch. 2017). 93   Ibid at *12. 94   Ibid at *13. 95   See Bayer, 564 U.S. at 317; Taylor v. Sturgell, 553 U.S. 880, 903–04 (2008). 87 88

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174  Research handbook on representative shareholder litigation Court issued its final decision rejecting the recommendation and affirming the Court of Chancery’s original decision. Like the Court of Chancery, the Supreme Court applied Arkansas and federal common law in analyzing whether issue preclusion was appropriate.96 After concluding that the Arkansas judgment had satisfied the core elements for issue preclusion, the Court addressed the adequacy of representation requirement “as part of the federal Due Process overlay”97 and noted, “the evaluation of the adequacy of the prior representation becomes the primary protection for the Due Process rights of subsequent derivative plaintiffs.”98 The Court applied the same Restatement framework as the Court of Chancery in its original decision and ultimately concluded that “the Arkansas Plaintiffs were adequate representatives.”99 Importantly, as to the care prong of the Restatement analysis, the Court held that “the Arkansas Plaintiffs’ decision to forgo a Section 220 demand in this instance does not rise to the level of constitutional inadequacy”100 but noted that it may have been “a closer call if the Arkansas Plaintiffs had not obtained any documents, particularly since the complaints were focused on state-law Caremark claims.”101

BIBLIOGRAPHY Barstow, David (2012) “Vast Mexico Bribery Case Hushed Up by Wal-Mart After Top-Level Struggle,” New York Times, available at www.nytimes.com/2012/04/22/business/at-wal-mart-in-mexico-a-bribe-inquirysilenced.html?pagewanted=all&_r=0. Blank, Joshua D. and Zacks, Eric A. (2005) “Dismissing the Class: A Practical Approach to the Class Action Restriction on the Legal Services Corporation,” Penn State Law Review vol. 110 pp.1–39. Clopton, Zachary D. (2015) “Transnational Class Actions in the Shadow of Preclusion,” Indiana Law Journal vol. 90 pp. 1387–1428. Cox, James D., “Addressing the ‘Baseless’ Shareholder Suit: Mechanisms and Consequences,” in The Elgar Handbook for Representative Shareholder Litigation, Jessica Erickson et al. eds (2018). Davis, Kenneth B. Jr (2008) “The Forgotten Derivative Suit,” Vanderbilt Law Review vol. 61 pp.387–451. Frankel, Alison (2015) “How Corporations Can Game Their Own Forum Selection Clauses,” Reuters, available at http://blogs.reuters.com/alison-frankel/2015/11/17/how-corporations-can-game-their-own-forum-selectionclauses/. Friedlander, Joel Edan (2016) “How Rural/Metro Exposed the Systemic Problem of Disclosure Settlements,” Delaware Journal of Corporate Law vol. 40 pp.887–919. Griffith, Sean J. (2017) “Private Ordering Post-Trulia: Why No Pay Provisions Can Fix the Deal Tax and Forum Selection Provisions Can’t,” in The Corporate Contract in Changing Times (Steven Davidoff Solomon & Randall S. Thomas eds) Griffith, Sean and Rickey, Anthony (2018) “Troubling Patterns in Merger Litigation Post-Trulia and How Delaware Courts Can Correct Them,” in The Elgar Handbook for Representative Shareholder Litigation, Jessica Erickson et al eds.

  Wal-Mart IV, 179 A.3d 824, 841–42, 850 (Del. Jan. 25, 2018).   Ibid. at 849.  98  Ibid.  99   Ibid. at 852–55. 100   Ibid. at 854 (emphasis in original). 101   Ibid. at 853 (emphasis in original). The Court also noted “the equities may not favor the Delaware Plaintiffs here” because they failed to “coordinate with the Arkansas Plaintiffs” or “express their concerns to the Arkansas court.” Ibid. at 832 n.29. As of the completion of this chapter, the Delaware plaintiffs filed a petition for a writ of certiorari with the U.S. Supreme Court, on which no action had been taken.  96  97

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Forum shopping in the bargain aisle  175 Kraakman, Reinier et al. (1994) “When Are Shareholder Suits in Shareholder Interests?” Georgetown Law Journal vol. 82 pp.1733–75. Lipton, Ann (2016) “Delaware’s Vulnerability,” Business Law Prof Blog, available at http://lawprofessors. typepad.com/business_law/2016/05/delawares-vulnerability.html. Macey, Jonathan R. and Miller, Geoffrey P. (1991) “The Plaintiffs’ Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform,” University of Chicago Law Review vol. 58 pp. 1–118. McLaughlin on Class Actions vol. 1 § 4:29. Micheletti, Edward B. and Parker, Jenness E. (2012) “Multi-Jurisdictional Litigation: Who Caused This Problem, and Can It Be Fixed?” Delaware Journal of Corporate Law vol. 37 pp.1–47. Myers, Minor (2014) “Fixing Multi-Forum Shareholder Litigation,” University of Illinois Law Review vol. 2014 pp.467–551. Regan, Paul L. (1999) “Great Expectations? A Contract Law Analysis for Preclusive Corporate Lock-Ups,” Cardozo Law Review vol. 21 pp.1–119. Rubenstein, William B. (2001) “A Transactional Model of Adjudication,” Georgetown Law Journal vol. 89 pp.371–438. Strine, Leo E. Jr et al. (2013) “Putting Stockholders First, Not the First-Filed Complaint,” Business Lawyer vol. 69 pp. 1–78. Charles Alan Wright et al., Federal Practice & Procedure vol. 18A § 4455 (2d ed.) (Westlaw database updated Apr. 2016).

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11.  Limiting litigation through corporate governance documents Ann M. Lipton*

1. INTRODUCTION For almost as long as it has existed, shareholder litigation (namely, claims brought by shareholders against corporate managers, under either state or federal law) has been viewed as vexatious and potentially frivolous, to a degree that surpasses the annoyances posed by other kinds of lawsuits.1 The chief complaint is that such lawsuits are lawyerdriven—in the sense that attorneys identify the cases and control the litigation, aided by nominal plaintiffs with little real stake in the dispute—alleging misconduct based on nothing more than a stock price drop (or, more recently, the announcement of a merger). In response, courts and legislators have erected various barriers to shareholder claims, developing both substantive and procedural law to facilitate quick dismissals and minimize discovery burdens in the early stages of a case.2 Though these efforts have made it far easier to dismiss claims outright, complaints continue that too many frivolous cases are filed, and that even litigating the motions to dismiss can be expensive and burdensome for defendants. As a result, there has been a surge of interest in “private ordering” solutions that would bar the courthouse door at the outset, either by deterring lawsuits in the first instance, or by allowing dismissals without any time-consuming inquiry into the merits of the claim. These come in the form of amendments to the corporation’s governing documents—its charter or its bylaws—to place procedural preconditions on shareholders’ ability to bring litigation. The most popular type of provision has been the forum selection clause, limiting lawsuits to the courts of a particular jurisdiction (Romano & Sanga 2015); other provisions that have been imposed include arbitration requirements,3

*  Thanks so much to Jim Cox, Onnig Dombalagian, Jessica Erickson, Sean Griffith, Thomas E. Rutledge and the participants in the Fourth Annual Corporate & Securities Litigation Workshop. 1   Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975); Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541 (1949). 2   See, e.g., The Private Securities Litigation Reform Act of 1995, Pub. L. 104–67, 109 Stat. 737 (imposing substantive and procedural requirements on plaintiffs bringing federal securities claims); In re Revlon, Inc. S’holders Litig., 990 A.2d 940, 960 (Del. Ch. 2010) (“The ability of defendants to challenge the legal sufficiency of representative actions on the pleadings, whether for compliance with Rule 23.1 or by invoking the protections of the business judgment rule, helps limit the degree to which entrepreneurial plaintiffs can litigate on a volume basis”); Del. Code Ann. tit. 8, § 102(b)(7) (2016) (permitting corporations to eliminate directors’ monetary liability for gross negligence). 3   Corvex Mgmt. LP v. CommonWealth REIT, No 24-C-13-001111, 2013 WL 1915769 (Cir. Ct. Balt. City May 8, 2013).

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Limiting litigation  177 fee shifting to require that losing plaintiffs pay defendants’ attorneys’ fees,4 and minimum stake requirements.5 The policy rationale behind these proposals is that frivolous shareholder litigation damages the very class of persons it purports to protect; that is, it increases costs to corporations and thus indirectly to shareholders themselves (Winship 2016). As a result, privately adopted litigation limits benefit shareholders and will be valued in the marketplace. Moreover, the market itself can serve as a corrective mechanism, so that litigation-limiting provisions adopted in defiance of shareholders’ preferences will result in a devaluation of the stock, thus facilitating management’s ouster (Henderson & Pritchard 2014; Weitzel 2013). Legally, the enforceability of litigation limits rests on the metaphor of a corporation as a contract among shareholders, or between shareholders and the corporation (Geis 2016). Ordinary contracts for similar limitations on litigation are enforced by courts even when the substantive right underlying the claim cannot be waived;6 thus, proponents of litigation limits in corporate governance documents argue that corporate contracts should receive the same treatment (Grundfest & Savelle 2013).7 In this chapter, I recount the history of proposals for litigation limits and the current state of the law. I then discuss some of the doctrinal and policy questions that have been raised regarding the wisdom of different types of litigation limits and the propriety of private ordering in this context. In particular, I explore how corporate managers’ structural and informational advantages may make litigation limits easy to abuse; moreover, litigation itself serves public purposes that may be more appropriately subject to public control.

2. HISTORY The call for privately ordered litigation limits came about gradually, in response to a variety of pressures. Originally, critics of abusive state law derivative litigation proposed that arbitration clauses be inserted into corporate charters (for example, Shell 1989). It was argued that arbitration would be faster and cheaper than judicial resolution, thus curbing some of the potential for misuse. The charter was deemed to be the appropriate location for such provisions, because charter amendments (unlike bylaws) would require shareholder consent to adopt, and shareholders could be placed on notice of the provision in their stock certificates. As the Supreme Court demonstrated increasing willingness to enforce arbitration clauses in a variety of contexts,8 proposals expanded to cover claims under the federal

  ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014).   Rothenberg v. Goldstein, No 9:15-cv-80505-KLR (S.D. Fla. filed Apr. 20, 2015) (challenging a bylaw that required the written consent of at least 3 per cent of shares before derivative or representative litigation could be filed). 6   The Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972); Shearson/Am. Express v. McMahon, 482 U.S. 220 (1987). 7   Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934, 957 (Del. Ch. 2013). 8   See Doctor’s Assocs., Inc. v. Casarotto, 517 U.S. 681 (1996); Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006); Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (1991). 4 5

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178  Research handbook on representative shareholder litigation securities laws. Proponents continued to advocate either that such provisions be approved by shareholders,9 or that they be included in the corporation’s governing documents at the initial public offering stage so that any public shareholder would be on notice prior to purchase (Schneider 1990). These proposals did not gain traction, however, due to doubts about their legality. The SEC took the position that arbitration clauses constituted an impermissible waiver of substantive federal rights (Schneider 1990; Weiss et al 2012), and there was no indication whether states would recognize these provisions as binding on shareholders. Beginning in 2002, a new problem arose: multijurisdictional litigation (Winship 2016). Several years earlier, Congress had imposed onerous procedural limitations on federal securities claims.10 Shortly thereafter, the dominant plaintiffs’ securities firm split in two, and one of the surviving halves collapsed in a kickback scandal. Suddenly, newer and smaller plaintiffs’ firms were competing for cases, and they increasingly did so by challenging mergers as unfair to target shareholders (Coffee 2012). Brought as class actions under state law, they were not subject to the daunting procedural hurdles of either state law derivative litigation or federal securities litigation. By 2014, between 85 percent and 95 percent of all mergers in excess of $100 million were attacked as unfair (Griffith & Rickey, Chapter 9 of this volume) and, as plaintiffs’ firms jockeyed for control of litigation, frequently multiple challenges to the same merger were lodged in different jurisdictions around the country (Cosenza 2016). This litigation, it was argued, exponentially increased the burden on defendant corporations (Grundfest & Savelle 2013), while encouraging competing plaintiffs’ attorneys to cheaply sell out the class.11 Moreover, the jurisdictional competition meant that more corporate governance claims were being resolved outside of Delaware, the state long recognized as expert in the field of corporate law. In In re Revlon, Inc. Shareholders Litigation,12 Vice Chancellor Laster suggested that the problem could be solved with charter provisions limiting intraentity claims—claims governed by the internal affairs doctrine13—to a single forum. Immediately, forum selection provisions began to proliferate, usually added to charters at the pre-IPO stage, or taking the form of manager-adopted bylaws in companies that were already publicly traded (Romano & Sanga 2015). Thus, the provisions were mostly adopted in a manner that avoided the need for public shareholder approval. The legality of these provisions was finally tested in the Delaware case of Boilermakers Local 154 Retirement Fund v. Chevron Corporation.14 There, director-enacted bylaws required that all intracorporate disputes be litigated in a Delaware forum.15 Stockholders  9   See Comm. On Capital Mkts., Interim Report 72, 74–84 (2006), http://capmktsreg. org/app/uploads/2014/08/Committees-November-2006-Interim-Report.pdf; Scott & Silverman 2013. 10   The Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737; The Securities Litigation Uniform Standards Act of 1998, Pub. L. 105-353, 112 Stat. 3227. 11   In re Revlon, Inc. Shareholders Litigation, 990 A.2d 940, 945. 12   990 A.2d 940, 960 (Del. Ch. 2010). 13   Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934, 952 & n.78, 960 n.129 (Del. Ch. 2013). 14   73 A.3d 934 (Del. Ch. 2013). 15   Ibid at 942.

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Limiting litigation  179 claimed that the bylaws exceeded directors’ powers under the Delaware Code and could not bind shareholders who had not explicitly agreed to them. Then-Chancellor Strine rejected the stockholders’ claims and upheld the bylaws as facially valid. First, Strine reasoned that because the bylaws only concerned internal affairs claims, they represented a reasonable regulation of stockholders’ rights, and thus fell within directors’ statutory authority.16 Strine also rejected the argument that stockholders had not assented to the bylaws and thus could not be contractually bound, holding that by purchasing stock in Delaware corporations, stockholders “assent[] to a contractual framework . . . that explicitly recognizes that stockholders will be bound by bylaws adopted unilaterally by their boards.”17 Strine recognized that there might be situations where application of a forum selection bylaw would be unfair or inequitable, but held that this fact alone would not justify invalidating the bylaw on its face. Rather, directors would be expected to waive the bylaw in good faith when it would work an injustice and, if they did not, a court could refuse to enforce the bylaw as either unreasonable contractually, or as an improper exercise of directors’ fiduciary responsibilities.18 Shortly after Boilermakers, the Delaware Supreme Court decided ATP Tour, Inc. v. Deutscher Tennis Bund, involving a certified question from a federal district court.19 The issue was the legitimacy of a management-enacted bylaw of a nonstock corporation that required the plaintiff to pay the defendants’ attorneys’ fees and expenses for any claim where the plaintiff did not “obtain a judgment on the merits that substantially achieve[d], in substance and amount, the full remedy sought.”20 The bylaw had two unusual features: first, it purported to apply to any claims brought against other members or the corporation itself, regardless of the subject matter—indeed, the reason for certification was concern over the bylaw’s application to antitrust claims21—and second, it purported to bind not only members, but also third parties who provided “substantial assistance” to members.22 The Delaware Supreme Court upheld the bylaw en banc. Elaborating on Boilermakers, the court held that even though corporate directors are authorized to adopt litigationlimiting bylaws, they are still prohibited from either passing such a bylaw in the first instance, or invoking it in a particular case, for an “improper purpose” in violation of their fiduciary duties.23 The mere fact that the directors intended to deter litigation, however, would not be considered improper.24 Strikingly, not only did the court ignore that the bylaw applied to nonmembers, but it also appeared confused as to its scope. Specifically, the court upheld feeshifting for intracorporate claims,25 even though the ATP bylaw extended much farther.26  Ibid at 950–51.   Ibid at 956. 18   Ibid at 958. 19   91 A.3d 554 (Del. 2014). 20   Ibid at 556. 21   Deutscher Tennis Bund v. ATP Tour, Inc., 480 F. App’x 124 (3d Cir. 2012). 22   ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 556 (Del. 2014). 23   Ibid at 559–60. 24  Ibid at 560. 25   Ibid at 557.­ 26   Justice Ridgely, a member of the Delaware Supreme Court at the time of ATP, later 16 17

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180  Research handbook on representative shareholder litigation Following ATP, corporations flocked to adopt their own versions of feeshifting bylaws (Sjostrom 2015), while commenters advocated for their use for securities claims as well as state law governance litigation (Bainbridge 2014). Meanwhile, in a series of related cases, courts in Massachusetts and Maryland upheld an arbitration bylaw adopted by a Real Estate Investment Trust organized under Maryland law.27 A Florida corporation’s bylaw imposing a 3 percent ownership requirement on any shareholder seeking to bring derivative or representative claims was challenged as a violation of the directors’ fiduciary duties, though the lawsuit was eventually dropped.28 A Delaware corporation adopted, and then discarded, a bylaw that limited plaintiffs’ ability to recover fees and expenses in stockholder lawsuits.29 The final act in the drama occurred in August 2015, when the Delaware legislature amended the Delaware General Corporate Law to address litigation limits. New statutory provisions explicitly permitted forum selection clauses to be inserted either into the bylaws or the charter,30 but overruled ATP by prohibiting the inclusion of feeshifting provisions.31 The amendments also prohibited any forum selection provisions that would bar access to Delaware courts32—thus barring the exclusive selection of either a non-Delaware forum (as at least one company successfully accomplished in the wake of Boilermakers33) or an arbitral forum. However, the amendments only addressed “internal corporate claims,” leading to speculation that they did not extend to limits on other types of claims, like federal securities litigation (Bainbridge 2016; Coffee 2015).34 In 2017, several companies went public with forum selection provisions in their charters that purported to govern claims brought under the federal Securities Act of 1933.35 As this

­ elivered an address affirming that ATP’s holding was confined to internal affairs claims. d See Henry duPont Ridgely, Justice, The Supreme Court of Del., Keynote Address at the Southern Methodist University Dedman School of Law Corporate Counsel Symposium: The Emerging Role  of Bylaws in Corporate Governance (31 Oct. 2014) (transcript available at www.­delawarelitigation.com/files/2014/11/The_Emerging_Role_of_Bylaws_in_Corporate_ Governance-​copy.pdf). 27   Del. Cnty. Emps. Ret. Fund v. Portnoy, 2014 WL 1271528 (D. Mass. Mar. 26, 2014); Katz v. CommonWealth REIT, No 24-C-13-001299 (Cir. Ct. Balt. City Aug. 31, 2015); Corvex Mgmt. LP v. CommonWealth REIT, 2013 WL 1915769 (Cir. Ct. Balt. City May 8, 2013). 28   Order, Rothenberg v. Goldstein, No 9:15-cv-80505-KLR (S.D. Fla. filed Sept. 10, 2015). Unusually, the directors sought and obtained shareholders’ ‘advisory’ approval of the bylaw after its adoption. See Complaint ¶12, Rothenberg v. Goldstein, No 9:15-cv-80505-KLR (S.D. Fla. filed Apr. 20, 2015). 29   Sydelle Guardino v. StemCells, Inc., et al., C.A. No 12266, compl. (Del. Ch. Apr. 27, 2016). 30   Del. Code Ann. tit. 8, § 115 (2016). 31   Del. Code Ann. tit. 8, §§ 102(f), 109(b) (2016). 32   Del. Code Ann. tit. 8, § 115 (2016). The Model Business Corporation Act (MBCA) was subsequently amended to include similar forum selection provisions. See MBCA § 2.08 (2016). Kentucky, interestingly, granted corporations the right to mandate a Kentucky forum, but only in the articles of incorporation. See KRS §§ 271B.7-400(7); 271B.1-400(1) (2016). 33   City of Providence v. First Citizens Bancshares, Inc., 99 A.3d 229 (Del. Ch. 2014). 34   Moving in the opposite direction, Oklahoma—home to few public corporations—amended its corporate code to require that the losing party pay the prevailing party’s attorneys’ fees in all derivative actions. See 18 Okl. St. § 1126 (2016). 35   See Blue Apron Holdings, Registration Statement (June 28, 2017), https://www.sec.gov/ Archives/edgar/data/1701114/000104746917004287/a2232570zs-1a.htm; Stitch Fix, Inc., Registration

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Limiting litigation  181 publication goes to press, a lawsuit is pending in Delaware Chancery seeking a declaratory judgment that articles of incorporation cannot extend to govern the conduct of federal claims.36 A decision is not expected until late 2018 or early 2019. In sum, proposals to limit shareholder litigation through private ordering have mutated over time. Initially rooted firmly in shareholder approval, they were later deemed to be an inherent aspect of management power to which shareholders implicitly assented merely by virtue of their investment. Though they were once limited to arbitration of derivative claims (or at least claims governed by the internal affairs doctrine), eventually proponents sought to expand them to cover different types of claims, and to impose a variety of procedural limitations.

3.  CONTINUING DOCTRINAL AND POLICY QUESTIONS 3.1  Should Litigation Limits Be Considered Matters of Corporate Internal Affairs? One fundamental question raised by litigation limits is the extent to which they may be deemed to concern corporate internal affairs, such that the law of the state of incorporation determines their enforceability—and, relatedly, how broadly such provisions may extend. The internal affairs of a corporation are the rules regarding the balance of power between investors, officers, and directors (DeMott 1985; Ribstein & O’Hara 2008). Corporate internal affairs are governed by the law of the chartering state, regardless of where the corporation conducts business or where the investor resides. Boilermakers concluded that forum selection bylaws concern corporate internal affairs when they apply to claims governed by the internal affairs doctrine because such lawsuits go to the heart of the relationship between stockholders and managers. As the court put it: bylaws would be [improperly] regulating external matters if the board adopted a bylaw that purported to bind a plaintiff, even a stockholder plaintiff, who sought to bring a tort claim against the company based on a personal injury she suffered that occurred on the company’s premises or a contract claim based on a commercial contract with the corporation.37

This conclusion is not without weaknesses. Litigation limits concern the civil procedural rules that are used to maintain an action, whereas the internal affairs doctrine has been traditionally understood to concern the substance of the claim itself (Brown 2015). Moreover, in ordinary contracts, the enforceability of forum selection clauses is first tested not by reference to the law that governs the contract as a whole, but by reference to the law of the court in which the claim is brought, in part to allow the selected jurisdiction to maintain control over its docket (Clermont 2015). But looking first to local law, Statement (Nov. 6, 2017), https://www.sec.gov/Archives/edgar/data/1576942/000119312517333497/ d400510ds1a.htm; Roku, Inc., Registration Statement (Sept. 18, 2017), https://www.sec.gov/Archives/ edgar/data/1428439/000119312517286740/d403225ds1a.htm. 36   See Matthew Sciabacucchi v. Matthew B. Salzberg, Docket No. 2017-0931-JTL (Del. Ch. Filed Jan. 5, 2018). 37   73 A.3d at 951–52.

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182  Research handbook on representative shareholder litigation rather than the law of the chartering state, is the opposite of how the internal affairs doctrine operates. As a result, some courts have expressed outright confusion as to what Boilermakers intended;38 others have looked first to their own doctrine on the subject, not Delaware’s (informed, naturally, by Delaware’s approval of such provisions), to determine enforceability.39 That said, the scope of the internal affairs doctrine has always been malleable (DeMott 1985), and ultimately it appears that at least as regards forum selection, courts outside of Delaware are eager to follow Delaware’s lead.40 Thus, if forum selection was once theoretically outside the scope of internal affairs, the law has now changed—or at least, due to near-uniform agreement on considerations governing the enforceability of such provisions, the issue has become moot. It remains to be seen, however, whether courts will be as eager to enforce more onerous litigation limits.41 For example, a state could determine that its interest in protecting residents who invest in foreign corporations is stronger than the interest of the chartering state in allowing managers to unilaterally adopt liability-insulating provisions.42 Yet Boilermakers’ rationale for treating forum selection bylaws as matters of internal affairs raises the related question whether litigation limits can apply to underlying claims that are not governed by the internal affairs doctrine, such as federal securities claims. Even if corporate governance documents are viewed as contractual, American law has long distinguished between the contract that forms the corporation and allocates power between its managers and shareholders—which is governed by the internal affairs doctrine—and the contract that governs the transfer of a security between buyer and seller, which is not (Lipton 2016). Securities claims concern the latter rather than the former. Indeed, if corporate governance documents address the rights of stockholders as stockholders, almost all securities claims concern the rights of investors before they become stockholders, at the point of entry into the corporate polity. Litigation limitations contained in the corporate governance contract may not extend to claims that do not arise out of it. There is good reason for the division. Federal securities law, like other kinds of external regulation, rests on its own set of public policies and priorities. By contrast, states—not the federal government—set the ground rules regarding what powers directors may

  Roberts v. TriQuint Semiconductor, Inc., 364 P.3d 328, 335 (Or. 2015).   In re CytRx Corp. Stockholder Derivative Litig., 2015 WL 9871275 (C.D. Cal. Oct. 30, 2015); North v. McNamara, 47 F. Supp. 3d 635 (S.D. Ohio 2014). 40   In re CytRx Corp. Stockholder Derivative Litig., 2015 WL 9871275 (C.D. Cal. Oct. 30, 2015); North v. McNamara, 47 F. Supp. 3d 635 (S.D. Ohio 2014); Butorin v. Blount, 106 F. Supp. 3d 833 (S.D. Tex. 2015). 41   So far, forum selection has been the most heavily litigated issue; arbitration provisions have apparently only been tested in the context of a single company, though the dispute generated three different court opinions. Del. Cnty. Emps. Ret. Fund v. Portnoy, No 13-10405-DJC, 2014 WL 1271528 (D. Mass. Mar. 26, 2014); Katz v. CommonWealth REIT, No 24-C-13-001299 (Cir. Ct. Balt. City Aug. 31, 2015); Corvex Mgmt. LP v. CommonWealth REIT, No 24-C-13-001111, 2013 WL 1915769 (Cir. Ct. Balt. City May 8, 2013). All three opinions assumed that the law of the organizing state applied. 42   Ordinarily, contract validity is determined by reference to the law of the state with the greatest interest in the dispute. Restatement (Second) Conflict of Laws §188 (1988). 38 39

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Limiting litigation  183 exercise to limit litigation (whether the limitation must appear in the charter, whether shareholders must vote, and so forth). State officials are not positioned to make the appropriate policy determinations when the matter involves a federal, rather than state, regulatory scheme. Indeed, some litigation limits, like feeshifting, may undermine federal policy and be preempted on that ground alone.43 Boilermakers recognized as much, anchoring directors’ legal authority to limit litigation in the fact that the affected claims were governed by the internal affairs doctrine.44 3.2  Are Litigation Limits an Appropriate Subject for Private Ordering? Leaving aside the issue of scope, questions continue to arise as to whether corporations should be able to individually select the rules that will govern litigation by their shareholders. Usually, these limits are unilaterally imposed by corporate directors, and directors have flexibility as corporate fiduciaries to invoke them, or not, in a particular case. Because directors may be inherently conflicted in such a decision—and certainly are operating from a position of informational advantage—litigation limits may be particularly susceptible to abuse.45 Forum selection, for example, represents the most mild of litigation limits, in that it preserves shareholders’ access to the courts and imposes no procedural hurdles beyond those imposed by the forum. Yet it may not be the panacea for multijurisdictional litigation that its proponents expect. Though multijurisdictional litigation has been characterized as a scourge that benefits plaintiffs’ attorneys at the expense of defendants (Grundfest & Savelle 2013), one study found that experienced defense counsel are adept at exploiting multijurisdictional litigation to conduct reverse auctions among plaintiffs’ counsel, resulting in cheap settlements (Krishnan et al 2017). Delaware courts have long recognized that when derivative actions are filed in multiple jurisdictions, defendants may encourage the weakest plaintiffs to move forward on the fastest schedule so as to win a quick dismissal that collaterally estops stronger plaintiffs.46 Forum selection provisions are another weapon in directors’ arsenal; directors can choose to adopt them—or 43   For example, to the extent that fee-shifting is meant to deter litigation, it may conflict with the complex set of rules Congress has already enacted to balance deterrence of frivolous federal securities litigation against the benefits of meritorious claims (Sjostrom 2015; Coffee 2014). 44   Boilermakers, 73 A.3d at 950–52. 45   In the simplest scenario, directors may be aware whether their internal documents contain incriminating or exculpatory evidence. Based on that information, they may choose to invoke an arbitration bylaw that limits discovery, or to waive the bylaw so that their innocence may be proclaimed in a public judicial forum. 46   La. Mun. Police Emples. Ret. Sys. v. Pyott, 46 A.3d 313, 347 (Del. Ch. 2012), rev’d, Pyott v. Louisiana Mun. Police Employees’ Ret. Sys., 74 A.3d 612 (Del. 2013); Avi Wagner v. Third Avenue Management, LLC, et al. and Third Avenue Trust, C.A. No 12184-VCL, transcript (Del. Ch. May 20, 2016; filed June 14, 2016) (“The defendants want to get out of litigation, and the best way to do it is to fight the weak plaintiff . . . [T]hey have the plaintiff they want and the allegations they want . . . This whole system of multi-forum litigation . . . creates a lot of systemic dysfunction. It’s certainly true that things should be resolved in one forum and at one time, but it doesn’t follow from that . . . that they should necessarily be followed under a system that incentivizes the filing of a fast complaint by a weak plaintiff so that defendants have the high ground”).

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184  Research handbook on representative shareholder litigation ­not—even on the eve of expected litigation,47 and then can selectively enforce them to pick their preferred plaintiff. Indeed, there is already evidence that some corporate directors have made precisely this attempt.48 The more onerous burdens imposed by arbitration and feeshifting raise even larger concerns. Arbitration allows the parties to choose the procedural rules they will employ, including the selection of arbitrators who may be affiliated with the litigants, the curtailment of discovery, and prohibitions on class actions (Lipton 2016). Because plaintiffs have little information about the claim without access to discovery, and often rely on the economies of scale of class litigation, the flexibility of arbitration can tilt the playing field in favor of defendants to the point of barring meritorious claims. Feeshifting is perhaps the most draconian of the proposed litigation limitations. Most stockholder litigation is representative; therefore, the nominal plaintiff expects to personally recover only a small fraction of the benefit obtained on behalf of the class. If the plaintiff is responsible for the full amount of the defendant’s costs, the risks may be too great to make litigation economical, particularly if—in line with the text of the ATP bylaw—plaintiffs must pay defendants’ fees even when they are partially successful. Feeshifting also creates perverse incentives: the more meritorious the claim, the longer the litigation continues, and the higher the plaintiff’s potential costs. Thus, feeshifting is likely to deter the strongest cases (Coffee 2014).49

47   See note 52, infra. Given the ease with which such bylaws can be adopted, Sean Griffith argues that all companies should be viewed as having a forum selection option, which they may exercise to manipulate multijurisdictional litigation to their advantage. He believes defendants ex ante would prefer to minimize litigation but, ex post, have incentives to settle with weak plaintiffs. His solution is for defendants to adopt “no pay” provisions that would preclude the corporation from paying attorneys’ fees for shareholder litigation. Then, lawsuits for nonmonetary relief would be discouraged, while lawsuits for damages could continue with fees to be obtained from any recovery (Griffith 2017). Yet Griffith assumes that corporations want to deter litigation in the first place—an assumption called into question if corporations use the prospect of multiforum litigation to negotiate lower premium deals in the expectation that they can settle on the cheap and avoid more aggressive challenges (Krishnan et al. 2017). 48  In Steven A. Kriegsman, et al. and CytRx Corp., C.A. No 11800-VCMR, tr. ruling (Del. Ch. May 2, 2016), a Delaware court stayed a Delaware action in favor of a California action, notwithstanding the existence of a bylaw that specified Delaware as the exclusive forum for derivative litigation. The California court eventually refused to approve a settlement and recommended that the parties continue their litigation in Delaware. The court explained, “we are skeptical of the Parties’ motivation for attempting to settle here . . . We cannot ignore the possibility that the current Motion may be an attempt to shop for a more hospitable forum in which to settle the dispute.” In re CytRx Corp. Stockholder Derivative Litigation, C.A. No 14-6414-GHK-PJW, order (C.D. Cal. 17 Aug. 2016). In another case, a Nevada corporation adopted a Utah forum selection bylaw, but then moved to stay a case filed in Utah in favor of a case filed in Nevada, raising suspicions that the company was selectively enforcing its bylaw in order to litigate against its preferred plaintiffs. See Alison Frankel, How corporations can game their own forum selection clauses, Reuters, http:// blogs.reuters.com/alison-frankel/2015/11/17/how-corporations-can-game-their-own-forum-selec​ tion-clauses/ (Nov. 17, 2015). 49   Albert Choi argues that properly drafted fee-shifting provisions may discourage frivolous direct litigation while providing greater incentive for attorneys to bring direct claims that have a high likelihood of success but relatively low damages (Choi 2016). Professor Choi recommends that

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Limiting litigation  185 The standard rejoinder is that shareholders may vote out directors who adopt litigation limits of which they disapprove, or enact their own counterbylaws, exactly as Chancellor Strine described. Moreover, if shareholders discount the share prices of companies that have adopted disfavored limits on litigation, that fact alone will compensate investors for the risk and subject the errant directors to the market for corporate control. And because today’s equities are mostly owned by sophisticated institutions who have sufficient stakes to attend to governance matters,50 there is less concern that rational apathy, or collective action problems, will prevent shareholders from taking action. Yet the question remains whether shareholders, acting from a position of informational disadvantage, can determine how litigation limits should be priced. They know little about how these limits may encourage future misbehavior by shielding directors, and they do not know which conditions will prompt directors to invoke—or not invoke—a limitation in response to particular circumstances. Thus, any pricing impact may simply “reflect the range of uncertainty as to the likely amount of managerial misappropriation of corporate returns to which shareholders are legally entitled” (Coffee 1988).51 And because directors can enact litigation limits at any time,52 the market must discount all shares for the possibility that a new litigation limit will be adopted in the future (Klausner 2013). 3.3  Is Contract and Consent the Correct Frame for Examining Litigation Limits? Thus, the larger question looms as to whether these provisions should be viewed through the lens of contract and consent in the first place. Within the corporate structure, shareholders and directors are not on an equal footing. Shareholder power is sharply limited, not merely by the practicalities of coordinating among potentially dispersed investors, but by legal ground rules that vest directors with broad discretion to take action on behalf of the corporation as they see fit. The justification for this power differential is that shareholders do not have either the skill or the incentives to make decisions on the corporation’s behalf; instead, directors are expected to protect shareholders’ interests (Lipton 2016). Boilermakers recognized as much, locating shareholders’ consent not in their acceptance (even tacit) of a particular bylaw, but in their buyin to the overall corporate structure, which includes directors’ managerial power. Courts have rejected challenges to bylaws that were adopted and invoked under conditions that did not give shareholders a meaningful chance to counter via exercise of their own governance powers,53 thus implicitly the matter be left to private ordering, but with more muscular judicial review, so that ATP­-style fee-shifting—where unsuccessful plaintiffs, but not defendants, pay fees—can be invalidated. 50   Vipal Monga & David Benoit, Companies Forgot About Mom-and-Pop Investors . . . Until Now, Wall St. J., July 19, 2016. 51   Moreover, if the company’s shares do not trade efficiently, there can be no assumption that information regarding charter and bylaw provisions will be incorporated into its stock price in the first place (Cox 2015). 52   See Butorin v. Blount, 106 F. Supp. 3d 833 (S.D. Tex. 2015); City of Providence v. First Citizens Bancshares, Inc., 99 A.3d 229 (Del. Ch. 2014); Groen v. Safeway Inc., 2014 WL 3405752 (Cal. Super. Ct. May 14, 2014). 53   See, e.g., Roberts v. TriQuint Semiconductor, Inc., 364 P.3d 328 (Or. 2015); see also City of Providence v. First Citizens Bancshares, Inc., 99 A.3d 229 (Del. Ch. 2014).

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186  Research handbook on representative shareholder litigation r­ecognizing that stockholders’ “consent” to bylaws is not rooted in their hypothetical power of repeal.54 The legal framework does not treat shareholders as autonomous agents bargaining opposite directors to protect their interests, as in contract; instead, it treats directors as trustees for shareholders, legally obligated to act not in their own interests, but as fiduciaries for the corporation (Lipton 2016). Both Boilermakers and ATP reiterated this point, stressing that litigation limits are tested not merely for contractual validity, but also for compliance with directors’ fiduciary duties, both at the time of adoption and at the time of invocation. Thus, the legal obligations of directors—not merely the market, or shareholders’ consent—are a critical pillar to protect against abuse. But those obligations must be enforced by courts, and to date, we have little information as to how much appetite courts actually have for delving into managerial motivations in a context so laden with structural conflict, especially given ATP’s puzzling pronouncement that deterrence of litigation (even, apparently, nonfrivolous litigation) is a proper managerial purpose. Many courts outside of Delaware have ignored fiduciary considerations entirely, treating litigation limits as a simple contractual term, indistinguishable from a term that might be found in a contract by two opposing parties independently pursuing their own interests.55 For this reason, theorists have argued that litigation limits at the very least require a higher form of shareholder consent than simply the consent attendant upon participation in the corporate structure. For example, James Cox distinguishes between the power of directors to manage the company from a business perspective, and the power of directors to alter the balance of power between shareholders and managers (Cox 2015). The latter, he argues, must be subject to more exacting judicial scrutiny, and should require shareholder approval.56 Verity Winship, recognizing that certain managerial duties are unwaivable (the duty of loyalty, compliance with federal securities laws), argues that the more onerous the burden on litigation—that is, the closer it comes to waiver—the more robust the consent required (Winship 2016).57 Other scholars tie investor consent to their reasonable expectations in light of established corporate practice (Hamermesh 2014; DeMott 2015). The difficulty with this reasoning, however, is its circularity: if investor consent is rooted in existing law, then 54   Even if shareholders were to repeal a forum selection bylaw, in many states, the directors would have the power to simply reinstate it. See, e.g., Christina Rexrode & Dan Fitzpatrick, Investors Push Back At BofA’s Reversal, Wall St. J., Oct. 31, 2014, at C1. 55   Del. Cnty. Emps. Ret. Fund v. Portnoy, WL 1271528 (D. Mass. Mar. 26, 2014); Katz v. CommonWealth REIT, No 24-C-13-001299 (Cir. Ct. Balt. City Aug. 31, 2015); Corvex Mgmt. LP v. CommonWealth REIT, 2013 WL 1915769 (Cir. Ct. Balt. City May 8, 2013); Hemg Inc. v. Aspen Univ., 2013 WL 5958388, at *1 (N.Y. Sup. Ct. Nov. 4, 2013); In re: CytRx Corp. Stockholder Derivative Litig., 2015 WL 9871275 (C.D. Cal. Oct. 30, 2015). 56   See also Brown (2015) (arguing that until Boilermakers, Delaware statutory law required that limits on shareholder power be placed in the charter, not the bylaws, where shareholder notice or consent would be required). Even the shareholder approval requirement for charter amendments may not be fully capable of protecting investors because of managers’ greater informational advantage (Bebchuk 1989). 57   Winship additionally argues that litigation limits should follow the scope of permissible waivers; thus, because only monetary claims for care violations are waivable, and such waivers must be included in the charter, litigation limitations that approach waivers of the duty of care should have similar constraints.

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Limiting litigation  187 it waxes and wanes as that law changes. Even a wrongly decided case—as Lawrence Hamermesh argues of ATP—changes investor expectations for the future. 3.4  Are Shareholder Rights Public or Private Law? The debate over the validity of shareholders’ consent may obscure the larger policy question, namely, whether the relationship between shareholders and a corporation is in fact properly characterized as private law. The fiduciary duties imposed by states on corporate managers are a form of government regulation (Ribstein 2010). The purpose of that regulation is to protect investors, reduce agency costs, and ultimately encourage investment, with the resulting economic benefits shared across society. If reduced enforcement of those duties weakens fidelity to them, the public benefit is similarly reduced (Cox 2015). Litigation itself has a particularly public character. When it comes to corporate governance, the law is developed overwhelmingly through common law rulemaking, rather than through statutory enactments or even regulatory enforcement (Griffith & Steele 2005); thus, measures that diminish opportunities for judicial analysis may retard the healthy development of legal standards for all corporations. Discovery alone has proved a key tool for giving the public insight into corporate operations, beyond what any mandatory disclosure could require (Gorga & Halberstam 2014). Even forum selection may have hidden drawbacks; Delaware already dominates the market for the creation of substantive corporate law, and the legal system may benefit from allowing other states breathing room to examine these issues, even if only in the context of applying Delaware rules of decision (Griffith & Lahav 2013). Ironically, in amending its corporate law to circumscribe the use of litigation limits, Delaware itself has implicitly recognized the public character of corporate litigation. By refusing to allow corporations to voluntarily select a non-Delaware forum, Delaware ensures that its own courts are available to decide questions of Delaware law; by banning feeshifting and mandatory arbitration, Delaware eliminates existential threats to its judicial system. It is difficult not to interpret Delaware as utilizing litigation limits to further its own provincial interests in funneling more litigation into Delaware, thus rendering somewhat hollow the idea of litigation limits as species of private ordering.

4. CONCLUSION It remains to be seen whether litigation limits are here to stay, perhaps in ever more creative permutations, or whether they are simply a passing fad. The more that litigation limits generate collateral litigation, the more their appeal may sour. The critical issue moving forward will be to determine the extent to which shareholder litigation is intended to compensate the individual investors, and the extent to which it is intended to deter misconduct and benefit the economy as a whole. Viewed as a compensation mechanism, it may be reasonable for investors to trade their litigation rights to spare themselves the (indirect) expenses of litigation; if such litigation has broader positive externalities, however, that determination cannot be made at the investor/corporate level. If excessive litigation remains a problem despite state and federal attempts to deter

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188  Research handbook on representative shareholder litigation f­ rivolous filings, the alternative might be a more robust system of governmental enforcement of shareholder rights, which may allow a more systemic cost–benefit calculation.

BIBLIOGRAPHY Bainbridge, Stephen, 2014. “The Case for Allowing Fee Shifting Bylaws as a Privately Ordered Solution to the Shareholder Litigation Epidemic,” available at professorbainbridge.com, www.professorbainbridge.com/ professorbainbridgecom/2014/11/the-case-for-allowing-fee-shifting-bylaws-as-a-privately-ordered-solution-tothe-shareholder-litigat.html (last visited Dec. 29, 2015). Bainbridge, Stephen M., 2016. “Fee-Shifting: Delaware’s Self-Inflicted Wound,” Delaware Journal of Corporate Law 40:851. Bebchuk, Lucian Arye, 1989. “Limiting Contractual Freedom in Corporate Law: The Desirable Constraints on Charter Amendments,” Harvard Law Review 102:1820–60. Brown, J. Robert, 2015. “The Future Direction of Delaware Law (Including a Brief Exegesis on Fee Shifting Bylaws),” Denver University Law Review Online 92:49–61. Choi, Albert H., 2018, “Fee-Shifting and Shareholder Litigation,” Virginia Law Review 104:59-111. Clermont, Kevin M., 2015, “Forum Selection After Atlantic Marine: Governing Law on Forum-Selection Agreements,” Hastings Law Journal 66:643. Coffee Jr, John C., 1988. “No Exit?: Opting Out, the Contractual Theory of the Corporation, and the Special Case of Remedies,” Brooklyn Law Review 53:919. Coffee, John C., 2012. Forum Selection Clauses and the Market for Settlements, New York Law Journal, 17 May 2012. Coffee, John C., 2014. “Fee-Shifting Bylaw and Charter Provisions: Can They Apply in Federal Court? The Case for Preemption, Testimony Before the SEC Advisory Committee,” available at https://ssrn.com/abstract=2508973. Coffee, John C., 2015. “Update on ‘Loser Pays’ Fee Shifting,” CLS Bluesky Blog available at http://clsbluesky. law.columbia.edu/2015/05/27/update-on-loser-pays-fee-shifting/. Cosenza, Elizabeth, 2016. “The Persistent Problem of Multi-Forum Shareholder Litigation: A Proposed Statutory Response to Reshuffle the Deck,” Virginia Law and Business Review 10:413. Cox, James D., 2015. “Corporate Law and the Limits of Private Ordering,” Washington University Law Review 93:257–92. DeMott, Deborah A., 1985. “Perspectives on Choice of Law for Corporate Internal Affairs,” Law and Contemporary Problems 48:161–98. DeMott, Deborah A., 2015. “Forum Selection Bylaws Refracted through an Agency Lens,” Arizona Law Review 57:269–97. Geis, George S., 2016. “Ex Ante Corporate Governance,” Journal of Corporate Law 41:609. Gorga, Érica & Michael Halberstam, 2014. “Litigation Discovery and Corporate Governance: The Missing Story About the ‘Genius of American Corporate Law’,” Emory Law Journal 63:1383–1498. Griffith, Sean J., 2017. “Private Ordering Post-Trulia: Why No Pay Provisions Can Fix the Deal Tax and Forum Selection Provisions Can’t,” in The Corporate Contract in Changing Times (Steven Davidoff Solomon & Randall S. Thomas, eds, forthcoming 2017). Griffith, Sean J. & Alexandra D. Lahav, 2013. “The Market for Preclusion in Merger Litigation,” Vanderbilt Law Review 66:1053–1138. Griffith, Sean J. & Myron T. Steele, 2005. “On Corporate Law Federalism: Threatening the Thaumatrope,” The Business Lawyer 61:1–23. Grundfest, Joseph A. & Kristen A. Savelle, 2013. “The Brouhaha over Intra-Corporate Forum Selection Principles: A Legal, Economic, and Political Analysis,” The Business Lawyer 68:325–410. Hamermesh, Lawrence A., 2014. “Consent in Corporate Law,” The Business Lawyer 70:161–73. Henderson, M. Todd & Adam C. Pritchard, 2014. “From Basic to Halliburton: Judges Made the Securities Class Action Mess, but Who Can Clean It Up?” Regulation, Winter 20–6. Klausner, Michael, 2013. “Fact and Fiction in Corporate Law and Governance,” Stanford Law Review 65:1325. Krishnan, C.N.V., Steven Davidoff Solomon, & Randall S. Thomas, 2017. “The Impact on Shareholder Value of Top Defense Counsel in Mergers and Acquisitions Litigation,” Journal of Corporate Finance 45: 480–495, available at https://ssrn.com/abstract=2773594. Lipton, Ann M., 2016. “Manufactured Consent: The Problem of Arbitration Clauses in Corporate Charters and Bylaws,” Georgetown Law Journal 104:583–641. Ribstein, Larry E., 2010. The Rise of the Uncorporation (New York: Oxford University Press). Ribstein, Larry E. and Erin Ann O’Hara, 2008. “Corporations and the Market for Law,” University of Illinois Law Review 2008: 661–729.

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Limiting litigation  189 Romano, Roberta & Sarath Sanga, 2015. “The Private Ordering Solution to Multiforum Shareholder Litigation,” Journal of Empirical Legal Studies 14:37–78. Schneider, Carl W. 1990. Arbitration in Corporate Governance Documents: An Idea the SEC Refuses to Accelerate, INSIGHTS, May. Scott, Hal S. & Leslie N. Silverman, 2013. “Stockholder Adoption of Mandatory Individual Arbitration for Stockholder Disputes,” Harvard Journal of Law and Public Policy 36:1187–1230. Shell, G. Richard, 1989. “Arbitration and Corporate Governance,” North Carolina Law Review 67:517–75. Sjostrom, William K., 2015. “The Intersection of Fee-Shifting Bylaws and Securities Fraud Litigation,” Washington University Law Review 93:379–423. Winship, Verity, 2016. “Shareholder Litigation by Contract,” Boston University Law Review 96:485–542. Weiss, Miles, Jesse Hamilton, & Cristina Alesc, 2012. Carlyle Drops Class-Action Lawsuit Ban as Opposition Mounts, Bloomberg (Feb. 3, 2012, 5:57 PM), www.bloomberg.com/news/articles/2012-02-03/carlyle-dropsclass-action-lawsuit-ban.html. Weitzel, Paul, 2013. “The End of Shareholder Litigation? Allowing Shareholders to Customize Enforcement Through Arbitration Provisions in Charters and Bylaws,” Brigham Young University Law Review 1:65–118.

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Section B Judicial Perspectives on Shareholder Litigation

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12.  Disclosure settlements in the state courts postTrulia: practical considerations James L. Gale

It has become commonplace for the announcement of any significant merger to be immediately followed with litigation, often involving multiple actions in multiple fora. More often than not, the transaction involved a Delaware corporation, and as a result, the issues inherent in such litigation were most often presented to Delaware’s Court of Chancery. This litigation trend has generated significant attention, controversy, and litigation across a spectrum of issues. This chapter focuses on the particular issue of judicial approval of “disclosure settlements,” which are settlements of class action lawsuits where the primary settlement consideration has typically involved a corporation making supplemental disclosures in exchange for a broad classwide release, with no further financial benefit to the shareholder class, but with significant attorneys’ fees paid to class counsel. Chancellor Andre G. Bouchard’s opinion in In re Trulia, Inc. Stockholder Litigation received almost immediate landmark status and came as the culmination of an evolving, substantial body of precedent from the Delaware Court of Chancery addressing disclosure settlements.1 Trulia acknowledged the consequences of what may have proved to be a too lenient standard of review of such settlements and announced a heightened standard for judicial approval that focuses on the respective value of the “give” and “get” of such settlements, restricting a broad release not commensurate with the limited benefit obtained, and conditioning an award of any attorneys’ fees on counsel having achieved supplemental disclosures that are “plainly material.”2 Chancellor Bouchard’s opinion further describes the particular challenge that a judge faces when assessing whether there is such materiality, where the nature of the settlement results in corporate defense counsel becoming the plaintiff class counsel’s ally in securing court approval for the settlement in order to allow the transaction to move forward, as a result of which the judge no longer enjoys the illuminating benefit of the adversarial process.3 As discussed more fully presently, Chancellor Bouchard suggested alternative procedures for judicial review that may allow for the continued benefit of that adversarial process in reviewing the settlement while the underlying transaction is allowed to proceed. Trulia has already been credited with leading to a reduction in the percentage of corporate transactions being subjected to litigation.4 Such a result would be expected considering the number of transactions that involve Delaware corporations, many of

  129 A.3d 884 (Del. Ch. 2016).   Ibid at 887, 891, 893, 898, and n.46. 3   See ibid at 893. 4   See Cornerstone (2016) (revealing that the rate of litigation related to mergers and acquisitions has dropped “substantially” following Trulia). 1 2

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192  Research handbook on representative shareholder litigation which may now have bylaws that compel litigation involving their transactions to be brought in the Court of Chancery.5 However, concern has been expressed that Trulia’s impact may be marginalized by the plaintiffs’ bar bringing suit in other states that will apply less exacting standards and continue the more accommodating review that disclosure settlements enjoyed in Delaware prior to Trulia. The concern is that judges in other states will be either ill-equipped, by experience or training, or simply unwilling to meaningfully implement an exacting standard based on Trulia. Chancellor Bouchard acknowledged that others have raised this concern. First noting the role that forum selection clauses may have in mitigating such concerns, if legitimate, the Chancellor expressed his “hope and trust that our sister courts will reach the same conclusion if confronted with the issue.”6 The purpose of this chapter is to identify at least some of the practical considerations that judges of those sister states may undertake, should the prediction that deal litigation will continue unabated in states outside of Delaware be proved accurate. The author recognizes, but here takes no side, on the clear debate between the plaintiffs’ bar, which champions the underlying litigation on behalf of shareholders, and those that characterize disclosure settlements as no more than a necessary “deal tax” that serves no salutary purpose (O’Connell et al 2015). There may be separate considerations to be faced by the federal judiciary if the focus shifts to litigation under the federal securities laws. If so, those considerations are outside the scope of this chapter. While other states certainly have not confronted the same frequency of disclosure settlements seen by the Chancery Court, there is widespread recognition of similar underlying policy considerations inherent in class action settlements. The class action procedure is regularly implemented and can achieve substantial social benefit. Judicial preference for settlements is entrenched. Naturally, judges may prefer settlement to the management challenges inherent in class action litigation. There is, at the same time, widespread judicial recognition that the class action vehicle is subject to abuse, and that, without judicial restraint, settlements can exact large attorneys’ fees unaccompanied by meaningful value for the represented class on whose behalf a comprehensive release is offered (Ratner, 2015). One of the author’s counterparts somewhat famously referred to such fees as “stinky fees.”7 Prior to Trulia, Vice Chancellor Laster expressed his displeasure for “junky cases,” in which plaintiff class counsel pursues “easy money.”8 Judge Richard Posner has recently called such abuses in the context of disclosure settlements a “racket” that “must end.”9 This combination of factors would appear to have been at play as the decisions by the Chancery Court only evolved toward Trulia over time, where a series of judicial approvals

  See ibid at 3.   In re Trulia, 129 A.3d at 899. 7   Ward v. Lance, Inc., No 10 CVS 16553, slip op. at 1–2 (N.C. Super. Ct. Feb. 28, 2011) (Tennille, J.) (describing “stinky fees” as fees that “just smell bad and have no economic justification,” and noting that “[s]tinky fee suits may actually discourage other legitimate and serious claims, thus doing further damage to our system”). 8   Transcript at 37, 59, 64, 70, Acevedo v. Aeroflex Holding Corp., No 7930-VCL (Del. Ch. July 8, 2015). 9   In re Walgreen Co. Stockholder Litig., 832 F.3d 718, 724 (7th Cir. 2016). 5 6

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Disclosure settlements in the state courts post-Trulia  193 of settlements was believed to have “created a real systemic problem.”10 There may be a similar evolution in other states, which may now be confronted with class action deal litigation on more than a sporadic basis. In that process, state court judges may be required to focus on variations between their state’s law and Delaware law, both procedural and substantive, which may either preclude or caution against a direct adoption and application of Trulia or the adoption of the approach for reviewing disclosure settlements that may now become favored by the Chancery Court. A foundational consideration is that judges cannot be expected to adopt a procedure that they believe will make it impossible to settle cases. If judges confronted with class action litigation conclude that the only practical way to settle the litigation is to allow for a significant award of attorneys’ fees, there will be a natural resistance to adopting a rule that prohibits any such fees from being awarded. There are also well-grounded public policy reasons not to adopt rules that would close the courthouse to legitimate litigation that challenges certain transactions. Litigation has long been recognized as playing a valuable role in the overall scheme of corporate governance, providing necessary checks and balances on the activities of corporate directors.11 And corporations likewise will resist a procedure that will effectively rob them of the ability to remove a litigation impediment to moving a transaction forward. Trulia accommodates those competing concerns in its balancing approach. But where the court’s ability to award attorneys’ fees is limited—for example, by the absence of the “corporate benefit” doctrine—how is that balance to be achieved? In predicting how Trulia will be applied in various states, it is significant that the Delaware courts recognize the corporate benefit doctrine as an exception to the American Rule prohibiting the award of attorneys’ fees to a successful litigant.12 The corporate benefit doctrine allows a court to award—and, presumably, parties to contract to pay— attorneys’ fees to class counsel because of the nonmonetary relief achieved for the class, unaccompanied by a common monetary fund from which fees can be taken, with the result that the fees are shifted to the settling corporation.13 The corporate benefit doctrine is contrasted with a separate exception to the American Rule known as the “common fund doctrine,” in which a monetary fund is created from which fees may be paid.14 The common fund exception is widely recognized. The corporate benefit doctrine is not.

10   Transcript of Oral Argument at 65, In re Aruba Networks Stockholder Litig., C.A. No 10765-VCL (Del. Ch. Oct. 9, 2015) (Laster, V.C.). Vice Chancellor Glasscock has made similar observations. See, e.g., In re Riverbed Tech., Inc. Stockholders Litig., C.A. No 10484-VCG, 2015 WL 5458041 (Del. Ch. Sept. 17, 2015). 11   See Shaner (2014: 327) (describing derivative litigation as “vital to a successful system of internal corporate governance and management accountability,” and noting that such litigation “is the most powerful tool available to stockholders in checking management power”). 12   The United States Supreme Court has described the American Rule as the “bedrock principle” that courts must consider when awarding attorneys’ fees. Baker Botts L.L.P. v. ASARCO LLC, 135 S. Ct. 2158, 2164 (2015) (quoting Hardt v. Reliance Standard Life Ins. Co., 560 U.S. 242, 252–53 (2010)). Under the American Rule, each litigant pays his or her own attorneys’ fees, regardless of whether the litigant wins or loses, absent a statute or contract that provides otherwise. Ibid. 13   See, e.g., Alaska Elec. Pension Fund v. Brown, 988 A.2d 412, 417 (Del. 2010); Dover Historical Soc’y, Inc. v. City of Dover Planning Comm’n, 902 A.2d 1084, 1090 (Del. 2006); CalMaine Foods, Inc. v. Pyles, 858 A.2d 927, 929 (Del. 2004). 14   See Boeing Co. v. Van Gemert, 444 U.S. 472, 478 (1980) (noting that the common fund

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194  Research handbook on representative shareholder litigation Trulia allows for a successful class counsel to obtain an award of attorneys’ fees as long as counsel can demonstrate that the disclosures had value to the class because they were material. Chancellor Bouchard expressed a preference for an “optimal” approach of a “mootness settlement,” whereby the corporation makes supplemental disclosures voluntarily without the benefit of a classwide release of all claims; the litigation is dismissed, but with prejudice only to the named class representative; the transaction is presented to shareholders for approval; and it moves forward if approved. Class counsel may then pursue an award of attorneys’ fees either by a negotiated settlement or, if necessary, through a contested legal proceeding.15 The benefits of such a procedure are obvious. The class is not required to give a broad release, and the settling corporation maintains an advocate’s incentive to contain the award of fees to a reasonable amount. But again, in other states there may be constraints to adopting such an approach. The majority of states strictly apply the American Rule and have not adopted the corporate benefit doctrine.16 The American Rule is generally considered not only to constrain the court’s ability to award attorneys’ fees, either as costs or damages, but also to prohibit parties from agreeing on the payment of such attorneys’ fees as a matter of contract. In those states that adhere strictly to the American Rule, in the absence of a common fund from which fees may be paid, an award of attorneys’ fees depends on statutory authority. Most often in merger litigation, the only statutory authority for an award of fees is the ­ octrine “rests on the perception that persons who obtain the benefit of a lawsuit without contribd uting to its costs are unjustly enriched at the successful litigant’s expense”). 15   See In re Trulia, Inc. Stockholder Litig., 129 A.3d 884, 896 (Del. Ch. 2016). 16   See, e.g., Client Follow-Up Co. v. Hynes, 434 N.E.2d 485, 491 (Ill. App. Ct. 1982) (recognizing the common fund doctrine but reaffirming that, “in the absence of a fund, a plaintiff’s attorney is not entitled to attorney’s fees merely because he has conferred a benefit upon members of a class” (quoting Hamer v. Kirk, 356 N.E.2d 524, 528 (Ill. 1976))); Hall v. Hamilton, 667 P.2d 350, 357 (Kan. 1983) (“The common-benefit doctrine is the subject of many varying interpretations based upon common law and statutory differences between the states. Each jurisdiction has adopted its own rules for the allowance or refusal to allow attorney fees in partition actions, and we see no compelling reason to adopt or base our holding here upon the rules adopted elsewhere”); Kindred v. City of Omaha Emps.’ Ret. Sys., 564 N.W.2d 592, 596 (Neb. 1997) (recognizing a common fund exception, but not an expansion on the doctrine); Am. Civil Liberties Union of N.M. v. City of Albuquerque, 992 P.2d 866, 876 (N.M. 1999) (declining to expand an award of attorneys’ fees by use of the substantial benefit doctrine); Kaufman Malchman & Kirby, P.C. v. Hasbro, Inc., 897 F. Supp. 719, 722 (S.D.N.Y. 1995) (applying Rhode Island law and stating that “Rhode Island courts have never found such a[] [common benefit] exception to exist”); In re Wachovia S’holders Litig., 607 S.E.2d 48, 52 (N.C. Ct. App. 2005) (recognizing the common fund doctrine but affirming that North Carolina does not recognize the incorporation of the common benefit doctrine); Petow v. Warehime, 996 A.2d 1083, 1088 (P.A. Super. Ct. 2010) (affirming that the court “do[es] not recognize the common or substantial benefit doctrine as the law in Pennsylvania”); Kanaly v. South Dakota ex rel. Janklow, 401 N.W.2d 551, 553 (S.D. 1987) (holding that no exception to the American Rule is permitted, because it is not expressly or specifically provided for by any statute and is therefore prohibited); Kaniecki v. O’Charley’s Inc., No M2012-02221-COA-R3CV, 2014 WL 575904, at *3–4 (Tenn. Ct. App. Feb. 11, 2014) (applying the American Rule strictly, but recognizing the common-fund doctrine and declining to apply the substantial benefit doctrine); Robes v. Town of Hartford, 636 A.2d 342, 350 (Vt. 1993) (“Vermont has not recognized the ‘common fund’ exception, and we see no reason to do so today”); Mkt. St. Sec., Inc. v. Midwest Air Grp., Inc., No 07-CV-345, 2009 WL 2985451, at *3 (E.D. Wis. Sept. 15, 2009) (noting that Wisconsin law has adopted the common fund doctrine but not the common benefit doctrine).

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Disclosure settlements in the state courts post-Trulia  195 particular state’s statute regulating shareholder derivative actions, which may allow for fees to be awarded if the litigation obtains substantial benefit for the corporation.17 In that event, separate procedural issues arise, some of which are discussed presently.18 With this background in mind, the following factors may arise alone or in combination when a court outside of Delaware is presented with a request to approve a disclosurebased class action challenging a merger transaction. The discussion assumes that the litigation is pending only in a single state and does not address separate considerations that may be involved where one state court is asked to defer to other pending litigation involving the same transaction in another state. The procedure for such discretionary stays is a generally well-settled and common procedure.19 A court’s first inquiry is to determine what law it should apply. There is not always an obvious choice involving an interplay in a court’s determination on whether it should honor a contractual choice and whether the issues at hand should be deemed substantive or procedural. Particular considerations arise where the corporation is incorporated in Delaware but has its principal place of business in the state being asked to consider the disclosure settlement. Many Delaware-based corporations have chosen to enact forum selection bylaws based on the authority of Boilermakers Local 154 Retirement Fund v. Chevron Corp.20 and City of Providence v. First Citizens BancShares, Inc.21 Trulia may increase the frequency of such bylaws. To date, most states have honored such bylaws when confronted with them.22 However, Trulia conceivably could present a counterincentive for a board of directors to waive the protection of such bylaws if the only pathway toward settlement is to agree to a settlement that might be expected to be rejected by the Chancery Court but approved by the local state court. Where a suit involving a Delaware corporation remains outside of Delaware and there is no contractual choice-of-law provision, the forum court must consider how the internal affairs doctrine should apply. The internal affairs doctrine calls for application of the law of the state of incorporation on matters affecting corporate governance.23 A suit that

17   See, e.g., N.C. Gen. Stat. § 55-7-46(1) (2015) (providing that, upon termination of a derivative proceeding, the court may “[o]rder the corporation to pay the plaintiff’s reasonable expenses, including attorneys’ fees, incurred in the proceeding if it finds that the proceeding has resulted in a substantial benefit to the corporation”). 18   This chapter does not address the impact that corporate bylaws could have on derivative litigation challenging corporate transactions, such as requiring any derivative plaintiff to own or control a minimum percentage ownership. 19   See N.C. Gen. Stat. § 1-75.12 (2015); see also Paramount RX, Inc. v. Duggan, No 14 CVS 13216, 2015 WL 1421391 (N.C. Super. Ct. Mar. 27, 2015); Justewicz v. Sealy Corp., No 12 CVS 2417, 2012 WL 5959397 (N.C. Super. Ct. Nov. 27, 2012). 20   73 A.3d 934 (Del. Ch. 2013). 21   99 A.3d 229 (Del. Ch. 2014). 22   See, e.g., North v. McNamara, 47 F. Supp. 3d 635 (S.D. Ohio 2014); In re MetroPCS Commc’ns, Inc., 391 S.W.3d 329 (Tex. Ct. App. 2013). But see, e.g., Roberts v. TriQuint Semiconductor, Inc., 364 P.3d 328 (Or. 2015) (refusing to enforce bylaw that was adopted following alleged wrongdoing). 23   See Sagarra Inversiones, S.L. v. Cementos Portland Valderrivas, S.A., 34 A.3d 1074, 1081–82 (Del. 2011) (describing the internal affairs doctrine as “a dominant and overarching choice of law principle,” and stating that “[a]n important rationale for the doctrine is that, ‘in order to prevent corporations from being subjected to inconsistent legal standards, the authority to regulate a

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196  Research handbook on representative shareholder litigation challenges a transaction for breaches of directors’ fiduciary duties would seem to clearly present an issue of corporate governance.24 The internal affairs doctrine is generally considered to require only that the substantive law of the incorporating state be applied, with procedural matters to be governed by the law of the forum state.25 There have been instances—such as, for example, in choosing a statute of limitations—where courts have elected to treat as a matter of substance an issue that otherwise is normally considered procedural, because to do otherwise would have an improper impact on the underlying matter of internal corporate governance.26 Reasoned arguments can be made on both sides of the issue as to whether the award of attorneys’ fees in a settlement involving a class challenge to a corporate acquisition is a matter of substance or procedure. It is not clear whether the award of attorneys’ fees would be determined from state to state as a matter of substantive or procedural law. A recent ruling from a New Jersey state court suggests that some courts may elect to treat the Trulia standard as a matter of substantive law when applied to transactions involving Delaware corporations.27 Where Delaware law is potentially persuasive but not controlling, a court may be confronted with significant differences between Delaware’s corporate laws and the corporate laws of the forum state. The forum state may apply a different standard of review for measuring the conduct of the board of directors. Following the Delaware Supreme Court’s decision in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.,28 the North Carolina General Assembly enacted legislation providing that a director’s duties do not change in a change-of-control environment.29 There may likely be significant variations in the procedural requirements for derivative litigation in the various states. For example, Delaware law allows for demand futility, whereas North Carolina by statute requires strict compliance with a statutory demand and waiting period.30 Such a variance can have very practical significance on a court’s selection of lead counsel or a lead complaint when confronted with multiple filings in the “race to the courthouse,” which in turn may require application of a “first to file” rule.31 That choice may prove to be significant in those states that do not allow for the corporation’s internal affairs should not rest with multiple jurisdictions’” (quoting VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108, 1112 (Del. 2005))). 24   See, e.g., In re Topps Co. S’holders Litig., 924 A.2d 951, 960 (Del. Ch. 2007) (“[T]he adjudication of cases involving the fiduciary duties of directors . . . is one of the most important methods of regulating the internal affairs of corporations”). 25   See ibid. 26   See, e.g., Tong v. Dunn, Nos. 11 CVS 1522, 13 CVS 1318, 2016 WL 3944092, at *4–5 (N.C. Super. Ct. July 8, 2016). 27   Vergiev v. Aguero, No L-2276-15, Statement of Reasons at 6 (N.J. Super. Ct. June 6, 2016), http://blogs.reuters.com/alison-frankel/files/2016/08/griffithnewjersey.pdf. 28   506 A.2d 173 (Del. 1986). 29   N.C. Gen. Stat. § 55-8-30(d) (2015) (“The duties of a director weighing a change of control situation shall not be any different, nor the standard of care any higher, than otherwise provided in this section”). 30   See ibid §  55-7-42; Allen v. Ferrera, 540 S.E.2d 761, 765 (N.C. Ct. App. 2000). Cf. In re Citigroup Inc. S’holder Derivative Litig., 964 A.2d 106, 120 (Del. Ch. 2009) (reciting the legal standard for demand futility under Delaware law). 31   See, e.g., Biondi v. Scrushy, 820 A.2d 1148, 1154 (Del. Ch. 2003), aff’d sub nom. In re HealthSouth Corp. S’holders Litig., 847 A.2d 1121 (Del. 2004) (unpublished table decision).

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Disclosure settlements in the state courts post-Trulia  197 corporate benefit doctrine, where the ultimate award of attorneys’ fees in connection with a disclosure-based settlement depends on statutory authorization, and the only potential authorizing statute is one that allows a court to award attorneys’ fees upon a finding that the litigation has achieved a substantial corporate benefit. But even there, difficult potential questions arise regarding whether a disclosure claim is deemed to be a direct action or a derivative action. Typically, the idea has been that a class complaint challenging a corporate transaction involves a panoply of claims, including those that challenge the process or overall fairness of the transaction, in addition to those that focus on the adequacy of disclosures for which shareholder approval is requested. In the typical disclosure settlement, only the disclosure claims are addressed in seeking approval of the settlement, with other claims being abandoned. The question may then arise whether the claim upon which the adequacy of the settlement is premised is one that allows for an award of attorneys’ fees as a derivative claim that achieves a benefit for the corporation. The argument as to whether a disclosure claim is a direct claim, a derivative claim, or both is not fully settled. For example, North Carolina, like other states, distinguishes between a direct claim, in which the shareholder seeks to recover for injuries specific to that shareholder or because of a special duty owed to that shareholder, and a derivative claim, in which the shareholder seeks recovery only for injuries or damages suffered by other shareholders in common, such as effect on share price.32 The argument in favor of a disclosure claim being a direct claim focuses on the fact that the shareholder is being asked to vote individually to approve corporate action. The argument in favor of a disclosure claim being a derivative claim is that all shareholders are similarly situated and are being asked collectively to vote in favor of the transaction. North Carolina’s intermediate appellate court has suggested that a disclosure claim may be direct,33 but the state’s highest court has not yet addressed the issue. A court may ignore such procedural distinctions when motivated by the inherent preference for settlement, as long as the amount of fees is not so unreasonable as to be uncomfortable to award or where the substance of the settlement does not appear out of bounds. Arguably, those were the motivations for Delaware’s early approval process before any pernicious effect of disclosure settlements became evident. Similar considerations may be evident in North Carolina’s approach to date in considering disclosure-based settlements, both before and after Trulia. North Carolina’s appellate courts historically have been staunch advocates of the American Rule.34 In one case, a North Carolina trial court was presented with a series of class actions challenging a bank merger.35 As the litigation progressed, primary responsibility was assumed by counsel, which had not brought a derivative action.36 Upon settlement, the trial court elected to grant the predominant share of fees to class counsel pursuant to the common benefit doctrine, finding that the lead class counsel should be

  See Barger v. McCoy Hillard & Parks, 488 S.E.2d 215, 220–21 (N.C. 1997).   See Ehrenhaus v. Baker, 717 S.E.2d 9, 27 (N.C. Ct. App. 2011). 34   See, e.g., ibid at 32. 35   In re Wachovia S’holders Litig., No 01 CVS 4486, 2003 WL 22996328 (N.C. Super. Ct. Dec. 19, 2003), rev’d, 607 S.E.2d 48 (N.C. Ct. App. 2005). 36  Ibid at *3. 32 33

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198  Research handbook on representative shareholder litigation credited with the benefits of the settlement.37 The trial court granted a lesser share of fees to counsel who had brought a derivative action but did not assume primary responsibility for the litigation.38 The North Carolina Court of Appeals rejected the trial court’s use of the corporate benefit doctrine and chose to adhere to the American Rule.39 Later, without discussing this earlier decision, the North Carolina Court of Appeals approved the award of fees for the settlement of a class claim without squarely addressing the authority upon which the award was based.40 While not addressing that initial question of authority, the court adopted a test for measuring the amount of fees awarded that was premised on factors derived from Rule 1.5 of the North Carolina Rules of Professional Conduct, most often applied in the context of a contingency fee allowing for the attorney to be paid a percentage of a recovery.41 Thereafter, the North Carolina Business Court was on several occasions requested to approve disclosure settlements, with class counsel regularly justifying the request by citing settlements and fee awards approved by the Delaware Chancery Court.42 By and large, class counsel simply assumed that the settling parties had the right to contract, and that the court had the right to approve, the award of attorneys’ fees, so long as the standard of reasonableness adopted earlier by the appellate court was satisfied. The Business Court approved the settlements based on the assumption that the appellate courts had tacitly recognized the court’s authority to do so.43 In a recent subsequent opinion, North Carolina’s intermediate appellate court held more squarely that parties can, through a settlement agreement, contract for the award of attorneys’ fees in order to settle class litigation, but in the process of so deciding did not discuss or seek to distinguish a long line of North Carolina Supreme Court opinions that prohibit a grant of attorneys’ fees as either damages or costs, whether by agreement or court order.44 The North Carolina Supreme Court has not yet addressed the question whether parties can contract for an award of attorneys’ fees to settle class litigation in the absence of express statutory authority, or whether, in the context of deal litigation, such authority may be found based on the statute authorizing derivative actions where the settlement yields no monetary fund.45  Ibid at *13.  Ibid at *18–19. 39   In re Wachovia S’holders Litig., 607 S.E.2d at 52–53. 40   Ehrenhaus v. Baker, 717 S.E.2d 9, 34–35 (N.C. Ct. App. 2011). 41   See, e.g., ibid at 33–34 (analyzing the reasonableness of an attorneys’ fee award based on North Carolina Rule of Professional Conduct 1.5); In re Harris Teeter Merger Litig., No 13 CVS 12579, 2014 WL 4748566, at *9 (N.C. Super. Ct. Sept. 24, 2014). 42   See Corwin v. British Am. Tobacco PLC, No 14 CVS 8130, 2016 WL 635191 (N.C. Super. Ct. Feb. 17, 2016); In re Pike Corp. S’holder Litig., No 14 CVS 1202, 2015 WL 5918183 (N.C. Super. Ct. Oct. 8, 2015); Nakatsukasa v. Furiex Pharm., Inc., No 14 CVS 6156, 2015 WL 4069818 (N.C. Super. Ct. July 1, 2015); In re Pokertek Merger Litig., No 14 CVS 10579, 2015 WL 270210 (N.C. Super. Ct. Jan. 22, 2015); In re Harris Teeter, 2014 WL 4748566; In re Progress Energy S’holder Litig., No 11 CVS 739, 2011 WL 5967183 (N.C. Super. Ct. Nov. 29, 2011). 43   See Ehrenhaus, 717 S.E.2d at 34–35. 44   Ehrenhaus v. Baker, 776 S.E.2d 699, 707 (N.C. Ct. App. 2015). 45   The underlying question of the court’s authority was presented to the North Carolina Supreme Court on an appeal of the approval of class settlement where the settling corporation had agreed to an award of attorneys’ fees but did not agree to the amount of fees the trial court 37 38

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Disclosure settlements in the state courts post-Trulia  199 If the reviewing court is satisfied of its authority to award attorneys’ fees in a disclosure settlement, it then must confront the difficult task of assessing the materiality of the disclosure and the comparative value of that disclosure in comparison to the amount of attorneys’ fees requested. These are related but distinct questions, and neither is particularly within the common experience of a judge who is not regularly involved in litigation challenging or valuing corporate transactions. The approach of assessing the reasonableness of fees based on the Rules of Professional Conduct becomes decidedly more difficult when there is no common fund from which the fees will be taken, as those factors are more easily applied when measuring an attorney’s share of a monetary settlement based on a contingency fee agreement. Those factors include: (1) the time and labor required, the novelty and difficulty of the questions involved, and the skill requisite to perform the legal service properly; (2) the likelihood, if apparent to the client, that the acceptance of the particular employment will preclude other employment by the lawyer; (3) the fee customarily charged in the locality for similar legal services; (4) the amount involved and the results obtained; (5) the time limitations imposed by the client or by the circumstances; (6) the nature and length of the professional relationship with the client; (7) the experience, reputation, and ability of the lawyer or lawyers performing the services; and (8) whether the fee is fixed or contingent.46 Those factors guard against an excessive fee when measured by an attorneys’ efforts, but they do not provide a meaningful, objective standard for measuring whether there is any significant nonmonetary benefit obtained through a supplemental disclosure. Those who have been deeply entrenched in the efforts to attack the overall landscape of disclosure settlements leading up to Trulia may be inclined to argue that Trulia has now made the test a simple one and that a court should apply a strict standard without hesitation. The discomfort confronted by a trial judge when attempting to measure the adequacy of a supplemental disclosure and the potential arrogance of belittling that discomfort is evident in the recent decision in In re Walgreen Co. Stockholder Litigation.47 There, the district court judge approved a disclosure settlement, including a significant attorneys’ fee award, but before doing so expressed a concern as to the court’s ability to assess the materiality of the supplemental disclosures, reaching no comfortable decision as to whether the disclosures were clearly material.48 Judge Posner had no such discomfort in criticizing the trial court’s hesitancy and suggesting that a simple awarded. See In re Pike Corp., 2015 WL 5918183. The case settled while the appeal was pending, and thus, no appellate decision was issued. See In re Pike Corp., 2015 WL 5918183, appeal dismissed sub nom. Orban v. Pike Corp., No 32A16 (N.C. Mar. 29, 2016). 46   N.C. R. Prof’l Conduct 1.5; Ehrenhaus, 717 S.E.2d at 33–34. 47   In re Walgreen Co. Stockholder Litig., No 1:14-cv-9786 (N.D. Ill. Nov. 20, 2015), rev’d, 832 F.3d 718 (7th Cir. 2016). 48   See Transcript of Proceedings at 36–37, In re Walgreen Co., No 1:14-cv-9786.

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200  Research handbook on representative shareholder litigation approach to addressing any such discomfort was available through the expediency of a court-appointed expert.49 Judge Posner observed that Federal Rule of Evidence 706 would allow the trial court to appoint an expert to assess the materiality of disclosures.50 He did not comment further on how such an approach would be implemented where one of the two advocates, the settling corporation, could not be expected to advocate against the settlement.51 Likewise, most states would grant the trial court similar authority, as most have adopted evidentiary rules modeled on the federal rules. However, in the typical process, should a court appoint its own expert, and should such expert’s opinion become the basis of the court’s decision, generally the expert would be made available for examination by the litigants, and opposing litigants would participate. But as Chancellor Bouchard pointed out, that adversarial process is no longer at play when both the class representative and the corporation promote the settlement.52 But in that circumstance, practical considerations arise as to how to involve an expert. Does the court assume its own role as an advocate? Is the court required to tender the equivalent of an expert disclosure or report before making the expert available for examination? There is also the potentially significant expert cost that presumably would be borne by the settling corporation. To date, in many cases, the advocate’s role left aside by the settling corporation has been assumed by an objecting class member. Professor Sean Griffith has been effective in opposing disclosure-based settlements.53 But often, an objector’s first notice of the settlement may be shortly before a fairness hearing is scheduled, and the particular circumstances of a settlement may demand that the court condition the time required for full consideration of arguments presented by the objector on a delay in the shareholder vote to consider the transaction and the many factors that may be involved in such a balancing determination. This chapter’s primary focus has been on the component of the disclosure settlement that provides for the award of attorneys’ fees, and on noting the issues that a nonDelaware court may encounter due to the absence of a recognized corporate benefit doctrine. Clearly, there are potential abuses when a settlement offers a release of claims that is not commensurate with the settlement consideration, and those considerations may be deserving of a separate article altogether. The significant point is that Trulia was adopted by the Court of Chancery after many years of handling deal litigation and developing standards under which disclosure settlements became prevalent. The Court of Chancery, based on the manifest results of its own procedures, has now elected to retrench. If, as predicted, the substantial volume of deal litigation now moves away from Delaware courts, to other state courts, those courts may ultimately follow the path toward a strict standard of review. But, before doing so, they depend on their own independent experiences, which will require weaving through the   In re Walgreen Co., 832 F.3d at 724.  Ibid. 51  Ibid. 52   In re Trulia, Inc. Stockholder Litig., 129 A.3d 884, 893 (Del. Ch. 2016). 53   See, e.g., Brief of Sean J. Griffith as Amicus Curiae, In re Trulia, 129 A.3d 884 (C.A. No 10020-CB); In re Riverbed Tech., Inc. Stockholders Litig., C.A. No 10484-VCG, 2015 WL 5458041, at *2, *6 (Del. Ch. Sept. 17, 2015). 49 50

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Disclosure settlements in the state courts post-Trulia  201 many issues presented by deal litigation involving high-dollar transactions proceeding at a fast pace and involving complex and sophisticated financial issues for which most judges are ill-trained. Until such time as it may be proven that no disclosure-based litigation has merit, judges will instinctively look for ways to settle such complex litigation. And often, some assurance of a pathway toward the recovery of attorneys’ fees for class counsel may be a predicate for any such settlement.

BIBLIOGRAPHY Cornerstone Research, 2016. “Shareholder Litigation Involving Acquisitions of Public Companies,” available at www.cornerstone.com. O’Connell, K. Tyler, Emily V. Burton, & Julia B. Ripple, October 2015. “Reducing the ‘Deal Tax’: Delaware’s Recent Scrutiny of Nonmonetary Settlements,” Business Law Today. Ratner, Morris A., 2015. “Class Counsel as Litigation Funders,” Georgetown Journal of Legal Ethics 28:271. Shaner, Megan W., 2014. “The (Un)Enforcement of Corporate Officers’ Duties,” UC Davis Law Review 48:271–336.

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13.  Changing attitudes: the stark results of thirty years of evolution in Delaware M&A litigation J. Travis Laster*

More than 30 years ago, during the remarkable “watershed year” of 1985,1 the Delaware Supreme Court issued four landmark decisions: Van Gorkom,2 Unocal,3 Moran,4 and Revlon.5 Together, these decisions established a new framework for reviewing third party mergers and acquisitions.6 Since then, Delaware courts have reviewed third party M&A scenarios, such as hostile bids and transactions involving a change of control, using an intermediate standard known as enhanced scrutiny. Under that standard, the

*  This chapter revisits themes that I addressed during a speech on November 18, 2015, to the Society of Corporate Secretaries and Governance Professionals in Wilmington, Delaware. 1   Veasey (1990) (reviewing Block et al. (1989)); accord Veasey (2004) (“The watershed year of 1985, featuring Smith v. Van Gorkom, Unocal, Moran v. Household, and Revlon, was indeed a time when many of the rules of the road did change in the context of mergers and acquisitions” (citations omitted)). The four written opinions actually were issued during a 14-month period between January 1985 and March 1986, making the reference to a single calendar year a form of interpretive license reminiscent of the long nineteenth century of European historians. Delaware’s long year is perhaps more temporally grounded because although the Delaware Supreme Court published the written decision in Revlon on March 13, 1986, outside the calendar year, the high court issued its injunction ruling orally from the bench on November 1, 1985, within the watershed. 2   Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), overruled on other grounds by Gantler v. Stephens, 965 A.2d 695 (Del. 2009). 3   Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985). 4   Moran v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985). 5   Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173 (Del. 1986). 6   By third party mergers and acquisitions, I mean a transaction negotiated at arm’s length, or a board’s arm’s length resistance to a hostile bid. I exclude from this term scenarios where the counterparty is a controlling stockholder, or where a majority of the directors have a traditional conflict of interest resulting from direct transaction-related benefits. The latter two transactional categories have long been governed by the entire fairness test, and during the 1980s they continued to be. See Rosenblatt v. Getty Oil Co., 493 A.2d 929 (Del. 1985); Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983). The principal doctrinal development for controlling stockholder transactions took place in the 1990s, when the Delaware Supreme Court held that the threat of inherent coercion created by the presence of a controlling stockholder meant that the use of a special committee of independent directors was not sufficient to restore business judgment review. See Kahn v. Lynch Commc’n Sys., Inc., 638 A.2d 1110 (Del. 1994). Recent Delaware Supreme Court decisions show evolving attitudes in this area as well. See In re Cornerstone Therapeutics Inc., S’holder Litig., 115 A.3d 1173 (Del. 2015) (holding that presence of controller and threat of inherent coercion are insufficient to call into question independence and disinterestedness of a director for purposes of pleading a claim for breach of fiduciary duty that would overcome exculpation under Del. Code Ann. tit 8 § 102(b)(7)) (2016); Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014) (holding that use of both a special committee and a majority-of-the-minority vote ab initio are sufficient to negate the threat of inherent coercion and cause the operative standard of review to be the business judgment rule).

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Changing attitudes  203 defendant directors bear the burden of proving that they sought to serve a legitimate corporate purpose and that their actions fell within a range of reasonableness (Laster 2013b).7 The concept of reasonableness can denote an objective standard that requires an assessment of what humans generally should do when presented with a particular set of factual circumstances. But there is no Platonic form of reasonableness, and attitudes and perceptions necessarily influence the determination. Whenever possible, judges charged with striving to apply neutral principles of law must draw those attitudes and perceptions from authoritative legal sources, such as constitutions, statutes, and judicial precedent. For the Delaware common law of fiduciary obligations, the attitudes and perceptions that emerge from the Delaware Supreme Court’s opinions and the justices’ scholarly writings necessarily and substantially influence a trial court’s assessment of what types of conduct are reasonable. Over the decades, the Delaware Supreme Court’s attitudes and perceptions of recurring third party M&A scenarios have evolved significantly, and the pragmatic application of enhanced scrutiny has evolved with them. Many of the attitudes exhibited in the opinions from the watershed year and its aftermath no longer hold. More recent Delaware Supreme Court case law manifests quite different perceptions. This chapter highlights four of these areas (more could be identified). In doing so, it does not suggest that the current attitudes burst forth suddenly or out of the blue. Most of the intervening evolutionary work took place at the Court of Chancery level, and this chapter does not attempt the daunting (but laudable) task of chronicling the intervening developments. Nor does this chapter suggest that the current attitudes are misguided, or that the process by which they have developed is inappropriate. To the contrary, the evolutionary process fulfills a promise that the Delaware court made 30 years ago in the landmark Unocal decision: “[O]ur corporate law is not static. It must grow and develop in response to, indeed in anticipation of, evolving concepts and needs.”8 Although other factors could be cited, this chapter points to two predominant influences: (1) the rise of sophisticated institutional investors who have the ability to influence the direction of the corporations in which they invest and determine the outcome of M&A events, and (2) the systemwide failure of stockholder-led M&A litigation to generate meaningful benefits for investors, setting aside occasional recoveries by a small subset of the bar. Regardless of the reasons, enhanced scrutiny as applied in the second decade of the current millennium differs markedly from enhanced scrutiny as applied during the watershed year and its aftermath. No longer can courts, practitioners, or scholars treat the old learning as authoritative, simply because the decisions have not been formally overruled. The law operates not only through the formal standard of review, but more directly through the manner in which it is applied. For enhanced scrutiny, the mode of application has become significantly more deferential to sellside boards.

7   See, e.g., Pell v. Kill, 135 A.3d 764, 784–86 (Del. Ch. 2016) (describing parameters of enhanced scrutiny); Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457–59 (Del. Ch. 2011) (same). 8   Unocal, 493 A.2d at 957.

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1. EARLY ATTITUDES TOWARD RECURRING M&A SCENARIOS The Delaware Supreme Court’s decisions during the watershed year of 1985 and for approximately a decade thereafter, culminating in its opinion in QVC,9 reflected a particular set of attitudes toward recurring M&A scenarios. One strong message was skepticism toward management-led, single-bidder processes, combined with encouragement of board-led, multibidder processes. Skepticism also greeted the deployment of defensive measures, particularly no-shop clauses, that appeared designed to limit a board’s ability to generate multibidder processes. When the Delaware Supreme Court deemed a defensive measure to be questionable, it prioritized the fiduciary responsibilities of the selling directors over the contract rights of the third party acquirer. The high court’s decisions during this era did not regard stockholders as capable of protecting their own interests through voting, leaving the court to fill the gap by enforcing the directors’ fiduciary duties. The resulting framework led to targeted preliminary injunctions that enjoined the specific features of the transaction agreements that the high court found problematic. 1.1  Skepticism about Management-Led, Single-Bidder Processes In its early enhanced scrutiny decisions, the Delaware Supreme Court consistently displayed skepticism toward management-led, single-bidder transactions while appearing to favor multibidder scenarios. Looking back on the case law from the era, Chancellor Allen remarked that “perhaps one of the clearest messages repeatedly affirmed by the Delaware Supreme Court’s corporate law jurisprudence from 1985 forward is that outside directors may not blindly rely upon a strong CEO without risk.”10 While serving on the Court of Chancery, Chief Justice Leo E. Strine, Jr. similarly described the “paradigmatic context for a good Revlon claim” as one where “a supine board under the sway of an overweening CEO bent on a certain direction, tilts the sales process for reasons inimical to the stockholders’ desire for the best price.”11 These judicial preferences burst forth in 1985 with the decisions in Van Gorkom and Revlon, which bookended the watershed year. Van Gorkom was the first of the four landmark opinions, and although the Delaware Supreme Court did not expressly apply enhanced scrutiny (it was not invented until five months later in Unocal), a broad consensus now exists that Van Gorkom was the Delaware Supreme Court’s initial—albeit unacknowledged—enhanced scrutiny decision.12 The blunt practical outcome of Van   Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1994).   Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1134, 1141 (Del. Ch. 1994), aff’d, 663 A.2d 1156 (Del. 1995). 11   In re Toys “R” Us, Inc. S’holder Litig., 877 A.2d 975, 1002 (Del. Ch. 2005). 12   See In re Dollar Thrifty S’holder Litig., 14 A.3d 573, 602 (Del. Ch. 2010) (“Van Gorkom, after all, was really a Revlon case”) (footnotes omitted); Gagliardi v. TriFoods Int’l, Inc., 683 A.2d 1049, 1051 n.4 (Del. Ch. 1996) (“I count [Van Gorkom] not as a ‘negligence’ or due care case involving no loyalty issues, but as an early and, as of its date, not yet fully rationalized, ‘Revlon’ or ‘change of control’ case”); see also Allen, Jacobs, and Strine, Jr. (2002: 459 n.39) (“Van Gorkom . . . must also be viewed as part of the Delaware courts’ effort to grapple with the huge increase in mergers and acquisition activity in the 1980s and the new problems that posed for judicial review  9 10

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Changing attitudes  205 Gorkom was to hold independent directors liable for approving a merger that resulted from a single-bidder process dominated by the CEO. The Delaware Supreme Court seemed to be sending a clear message: Don’t do what the Van Gorkom directors did. Revlon, fourteen months later, appeared to make explicit what was implicit in Van Gorkom, namely that a sellside board was supposed to engage with multiple bidders. In Revlon, a board of directors initially resisted a hostile bid, but once the bid reached a certain level it authorized management to explore a management buyout. The Delaware Supreme Court held that “[t]he Revlon board’s authorization permitting management to negotiate a merger or buyout with a third party was a recognition that the company was for sale.”13 Then, in the ringing words that have formed the principal legacy of the decision, the Delaware Supreme Court stated that “[t]he directors’ role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.”14 The reference to an auction seemed to contemplate multiple bidders. In Barkan,15 three years later, the Delaware Supreme Court used dictum to weigh in at length on its preference for multiple-bidder scenarios. Barkan arose in the relatively rare procedural posture of an objector appealing the approval of a settlement. Two groups of stockholder plaintiffs had challenged a management buyout in which the board neither sought out nor received competing bids. The lead plaintiffs filed suit immediately after the announcement of an earlier transaction that was subsequently abandoned in favor of the MBO, did not engage in meaningful litigation activity, did not update their complaints to challenge the MBO, and accepted as the consideration for their settlement a price bump negotiated independently by a large stockholder. When they sought approval of the settlement, Chancellor Allen was “frank to say that [he] regard[ed] this as a difficult motion,”16 and he detailed many concerns about the underlying transaction and how the plaintiffs had approached their case. But he approved the settlement. On appeal, the Delaware Supreme Court affirmed, then took the opportunity to express its own concerns about the deal process. First, the high court addressed whether enhanced scrutiny would have applied to the plaintiffs’ postclosing claims for breach of fiduciary duty, had they pressed them at trial: There is some dispute among the parties as to the meaning of Revlon, as well as its relevance to the outcome of this case. We believe that the general principles announced in Revlon, in [Unocal], of director conduct”); Allen (1998: 325) (“In retrospect, [Van Gorkom] can be best rationalized not as a standard duty of care case, but as the first case in which the Delaware Supreme Court began to work out its new takeover jurisprudence”); Black and Kraakman (2002: 522) (“Van Gorkom should be seen not as a business judgment rule case but as a takeover case that was the harbinger of the then newly emerging Delaware jurisprudence on friendly and hostile takeovers, which included the almost contemporaneous Unocal and Revlon decisions”); Macey and Miller (1988: 128) (“Trans Union is not, at bottom, a business judgment case. It is a takeover case”); Bainbridge (2002: 51–52) (interpreting “the oft-maligned decision in Smith v. Van Gorkom” as addressing a breakdown in the group decision-making process in which the board “blindly relied on Van Gorkom,” thereby enabling Van Gorkom to not disclose and the board to not discover “key facts suggesting that the deal was not as attractive as it seemed on first look”). 13   Revlon Inc. v. MacAndrew & Forbes Hldgs., Inc., 506 A.2d 173, 181 (Del. 1986). 14  Ibid. 15   Barkan v. Amsted Indus., 567 A.2d 1279 (Del. 1989). 16   In re Amsted Indus. Inc. Litig., 1988 WL 92736, at *1 (Del. Ch. Aug. 24, 1988).

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206  Research handbook on representative shareholder litigation and in [Moran] govern this case and every case in which a fundamental change of corporate control occurs or is contemplated. However, the basic teaching of these precedents is simply that the directors must act in accordance with their fundamental duties of care and loyalty. It is true that a court evaluating the propriety of a change of control or a takeover must be mindful of “the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders.” Nevertheless, there is no single blueprint that a board must follow to fulfill its duties. A stereotypical approach to the sale and acquisition of corporate control is not to be expected in the face of the evolving techniques and financing devices employed in today’s corporate environment. Rather, a board’s actions must be evaluated in light of relevant circumstances to determine if they were undertaken with due diligence and good faith.17

Today, the “no single blueprint” language is cited ubiquitously in support of an argument that a board did not have to contact multiple bidders, but the central thrust of this passage cut in the opposite direction. The Delaware Supreme Court was confirming that enhanced scrutiny, which at that point carried the connotation of multiple bidders, applied generally to “every case in which a fundamental change of corporate control occurs or is contemplated” and would have provided the operative standard of review for the claims that the plaintiffs had settled. Next, the Delaware Supreme Court directly reinforced its preference for multiple bidders, explaining that a single-bidder process, while permissible, should be the exception rather than the rule: This Court has found that certain fact patterns demand certain responses from the directors. Notably, in Revlon, we held that when several suitors are actively bidding for control of a corporation, the directors may not use defensive tactics that destroy the auction process. When it becomes clear that the auction will result in a change of corporate control, the board must act in a neutral manner to encourage the highest possible price for shareholders. However, Revlon

17   Barkan, 567 A.2d at 1286 (quoting Unocal) (citations omitted). Other Delaware Supreme Court decisions similarly have held that enhanced scrutiny applies to postclosing breach of fiduciary duty claims. See Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 242–44 (Del. 2009) (agreeing with Court of Chancery that enhanced scrutiny governed postclosing claim that directors acted in bad faith when approving sale of corporation for cash, but reversing denial of summary judgment on grounds that plaintiffs had not cited evidence to support their theory of bad faith); McMullin v. Beran, 765 A.2d 910, 918–20 (Del. 2000) (reversing the Court of Chancery’s dismissal of a claim that directors had failed to obtain the best value reasonably available in a merger when selling to a third party in a transaction that allegedly satisfied the controlling stockholder’s need for liquidity and holding, in the context of a postclosing challenge to a cash sale, that the directors had the burden to show that they acted reasonably to obtain the best value reasonably available and made a reasonably informed decision to approve the challenged merger); In re Santa Fe Pac. Corp. S’holder Litig., 669 A.2d 59, 71 (Del. 1995) (reversing dismissal of post-closing claim that directors had breached their fiduciary duties by adopting unreasonable defensive measures as part of a third party arm’s length merger agreement and holding that enhanced scrutiny governed the claim and that the case therefore “differ[ed] from cases where the presumption of the business judgment rule attaches ab initio and to survive a Rule 12(b)(6) motion, a plaintiff must allege well-pleaded facts to overcome the presumption”). These decisions did not address whether a fully informed, noncoerced stockholder vote (as opposed to the mere fact of closing) would lower the standard of review. The Delaware Supreme Court has now held that stockholder approval both restores the business judgment rule and renders it irrebutable. See Singh v. Attenborough, 137 A.3d 151 (Del. 2016); Corwin v. KKR Fin. Hldgs. LLC, 125 A.3d 304 (Del. 2015).

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Changing attitudes  207 does not demand that every change in the control of a Delaware corporation be preceded by a heated bidding contest. Revlon is merely one of an unbroken line of cases that seek to prevent the conflicts of interest that arise in the field of mergers and acquisitions by demanding that directors act with scrupulous concern for fairness to shareholders. When multiple bidders are competing for control, this concern for fairness forbids directors from using defensive mechanisms to thwart an auction or to favor one bidder over another. When the board is considering a single offer and has no reliable grounds upon which to judge its adequacy, this concern for fairness demands a canvas of the market to determine if higher bids may be elicited. When, however, the directors possess a body of reliable evidence with which to evaluate the fairness of a transaction, they may approve that transaction without conducting an active survey of the market. As the Chancellor recognized, the circumstances in which this passive approach is acceptable are limited. “A decent respect for reality forces one to admit that . . . advice [of an investment banker] is frequently a pale substitute for the dependable information that a canvas of the relevant market can provide.”18

Today, the frequently quoted portion of this passage is the line stating that “Revlon does not demand that every change in the control of a Delaware corporation be preceded by a heated bidding contest.” The overall sense of the passage, however, seems to convey a general expectation that directors “conduct[] an active survey of the market.” While directors could forgo that step and deploy a single-bidder strategy if they had “a body of reliable evidence with which to evaluate the fairness of a transaction,” the Barkan decision cautions that “the circumstances in which this passive approach is acceptable are limited.”19 A reader of the Delaware Supreme Court’s early third party M&A cases thus would get the message that single-bidder processes should be rare. The high court’s attitude seemed to be that single-bidder processes carried a risk that management would steer a transaction to a favored bidder, and that without the information gained from contacting other potential transaction partners, a board could not make a well-informed decision as to whether to sign off on management’s chosen alternative. The Delaware Supreme Court’s preference, therefore, was for the board to reach out to multiple transaction partners and not pursue exclusively single-bidder deals. 1.2  Skepticism about Defensive Measures in Merger Agreements Hand in hand with the Delaware Supreme Court’s skepticism toward single-bidder processes came a complementary attitude to defensive measures in merger agreements. Consistent with its preference for multibidder scenarios, the Delaware Supreme Court condemned the use of defensive measures that appeared designed to end a sale process, but commended the use of provisions that appeared designed to elicit additional bids. As a result, the early Delaware Supreme Court decisions took a particularly negative view of no-shop clauses. Revlon introduced this concept. As the final step in its resistance to a hostile offer, the Revlon board approved a management buyout with a financial sponsor (Forstmann). The unsolicited bidder (Pantry Pride) raised its bid again and announced that it would engage   Barkan, 567 A.2d at 1287 (internal citations omitted).   Later in the opinion, the Delaware Supreme Court reiterated this perspective in virtually identical words, stating, “The situations in which a completely passive approach to acquiring [market] knowledge is appropriate are limited.” Ibid at 1288. 18 19

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208  Research handbook on representative shareholder litigation in fractional bidding to top any further increase by Forstmann. At that point, in return for an increase of approximately 2 percent in the deal price, the board approved a revised merger agreement with Forstmann that included an asset lockup, a no-shop provision, and a termination fee.20 After holding generally that the board breached its fiduciary duties by prematurely locking up its favored transaction, the Delaware Supreme Court focused on the defensive measures. Lockups, the high court held, were not “per se illegal under Delaware law,”21 but the decision distinguished between lockups that “can entice other bidders to enter a contest for control of the corporation, creating an auction for the company and maximizing shareholder profit,” and lockups that “end an active auction and foreclose further bidding.”22 The Delaware Supreme Court disapproved of the asset lock-up in Revlon because Forstmann “had already been drawn into the contest on a preferred basis, so the result of the lock-up was not to foster bidding, but to destroy it.”23 The high court used the same analysis for the no-shop clause. It was not “per se illegal,” but its use was “impermissible under the Unocal standards when a board’s primary duty becomes that of an auctioneer responsible for selling the company to the highest bidder.”24 As with the lockup option, the board’s use of the no-shop clause fell short in Revlon because “[t]he agreement to negotiate only with [Forstmann] ended rather than intensified the board’s involvement in the bidding contest.”25 The court found it “ironic that the parties even considered a no-shop agreement when [the board] had dealt preferentially, and almost exclusively, with Forstmann throughout the contest.”26 This left the termination fee, which the Delaware Supreme Court also enjoined. The fee did not appear invalid on its own, but rather because it was “part of the overall plan to thwart Pantry Pride’s efforts.”27 In Macmillan, three years later,28 the Delaware Supreme Court deployed the same doctrinal analysis. The complex factual scenario in Macmillan led to a board confronting competing bids from a financial buyer (KKR) and a strategic bidder (a company controlled by Robert Maxwell). After management tipped off KKR about the state of the auction,29 the board entered into an agreement with KKR that included an asset lockup and a no-shop provision. In analyzing these provisions, the Delaware Supreme Court reiterated the distinction between measures designed to draw other parties into the bidding and those designed to foreclose further bidding: Although we have held that such agreements are not per se illegal, we recognized that like measures often foreclose further bidding to the detriment of shareholders, and end active auc-

20   Revlon Inc. v. MacAndrews & Forbes Hldgs., Inc. 506 A.2d 173, 178–79 (Del. 1986) (footnotes omitted). 21  Ibid at 183. 22  Ibid. 23  Ibid. 24   Ibid at 184. 25  Ibid. 26  Ibid. 27  Ibid. 28   Mills Acq. Co. v. Macmillan, Inc., 559 A.2d 1261 (Del. 1989). 29   See ibid at 1275; accord ibid at 1285–86.

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Changing attitudes  209 tions prematurely. If the grant of an auction-ending provision is appropriate, it must confer a substantial benefit upon the stockholders in order to withstand exacting scrutiny by the courts.30

The Delaware Supreme Court concluded that the asset lockup in Macmillan “was not necessary to draw any of the bidders into the contest” and did not result in a materially better bid from KKR.31 And because the assets involved were the company’s crown jewels, the court also noted that “at the very least the independent members of the board must attempt to negotiate alternative bids before granting such a significant concession.”32 This had not occurred, and the asset lockup was therefore invalid. Following Revlon, the Macmillan decision subjected the no-shop clause to the same analysis: As for the no-shop clause, Revlon teaches that the use of such a device is even more limited than a lock-up agreement. Absent a material advantage to the stockholders from the terms or structure of a bid that is contingent on a no-shop clause, a successful bidder imposing such a condition must be prepared to survive the careful scrutiny which that concession demands.33

Strikingly for a presentday reader, the Delaware Supreme Court regarded the no-shop clause as more worrisome than the asset lockup. In the Barkan decision, the Delaware Supreme Court again criticized the use of no-shop clauses, observing that “[w]e certainly do not condone in all instances the imposition of the sort of ‘no-shop’ restriction that bound Amsted’s Special Committee.”34 The high court explained that “[w]here a board has no reasonable basis upon which to judge the adequacy of a contemplated transaction, a no-shop restriction gives rise to the inference that the board seeks to forestall competing bids.”35 The directors in Barkan had received advice that an ESOP-funded management buyout carried tax advantages that meant no other bidder could pay a higher price, but the Delaware Supreme Court still recommended eschewing a no-shop clause and contacting other bidders: “Even here, a judicious market survey might have been desirable, since it would have made it clear beyond question that the board was acting to protect the shareholder’s interests.”36 Read together, Revlon, Macmillan, and Barkan suggested that Delaware courts would take a hard look at defensive measures, and particularly those granted as part of a single-bidder process. That scenario played out five years later in QVC. After the epitome of a single-bidder process,37 the board of directors of Paramount Communications Inc. entered into a merger agreement with Viacom Inc. that “contained several provisions designed to make it more difficult for a potential competing bid to succeed,” including a no-shop provision, a termination fee, and a stock option lockup.38 Despite these defenses,   Ibid at 1284.   Ibid at 1286 (“When one compares what KKR received for the lockup, in contrast to its inconsiderable offer, the invalidity of the agreement becomes patent”). 32  Ibid. 33   Ibid (emphasis added). 34   Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1288 (Del. 1989). 35  Ibid. 36  Ibid. 37   Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 36–39 (Del. 1994). 38   Ibid at 39. 30 31

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210  Research handbook on representative shareholder litigation QVC launched a higher priced, all-cash tender offer for Paramount. “Within hours after QVC’s tender offer was announced, Viacom entered into discussions with Paramount concerning a revised transaction.”39 Although the Delaware Supreme Court regarded this as an “opportunity for a ‘new deal’ with Viacom,”40 the Paramount board approved what was “essentially the same” merger agreement.41 In the ensuing litigation, the Delaware Supreme Court held that the Paramount directors’ decision to enter into the original merger agreement with Viacom “was not reasonable,” because “the Paramount Board clearly gave insufficient attention to the potential consequences of the defensive measures demanded by Viacom.”42 The problem was that the stock option lockup and termination fee “clearly made Paramount less attractive to other bidders,” and the no-shop clause “inhibited the Paramount Board’s ability to negotiate with other potential bidders, particularly QVC which had already expressed an interest in Paramount.”43 On the latter issue, the opinion quoted the passage from Barkan in which the court observed that the grant of a no-shop restriction without an adequate basis of information “gives rise to the inference that the board seeks to forestall competing bids.”44 In effect, the defensive measures locked the Paramount board into its singlebidder strategy, rather than providing an opportunity for the board to explore alternatives after securing the initial bid.45 The scenario that Barkan anticipated had come to pass. Particularly after QVC, a reader of the Delaware Supreme Court’s M&A case law would perceive congruence between the high court’s attitude toward defensive measures and its attitude toward single-bidder processes. Both should be rare and only deployed where the board has a reliable basis for believing it has obtained the best transaction reasonably available. A trial judge attempting to glean the metes and bounds of the range of reasonableness in similar transactional scenarios would apply the standard with these attitudes in mind. 1.3  The Primacy of Fiduciary Duties over Contract Rights In light of the Delaware Supreme Court’s skepticism toward single-bidder processes and other forms of bidder favoritism, a third approach from the early M&A cases is perhaps less surprising: When a defensive provision proved problematic, the Delaware Supreme Court prioritized the fiduciary duties of the sellside directors over the third party contract rights of the acquirer and deployed a targeted injunction to disable the problematic feature. Revlon, Macmillan, and QVC each resulted in a targeted preliminary injunction  Ibid at 40.  Ibid. 41  Ibid. 42   Ibid at 49; accord ibid at 36 (“[T]he conduct of the Paramount Board was not reasonable as to process or result”). 43   Ibid at 49. 44   Ibid at 49 n.20 (quoting Barkan v. Amsted Indus., Inc., 567 A.2d 1279 1288 (Del. 1989)). 45   The Delaware Supreme Court also criticized the Paramount Board for not taking advantage of the opportunity that the QVC bid presented to re-negotiate its deal with Viacom and choosing instead “to cling to its vision of a strategic alliance with Viacom.” QVC, 637 A.2d at 50. The court found that the directors “remained prisoners of their own misconceptions and missed opportunities to eliminate the restrictions they had imposed on themselves.” Ibid. 39 40

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Changing attitudes  211 against specific features of the challenged third party transaction, which thereby allowed a competitive sale process to unfold. In Revlon and Macmillan, the outcome of the sale process flipped, with Pantry Pride acquiring Revlon and Maxwell acquiring Macmillan. In QVC, the outcome remained the same, with Paramount outbidding QVC. Perhaps the best indication of the Delaware Supreme Court’s early attitude toward third party contract rights was the absence of any mention of the issue in Revlon or Macmillan. In Revlon, the merger agreement contained a crown-jewel asset lockup, a no-shop clause, and a termination fee, and the Court of Chancery enjoined all three defensive measures.46 The Delaware Supreme Court affirmed the targeted injunction without discussing the acquirer’s contract rights.47 The Delaware Supreme Court went a step further in Macmillan, where the merger agreement included a crown-jewel asset lockup, a no-shop clause, and a provision waiving the company’s rights plan to allow KKR’s transaction to proceed.48 The Court of Chancery enjoined the waiver of the rights plan but not the asset lockup and no-shop clause. On appeal, the Delaware Supreme Court affirmed the injunction against the waiver of the rights plan but reversed the denial of the injunction against the asset lockup and no-shop clause, holding that those features were invalid and should be enjoined as well.49 The high court did not discuss the acquirer’s contract rights. The issue of the acquirer’s contract rights finally came to the fore in QVC, where the defensive measures included a no-shop provision, a termination fee, and a stock option lockup.50 The Court of Chancery enjoined the no-shop provision and the stock option lockup, but not the termination fee.51 On appeal, the Paramount directors and Viacom each advanced arguments premised on Viacom’s contract rights. The Paramount directors contended that once they approved the initial merger agreement with Viacom, “they were precluded by certain contractual provisions, including the No-Shop Provision, from negotiating with QVC or seeking alternatives.”52 After the Delaware Supreme Court’s decision in Van Gorkom, this argument had substantial force,53 but the QVC court brushed it aside, stating:   Revlon Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 183–84 (Del. 1986).  Ibid at 184–85. 48   Mills Acq. Co. v. Macmillan, Inc., 1988 WL 108332, at *19 (Del. Ch. Oct. 18, 1988), rev’d in part, 559 A.2d 1261 (Del. 1989). 49   Macmillan, 559 A.2d at 1285–86, 1288. 50   QVC, 637 A.2d at 39. 51   QVC Network, Inc. v. Paramount Commc’ns, Inc., 635 A.2d 1245, 1270-73 (Del. Ch. 1993), aff’d, 637 A.2d 34 (Del. 1994). 52   QVC, 637 A.2d at 48. 53   See Balotti and Sparks, III (2002: 468–69) (“In Smith v. Van Gorkom, the Delaware Supreme Court established that Delaware law does not give directors, just because they are fiduciaries, the right to accept better offers, distribute information to potential new bidders, or change their recommendation with respect to a merger agreement even if circumstances have changed”) (citation omitted); Allen (2000: 654) (“One of the holdings of the Delaware Supreme Court in Van Gorkom was that corporate directors have no fiduciary right (as opposed to power) to breach a contract”) (citations omitted); Johnston (1998: 778) (“[T]here is . . . no public policy that permits fiduciaries to terminate an otherwise binding agreement because a better deal has come along, or circumstances have changed”); Sparks, III (1997: 817) (“[Van Gorkom] makes it clear that under Delaware law there is no implied fiduciary out or trump card permitting a board to terminate a merger agreement 46 47

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212  Research handbook on representative shareholder litigation Such provisions whether or not they are presumptively valid in the abstract, may not validly define or limit the directors’ fiduciary duties under Delaware law or prevent the Paramount directors from carrying out their fiduciary duties under Delaware law. To the extent such provisions are inconsistent with those duties, they are invalid and unenforceable.54

In this passage, the Delaware Supreme Court explicitly prioritized fiduciary duties over contract rights and made the validity of the latter turn on compliance with the former. At a later point in the decision, the Delaware Supreme Court addressed Viacom’s argument that it possessed vested contract rights, including the right to enforce the no-shop provision and stock option lockup. As to the no-shop clause, the Delaware Supreme Court rejected Viacom’s contention in language resembling its response to the Paramount directors: The No-Shop Provision could not validly define or limit the fiduciary duties of the Paramount directors. To the extent that a contract, or a provision thereof, purports to require a board to act or not act in such a fashion as to limit the exercise of its fiduciary duties, it is invalid and unenforceable. Despite the arguments of Paramount and Viacom to the contrary, the Paramount directors could not contract away their fiduciary obligations. Since the No-Shop Provision was invalid, Viacom never had any vested contract rights in the provision.55

Once again, fiduciary duties trumped contract rights, rendering the latter a nullity. The Delaware Supreme Court also rejected Viacom’s attempt to enforce the stock option lockup, which arguably presented different issues because it did not directly limit the board’s ability to act. The Delaware Supreme Court nevertheless held that the stock option lockup was invalid as well because of its ‘“draconian’ aspects,” and stated that “[a]ccordingly, Viacom never had any vested contract rights in that Agreement.”56 Importantly, under the QVC court’s analysis, whether or not a third party acquirer had enforceable contract rights depended on whether the sellside directors complied with their before it is sent to a stockholder vote”); Johnston & Alexander (1997: 15) (explaining that in Van Gorkom, “the Delaware Supreme Court held that directors of Delaware corporations may not rely on their status as fiduciaries as a basis for (1) terminating a merger agreement due to changed circumstances, including a better offer; or (2) negotiating with other bidders in order to develop a competing offer”). 54   QVC, 637 A.2d at 48 (citing Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 184–85 (Del. 1986)). The opinion later reiterated this point, stating that “the No-Shop Provision could not define or limit [the directors’] fiduciary duties.” Ibid at 50. Elsewhere, however, in a footnote, the Delaware Supreme Court hedged a bit: “We express no opinion whether certain aspects of the No-Shop Provision here could be valid in another context. Whether or not it could validly have operated here at an early stage solely to prevent Paramount from actively ‘shopping’ the company, it could not prevent the Paramount directors from carrying out their fiduciary duties in considering unsolicited bids or in negotiating for the best value reasonably available to the stockholders.” Ibid at 49 n.20. This language narrowed QVC’s ruling by suggesting that a no-shop provision could restrict a board’s conduct under some circumstances, but it oddly implied that the validity of the provision would not be determined at the time the board approved it, but rather after the fact based on subsequent events. See Laster (2013a: 822–26) (noting similarities between this aspect of QVC and language in the Delaware Supreme Court’s much criticized opinion in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003)). 55   QVC, 637 A.2d at 51. 56  Ibid.

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Changing attitudes  213 fiduciary duties when agreeing to the terms of the contract. The QVC decision did not require a substantial degree of participation by Viacom in the breach. It was sufficient that “Viacom, a sophisticated party with experienced legal and financial advisors, knew of (and in fact demanded) the unreasonable features.”57 Having done so, Viacom “cannot be now heard to argue that it obtained vested contract rights by negotiating and obtaining contractual provisions from a board acting in violation of its fiduciary duties.”58 The stockholders’ interests took precedence, and to enforce provisions that resulted from a breach of duty would “get the shareholders coming and going.”59 As the QVC court saw it, “Viacom’s . . . fate must rise or fall, and in this instance fall, with the determination that the actions of the Paramount Board were invalid.”60 Based on this analysis, the Delaware Supreme Court both affirmed the injunction ruling and expanded its scope to include the termination fee. Particularly after QVC, a reader of the Delaware Supreme Court’s early M&A decisions would draw the message that the Delaware courts would give little weight to an acquirer’s contract rights. The court’s approach to defensive measures appeared to resemble the concept of assumption of risk: If a sophisticated, well-advised bidder agreed to a provision, it did so recognizing that it would not be able to enforce the provision if it were held invalid because of a sellside breach of fiduciary duty. Again, a trial court seeking to derive the parameters of reasonableness from the Delaware Supreme Court’s decisions would incorporate the assumption-of-risk concept and reject the contract-based rejoinders of acquirers, particularly in the context of preliminary injunction applications. 1.4  The Role of the Stockholder Vote A fourth characteristic of the Delaware Supreme Court’s early M&A cases was the lack of deference to stockholder voting. The Revlon, Macmillan, and QVC decisions did not discuss the possibility of the stockholders protecting themselves by voting.61 At least two factors likely contributed to the absence of any mention of the stockholder vote from the Delaware Supreme Court’s early opinions. One factor was that, during this period, the Delaware Supreme Court endorsed a strongly boardcentric model in which the board of directors exercised the corporation’s power and authority during a third party M&A scenario and did so as fiduciaries for the corporation and its stockholders. In the seminal Unocal decision that created the enhanced scrutiny test, the Delaware Supreme Court rejected the theory, popular among academics of the day, that the board should take a passive role when confronted with a takeover attempt.62 In Revlon, the Delaware Supreme Court extended the concept of

 Ibid.  Ibid. 59   Ibid (quoting ConAgra, Inc. v. Cargill, Inc., 382 N.W.2d 576, 687–88 (Neb. 1986)). 60  Ibid. 61   In fairness, had the argument been made, it seems likely that the Delaware Supreme Court would have viewed the asset lockups in Revlon and Macmillan and the stock option lockup in QVC as sufficiently draconian to generate inequitable coercion and prevent the vote from being meaningful, but it is noteworthy that the issue is not even mentioned. 62   Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954–55 nn.8 & 10 (Del. 1985) (“It has 57 58

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214  Research handbook on representative shareholder litigation an active board to all M&A scenarios.63 The resulting framework required that “the directors . . . determine the best interests of the corporation and its stockholders.”64 It also required that the board act affirmatively “to protect the corporate enterprise, which includes stockholders, from harm reasonably perceived, irrespective of its source.”65 The board’s statutory and fiduciary obligations were unyielding and could “not be delegated to the stockholders.”66 A second factor was the Delaware Supreme Court’s doubts about stockholders’ ability to make the decisions necessary to determine the outcome of an M&A event. The enhanced scrutiny decisions of the 1980s depicted investors as “a diffuse, disaggregated group of retail . . . shareholders who, although educated and intelligent, [were] financially unsophisticated and lack[ed] the power and motivation to influence corporate governance or policy” (Jacobs 2012: 20). Stockholders were “unable to act collectively to influence management or governance policy” (Jacobs 2012: 21)67 so they “need[ed] the courts to protect them from overreaching boards, majority shareholders, or hostile bidders” (Jacobs 2015: 171). This, of course, was the era when the Delaware Supreme Court endorsed the ability of a board to respond to the threat of “substantive coercion,” which it defined as the risk that stockholders might decide takeover outcomes incorrectly because of their “ignorance or mistaken belief ” about the value of the corporation.68 The Delaware Supreme Court’s unwillingness to view the stockholder vote as a meaningful check on director action had an important consequence. It meant that litigation provided the only effective means of enforcing the directors’ fiduciary duties. The absence of an alternative decisionmaker to whom the court could defer likely reinforced the Delaware Supreme Court’s strong attitudes toward other aspects of third party M&A scenarios.

2. CURRENT ATTITUDES TOWARD RECURRING M&A SCENARIOS A traveler leaping over the 30 years that followed the decisions in Revlon, Barkan, and Macmillan, or the approximately 20 years that followed the decision in QVC, would find that the Delaware Supreme Court’s attitudes have changed. Today’s approach is best

been suggested that a board’s response to a takeover threat should be a passive one. However, that clearly is not the law of Delaware, and as the proponents of this rule of passivity readily concede, it has not been adopted either by courts or state legislatures”) (citation omitted). 63   Revlon Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 184 n.16 (Del. 1986) (“The directors’ role remains an active one, changed only in the respect that they are charged with the duty of selling the company at the highest price attainable for the stockholders’ benefit”). 64   Ibid at 181. 65   Unocal, 493 A.2d at 954. 66   Paramount Commc’ns, Inc. v. Time Inc., 571 A.2d 1140, 1154 (Del. 1989). 67   See Easterbrook and Fischel (1983: 416) (“Shareholders, the argument runs, are merely passive financial investors who lack the expertise and incentive to become involved in making business decisions”). 68   Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1385 (Del. 1995); Time Inc., 571 A.2d at 1153 n.17.

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Changing attitudes  215 represented by C & J Energy,69 a decision that the Delaware Supreme Court issued in 2014. In contrast to the Delaware Supreme Court’s early decisions, the C ‌& J Energy opinion: (1) does not display skepticism toward a single-bidder, CEO-driven process; (2) regards a no-shop provision as routine; (3) limits the circumstances in which courts will issue targeted injunctions and stresses the contract rights of bidders; and (4) defers to the stockholder vote as the primary check on deal practice. By citing these contrasts, I am not suggesting any disagreement with the outcome in C & J Energy. Nor am I implying that the attitudes embodied in C & J Energy emerged out of thin air. To the contrary, the C & J Energy decision elevated to the level of Delaware Supreme Court doctrine a series of attitudes that the Court of Chancery had developed during the intervening years.70 For present purposes, the point is to show how far we have come, which is best accomplished by contrasting where we are with where we were. 2.1  The Facts of C & J Energy The transaction in C & J Energy was a stock-for-stock merger between C & J Energy Services, Ltd and a subsidiary of Nabors Industries, Ltd. C & J was nominally the acquirer, and its management team would run the combined entity, but Nabors would hold a majority equity stake in the surviving company, giving the postclosing entity a controlling stockholder.71 The C & J–Nabors transaction resulted from a CEO-driven, single-bidder process. Joshua Comstock, C & J’s founder, chairman, and CEO, spearheaded the discussions. Talks between the two companies’ CEOs started in January 2014, and although Comstock discussed the deal with some of C & J’s directors, he did not receive formal board approval to negotiate until April. Later in the process, he made a revised offer without board approval. The plaintiffs argued that Comstock acted without authority and misled the board about key issues. The Delaware Supreme Court found “at least some support for the plaintiffs’ contention that Comstock at times proceeded on an ‘ask for forgiveness rather than permission’ basis.”72 Before entering into the merger agreement, C & J did not reach out to other potential transaction partners. There were indications in the record that some of the subtle conflicts that permeate M&A scenarios played out in the C & J–Nabors deal. For example, the Nabors CEO “assured Comstock throughout the process that he would be aggressive

69   C & J Energy Servs., Inc. v. Miami Gen. Empls.’ & Sanitation Empls.’ Ret. Tr., 107 A.3d 1049 (Del. 2014). 70   Evidencing this, of the approximately 60 legal citations in the C & J Energy decision, some 17 are to Delaware Supreme Court precedents, while approximately 43 are to Court of Chancery precedents, including 20 citations to decisions issued by Chief Justice Strine while serving as a member of the Court of Chancery. Figuring particularly prominently are his decisions in In re El Paso S’holders Litig., 41 A.3d 432 (Del. Ch. 2012), In re Netsmart Techs., Inc., 924 A.2d 171 (Del. Ch. 2007), In re Toys “R” Us, Inc. S’holder Litig., 877 A.2d 975 (Del. Ch. 2005), and In re Pennaco Energy, Inc., 787 A.2d 691 (Del. Ch. 2001). 71   Nabors was a Bermuda corporation, and its majority ownership was necessary to obtain the more favorable tax rates offered by that jurisdiction. See C & J Energy, 107 A.3d at 1052. 72   Ibid at 1059.

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216  Research handbook on representative shareholder litigation in protecting Comstock’s financial interests if a deal was consummated.”73 After the key terms of the transaction had been negotiated, but before it was formally approved, Comstock asked for a side letter “affirming that C & J’s management team would run the surviving entity and endorsing a generous compensation package.”74 When the Nabors CEO balked, Comstock threatened to not sign or announce the deal. The Nabors CEO gave in, and the deal was announced as planned.75 There were also indications that C & J’s financial advisor acted more as a “banker for the deal” than as a banker for C & J. The banker also financed the deal and received fees in that capacity.76 There were thus reasons to think that the two principal actors for C & J—its CEO and its banker—were focused on Nabors and had personal reasons to favor a transaction with that entity, rather than being broadly open to alternatives. According to the plaintiffs, the agreed-upon exchange ratio implied that C & J stockholders received value in the transaction that was less than C & J’s predeal market price and below what the company’s financial advisors calculated as its standalone value.77 The defendants argued that with synergies, the transaction would generate up to a 20 percent premium over the predeal market price. The final merger agreement included a no-shop clause and a termination fee equal to 2.25 percent of the deal value. Comstock signed a voting agreement agreeing to vote his shares in favor of the merger, with a provision that caused the voting agreement to terminate if the board exercised its right to terminate the merger agreement.78 2.2  The Court of Chancery Decision No competing bidder emerged, but stockholder plaintiffs sued to enjoin the C & J–Nabors transaction. In addition to the factual issues just discussed, the stockholder plaintiffs argued that the C & J board had not focused sufficiently on the fact that it was selling control of C & J. They asserted that the board minutes and bankers’ books for the key meeting at which the board approved the deal treated the transaction as an acquisition, had no discussion of any exploration of alternatives or a sale process, and did not include a determination that the deal was the best transaction reasonably available. Given the factual record, the stockholder plaintiffs argued that it was reasonably probable that the directors could not bear their burden, under the enhanced scrutiny standard, to show that the transaction was the best transaction reasonably available and that their actions fell within a range of reasonableness. The board could not make this showing, they contended, because the directors treated the Nabors deal as an acquisition and had not

  Ibid at 1064.  Ibid. 75   Ibid at 1065. 76   Ibid at 1056–57. 77   See, e.g., Transcript of Oral Argument at 5-6, Miami Gen. Empls & Sanitation Empls. Ret. Tr. v. C & J Energy Servs., Inc., C.A. No 9980-VCN (Del. Ch. Nov. 24, 2014) (No 116). 78   This simplified recitation of the facts does not capture the full depth or breadth of the parties’ arguments or the Delaware Supreme Court’s factual recitation. It suffices to show, however, that several of the features which seemed to be hot-button issues for the Delaware Supreme Court in an earlier era were present in the case. 73 74

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Changing attitudes  217 done anything to explore alternative transactions. As a remedy, the stockholder plaintiffs sought a targeted preliminary injunction reminiscent of the cases from the 1980s. As framed in their opening brief, they argued that “the Court should enjoin the shareholder vote on the Merger and the enforcement of the deal protection provisions to allow C & J’s Board to appropriately explore reasonable alternative transactions.”79 The Court of Chancery did not issue a written opinion. At the conclusion of the preliminary injunction hearing, the Court of Chancery announced its decision from the bench in an 18-page transcript ruling. In assessing the merger process, the court focused on what it considered the “major problem” for the process: the fact that the C & J board did not approach the merger as a sale but instead persisted in viewing it as an acquisition.80 The court found preliminarily that “C & J’s board took no steps to sell or shop the company” and ruled that “[i]n order to justify not shopping the company or engaging in other techniques available to sellers, it is generally viewed as imperative that the board have impeccable knowledge of the value of the company that it is selling.”81 Although the court did not cite Barkan, and although the court referred to “impeccable knowledge” rather than “reliable grounds upon which to judge its adequacy,” the court’s analytical approach recalled Barkan’s discussion about when a single-bidder strategy would be appropriate. The defendants relied heavily on a 2013 opinion in which the same member of the Court of Chancery had declined to grant a preliminary injunction.82 The court’s ruling predominantly consisted of comparing the facts of C & J Energy to the earlier decision, which the court said “approached the line for what may be considered an adequate sales process, in a single-bidder effort.”83 The court ultimately concluded that there was “a likelihood of success on the merits as to a breach of the duty of care . . . that goes to the absence of an effort to sell.”84 After receiving submissions from the parties on the form of relief, the court entered an order that went beyond a negative injunction enjoining the no-shop provision. The order instead directed the company to conduct a sale process: C & J Energy Services, Inc. (the “Company”), through its directors who have not been designated to be directors of C & J Energy Services, Ltd., is hereby ordered to solicit alternative proposals to purchase the Company (or a controlling stake in the Company) that are superior to the Proposed Transaction, as such term is defined by the Merger Agreement, for a period of 30 days from November 24, 2014.85

The order further provided that “[t]he solicitation of proposals consistent with this Order and any subsequent negotiations of any alternative proposal that emerges will

79   Plaintiff’s Opening Brief in Support of Motion for Preliminary Injunction at 51, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 78). 80   Transcript of Oral Argument at 9, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 116). 81   Ibid at 10–11. 82   In re Plains Expl. & Prod. Co. S’holder Litig., 2013 WL 1909124 (Del. Ch. May 9, 2013). 83   Transcript of Oral Argument at 8, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 116). 84   Ibid at 13. 85   Order Granting Preliminary Injunction ¶ 1, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 106).

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218  Research handbook on representative shareholder litigation not ­constitute a breach of the Merger Agreement in any respect.”86 In substance, this paragraph likely reached the same result as the Delaware Supreme Court in QVC, where the high court held that the acquirer had no vested contract rights in a provision that resulted from a breach of fiduciary duty, but it was framed using the different language of “not constitut[ing] a breach.” 2.3  The Delaware Supreme Court’s Decision The Court of Chancery certified its ruling for interlocutory appeal, and the Delaware Supreme Court accepted the appeal and reversed. Its decision shows how far judicial attitudes have evolved since the early M&A decisions of the 1980s.87 Although the standard of review—enhanced scrutiny—was the same, it was applied from a different perspective and with a different attitude. First, the high court exhibited no concern at all about the management-led, singlebidder process. The court stated the general rule as follows: “When a board exercises its judgment in good faith, tests the transaction through a viable passive market check, and gives its stockholders a fully informed, uncoerced opportunity to vote to accept the deal, we cannot conclude that the board likely violated its Revlon duties.”88 Later the court elaborated, explaining that a board may pursue the transaction it reasonably views as most valuable to stockholders, so long as the transaction is subject to an effective market check under circumstances in which any bidder interested in paying more has a reasonable opportunity to do so. Such a market check does not have to involve an active solicitation, so long as interested bidders have a fair opportunity to present a higher-value alternative, and the board has the flexibility to eschew the original transaction and accept the higher-value deal.89

This language has nothing of the sense of Barkan, where contacting multiple bidders was the general rule and using a single-bidder strategy an exception. The C & J Energy approach makes the single-bidder strategy equally viable as a general rule. Although there remains “no single blueprint that a board must follow to fulfill its duties,”90 C & J Energy goes a long way toward establishing the single-bidder-plus-reasonable-defensivemeasures strategy as a single blueprint that sellside boards can opt to use.

  Ibid ¶ 2.   In addition to reversing on the merits of the enhanced scrutiny analysis, the Delaware Supreme Court faulted the Court of Chancery for granting an injunction after determining that there was a “plausible showing of a likelihood of success on the merits,” rather than the actual injunction standard, which is a reasonable probability of success on the merits. See Transcript of Oral Argument at 13, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 116). Personally, I suspect the use of “plausible” was a slip of the tongue. Vice Chancellor Noble noted at several points that it was late in the day, and although he technically did not describe the standard accurately, I have no doubt that after 12 years on the bench (as of 2014), he knew and faithfully applied the appropriate standard for a preliminary injunction. 88   C & J Energy Servs., Inc. v. Miami Gen. Empls’ & Sanitation Empls. Ret. Tr., 107 A.3d 1049, 1053 (Del. 2014). 89   Ibid at 1067–68. 90   Cf. Barkan, 567 A.2d at 1286. 86 87

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Changing attitudes  219 Relatedly, the C & J Energy decision signaled a more restrictive view of the degree to which situationally specific conflicts warrant a hard look at M&A scenarios. In the court’s words: It is too often forgotten that Revlon, and later cases like QVC, primarily involved board resistance to a competing bid after the board had agreed to a change of control, which threatened to impede the emergence of another higher-priced deal. No hint of such a defensive, entrenching motive emerges from this record.91

The implication appears to be that, absent a competing bidder, a reviewing court does not need to be as worried about subtle conflicts of interest. Second, in contrast to the early M&A decisions, the court did not even pause over the no-shop clause. The Delaware Supreme Court instead wrote that “a potential competing bidder faced only modest deal protection barriers.”92 The court later observed that “there were no material barriers that would have prevented a rival bidder from making a superior offer.”93 Just as poison pills were once exceptional but are now commonplace,94 the once remarkable no-shop clause has become unremarkable. Third, the Delaware Supreme Court heavily criticized the mandatory nature of the preliminary injunction, which it aptly described as “unusual.”95 As framed, the injunction did “require[] C & J to shop itself in violation of the merger agreement between C & J and Nabors, which prohibited C & J from soliciting other bids,” and it attempted to deal with the potential question of breach by declaring that the solicitation would not constitute a breach.96 The high court correctly observed that a mandatory injunction   107 A.3d at 1053.   Ibid at 1052. 93   Ibid at 1070; accord ibid (“But in this case, there was no barrier to the emergence of another bidder and more than adequate time for such a bidder to emerge”). 94   In re Gaylord Container Corp. S’holders Litig., 753 A.2d 462, 481 (Del. Ch. 2000) (“The Rights Plan, for example, is a garden-variety poison pill. Whether or not Delaware law should have authorized the utilization of this extraordinary option in the first instance is water under the M & A bridge. As the Supreme Court has observed, Delaware courts have authorized the adoption of a poison pill in many cases”). 95   C & J Energy, 107 A.3d at 1051; accord ibid at 1053–54. 96   Ibid at 1053. I attribute the language of the injunction to good lawyering by the C & J defendants, who submitted the form of order that Vice Chancellor Noble adopted and pressed him to fix its implementing language rapidly, within a day after his injunction ruling. See Letter to Hon. John W. Noble from Stephen C. Norman, Esq., Enclosing Proposed Form of Order Regarding Preliminary Injunction, C & J Energy Servs., Inc., C.A. No 9980-VCN (No 105). By framing the order in mandatory terms and including the “no breach” provision, the defendants substantially strengthened their hand on appeal. Vice Chancellor Noble would have been better served by eschewing the defendants’ form of order and issuing a traditional prohibitive injunction against the transaction as a whole that would have remained in place until the parties agreed to waive the no-shop provision. While serving as a vice chancellor, Chief Justice Strine issued this type of injunction in the Topps case, where his ruling provided that “[t]he Merger vote will be enjoined until after Topps has granted Upper Deck a waiver of the Standstill to: (1) make an all shares, non-coercive tender offer of $10.75 cash or more per share, on conditions as to financing and antitrust no less favorable to Topps than contained in Upper Deck’s most recent offer; and (2) communicate with Topps about its version of relevant events.” In re Topps Co. S’holders Litig., 926 A.2d 58, 92–93 (Del. Ch. 2007). The order was framed 91 92

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220  Research handbook on representative shareholder litigation should only issue after trial or on undisputed facts, and the Court of Chancery “did not rely on undisputed facts showing a reasonable probability that the board had breached its fiduciary duties when it imposed the mandatory injunction.”97 The trial court’s injunction in C & J Energy, however, was only semantically different from the traditional, negative, preliminary injunction in QVC, which enjoined a no-shop clause to the same effect. That ruling was not based on undisputed facts, and although it was not a mandatory injunction that required Paramount to explore other bids, it permitted the board to do precisely that. The Delaware Supreme Court then went further and, in contrast to the early M&A decisions, emphasized and elevated the importance of the bidder’s contract rights: Such an injunction cannot strip an innocent third party of his contractual rights while simultaneously binding that party to consummate the transaction. To blue-pencil a contract as the Court of Chancery did here is not an appropriate exercise of equitable authority in a preliminary injunction order. That is especially true because the Court of Chancery made no finding that Nabors had aided and abetted any breach of fiduciary duty, and the Court of Chancery could not even find that it was reasonably likely that such a breach by C & J’s board would be found after trial.98

Two themes are critical here: the showing necessary to enjoin a provision, and the concept of “blue-penciling” a contract. On the showing necessary to enjoin a provision, the C & J Energy court requires significantly more than was required in QVC. In the earlier case, the Delaware Supreme Court required only a showing that a sophisticated and well-advised acquirer had sought and obtained the defensive provision, at which point the bidder’s rights rose or fell with the validity of the provision from a fiduciary duty standpoint.99 The C & J Energy decision appears to expect a showing of knowing participation that is distinct from negotiation, along the lines of conduct that induced the underlying breach.100 as a prohibitive injunction against the transaction as a whole, but it achieved the same practical result as a targeted mandatory injunction against the use of the standstill agreement to block the topping bidder’s tender offer. Had Vice Chancellor Noble drafted his order similarly, it likely would not have changed the result on appeal, but it could have muted some of the senior tribunal’s more pointed criticisms.  97   C & J Energy, 107 A.3d at 1053.  98   Ibid at 1054.  99   QVC Network, Inc. v. Paramount Commc’ns, Inc., 637 A.2d 34, 51 (Del. 1994). 100   See Malpiede v. Townson, 780 A.2d 1075, 1097–98 (Del. 2001): “Knowing participation in a board’s fiduciary breach requires that the third party act with the knowledge that the conduct advocated or assisted constitutes such a breach. Under this standard, a bidder’s attempts to reduce the sale price through arm’s-length negotiations cannot give rise to liability for aiding and abetting, whereas a bidder may be liable to the target’s stockholders if the bidder attempts to create or exploit conflicts of interest in the board. Similarly, a bidder may be liable to a target’s stockholders for aiding and abetting a fiduciary breach by the target’s board where the bidder and the board conspire in or agree to the fiduciary breach” (citations omitted). See also, e.g., In re Del Monte Foods Co. Shareholders Litig., 25 A.3d 813, 841 (Del. Ch. 2011) (granting targeted, prohibitory injunction where acquirer “knew of and knowingly participated in the breach of duty”); In re Transkaryotic Therapies, Inc., 954 A.2d 346, 373 n.118 (Del. Ch. 2008) (denying summary judgment on aiding and abetting claim where there was evidence that acquirer offered a director an inducement for his vote); Goodwin v. Live Entm’t, Inc., 1999 WL 64265, at *28 (Del. Ch. Jan. 25, 1999) (recognizing possibility that third party could be liable as aider and abetter if the third party

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Changing attitudes  221 Relatedly, the C & J Energy decision’s reference to “blue-penciling” casts doubt on the continuing viability of the type of targeted preliminary injunction that was issued in Revlon, Macmillan, and QVC. The language of C & J suggests that a preliminary injunction has become an all-or-nothing proposition: either the entire deal should be enjoined or no injunction should issue. Later in its decision, the Delaware Supreme Court returned to this point: Preliminary injunctions are powerful tools, and their bluntness can be disconcerting to plaintiffs, defendants, and trial judges. But the traditional use of a preliminary injunction in the Court of Chancery is to preserve the status quo—for example, to enjoin a corporate transaction until there is a full trial if the court believes there is a reasonable probability a fiduciary breach has occurred—not to divest third parties of their contractual rights. Even after a trial, a judicial decision holding a party to its contractual obligations while stripping it of bargained-for benefits should only be undertaken on the basis that the party ordered to perform was fairly required to do so, because it had, for example, aided and abetted a breach of fiduciary duty. To blue-pencil an agreement to excise a provision beneficial to a third party like Nabors on the basis of a provisional record and then declare that the third party could not regard the excision as a basis for relieving it of its own contractual duties involves an exercise of judicial power inconsistent with the standards that govern the award of mandatory injunctions under Delaware law.101

Consistent with Court of Chancery decisions authored by Chief Justice Strine while a member of the trial court, this passage reflects the perspective that a preliminary injunction should address the transaction as a whole.102 Under this approach, the targeted preliminary injunctions in Revlon, Macmillan, and QVC would not have been issued. Finally, and in contrast to stockholders’ earlier view, the C & J Energy decision explained that stockholders can protect themselves by voting down a suboptimal deal. As a result, Delaware courts should defer in the first instance to the stockholder vote rather than granting injunctive relief: That [the balancing of hardships counsels against an injunction] is especially the case when the stockholders subject to irreparable harm are, as here, capable of addressing that harm themselves by the simple act of casting a “no” vote. In a situation like this one, where no rival bidder has emerged to complain that it was not given a fair opportunity to bid, and where there is no reason to believe that stockholders are not adequately informed or will be coerced into accepting the transaction if they do not find it favorable, the Court of Chancery should be reluctant to take the decision out of their hands.103

In short, empowered institutional investors can best look out for their own interests, and when stockholders can protect themselves through voting, trial courts should not interfere. “purposely induced the breach of the duty of care”), aff’d, 741 A.2d 16 (Del. 1999); Zirn v. VLI Corp., 1989 WL 79963, at *6 (Del. Ch. July 17, 1989) (finding that complaint stated a claim for aiding and abetting where complaint supported inference that acquirer took advantage of conflict faced by directors and used it to secure benefits). 101   C & J Energy, 107 A.3d at 1072 (citations omitted). 102   See In Re El Paso S’holders Litig., 41 A.3d 432, 449–51 (Del. Ch. 2012); In re Netsmart Techs., Inc., 924 A.2d 171, 209 (Del. Ch. 2007); In re Toys “R” Us, Inc. S’holder Litig., 877 A.2d 975, 1021 (Del. Ch. 2005). 103   C & J Energy, 107 A.3d at 1072–73 (citations omitted).

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3. POSSIBLE REASONS FOR THE CHANGING ATTITUDES AND PERCEPTIONS To reiterate, the attitudes and perspectives embodied in C & J Energy did not burst forth unheralded. They are consistent with decisional developments in the Court of Chancery over the past 15 years or so. The significant contribution of C & J Energy was to elevate the Chancery approach to Supreme Court doctrine. It is impossible to identify with any degree of precession the reasons why judicial attitudes have evolved so significantly, but there are several likely candidates.104 In my view, the predominant contributor has been the rise of sophisticated stockholders with the ability to influence the direction of corporate governance and the outcome of M&A events (Armour et al 2011; Kahan and Rock 2010).105 Both Chief Justice Leo E. Strine, Jr and retired Justice Jack B. Jacobs have written about the need for the law to adapt to a world in which institutional investors play a significant role (see, e.g., Jacobs 2011, 2012; Strine Jr 2010). In 2000, writing while a member of the Court of Chancery, Chief Justice Strine systematically dismantled the concept of substantive coercion and the premise of the disempowered stockholder.106 During his years as a Vice Chancellor, Chief Justice Strine regularly deferred to the stockholder vote, as did other members of the court.107 He also argued for elevating the role of the stockholder vote in other areas, such as when combined with committee approval as a means of achieving business judgment review for a controller squeezeout.108 Recognizing that stockholders are empowered and capable of making their own decisions

104   During the later stages of drafting this chapter, I came across work which identifies similar themes on a broader scale. See Solomon and Thomas (2016). I agree with their excellent analysis. 105   See, e.g., Armour et al. (2011) (describing influence of institutional investors on M&A regimes); Kahan & Rock (2010) (documenting rise of institutional investor ownership and influence). See generally Bd. of Governors of the Fed. Res. Sys., Flow Of Funds Accounts Of The United States: Annual Flows and Outstandings 1985–1994, at 82 tbl.L.213 (2004), available‌ www.federalreserve.gov/Releases/z1/20040115/annuals/a1985-1994.pdf. 106   Chesapeake Corp. v. Shore, 771 A.2d 293, 324–29 (Del. Ch. 2000). 107   See, e.g., In re El Paso Corp. S’holder Litig., 41 A.3d 432, 434-35 (Del. Ch. 2012) (“Although the pursuit of a monetary damages award may not be likely to promise full relief, the record does not instill in me the confidence to deny, by grant of an injunction, El Paso’s stockholders from accepting a transaction that they may find desirable in current market conditions, despite the disturbing behavior that led to its final terms”); In re Dollar Thrifty S’holder Litig., 14 A.3d 573, 618 (Del. Ch. 2010) (ruling that the balance of harms tilted against injunction because stockholders could decide for themselves to vote a deal down and take the chance of receiving an actionable higher bid); In re Netsmart Techs., Inc. S’holders Litig., 924 A.2d 171, 208 (Del. Ch. 2007); (“[W]hen [the] court is asked to enjoin a transaction and another higher-priced alternative is not immediately available, it has been appropriately modest about playing games with other people’s [(i.e., the stockholders’)] money”); In re Pennaco Energy, Inc. S’holders Litig., 787 A.2d 691, 715 (Del. Ch. 2001) (“After all, even when a sufficient merits showing is made by a plaintiff, this court is justifiably reluctant to enjoin a premium-generating transaction when no other option is available, except insofar as is necessary for the disclosure of additional information to permit stockholders to make an informed decision whether to tender”). 108   In re MFW Shareholders Litig., 67 A.3d 496, 524–36 (Del. Ch. 2013, aff’d sub nom. Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014); In re Cox Commc’ns, Inc. S’holders Litig., 879 A.2d 604, 642–48 (Del. Ch. 2005).

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Changing attitudes  223 changes the role of the judiciary. When stockholders cannot protect themselves, litigation becomes the principal check on fiduciary behavior. But when stockholders can protect themselves, they do not need judges. Only when the voting process itself is undermined does a role for the judge remain. Otherwise, property owners can best make their own decisions about the fate of their property. In C & J Energy, the existence of empowered stockholders able to decide whether to accept the Nabors deal directly explains the Delaware Supreme Court’s message that trial courts defer to the stockholder vote for purposes of the balancing of the hardships under the preliminary injunction standard. But it also has a second-order effect on the degree of intrusiveness of the court’s review. If the court system appears to be the only viable check on fiduciary opportunism, then the litigation framework has to include components that permit meaningful review of a board’s decision, and the court has to take a hard look at the directors’ conduct. The innovative standard of enhanced scrutiny accomplished this through its range-of-reasonableness test and the shifting of the burden of proof to the defendant directors. When warranted, a court need not defer automatically to the decisions of even disinterested and independent directors, precisely because they could be undermined by the situationally specific conflicts of interest inherent in the settings that trigger enhanced scrutiny.109 The court instead evaluates the reasonableness of the directors’ actions for evidence of conscious or subconscious pretext.110 But if stockholders can be trusted to make the ultimate decision on a transaction, then the court system can step back. In my view, this effect can be seen in C & J Energy, where the court discounts the CEO’s self-interested bargaining over the terms of his employment, minimizes the banker’s dual role as sellside advisor and financier for the deal, and repeatedly stresses the independence of the directors, despite their relative lack of involvement in a management-led process. Again, my point is not to suggest that the C & J Energy decision was decided incorrectly, but simply to contrast its tone with the Delaware Supreme Court’s early M&A decisions, which took a harder, even moralistic stance toward conflicts of interest (Rock 1997). A more removed approach to examining sellside directors’ actions is also, in my view, a product of a second major factor: the generalized failure of stockholder-led M&A litigation. In the aggregate, stockholder-led M&A litigation did not establish a track record suggesting that it was contributing to the public good, rather than operating as a means of rent extraction for plaintiffs’ lawyers. In the early landmark M&A cases, the primary litigant was a disadvantaged bidder, with stockholder plaintiffs at most occupying a secondary role.111 The bidder’s presence provided a powerful driver for meaningful 109   See, e.g., Dollar Thrifty, 14 A.3d at 598 (“[W]here heightened scrutiny applies, the predicate question of what the board’s true motivation was comes into play. The court must take a nuanced and realistic look at the possibility that personal interests short of pure self-dealing have influenced the board to block a bid [Unocal] or to steer a deal to one bidder rather than another [Revlon]”). 110   See ibid (“Through [enhanced scrutiny], the court seeks to assure itself that the board acted reasonably, in the sense of taking a logical and reasoned approach for the purpose of advancing a proper objective, and to thereby smoke out mere pretextual justifications for improperly motivated decisions”). 111   See Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1366 (Del. 1995); Paramount Commc’ns Inc. v. QVC Network Inc., 637 A.2d 34, 36 (Del. 1994); Mills Acq. Co. v. Macmillan, Inc., 559 A.2d 1261, 1264 (Del. 1989); Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 179 (Del. 1986); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 949 (Del. 1985).

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224  Research handbook on representative shareholder litigation litigation. The bidder retained highly qualified counsel, paid on an hourly basis, who had every reason to match the lawyers representing the defendants in terms of thoroughness and effort. The bidder’s presence also changed the remedial dynamic because the bidder’s alternative transaction provided a concrete alternative that put real economic value behind its arguments. The litigation framework that the bidder-driven cases generated, however, was designed to be sensitive to the possibility of disloyalty under ambiguous circumstances. It therefore adopted proplaintiff features like the reasonableness standard and the placing of the burden of proof on the defendants. Specialized plaintiffs’ firms soon realized that they did not need a competing bidder to invoke these principles. They could file suit and argue that the defensive measures in a merger agreement had deterred other bidders from emerging. At that point, the very litigation features that made enhanced scrutiny meaningful unfortunately made it easy for plaintiffs to state claims and difficult for the defendants to dispose of weak cases. The Delaware Supreme Court effectively endorsed the bringing of weak cases when it declined to dismiss a postclosing challenge to defensive measures in a third party merger agreement, stating “This case may very well illustrate the difficulty of expeditiously dispensing with claims seeking enhanced judicial scrutiny at the pleading stage where the complaint is not completely conclusory.”112 Slowly at first, and then at an accelerating pace, the volume of stockholder-led M&A litigation increased (Cain and Davidoff 2015: 475–6). During the first decade of the twenty-first century, it became an epidemic, with challenges to more than 90 percent of all takeovers in excess of $100 million (Cornerstone 2015). This in itself was an obvious sign of a misaligned incentives, as it could not have been true that 90 percent of all takeovers had deep fiduciary flaws. More tellingly, the avalanche of lawsuits produced comparably minimal value for stockholders. The vast majority of cases were resolved through disclosure-only settlements, in which the defendants agreed to make supplemental disclosures to stockholders in advance of the vote on the merger, and the merger parties and their directors, officers, affiliates, and advisors received a court-approved global release of known and unknown claims. As compensation for providing the ostensible benefits conferred by these settlements, the plaintiffs’ attorneys received an award of attorneys’ fees, which for many years clustered in the mid- to high six figures (Cain and Davidoff 2015; Fisch et al 2015; Friedlander 2016). The disclosure-only settlement’s attractiveness to both defendants’ and plaintiffs’ lawyers channeled virtually all M&A cases toward the same nonsubstantive result. While some plaintiffs’ firms engaged in meaningful litigation activity and achieved monetary recoveries for investors, they were comparatively rare.113 The ubiquity of stockholder litigation coupled with the routine generation of disclosure-only settlements amounted to a systemic failure. The degradation of the M&A litigation environment demanded a retooling of standards that would reduce the ability of the plaintiffs’ bar to bring litigation and extract   In re Santa Fe Pacific Corp. S’holder Litig., 669 A.2d 59, 72 (Del. 1995).   See Friedlander (2016: 904) (describing a two-tiered plaintiffs bar in which “[o]ne tier of law firms pursued disclosure settlements as a business model” while “[a]nother tier of law firms never presented disclosure settlements to the Court of Chancery, and instead brought Revlon cases with the objective of seeking a significant monetary recovery or significant non-monetary relief ”). 112 113

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Changing attitudes  225 settlements. At the same time, voting by sophisticated stockholders had emerged as an alternative, market-based means of protecting against fiduciary overreaching. The natural course was to weaken the availability of the litigation option, recognizing that because of how stockholder plaintiffs had been managing that mechanism, little would be lost. To the contrary, and paradoxically, weakening the incentive for stockholder plaintiffs to file suit on every deal and seek a disclosure-only settlement might be expected to have the real-world effect of increasing oversight. Without the (relatively) cheap deal insurance of a disclosure-only settlement, transaction counsel could again do their jobs by arguing against egregious norm violations that might draw a meaningful lawsuit. A step back in terms of scrutiny becomes a step forward in terms of integrity. The generalized failure of the stockholder-led M&A litigation model also suggests a reason for the Delaware Supreme Court’s current skepticism toward targeted injunctions and the prioritization of the contract rights of the acquirer. In general, over time, courts have become more comfortable with defensive measures as they have gained greater familiarity with them. No-shop clauses in particular have become virtually omnipresent, making it difficult to maintain the extreme stance exhibited in Revlon and Macmillan. Moreover, in litigation, bidders have argued effectively—and usually accurately—that they were outsiders to the sellside board’s process, who were simply bargaining at arm’s length, and who therefore should not be prejudiced by a potential sellside breach. Defendants also have argued, again with some truth, that granting a degree of deal certainty to a bidder could inure to target stockholders in the form of a higher price. Indeed, scholarly work has demonstrated that some degree of protection for the initial bidder helps to induce the first bid and can create value for stockholders (Coates IV and Subramanian 2000; Restrepo and Subramanian 2016). In short, the inclusion of some degree of defensive measures became expected and accepted. Recent Court of Chancery decisions call them “standard merger terms.”114 These trends explain why the courts have shown greater deference toward the use of defensive measures, but they do not explain why a reviewing court cannot enjoin a particularly extreme provision—as opposed to the transaction as a whole—if warranted on the facts of a given case. Granting this type of relief has not only the pedigree of Revlon, Macmillan, and QVC, but also support in the doctrine of severability, which

114   See, e.g., In re Answers Corp. Shareholders Litig., 2011 WL 1366780, at *4 n.47 (Del. Ch. Apr. 11, 2011) (describing “a termination fee plus expense reimbursement of 4.4% of the Proposed Transaction’s equity value, a no solicitation clause, a ‘no-talk’ provision limiting the Board’s ability to discuss an alternative transaction with an unsolicited bidder, a matching rights provision, and a force-the-vote requirement” as “standard merger terms”); In re Atheros Commc’ns, Inc. S’holder Litig., 2011 WL 864928, at *7 n.61 (Del. Ch. Mar. 4, 2011) (characterizing a no-solicitation provision, a matching right, and a termination fee as “standard merger terms”); In re 3Com S’holders Litig., 2009 WL 5173804, at *7 (Del. Ch. Dec. 18, 2009) (describing “the no solicitation provision, the matching rights provision, and the termination fee” as “standard merger terms”); In re Novell, Inc. S’holder Litig., 2013 WL 322560, at *10 (Del. Ch. Jan. 3, 2013) (describing “the no solicitation provision, the matching rights provision, and the termination fee” as “customary” and “routine terms”); In re Ness Techs., Inc., 2011 WL 3444573, at *2 (Del. Ch. Aug. 3, 2011) (describing a “‘no shop’ provision”, a ‘no talk’ provision, a termination fee amounting to 2.72% of the sale price, and a fiduciary out that requires the Board to determine that a higher bid is a ‘superior offer’ before it can engage in negotiations” as “relatively mundane deal protections”).

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226  Research handbook on representative shareholder litigation enables a court to invalidate a portion of a contract or statute and enforce the remainder (Movsesian 1995).115 Merger agreements often contain severability clauses that expressly incorporate this doctrine as a matter of contract. Permitting targeted injunctions also comports with the general remedial principle that if a court can grant a broad form of relief, it also can grant a lesser and narrower form of relief that otherwise would be encompassed by the broad relief. Here again, the systemic failure of stockholder-led M&A litigation provides an explanation, because a judicial willingness to entertain targeted injunctions easily could open the door to a new form of litigation abuse. If, for example, stockholder plaintiffs could obtain targeted relief enjoining aggressive deal protection measures, in the absence of a competing bid, then plaintiffs’ firms would have an incentive to continue challenging deals in an effort to obtain that type of relief. This would have two effects. First, the Delaware courts would be forced to rule on multiple iterations and combinations of defensive measures, determining which were overly restrictive given the extent of the board’s knowledge at the time it entered into the transaction and which were not. Some might argue that over time, clear patterns would develop, and the resulting decisions would generate a public good. Others would argue, with considerable force, that this would involve the Delaware judiciary substituting its views about the level of deal protection that was appropriate in the context of a particular negotiation for those of directors. Second, the threat of a targeted injunction would create settlement pressure, enabling the M&A plaintiffs’ bar to transition quickly from disclosure-only settlements to deal-tweak settlements, such as moderate reductions in the size of a termination fee. The Delaware Supreme Court’s preference for all-or-nothing injunctions can thus be seen as part of its response to the litigation epidemic.116 One certainly can posit other factors that potentially contributed to the substantial evolution in the Delaware Supreme Court’s attitude toward recurring M&A scenarios, including changes in the composition of the Delaware Supreme Court and in the broader legal environment in which Delaware operates (Davidoff 2012; Roe 2003). In this author’s view, however, the rise of the institutional investor and the generalized failure of stockholder-led M&A litigation explain the bulk of the attitudinal shift. Powerful stockholders do not need judges to make their decisions for them, and when the litigation that would generate those decisions seems to be doing little good, it only makes sense to recalibrate the system. 115   Restatement (Second) of Contracts § 183, cmt. a (1981) (discussing concept of “divisibility” or “severability”). 116   The Delaware Supreme Court’s current treatment of a merger as an integrated whole rather than a series of severable events is also reflected in its recent analysis of the effect of a fully informed stockholder vote on the standard of review applicable to a third party M&A situation. See, e.g., Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015) (holding that a fully informed stockholder vote restores the business judgment rule as the standard of review, with a claim for waste as the only remaining challenge). In effect, the stockholder approval that is required by statute to effect a merger is now also treated as stockholder approval of each step in the process that led to the merger. Stockholder approval of the merger is also treated as stockholder approval of each contractual provision in the merger agreement, including defensive measures that may tend to foreclose or discourage competitive bidding. For both the injunction and the vote, the merger is a package deal.

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Changing attitudes  227

4. CONCLUSION The Delaware Supreme Court’s attitudes toward recurring aspects of third party M&A litigation have changed markedly over three decades. In contrast to the skepticism of the 1980s, the Delaware Supreme Court has now signaled: (1) presumptive validity of a singlebidder process combined with a passive market check; (2) presumptive deference to the stockholder vote absent a competing bid; and (3) prioritization of the bidder’s contract rights and hostility toward targeted injunctions. Each of these steps is a deregulatory move that makes it less likely that a Delaware court will issue an injunction in a deal case. For lawyers and law professors, that might be an unwelcome change. But for anyone who believes that markets should decide the outcome of M&A events rather than courts, it is a positive development.

BIBLIOGRAPHY Allen, William T., 1998. “The Corporate Director’s Fiduciary Duty of Care and the Business Judgment Rule Under U.S. Corporate Law,” Comparative Corporate Governance—State of the Art and Emerging Research (Klaus J. Hopt et al eds.). Allen, William T., 2000. “Understanding Fiduciary Outs: The What and the Why of an Anomalous Concept,” The Business Lawyer 55:653–60. Allen, William T., Jack B. Jacobs, & Leo E. Strine, Jr, 2002. “Realigning the Standard of Review of Director Due Care with Delaware Public Policy: A Critique of Van Gorkom and Its Progeny as a Standard of Review Problem,” Northwestern University Law Review 96:449. Armour, John, Jack Jacobs, & Curtis Milhaupt, 2011. “The Evolution of Hostile Takeover Regimes in Developed and Emerging Markets: An Analytical Framework,” Harvard International Law Journal 52:219–85. Bainbridge, Stephen M., 2002. “Why A Board? Group Decisionmaking in Corporate Governance,” Vanderbilt Law Review 55:1–55. Balotti, R. Franklin & A. Gilchrist Sparks, III, 2002. “Deal-Protection Measures and the Merger Recommendation,” Northwestern University Law Review 96:467. Black, Bernard & Reinier Kraakman, 2002. “Delaware’s Takeover Law: The Uncertain Search for Hidden Value,” Northwestern University Law Review 96:521–565. Cain, Matthew D. & Steven M. Davidoff Solomon, 2015. “A Great Game: The Dynamics of State Competition and Litigation,” Iowa Law Review 100:465–500. Coates, IV, John C., Guhan Subramanian, 2000. “A Buy-Side Model of M&A Lock-Ups: Theory and Evidence,” Stanford Law Review 53:307. Cornerstone Research, 2015. “Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2014 M&A Litigation,” available at www.cornerstone.com. Davidoff, Steven M., 2012. “The SEC and the Failure of Federal Takeover Regulation,” Florida State Law Review 34:502. Easterbrook, Frank H. & Daniel R. Fischel, 1983. “Voting in Corporate Law,” Journal of Law and Economics 26:395–427. Fisch, Jill, Sean Griffith, & Steve Davidoff Solomon, 2015. “Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform,” Texas Law Review 93:557–624. Friedlander, Joel Edan, 2016. “How Rural/Metro Exposed the Systemic Problem of Disclosure Settlements,” Delaware Journal of Corporate Law 40:877–919. Jacobs, Jack B., 2011. “‘Patient Capital’: Can Delaware Corporate Law Help Revive It?” Washington and Lee Law Review 68:1645–64. Jacobs, Jack B., 2012. “Does the New Corporate Shareholder Profile Call for a New Corporate Law Paradigm?” Fordham Journal of Corporate and Financial Law 18:19–32. Jacobs, Jack B., 2015. “Fifty Years of Corporate Law Evolution: A Delaware Judge’s Retrospective,” Harvard Business Law Review 4:141–72. Johnston, John F., 1998. “Recent Amendments to the Merger Sections of the DGCL Will Eliminate Some—But Not All—Fiduciary Out Negotiation and Drafting Issues,” Mergers and Acquisitions Law Report (BNA) 20:777.

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228  Research handbook on representative shareholder litigation Johnston, John F. & Frederick H. Alexander, 1997. “Fiduciary Outs and Exclusive Merger Agreements— Delaware Law and Practice,” Insights No 2 11:15. Kahan, Marcel & Edward Rock, 2010. “Embattled CEOs,” Texas Law Review 88:987. Laster, J. Travis, 2013a. “Omnicare’s Silver Lining,” Journal of Corporation Law 38:822. Laster, J. Travis, 2013b. “Revlon Is a Standard of Review: Why It’s True and What It Means,” Fordham Journal of Corporate and Financial Law 19:5–55. Macey, Jonathan R. & Geoffrey P. Miller, 1988. “Trans Union Reconsidered,” Yale Law Journal 98:127–43. Movsesian, Mark L., 1995. “Severability in Statutes and Contracts,” Georgia Law Review 30:41–83. Restrepo, Fernan & Guhan Subramanian, 2016. “The Effect of Prohibiting Deal Protection in M&A: Evidence from the United Kingdom,” available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2820434. Rock, Edward B., 1997. “Saints and Sinners: How Does Delaware Corporate Law Work?” UCLA Law Review 44:1009–1107. Roe, Mark J., 2003. “Delaware’s Competition,” Harvard Law Review 117:588–646. Solomon, Steven Davidoff & Randall S. Thomas, 2016. “The Rise and Fall of Delaware’s Takeover Standards,” available at http://.ssrn.com/sol3/papers.cfm?abstract_id=2830257. Sparks, III, A. Gilchrist, 1997. “Merger Agreements under Delaware Law—When Can Directors Change Their Minds?” University of Miami Law Review 51:815–21. Strine, Jr, Leo E., 2010. “One Fundamental Corporate Governance Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and Think Long Term?” Business Lawyer 66:1–26. Veasey, E. Norman, 1990. “Book Review: D. Block, B. Barton and S. Radin, The Business Judgment Rule: Fiduciary Duties of Corporate Directors,” Delaware Journal of Corporate Law 15:573–8. Veasey, E. Norman, 2004. “Counseling Directors in the New Corporate Culture,” Business Lawyer 59:1447–58.

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14.  Appraisal rights in complete tender offers in Israel: a look into Israeli case law Ruth Ronnen

Appraisal decisions require courts to estimate the value of companies, a task that is difficult for judges and finance professionals alike. In order to determine the value of a company, one has to foresee its future, and as the Jewish saying goes: “since the destruction of the Temple, prophecy has been taken from prophets and given to fools.” As most of us are not prophets (and hopefully not fools), it is an almost impossible task to foresee the future cash flow of a company. However, alongside the use of experts to estimate the “objective” value of an asset— whether it is a company, its shares, or any other asset—there is another common method that estimators use: looking at market prices. When, for example, a real estate appraiser estimates the value of land or of an apartment, one of the basic tools they use is checking the prices of similar assets and deriving the “right” price of the assessed asset from the comparison. The assumption behind this method is simple—the best way to know the value of an asset is to check what “real” people in “real” transactions are willing to pay for it. In this chapter, I would like to briefly discuss these two methods, and their application to appraisal rights. I would like to discuss whether and how courts make use of information derived from the “market” in order to estimate the value of companies, and how courts use expert opinions.

1.  GOING PRIVATE UNDER ISRAELI LAW Under Israeli law, appraisal is available only for “going private” tender offers. Section 336 of the Companies Law deals with a controlling shareholder’s purchase of minority shares in a public company in order to “go private.”1 According to this section, a person shall not purchase more than 90 percent of the shares in a public company, other than by way of a “complete tender offer” (or “full tender offer”)—a tender offer of all of the shares. Section 337 then states that “[w]here a complete tender offer is accepted by the offerees in such a way that the rate of holding of the offerees who did not accept the offer is less than five percent of the issued share capital . . . all of the shares that the offeror sought to purchase shall be transferred to it.” This section assures minority shareholders that even if they do not accept the offer and most other shareholders do, they will not be left as a tiny minority shareholder (of less than 5 percent) in a company held by one majority shareholder. It also enables the buyer,

  Companies Law, 5759–1999.

1

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230  Research handbook on representative shareholder litigation the majority shareholder, to buy all of the shares and avoid the “holdout problem,” in which offerees demand an extortionate price to sell their shares knowing that the controller needs them to complete the deal. To protect minority shareholders who are forced to sell under the terms just described, Section 338 offers them “appraisal rights.” According to Section 338, “The court may, on the application of any offeree in a complete tender offer accepted as aforesaid in section 337(a), rule that the consideration for the shares was less than their fair value, and that the fair value should be paid as determined by the court.” If a petition for an appraisal prevails in court, the purchaser must add to the original price of the tender offer the difference between the offer price and the “fair price,” with no way out from the deal. The purchaser therefore faces serious legal exposure, and a very rare judicial intervention in one of the most substantial deal terms: its price. Petitions for appraisal in Israel are in most cases motions to certify class actions on behalf of the class of all of the offerees (usually all of the minority shareholders). To prevail on a class certification motion, the plaintiff must show that the final price was not “fair.” This is usually done by an expert opinion stating that the fair value of the shares was higher than the final price. According to Section 338 (as quoted above), “any offeree”—including consenting shareholders, not just dissenting shareholders—has an appraisal right. However, the Companies Law was amended in 2011 and, as of today, the offeror may state in the offering documents that a shareholder that accepted the offer will not be eligible for appraisal rights. That eliminates appraisal rights for such shareholders and excludes them from the plaintiffs’ class. Most offerors use that right in their offers.

2.  ESTIMATING “FAIR VALUE” The core difficulty with appraisal claims is the complexity of estimating the value of a company, as noted above. Multiple methods are used to determine the fair price of the shares (or in assessing the fair value of the company). Some of these include asset-based methods and discounted cash flow, among many others. Moreover, it is common knowledge that appraisal is not an exact science: every calculation based on approximate data will produce approximate results.2 The estimations often rely on the expected future of the company, and the prospects of it being successful. When using the DCF method, it is necessary to estimate the future cash flow of the company. To do that, it is necessary to foresee future macroeconomic conditions, the competition that the company may face, the demand for the company’s products or services, and so on. Obviously, trying to foresee all of these elements and their effect on the company’s future is nigh on impossible. As a result of these difficulties, expert opinions as to what the “fair value” of the company is can vary and the differences between them can reach billions of shekels.

2

  LCA 779/06 Kital Holdings & Int’l Dev. Ltd. v. Maman (Aug. 28, 2012).

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Appraisal rights in complete tender offers in Israel   231

3.  OBJECTIVE “ANCHORS” IN DETERMINING FAIR VALUE Due to these difficulties and the necessity of dealing with the question of “fair value,” courts are trying to find some objective and reliable anchors on which to rely in determining “fair value.” Such anchors may be, if they become part of the case law, factors that the offeror can rely on as well, in order to mitigate the risk of a court’s retroactive intervention in the deal’s price. Some of these possible “anchors” include: ●

market price; the consent of most minority shareholders to the offer; ● a prior deal, with a “large” minority shareholder; ● a sophisticated shareholder’s consent to the offer. Such shareholder may be: ●

● An



●

institutional investor (either an investor that negotiated the price with the buyer or one that did not do so; an investor that held a substantial portion of shares that was large enough to “veto” the proposal or an investor with a portion that has no veto power); ● A private investor that holds a large portion of the shares (that may have negotiated the price with the buyer or held a portion of shares that was large enough to “veto” the proposal);

negotiating the price through an independent committee.

We will now discuss these methods in further detail. 3.1  Market Price According to the efficient capital market hypothesis, the market price reflects the fair price. The market price aggregates the various valuations of the market participants as reflected in trading. Despite that fact, the market price is not considered an anchor for the courts in Israel in fair value claims. According to the majority opinion of the Israeli Supreme Court in the Kital case,3 the market price of the shares bought in a complete tender offer is irrelevant when deciding the fair value of the shares. The main reason for that holding is that most public companies traded on the Tel Aviv stock market suffer from illiquidity. Therefore, their market price does not necessarily reflect the value of the company, and it can be easily influenced by the majority shareholder. According to Delaware law, on the other hand, “[i]f there is an established market for shares of a corporation the market value of such shares must be taken into consideration in an appraisal of their intrinsic value” (though market value is not the sole element that would be considered).4 Could the market price be relevant in Israel for companies with highly liquid securities?

  Ibid.   Application of Del. Racing Ass’n, 213 A.2d 203, 211 (Del. 1965).

3 4

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232  Research handbook on representative shareholder litigation In the Atzmon ruling, the court discussed that issue.5 In that case the offerors argued that the shares were widely traded on the stock exchange and therefore their market value should be an indication of their fair value. In the Kital case,6 Judge Danziger referred again to the Delaware case law in this context, and mentioned that even in Delaware the market price will not be relevant in cashout mergers. In the Atzmon ruling,7 as well as the Kital ruling,8 the court mentions that Delaware case law treats controlled companies differently. In such cases, share value evaluation will not be made according to market price, since that price does not reflect their full internal value. That is the usual situation in Israel when the controlling shareholder wishes to purchase the shares of minority shareholders. As this is the case for most companies in Israel, the court’s conclusion was that market price is not relevant under Israeli law. This is so even when the share is included in one of the leading stock exchange indexes. This fact is insufficient in forming an indication that market price reflects company value, and that the consideration offered by the offeror is fair. In this context, the controlling shareholder usually enjoys access to inside information not reflected in the price and foreknowledge of the cashout tender offer’s timing, informational advantages that may make the use of market price subject to manipulation. 3.2  Consent of Most of the Minority Consent of most of the minority shareholders to the tender offer could be considered a relevant factor in estimating the value of the company. However, the Israeli Supreme Court rejected the notion that the consent of most of the minority of the shareholders— the consent of the majority of the offerees—is in itself a relevant factor when estimating the fair value of the shares. The Supreme Court ruled in the Kital decision that if most of the minority’s consent was to be considered an indication of fair price, it would have made the Companies Law’s appraisal right almost useless.9 This is due to the fact that most of the minority of the offerees accepted the offered price in all appraisal cases. Otherwise, the buyout would not have been completed and there would be no reason to seek the court’s assistance. Similar notions were expressed by the court in the Atzmon case,10 where it was determined that majority consent to the tender offer does not form . . . an indication of fair value . . . share value issue is decided only according to its essential value appraisal. The instruction determining the appraisal remedy pre-supposes that most of the offerees consented to the price offered in the tender offer . . . and still provides the minority shareholders refuge in the form of approaching the court to examine whether share value according to the tender offer was fair.

This ruling was problematic before the amendment of the Companies Law, when all shareholders, including those that accepted the majority’s offer, could apply for appraisal      7    8    9   10    5  6

CA 10406/06 Atzmon v. Bank Hapoalim Ltd. (Dec. 28, 2009). Kital, supra note 2. Atzmon, supra note 5. Kital, supra note 2. Ibid. Atzmon, supra note 5.

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Appraisal rights in complete tender offers in Israel   233 rights. When this was the law, it was reasonable for every shareholder to agree to the offer (disregarding its price), and then go to court and apply for the fair value. The court could only raise the price, so there was no risk involved.11 If there is no relevance to the minority shareholders’ agreement to the offer, why “ask” the shareholders whether they agree to sell their shares at the offered price in the first place? Why not go immediately to court, and ask the court to evaluate and set the fair price? However, today, the shareholder’s decision to tender or not is more crucial because only dissenting shareholders can apply for appraisal rights. Despite that, as I mentioned, the law in Israel does not give any weight to this decision, disregarding also the size of the majority that accepted the offer. 3.3  Possible Manipulation of the Share Price In the Atzmon decision,12 the court addressed the issue of possible share price manipulation. It also addressed the situation where it was proven that the offeree shareholders were not given all the relevant information necessary to assess the offer’s fairness. An offer accepted in this situation may also raise issues as to whether it was binding under “regular” contract law. The share price manipulation issue is meaningful in the Israeli market, in which most companies are dominated by one controlling shareholder who holds the majority of shares and only the minority shares trade on the stock exchange. Beyond the informational asymmetry between majority and minority shareholders, the controlling shareholder could use other manipulations to influence share value. One such method is harming the shares’ tradability. This issue arose in the Pinros decision.13 In that case, shares of a controlled company were transferred to the “preservation list” on the stock exchange. The stock exchange adds companies to this list when their public holding rate is small. When a company is included in the preservation list, its shares are no longer traded on the stock exchange in the “continuous trading stage.” A company that is included in the preservation list for two consecutive years is dropped from the stock exchange altogether. The transfer of shares to the preservation list harms them in two ways: it harms their tradability (since they do not continuously trade); and it creates concerns that the company will be dropped from the exchange if it fails to return to the main list within two years. (After one year, it becomes more difficult to return the main trading list.) In the Pinros case,14 the controlling shareholder issued a tender offer. The offer acceptance date was the date on which the shares were supposed to start trading on the preservation list for the second year, raising the concern that the company would be dropped from the stock exchange within a year. The petitioner argued that the controlling shareholders did not act to remove the company from the preservation list—although they could have done so—to enable them to purchase the minority shares under the tender offer for a   Companies Law, 5759–1999, § 338(a).   Atzmon, supra note 5. 13   Class Action (TA) 7477-10-11 Goldstein v. Pinros Holdings Ltd. (Mar. 18, 2013); Class Action (TA) 7477-10-11 Goldstein v. Pinros Holdings Ltd. (Feb. 24, 2016) (hereinafter Pinros 2016) [a decision of the undersigned]. 14   Ibid. 11 12

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234  Research handbook on representative shareholder litigation lower price. The petitioner therefore claimed the tender offer (which was accepted by 78 percent of minority shareholders) was an “extortionate transaction.” The court accepted the petitioner’s arguments. A class action against the controlling shareholders was approved and the plaintiffs ultimately prevailed as a result of the determination that: The fact that company shares were transferred to preservation list trading, could not only not harm the controlling shareholders, but rather benefit them. This is so in case the controlling shareholders wish to make a tender offer and purchase all of the shares of the minority shareholders. In that case, the controlling shareholders will prefer the share price to be as low as possible. However, the fact that the shares are not traded in the main list, and the concern that their trading could be discontinued altogether, is not a concern relevant to the controlling shareholders in this case – since they wish to turn the company into a private company anyway, and do not intend to sell their holdings in it.

Due to the possibility of the controlling shareholder manipulating share price by preventing the removal of shares from the preservation list to harm their price, the consent of minority shareholders did not indicate price fairness, and the court was required to examine the fair value of the shares and compare it with the tender offer price. 3.4  A Prior Deal with a Large Minority Shareholder Under Israeli law, a price that resulted from an arm’s-length negotiation between two independent and sophisticated parties is considered a credible proxy to the fair market value of the shares. A deal price where the bulk of the company’s shares were sold within the relevant period is therefore a relevant and reliable factor to be considered by the court when estimating the fair value of the company. The rationale for this is that in private law, courts rarely interfere with the parties’ agreed sale price of an asset. The very basic presumption of the law is the freedom of the parties to set the terms of their contract as they wish. Therefore it is not surprising, in my opinion, that in Atzmon,15 then in Kital,16 the Supreme Court was willing to rely on the sale price of a block of shares as a relevant factor in determining the fair value of the shares of the same company. In Atzmon,17 the court addressed several factors to be considered when examining a transaction in which shares were voluntarily sold outside the stock exchange. In that context, the court first addressed the number of shares sold in that transaction, on the theory that the larger the block of shares, the more likely it was that the seller would not have agreed to sell for less than their true value. When dealing with the sale of company control, the share price also includes a control premium. Thus, a tender offer price that is no less than the price at which control was also sold is a very strong indication of a fair price. Another matter the court addressed is the time period from the previous transaction up to the tender offer. Naturally, the longer the time gap, the lesser the impact of the previous transaction, and vice versa. In the case of a lengthy period, the offeror in the tender   Atzmon, supra note 5.   Kital, supra note 2. 17   Atzmon, supra note 5. 15 16

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Appraisal rights in complete tender offers in Israel   235 offer will have to prove that, since the previous transaction, no significant changes have occurred in company value. The court mentioned a period of six months as one beyond which the significant indication of price fairness weakens. The above leads to the conclusion that where, a short while prior to the tender offer, a significant transaction was made outside the stock exchange, under which a minority shareholder sold a block of shares to the controlling shareholder, the price determined in that transaction is a significant indication of share price value. If the price offered to the minority shareholders in the tender offer is not less than that price, this could attest to this price being a “fair price.” On the other hand, the Delaware Chancery Court (Judge Laster) recently decided in the Dell case that a “deal price” will not inevitably equal fair value.18 Such a ruling may shift the weight back to the courts to evaluate—with little help from objective “anchors”—the fair value. 3.5  Consent of a Sophisticated Shareholder Based on similar considerations, the Israeli Supreme Court accepted the proposition that acceptance of the tender offer by certain shareholders may be used as a relevant factor indicating the fairness of the offered price. This ruling rests on the presumption that in certain cases, the price to which the “sophisticated shareholder” agreed was a result of an arm’s-length negotiation between that shareholder and the buyer before the offer was made, and can be therefore used as a good proxy for the fair value of the company. In the Kital decision,19 the Supreme Court ruled that the agreement to the offer by an institutional investor which the court considered to be “sophisticated,” and which was aware of all of the relevant facts and reached a decision based on these facts, is a good indication of the fairness of the price. Other decisions of the Economic Division of the Tel Aviv district court followed that line, and ruled that the agreement of a sophisticated shareholder to the complete tender offer is a good indication to the fairness of the price. However, the court stated that if there is good evidence that the sophisticated shareholder agreed to the price due to irrelevant considerations (such as liquidity needs, interfacing connections to the offeror, and so on) then his agreement would have no relevance to the court’s decision. The burden of proof in this context is on the plaintiff. It is obviously difficult to track the precise reasons why the sophisticated shareholder agreed to the offer, and if no evidence to the contrary is offered, the presumption is that the agreement indicates that the price was fair. In this context, there are several relevant factors that should be taken into consideration: first, whether the relevant shareholder is an institutional shareholder or a private shareholder; second, whether the “large” shareholder actually negotiated the offered price with the buyer; third, whether the consent of that shareholder was crucial to the success of the deal (in other words, did that shareholder hold an amount of shares providing him a “veto power” to reject the offer).

  In re Appraisal of Dell Inc., No. 9322-VCL (Del. Ch. Oct. 17, 2016) (Laster, V.C.).   Kital, supra note 2.

18 19

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236  Research handbook on representative shareholder litigation 3.6  Institutional Holders versus Private Holders Regarding the first factor, the question is whether there is a difference between a private shareholder, who holds his own shares, and an institutional shareholder in this context? One answer, given by the Tel Aviv District Court in the Ulitzky decision,20 is that institutional shareholders are more trustworthy than private shareholders because of the responsibility given to them by the state—the responsibility to invest other people’s money. But one might also think that the best way to determine fair value is by checking the decision of someone who made a decision that will affect him personally, rather than someone whose decision will affect other people. If this is the case, than a private shareholder will be a “better candidate” to look after (as was mentioned in the Pinros decision21). The Kital ruling was criticized in the academic literature for this reason.22 The authors of “Following the Kital Ruling: The Burden of Proof in a Complete Tender Offer”23 state that institutional entities suffer from conflicts of interest between the investors whose money is being invested and the management of the institutional entity. The managers of the institutional investor could be influenced by conflicts of interest stemming from their business activity beyond the management of investors’ funds. In addition, they could be driven by liquidity considerations and the wish to present short-term profits. If this is the case, then the consent of institutional shareholders should rarely be a factor that courts consider in estimating fair value. 3.7  Actual Negotiations with the Sophisticated Offeree As for the second factor, the question is whether it is necessary to show that the sophisticated shareholder actually negotiated the price with the buyer before the complete tender offer was made, in order to use his consent as an indicator of fair value. The idea behind the Supreme Court’s ruling seems to be that the large sophisticated shareholder’s agreement reflects a thorough analysis of the share price. The sophisticated holder has the tools to assess fairness, and it is usually worthwhile for them to invest in checking into the value of the shares, since his portion of the shares is relatively large and so a price difference has a larger effect on him. Therefore, his agreement has more weight than the agreement of a “regular,” small shareholder (whose agreement would have no effect at all, as mentioned previously). There are cases in which evidence exists of real negotiations between the offeror and the sophisticated offeree before the tender offer was made, regarding the price to be offered within the tender offer, to which the sophisticated offeree will consent. However, the sophisticated offeree presumption does not require, as a necessary precondition to its application, actual negotiations between the “sophisticated offeree” and the offeror.   Class Action (TA) 36604-02-10 Magen v. Ulitzky Mining (1990) Ltd. (Dec. 21, 2015).   Pinros 2016, supra note 13. 22   Kital, supra note 2. 23   Hadas Aharoni-Barak & Assaf Hamdani, Following the Kital Ruling: The Burden of Proof in a Complete Tender Offer, Ta’agidim, Nov. 2012, at 17. 20 21

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Appraisal rights in complete tender offers in Israel   237 Actual negotiations will cause Israeli courts to give greater weight to the sophisticated offeree’s consent to the tender offer, since they resemble a transaction under market terms. That is in contrast to the situation in which the sophisticated offeree consented to the tender offer as is, without prior negotiations (a “take it or leave it” offer), in which case consent is less significant. However, the consent of a sophisticated offeree with whom no negotiations were held can be meaningful too. Mainly, this applies to a sophisticated offeree whose consent could determine the fate of the tender offer. This was the situation in the Kaniel case24—in which the selling company held a position in which, without its consent, the tender offer could not have been accepted—and in the Matam case.25 When a certain shareholder is aware that, without their consent, the tender offer could not go through, it could be assumed that their consent is meaningful as an indication of offer price fairness. In other words, when there is one offeree who will determine whether the offer will be accepted or rejected, the tender offer could be deemed as pointed at them. The offer can be viewed as being made under hypothetical negotiations between the offeror and the offeree. Had there been no other offerees, negotiations would have naturally been held between the offeror and that offeree alone, who would have decided whether to accept or reject it. The fact that there are other offerees usually need not impact the legal outcome, and, as mentioned, the rules applied here should be similar to those applied when, prior to the offer, a transaction was made with a significant minority shareholder outside the stock exchange. In the Malachi case,26 it was determined that no negotiations were held with the sophisticated offerees. However, their consent was a relevant factor since it was proven that the offeror tried to assess their “desires.” This conclusion was based on the fact that the initial price offer was later increased by the offeror—probably to ensure the consent of the sophisticated offerees. 3.8 Consent of Several Sophisticated Offerees versus Consent of One Offeree Another issue in the Malachi case dealt with the fact that in that case,27 several sophisticated offerees consented to the tender offer. The question is whether such consent carries greater or lesser weight than that of one offeree. In that context, several issues should be taken into consideration. First, as mentioned previously, the consent of the majority of the “regular” nonsophisticated offerees does not in itself indicate price fairness (as determined in Kital,28 as well as in Atzmon29). The significant consent is, as mentioned, only that of “sophisticated” offerees, that is, those regarding whom it could be assumed—contrary to what could be assumed regarding 24   CC (TA) 1209/03 Shkolnik v. Kaniel Beverages Packages Ltd. (May. 8, 2007) [a decision of the undersigned]. 25   Class Action (TA) 20457-03-11 Safra v. M.T.M. Indus. & Craft Bldgs. Ltd. (June 9, 2014). 26   CC (TA) 9714-07-15 Elad High Plateau Acquisition Inc. v. Malachi (Dec. 8, 2015). 27   Ibid. 28   Kital, supra note 2. 29   Atzmon, supra note 5.

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238  Research handbook on representative shareholder litigation “regular” offerees—that they possess the tools to examine the tender offer and the price offered in it, and would refuse the offer should they believe the price is unfair. Another issue is whether, for the purpose of defining an offeree as “sophisticated,” they should hold a large block of shares. In the Kital case,30 the court emphasized the amount of shares held by the “sophisticated” offeree as one of the indications classifying the offeree as sophisticated. Indeed, holding a large amount of shares is relevant not to sophistication in itself, but to the offeree’s motivation to make extensive inquiries concerning the price offered in the tender offer, and its comparison with the “fair” price of the share. In the case of a shareholder that holds a larger block of shares, it is more likely that it would benefit them to invest resources in making inquiries about the company to evaluate its price. It should further be taken into consideration that the investment interest of the selling shareholder depends on their total investment in the company, and the size of that investment relative to its overall portfolio. An offeree whose holdings in the company form a significant part of their investment portfolio differs from one whose holdings in the company are a marginal, insignificant part of their overall portfolio. Therefore, to determine what weight to give to the consent of the sophisticated investor, the investor’s decision to tender should be assessed in light of their overall investment status. The consent of one offeree with a significant holding in the company that is also significant to their portfolio carries more value than the consent of several “small” sophisticated offerees. On the other hand, there are considerations showing that there is significant value in the consent of several “sophisticated” offerees, even if they are not large shareholders. As mentioned, the distinction made by the court between sophisticated offerees and nonsophisticated ones relates first and foremost to the issue of their tools in assessing the tender offer. If there are several offerees with tools enabling them to examine the offer in an informed manner and make an informed decision regarding it, then the consent of several offerees carries greater value than that of only one offeree. It also reduces the risk of a mistake by one offeree, and the concern of consent stemming from irrelevant considerations (such as liquidity needs etc.). Regarding the consent of nonsignificant sophisticated offerees, the implication of the amendment to the Companies Law should be noted too, by virtue of which a shareholder who consented to a tender offer is no longer permitted to file a fair value claim or be considered as part of the class in such a class action claim. In light of that amendment, it seems that the consent of a sophisticated offeree should be given additional weight. Such an offeree refusing a tender offer takes into consideration the possibility that, despite their objection, the tender offer will be accepted (assuming that their vote is not required for the offer to be accepted). In that case, the offeree is entitled to request an appraisal remedy (personally or on behalf of a class) claiming the difference between offer value and fair value. However, the option of petitioning for an appraisal remedy is not available to a sophisticated offeree who accepted the tender offer. The fact that only those refusing a tender offer could enjoy an appraisal remedy (under a motion filed by them or by another offeree) could increase a nonsignificant sophisticated offeree’s motivation to refuse an offer. Thus, their consent 30

  Kital, supra note 2.

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Appraisal rights in complete tender offers in Israel   239 to an offer carries considerable weight and attests to the assumption that they considered the offer’s price to be fair. 3.9  Negotiating the Price through an Independent Committee Another option that has not yet been explored in Israel is negotiating the price of the tender offer with an independent committee. This option was offered in an article by Hamdani and Barak’s previously cited article following a Delaware court ruling in CNX. According to this option, the majority shareholder will negotiate the offer price with an independent committee that will represent the minority shareholders. Such a committee should be given full authority. If the court is convinced that the committee was independent, and that it did actually have full negotiation authority, the price that is reached and agreed upon by the committee may very well be considered by the court as an indication for the fair value, at least in the same way as a prior deal would have been considered by it. If such a possibility will be accepted by courts in Israel, it could be a helpful tool for majority shareholders making a complete tender offer that want to mitigate the risk of future litigation and interference of the court with the deal’s price. Another interesting option is for the court to select one of the parties’ expert opinions and evaluate the value of the shares according to it. If the parties are aware of this in advance, than the evaluations made by their experts are expected to be more “reasonable” and closer to each other. 3.10 Should “Fair Value” Represent the Value of the Company or of the Purchased Shares? In those cases where the court has no external “anchors” of the kind discussed above (consent of a sophisticated offeree or a previous transaction outside the stock exchange), the court is required to perform an appraisal to determine whether the tender offer price was fair. Examination of that question requires assessment of a preliminary question: should the court appraise the shares purchased under the tender offer, or should it evaluate the company value as a whole, as a going concern (and derive share value according to their relative share in the company)? One of the questions in this context is whether share liquidity should be considered as a relevant factor when estimating the value of those shares. Obviously, the fact that the share marketability of a certain company is low impacts its stock exchange value, that is, impacts share price in a transaction between a willing seller and willing buyer in the stock exchange. Therefore, the difference between these approaches could be significant. Thus, should the court be required to appraise the value of purchased shares, it could lead to lower appraisal values—both because these are minority shares lacking a control premium, and because there may be little or no market for these shares. However, if company value is to be calculated as a whole, neither the lack of a control premium nor the illiquidity of the shares will detrimentally affect their value. According to Delaware case law, in appraisal cases the court should determine the value of the company itself as a going concern. The relative share of the shareholder is irrelevant, except with regard to the determination of their share in overall company value. This determination was aimed at preventing unfair profit for the majority

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240  Research handbook on representative shareholder litigation shareholders purchasing the shares of minority holders, a result the court deemed undesirable.31 For that matter, the Delaware court distinguished between the value appraisal of shares held by the company itself (and forming a part of company assets to be appraised)—in which case low share marketability carries weight in the appraisal—and the appraisal of minority shares purchased in the tender offer. Then, as mentioned, the appraisal is not of the specific shares but rather appraisal of company value as a going concern, when minority share value is derived from that value according to the relative share of the minority in the company. In the Kital case,32 the Supreme Court determined that in motions for an appraisal remedy, the court has to consider the difference between a transaction under which the minority shareholders wish to voluntarily “detach” themselves from the company (for example, due to a change in its activity fields) and a transaction in which those shareholders are forced to sell their shares to the majority shareholders. In that matter, the court also referred to the “main position amongst scholars in the U.S. and the Delaware court ruling,” stating that no discount should be made due to minority shares under an appraisal remedy. That leads to the conclusion that no reduction is to be made in the value of minority shares purchased which lack a control premium. This conclusion also impacts the question of a possible price discount due to lack of marketability. Should such discount be made, the result will be that the controlling shareholder purchasing the minority shares will pay the minority shareholders a price for their shares that is lower than their relative share in the company, when that value is calculated according to the DCF method. In other words, the majority could purchase part of the company for less than its value. The result is that the controlling shareholder will be getting the value difference due to nonmarketability (purchasing the minority shares for a price lower than that reflecting their relative share in the company). Should the law enable the controlling shareholders to purchase minority shareholders’ shares for a price lower than that reflecting their relative share in the company, the controlling shareholders will always obtain a high profit from purchasing the minority in companies with low share marketability. Such profit actually reflects a “control premium” of the controlling shareholders, which minority shareholders are deprived of. Another reason for the conclusion that minority share value should not be discounted due to low marketability is the fact that, as mentioned above, shares’ marketability could often be controlled by the controlling shareholder. Controlling shareholders are usually less affected by reductions in share marketability, since controlling shareholders usually do not wish to market their shares on the stock exchange. They usually trade small quantities. When the controlling shareholder wishes to sell company control, they usually do that in a transaction outside the stock exchange. Should the controlling shareholder be allowed to purchase the minority shares for a discounted price reflecting their nonmarketability (or limited marketability), their incentive would be to ensure reduce share marketability. Minority shareholders will be affected

31 32

  Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1145 (Del. 1989).   Kital, supra note 2.

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Appraisal rights in complete tender offers in Israel   241 by that both before the tender offer (when they will struggle to “rid themselves” of their shares) and under the tender offer—when their shares’ “fair” price will be deemed lower. Therefore, low share marketability should be disregarded in the appraisal of their fair value.

4. CONCLUSION The Israeli case-law regarding appraisal decisions is still in the making. This chapter did not deal with several other questions that arise as far as appraisal decisions are concerned: What should be the method of evaluating the fair value? Is DCF always the best method? Moreover, since courts may have to rely on expert opinions, what is expected of the experts? Can their fee be contingent? If not, it may be very difficult for the minority shareholder to finance such an opinion. Finally, how should courts examine the expert opinions and determine the fair value of the shares, in those cases where there is no alternative “anchor” to do so? However, Israeli case-law did address in several cases the question of whether the price paid for the minority’s shares was their “fair price.” In doing so, the courts were aware of the difficulty in relying on expert testimony, and considered other alternatives. In some rulings, courts relied on sophisticated shareholders’ agreement to the offered price as a possible indication to the price’s fairness. These rulings may effect controlling ­shareholders that plan to make a tender offer, and may give additional power to those minority shareholders that can be considered “sophisticated.” Courts have to be aware of that and make sure that this additional power is not used coercively.

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Section C Appraisal Actions

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15.  Recent developments in stockholder appraisal Charles R. Korsmo and Minor Myers* 33

This chapter provides an overview of stockholder appraisal activity, including data from 2015, together with an evaluation of recent legal developments, both judicial and legislative. The year 2015 was a record one for stockholder appraisal in terms of the number of mergers challenged and the dollar amounts involved. The evidence shows, however, that appraisal remains relatively rare and continues to be focused on deals with abnormally low merger premia and sales processes marked by conflicts of interest. Developments in the Delaware legislature and Court of Chancery suggest a growing acceptance of the recent blossoming of appraisal arbitrage as an investment strategy, coupled with sensible prophylactic measures against potential abuses of the appraisal remedy.

1. INTRODUCTION In the past five years, the appraisal remedy has gone from being an arcane and littleknown feature of stock ownership to a routine feature of the Delaware Court of Chancery docket and a topic of heated debate. This change has largely been driven by the emergence of so-called appraisal arbitrage, where sophisticated funds pursue appraisal litigation as part of a deliberate investment strategy, often buying stakes in merger targets after a deal has already been announced. Critics of appraisal arbitrage have described it as an “abuse” of the appraisal remedy and have suggested that it could deter beneficial mergers. We have previously argued that the evidence suggests appraisal arbitrage can serve a useful governance function, deterring managerial opportunism in a way that redounds to the benefit of all stockholders and, ultimately, to the benefit of issuers of public equity. In this chapter, we present and evaluate recent activity in appraisal litigation, and we find the evidence continues to support our contention that appraisal provides useful deterrence effects against abusive transactions. Recent years have also seen significant legal developments. These include the first amendments to the Delaware code in response to the increase in appraisal arbitrage, as well as the largest batch yet of judicial opinions in the new era. Both the legislative and judicial responses to the growth of appraisal litigation have been measured, reflecting cautious acceptance of appraisal arbitrage as a useful tool in deterring opportunistic *  Thanks to participants in the 2016 Corporate and Securities Litigation Workshop. The authors are the principals of Stermax Partners, which provides compensated advice on stockholder appraisal and manages appraisal-related investments, and have economic interests in the outcome of appraisal proceedings. They received no compensation for the preparation of this chapter, and none of the views expressed here were developed directly out of their advisory work, although, of course, general experience serves as helpful background.

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244  Research handbook on representative shareholder litigation transactions, while attempting to put a damper on potentially destructive practices. These efforts paralleled a significant judicial crackdown on frivolous fiduciary duty class actions challenging mergers, which may reflect a judicial desire to steer merger challenges into appraisal, where they are less likely to be distorted by the agency problems that plague class actions (Korsmo & Myers 2014). This chapter focuses on Delaware law and proceeds in three parts. First, we offer a short introduction to the appraisal remedy itself. Second, we provide an overview of the empirical data on modern appraisal litigation—including the rise of appraisal arbitrage—with a focus on recent data from 2015. Third, we describe and evaluate recent judicial opinions and legislative actions regarding appraisal, both of which reflect an increasing acceptance of appraisal arbitrage as part of the constellation of Delaware corporate governance tools, together with a desire to head off potential abuses.

2.  THE APPRAISAL REMEDY The appraisal remedy in Delaware provides minority stockholders a right to dissent from a merger transaction, forgo the consideration they would otherwise receive, and seek a judicial determination of the “fair value” of their stock in the Court of Chancery. This section outlines the operation of Delaware’s appraisal statute. Appraisal is a longstanding feature of corporate law, and has been available in its modern form for a century (Thompson 1995). While a definitive statement of the “original intent” of appraisal is elusive, the standard account ties the emergence of the remedy to other contemporary changes in corporate law and patterns of stock ownership. Earlier corporate codes had, by analogy to partnership law, insisted that stockholders consent unanimously to mergers and other extraordinary transactions (Carney 1980). With the rise of very large corporations and increasingly dispersed ownership of stock traded via public markets, this unanimity requirement generated difficult holdout problems. As a result, in the decades around the turn of the century, states began amending their corporate codes to eliminate the requirement of unanimous shareholder consent to fundamental transactions. This change, however, left minority shareholders vulnerable to majority stockholder opportunism or otherwise exploitative mergers. Thus, state corporate codes began to offer appraisal as a replacement protection. In an appraisal proceeding, the terms on which minority stockholders exit their investment are set by a judge rather than by a board of directors (Geis 2011). Section 262 of the Delaware General Corporation Law (DGCL) governs the remedy, and only a merger transaction triggers stockholders’ appraisal rights in Delaware. For public companies, the form of merger consideration affects appraisal eligibility. Only when stockholders are required to accept cash or unmarketable securities is appraisal available. Notably, when the merger consideration is entirely publicly traded stock, stockholders have no appraisal rights. Elsewhere we have criticized this so-called market-out exception to appraisal eligibility because the form of merger consideration is irrelevant to the question that matters to stockholders: the adequacy of the consideration (Korsmo & Myers 2016A; Goetz 2010). Appraisal statutes require minority stockholders to jump through a number of procedural hoops in order to preserve and assert their appraisal rights. In Delaware, for

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Recent developments in stockholder appraisal  245 example, a dissenting stockholder must not vote in favor of the merger and must make a written demand to the company in advance of any stockholder vote informing the company of the intent to seek appraisal and the number of shares held. After making demand, the dissenter may, within 60 days of the effective date of the merger, unilaterally withdraw his dissent and accept the merger consideration. Meanwhile, appraisal rights are forfeited if no petition is filed in the Court of Chancery within 120 days of the merger’s closing. The sole merits issue in an appraisal proceeding is the fair value of the dissenting stockholder’s shares. In Delaware, fair value is calculated as of the effective date of the merger, and will include any applicable control premium but exclude any synergies or other value gained in anticipation of the merger. The court is not constrained to use any particular valuation technique, but is empowered to rely on any technique generally considered acceptable within the financial community. Both parties bear the burden of proof on the question of fair value, and the court must make its own independent determination of value. Trial involves extensive testimony by competing expert witnesses. The merger price itself is not formally presumed to constitute fair value, though in practice the court often affords substantial weight to a merger price that emerges from a competitive sales process. The trial award entitles the dissenting stockholders to cash equal to the judicially determined fair value, together with interest. The DGCL awards interest at the legal rate, which in Delaware is 5 percent above the Federal Reserve discount rate. As discussed more fully below, Delaware recently amended its appraisal statute to allow companies to avoid the accrual of interest by prepaying petitioners. The structure of the appraisal remedy and the timeline of a typical merger transaction make it possible to invest in appraisal litigation in a way that is seldom feasible for other forms of stockholder litigation. Investing in a company with an intent to pursue appraisal has come to be known as “appraisal arbitrage.” After a merger transaction has been publicly announced, outside investors can consider whether the transaction undervalues the target stock. If they believe the Court of Chancery would be likely to find a substantially higher “fair value,” they simply need to establish a position and dissent before the stockholder vote. For two-step transactions under 251(h) and other mergers effected without a shareholder vote, an investor can establish a position and dissent right up until the closing date. Appraisal actions differ in several important ways from the more familiar fiduciary duty class action. Most fundamentally, an appraisal petition is an individual action. While multiple petitions may be consolidated into a single proceeding, any stockholder who wishes to dissent must affirmatively meet the procedural requirements in the DGCL. Unlike an optout class action, a stockholder seeking appraisal does so only on his own behalf, and not on behalf of any other stockholders. While a fiduciary duty plaintiff can spread the costs of litigation across a large class, an appraisal petitioner generally must have a large enough stake to justify the costs. Furthermore, an appraisal petitioner—unlike a member of a fiduciary duty class—must forgo the merger consideration and bear the risk that fair value will be found to be less than the merger price. Together, these costs and risks force an appraisal petitioner to consider carefully the strength of his claim prior to bringing a suit. By contrast, an entrepreneurial plaintiffs’ attorney pursuing a fiduciary duty class action can generally find a small stockholder to serve as lead plaintiff. Unsurprisingly, these structural differences between appraisal actions and fiduciary duty class actions manifest in strikingly different patterns of litigation, which we have explored elsewhere (Korsmo & Myers 2014).

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3.  MODERN APPRAISAL ACTIVITY Until approximately 2010, appraisal litigation was relatively rare in the public company context. When it occurred, it tended to represent a last-ditch maneuver by a disgruntled long-term stockholder unhappy with a merger. Since 2011, however, the landscape has changed substantially, and appraisal has become a potent governance tool. The modern period has been characterized by a substantial increase in the number of challenged transactions, as well as in the number of dollars at stake. It has also seen a change in the identity of the typical appraisal petitioner, with specialized repeat players now filing the bulk of the claims and holding the vast majority of the money at stake. In this section, we sketch these changes, with a focus on 2015. In sum, 2015 saw a rebound following a period of reduced appraisal activity in 2014. This rebound mirrored a surge in the merger market as a whole, which reached an all-time record dollar volume in 2015. This rebound in appraisal activity was accompanied by a sharp and widely noted decrease in the frequency of fiduciary duty challenges to merger transactions, though such challenges still substantially outnumber appraisal petitions (see Griffith and Rickey, Chapter 9, this volume). Our data focuses on appraisal petitions challenging public company mergers filed in the Delaware Court of Chancery. We exclude any natural persons who file their petitions pro se, as these are of little economic significance. Our analysis and presentation focuses on the effective date of the merger, rather than the date when the merger is announced or the date when the first petition is filed. The effective date is generally more meaningful and forms a single point of reference, whereas petitions challenging a single transaction may be filed in different years. The effective date also better captures the appraisal petitioner’s timing, given that the investment must be made prior to that time. From 2004 through the end of 2015, approximately 200 appraisal petitions involving publicly traded stock were filed in Delaware by counseled petitioners. 2015 reflected a new high, with a total of 52 counseled petitions filed, surpassing the previous high-water mark of 37 in 2013. Figure 15.1 shows the number of petitions filed per year. The number of filed petitions—a number frequently trumpeted by journalists—is not always particularly meaningful. For one thing, the number of petitions may naturally 60

Petitions filed

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Figure 15.1  Counseled appraisal petitions per year, 2004–2015

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Recent developments in stockholder appraisal  247 fluctuate along with underlying activity in the merger market. The year 2014 showed a dramatic decline in the number of appraisal petitions, but this decline largely tracked a drop in overall merger activity in 2014, a year which saw the fewest appraisal-eligible deals of any year in our sample. In addition, the raw number of filings may both understate and overstate the actual level of appraisal activity. It understates appraisal activity because it counts only petitions actually filed in court, so any disputes that are settled before the filing of a petition are unobservable. Undoubtedly, some particularly strong claims are settled in this fashion. As a result, actual filings may somewhat undercount the actual number of appraisal disputes. Numbers of petitions may also overstate the level of appraisal activity. Multiple petitions are often filed challenging the same merger and are ultimately consolidated into a single proceeding. It makes little difference whether multiple dissenters each file separate petitions and are then consolidated, rather than simply joining together in a single petition at the outset. The PetSmart merger, for example, saw seven petitions filed—some involving multiple individual dissenters—with six petitions brought by parties represented by the same lawyer. More meaningful than the raw number of petitions filed is the percentage of appraisaleligible deals where at least one dissenter files a petition. This is shown in Figure 15.2. Through 2010, appraisal activity was generally around 5 percent of eligible transactions. This figure began to rise in 2011, peaking at 17 percent in 2013 before falling slightly to 13 percent in 2014. In 2015, the figure was 14.5 percent. These figures represent more of a continuation than a marked change from the pattern of the past several years. This leveling off may indicate that the recent period of growth has plateaued, and appraisal activity has reached a new equilibrium in the vicinity of 15–20 percent. The value at stake in appraisal proceedings in 2015 also rebounded from 2014, hitting a record $2.75 billion, again tracking an increase in the total value of merger transactions, which hit a record in 2015 (see Figure 15.3). Again, this value represented only a very small percentage (0.12 percent) of the aggregate value of appraisal-eligible deals dissented, as compared to an average of 0.35 percent since the level of appraisal activity began to increase in 2011 through the end of 2014. The value in appraisal in 2015 was highly concentrated on three mergers in particular, involving Safeway, AOL, and PetSmart. These cases represent three out of only four transactions where more than 5 percent of shares 20%

Percentage

15% 10% 5% 0%

2004

2005

2006

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Figure 15.2  Appraisal petitions as a percentage of appraisal-eligible transactions, 2004–2015

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Millions of 2015 dollars

2,800 2,400 2,000 1,600 1,200 800 400 0

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Figure 15.3 Value of dissenting shares in Delaware appraisal, 2004–2015 (in millions of constant 2015 dollars) sought appraisal, the other being a much smaller company where the bulk of the dissenting shares were held by a long-term stockholder and first-time appraisal petitioner. Together, Safeway, AOL, and PetSmart accounted for more than $1.8 billion—­approximately 65 percent—of the value at stake in appraisal. In the PetSmart case alone, nearly at least $890 million in stock sought appraisal, the largest single case yet. Even excluding these three large cases, however, the value seeking appraisal in 2015 was greater than $500 million, an amount that had been exceeded only in two other years in our data. As has been the case every year since 2011, the majority of value at stake in appraisal in 2015 came from repeat petitioners. The dominance of specialist appraisal arbitrageurs, however, was not as great in 2015 as it has been in recent years. Several large institutional investors—including the hedge fund Third Point and Stichting APG (a Dutch pension fund)—resorted to appraisal in 2015. Altogether, petitions from first-time or nonspecialist petitioners totaled approximately $1 billion, easily a record. This shift may reflect greater awareness and acceptance of appraisal, both as part of an overall investment strategy and as a tool for institutional shareholders. Appraisal does, however, carry significant risk even for sophisticated nonspecialists, as evidenced by the experience of T. Rowe Price—a large mutual fund—in the recent Dell appraisal case. Vice Chancellor Laster found that, due to a series of administrative mistakes too technical and tedious to relate here, T. Rowe Price had failed to comply with the requirements of Section 262. He thus excluded T. Rowe Price from the eventual recovery, costing it approximately $200 million. This embarrassing episode ultimately resulted in T. Rowe Price’s investment manager reimbursing its investors the lost $200 million. It remains to be seen whether this example—which took place in 2016—chills nonspecialist participation in appraisal going forward. While not directly related to appraisal, it is worth remarking on an important parallel development. From 2010 through 2014, fiduciary duty class actions challenging merger transactions were well-nigh ubiquitous. Well over 90 percent of deals larger than $100 million faced at least one class action, with large deals often facing a blizzard of class action filings in multiple jurisdictions (Cain & Davidoff Solomon 2014). There was a sharp drop

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Recent developments in stockholder appraisal  249 in the frequency with which mergers were challenged by fiduciary duty class actions in 2015 (Griffith and Rickey, Chapter 9, this volume). This drop followed a series of judicial opinions scrutinizing and rejecting settlement agreements providing substantial fees for plaintiffs’ attorneys but little or no value for stockholders.

4.  LEGAL DEVELOPMENTS IN APPRAISAL The past year has seen the first real legal response to the rise of appraisal arbitrage. This response has two components, and arguably a third. First, the Delaware legislature amended the appraisal statute in response to concerns—well-founded or not—about potentially abusive tactics by appraisal petitioners. Second, the Court of Chancery generated the first significant batch of merits opinions for cases filed in the new era. Finally, while not appraisal-related on the surface, the recent judicial crackdown on disclosureonly settlements in fiduciary duty class actions has a variety of implications for appraisal. The appraisal amendments emerged from an unlikely place. The initial suggestion to amend the appraisal statute grew out of public anger over feeshifting bylaws. Soon after the Delaware Supreme Court had seemingly endorsed feeshifting bylaws, the Corporation Law Council of the Delaware state bar leapt into action, proposing an amendment that would prohibit such bylaws. In the face of significant controversy, the Delaware legislature did not act on the Council’s proposed amendment but instead passed a resolution that invited the Council to further analyze the topic. In a surprising nonsequitur, the resolution also requested that the Council delve into “the operation and administration of the statutes and court rules governing the exercise of appraisal rights; and the rate of interest on any fair value determination in an appraisal.” After examining the appraisal statute, the Council released two appraisal-related DGCL amendments in March 2015. To guard against small claims brought for nuisance value, the first amendment introduced a de minimis rule: Only where the dissenting group held more than $1 million worth of stock or 1 percent of shares was appraisal available. The second amendment was driven by concerns that appraisal arbitrageurs might park money in appraisal in order to take advantage of Delaware’s purportedly “above-market” interest right. The Council’s proposal would give the company the unilateral right to pay over some amount, and doing so would stop the running of interest on amounts so paid. The 2015 Council proposal was especially notable in that it declined to propose any of the more radical proposals proffered by detractors of appraisal. The most common such proposal would restrict appraisal eligibility to those stockholders who held on the record date for voting on the merger. Instead, the Council emphasized the possible governance benefits of an active appraisal market. Disappointed with the incrementalism of the Council, a handful of M&A law firms based of New York City wrote to the Council insisting on more aggressive reforms. The proposed amendments were not enacted by the legislature in 2015—a highly unusual occurrence. News reports at the time suggested that the Dole Food Company was a major instigator of this push for radical changes to the statute. Dole, of course, happened to be the defendant in one of the larger appraisal cases in Delaware at the time. Following an August 2015 court opinion finding that Dole’s managers had engaged in a

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250  Research handbook on representative shareholder litigation pervasive scheme of fraud and award of damages to public stockholders, Dole appears to have fallen silent on the issue. In 2016, the Council again recommended the same two amendments. In the absence of Dole’s lobbying efforts, the amendments were ultimately enacted in the summer of 2016. The amendments are, on balance, positive developments. While evidence of nuisance claims had previously been lacking, in 2015 we did for the first time observe small-value claims ( $20B $10 – 20B $5 – 10B S&P/TSX Median: $3B

$1 – 5B

Dataset Median: $1.2B

$500M – 1B $225M – 500M $0 – 225M –

2

4

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Number of Companies

Figure 27.2  Defendant companies by market capitalization In addition to the median of the data being much greater than the S&P/TSX Venture Composite Index median, only six of the 74 cases involved companies listed on the TSX Venture Exchange. Of these six cases, two have settled as of June 2017, and the settlement amounts in these two cases were among the lowest recorded during the sample period. However, surprisingly, plaintiffs do not seem to be litigating the largest public companies either, as illustrated in Figure 27.2.82 As a benchmark, the S&P/TSX Composite Index includes issuers with market caps ranging from $355 million to $138 billion, with an average of $8 billion and a median of $3 billion.83 The median of the data excluding the non-TSX public companies is much lower than the S&P/TSX Composite Index median. Is this because the largest public companies have, or are perceived to have, stronger internal controls in place and do not tend to violate their continuous disclosure

measure the performance of securities listed on the TSX Venture Exchange, and included 425 issuers as of June 2, 2017. The TSX Venture Exchange is the primary venture equity market in Canada, and there were 2,000 companies listed on this stock exchange as of June 2, 2017. 82   As mentioned in the introduction to this chapter, Canada’s capital markets represent only 2–3 percent of global market capitalization, while the capital markets in the US are more than 13 times larger. Thus, large companies are defined differently in Canada. Further, Canadian capital markets are characterized by a disproportionately large number of small companies and a small number of very large companies (Puri 2012). Additionally, in Canada, there is no quantitative materiality requirement. In contrast, the US disclosure regime includes quantitative percentage thresholds, which may result in lower disclosure obligations for very large companies (Georgiev 2017). 83   TMX Indices. TSX real-time indices https://web.tmxmoney.com/indices.php?section=tsx &index=^TSX#indexInfo (accessed on June 2, 2017). The S&P/TSX Composite Index provides approximately 95 percent coverage of the Canadian equities market and included 250 issuers as of June 2, 2017. It is the principal gauge for Canadian-based, TSX-listed companies. The TSX is the primary stock exchange in Canada, and there were 3,000 companies listed on the TSX as of June 2, 2017.

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Data Set

Percentage of Market

35

S&P/TSX

30 25 20 15 10 5

er th O

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gy

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ia nc na

En

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Industry

Figure 27.3  Defendant companies by industry obligations as often? It does not appear that plaintiffs and their lawyers are concerned about the immense resources that may be available to such companies, which the plaintiffs’ side would then have to match. In fact, when there have been allegations of continuous disclosure violations against some of Canada’s largest companies, a carriage fight between plaintiff firms ensues, signalling a high level of interest in pursuing such companies. For example, the class action proceedings involving Barrick Gold Corporation in 2014 and Valeant Pharmaceuticals International, Inc. in 2015 (market capitalizations of approximately $23 billion and $81 billion, respectively) gave rise to carriage fights that were ultimately resolved by the court.84 In terms of industry sector, 34 percent of the 47 companies named as defendants were mining companies. As a comparison, the materials sector, which includes mining, constitutes around 12 percent of the S&P/TSX Composite Index.85 Thus, a disproportionately high percentage of public companies from the mining industry were subject to securities class actions for secondary market misrepresentations, as illustrated in Figure 27.3. In contrast, financial institutions were disproportionately less likely to be named as ­defendants. Around 15 percent of the companies named as defendants in the dataset were 84   The market capitalization values correspond to one month prior to the earliest class action filing dates. See Mancinelli v. Barrick Gold Corporation, 2016 ONCA 571, 131 O.R. (3d) 497; Kowalyshyn v. Valeant Pharmaceuticals International, 2016 ONSC 3819, [2016] O.J. No 3043.  85   TMX Indices. TSX real-time indices available at https://web.tmxmoney.com/indices.php?sec tion=tsx&index=^TSX#indexInfo (accessed on June 2, 2017). Note that the S&P/TSX Composite Index does not provide a perfect comparison, given that the data only reflects approximately 95 percent of the Canadian equities market by market capitalization and included 250 issuers as of June 2, 2017.

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Securities class actions in Canada  499 from the financial services sector, but the sector constitutes nearly 36 percent of the S&P/ TSX Composite Index.86 What does this indicate about companies in the mining industry as compared to those in financial services? Financial institutions are subject to both market conduct regulation through securities laws as public companies and prudential regulation through regulators such as the Office of the Superintendent of Financial Institutions and the Financial Services Commission of Ontario, which may impose additional internal controls and processes. In contrast, mining companies are only subject to market conduct regulation. The mining industry is one of two industries for which the CSA has issued additional guidance and rules consolidating and expanding on the disclosure and reporting obligations, including technical reports.87 One reason for this may be that the mining sector constitutes a relatively large part of the Canadian capital markets and, thus, any disclosure scandals would have a greater economic impact. Despite the detailed rules, a 2013 review by the Ontario Securities Commission (the “OSC”) of the technical reports filed by Ontario mining issuers found “an unacceptable level of compliance” with the disclosure and reporting requirements.88 Finally, gatekeepers, such as auditors, underwriters, and lawyers, were rarely, if ever, named as defendants by plaintiffs and their lawyers. Could this be attributable to the legislation, which provides that experts are only liable if an expert report, opinion, or statement contains the misrepresentation, and it is quoted or summarized with the expert’s written consent?89 Plaintiffs and their lawyers named public companies and/or their officers and directors in 70 of the 74 cases (95 percent).90 None of the cases named the companies’ lawyers as defendants. Only seven of the 74 cases (9 percent) named the companies’ underwriters as defendants. In 2016, the ONSC held that underwriters are not “experts” for the purposes of a statutory civil liability action and “are not intended to be caught by the secondary market liability provisions.”91 The court reasoned that underwriters are already subject to primary market liability under section 130 of the Ontario Securities Act.92 This decision will likely further discourage claims against underwriters. Finally, 13 of the 74 cases (18 percent) named the companies’ auditors as defendants. Canadian auditors have generally succeeded in narrowing the scope of their liability through legislation and common law because of the perception of a “liability crisis” (Puri & Ben-Ishai 2003). The low percentage of cases involving auditors in the dataset suggests that liability floodgates arguments often made by auditors may be overblown.

86   TMX Indices. TSX real-time indices available at https://web.tmxmoney.com/indices.php?sec tion=tsx&index=^TSX#indexInfo (accessed on June 2, 2017). 87   NI 43-101 Standards of Disclosure for Mineral Projects; Form 43-101F1 Technical Reports. The other industry is oil and gas. 88   See OSC Staff Notice 43-705, 2013. “Report on Staff’s Review of Technical Reports by Ontario Mining Issuers.” 89   See, e.g., R.S.O. 1990, c. S-5, § 138.3. The examples of “experts” included in the Ontario Securities Act include auditors but not underwriters. 90   In the remaining four cases, only auditors or underwriters were named as defendants. 91   LBP Holdings v. Allied Nevada Gold Corp., 2016 ONSC 1629 at para 47, 130 O.R. (3d) 401. 92   Ibid at para 62.

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5.  STANDING AND TYPES OF PLAINTIFFS Who has standing to pursue a statutory secondary market claim in Canada? If a misrepresentation is made in a document or statement, any person or company who transacts in a company’s securities has a right of action.93 What are the dynamics at play? What types of investors pursue secondary market statutory liability actions? Does the type of investor—retail or institutional—have an impact on settlements or settlement amounts? Retail investors generally do not have the resources or expertise to pursue litigation when harmed. Given the cost of litigation and the high threshold to obtain leave under the 2005 civil statutory scheme, one would expect that retail investors would commence few actions unless brought as class proceedings. However, for statutory claims pursued as a class action, the new civil liability regime has made it easier for plaintiffs to seek certification and for a class to go forward by removing the reliance requirement that continues to exist in the common law. In addition, the 1992 legalization of contingency fee arrangements for class actions has been an impetus for class actions, along with third party litigation financing (Puri 1998). By comparison, institutional investors are more sophisticated, better informed, and have more resources. On this basis, one would expect institutional investors to pursue more statutory liability actions. But the story for institutional investors is slightly more complicated. They often face conflicts of interest in acting as representative plaintiffs due to their commercial relationships with the very companies that might be potential defendants (Cox & Thomas 2006; Cox & Thomas 2005). Additionally, institutional investors may not be inclined to divert their resources to litigation efforts, away from their core business of investing. Based on our data, retail investors were more likely to commence actions as compared to institutional investors. Of the 74 cases, 60 (81 percent) were commenced by retail investors, six (8 percent) were commenced by both institutional and retail investors, and only eight cases (11 percent) were commenced by institutional investors alone.94 This may be because plaintiffs’ counsel typically play a pivotal role in commencing class actions and will actively look for representative plaintiffs to lead actions.95 Further, it may be relatively easier to find a retail investor willing to take up the role of a representative plaintiff than an institutional investor for the reasons mentioned above. In terms of plaintiffs’ counsel, one law firm was involved in 66 percent of the cases in the sample.96 This suggests that plaintiffs’ lawyers have developed an expertise in securities class actions, attracting plaintiffs to the few law firms with this expertise. Representation on the defendants’ side was significantly more fragmented. Despite the relatively few cases commenced by institutional investors, research shows

  See, e.g., R.S.O. 1990, c. S-5, § 138.3.   In the US, there may be more cases commenced by institutional investors because of the rebuttable presumption under the Private Securities Litigation Reform Act of 1995 that the lead plaintiff should have “the largest financial interest in the relief sought by the class.” 95   Some plaintiffs’ counsel reportedly hire lobbyists to persuade institutional investors to assume the representative plaintiff position (Cox & Thomas 2006). 96   Siskinds LLP was involved in 66 percent of the cases. Other firms included Sutts, Strosberg LLP, and Koskie Minsky LLP. 93 94

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Securities class actions in Canada  501 that the type of investor may have an impact on the settlement value obtained. In the United States, institutional lead plaintiffs are associated with improved settlements and larger recoveries (Cox & Thomas 2006). In Canada, the data shows that claims commenced by institutional investors were not necessarily more likely to obtain a settlement than claims commenced by retail investors. To illustrate, as of June 2017, five of the eight cases (63 percent) commenced by institutional investors were completed (that is, settled, dismissed, or time-barred), of which four (80 percent) have settled. Similarly, 34 of the 60 cases (57 percent) led by retail investors have been completed, of which 27 (79 percent) have settled. However, the data shows that as of June 2017, in cases led by institutional investors, the average settlement is approximately $29 million, while in cases led by retail investors it is only $10 million. The low number of suits brought by institutional plaintiffs makes it difficult to draw definitive conclusions. However, the relationship between settlements and retail and institutional investor-led cases in the dataset is consistent with the finding that institutional investors are often associated with higher settlements (Cox & Thomas 2006). Therefore, while the type of investor does not necessarily influence whether a settlement is obtained, the data suggests that cases led by institutional investors resulted in higher settlements. One reason for this may be that institutional investors tend to own a larger proportion of shares than retail investors, and therefore incur greater damages (Cox & Thomas 2006). Institutional investors also tend to reject early settlements that would fail to adequately compensate their losses (Cox & Thomas 2006). Overall, the four settled cases involving institutional plaintiffs, along with findings from other studies, seem to suggest that it may be preferable from the investor recovery perspective to have an institutional investor as the representative plaintiff. However, it might be more difficult for plaintiffs’ counsel to get institutional investors on board.

6. STATUS OF SECONDARY MARKET SECURITIES CLASS ACTIONS IN CANADA 6.1  Progression of Cases As mentioned previously, plaintiffs are required to obtain leave of the court to commence secondary market statutory liability actions. Additionally, plaintiffs are required to seek certification under the respective province’s Class Proceedings Act.97 The certification process is an additional screening mechanism to filter out frivolous class actions. All secondary market statutory liability actions originate in the province’s trial courts, where the court decides whether to grant leave and to certify a class proceeding. As illustrated in Figure 27.4, both representative plaintiffs and defendants have the right to appeal the trial court’s decision on leave and certification in the divisional court or the province’s court of appeal. If either party wants to appeal the appellate court’s decision in the Supreme Court, they must seek permission to appeal. Once plaintiffs obtain leave and certification to commence an action as a class, the case proceeds to judgment on the merits in the trial   See, e.g., S.O. c. 6 § 5(1); Class Proceedings Act, R.S.B.C. 1996, c. 50, § 4(1).

97

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502  Research handbook on representative shareholder litigation Either party has the right to appeal the decision by the trial court at the divisional court and/or the appellate court level. To appeal the appellate court’s decision at the Supreme Court, either party must seek permission.

Pre-certification, defendants can bring a motion to strike and/or a motion for summary judgment.

Claim Commenced

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Certification requires a plan that sets out a workable method for advancing the action.

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Average time to settlement or case dismissal ~3 years

Figure 27.4  Progression of an action court. Again, either party has a right to appeal the trial court’s judgment in the court of appeal, but there is no appeal as of right at the Supreme Court level. Parties require permission to appeal. Certification in Canada requires a representative to prepare a plan that sets out a workable method for advancing the action on behalf of the class.98 The onerous certification and leave requirements build an early barrier to entry for securities class actions in Canada (Puri 2012). None of the 74 cases have proceeded to a judgment on the merits, although many cases have settled (46 percent). Of the 74 cases in the dataset, 43 (58 percent) have settled, been dismissed, or become time-barred as of June 2017. Of these 43 cases, 34 (79 percent) were settled, seven were dismissed, and two were time-barred (including Timminco). Settlement amounts have ranged from as low as $105,000 to $166 million, with an average of $18 million and a median of $12 million.99 In all, 31 of the 74 cases (42 percent) were still ongoing as of June 2017. Based on the sample data, the average time until a class action was settled, dismissed, or time-barred was three years. The shortest time was about 11 months for a case filed in 2008. The longest was slightly over nine years, which was for the first case filed in Canada under the statutory civil liability scheme in 2006. This data suggests that the procedural hurdles before a class action can even get under way may be slowing down the progress of the cases.   See, e.g., S.O. c. 6 § 5(1)(e)(ii); R.S.B.C. 1996, c. 50, § 4(1)(e)(ii).   Most of the cases in the dataset involved more than one settlement with multiple defendants. In some instances, all settlements occurred at the same time, while in others, different defendants settled separately. For the purposes of this chapter, all settlements corresponding to the same claim have been aggregated. The settlements in the dataset also included a unique settlement involving no payment to the plaintiffs and an agreement for both parties to cover their own costs, which has been excluded from the figures above as an outlier. 98 99

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Securities class actions in Canada  503 Aside from the merits, there are different pressures for both parties to settle. As mentioned previously, the new regime has made it easier for plaintiffs to seek certification in a class action by removing the reliance requirement and thus providing a common legal issue. Therefore, it would be pragmatic for public companies to avoid prolonged litigation and to reach an early settlement. This would help mitigate the reputational risk and damage to the company, including the impact on stock prices. Of the cases that settled, 68 percent had not actually been certified but were certified for the purpose of settlement, indicating that it is common for an action to reach a settlement without certification. This suggests that both defendants and plaintiffs may be conducting a cost–benefit analysis. Defendants may be willing to settle to minimize the nuisance value, to avoid diverting management’s time from the business to litigation, and to preserve their market reputation. Defendants may also be incentivized to settle earlier rather than risk certification, which is more likely to happen now because it is easier to find a common issue under the statutory scheme than the common law. Further, the higher threshold for obtaining leave may now push plaintiffs to accept early settlement offers even before leave is obtained. Are plaintiffs also incentivized to settle for less than they might get post certification, so as to obtain an earlier settlement with less effort and fewer resources used? Plaintiffs’ counsel, who tend to play a more leading role in obtaining settlements than do plaintiffs, may be willing to accept a lower amount earlier rather than a higher amount later, given the significant resources that are required to carry a class action and the risk discount involved.100

7. RELATIONSHIP BETWEEN PUBLIC AND PRIVATE SECURITIES ENFORCEMENT Public and private securities enforcement regimes should not operate in silos but, rather, should complement each other.101 Striking the right balance between the two is key to fostering investor confidence and efficient capital markets. In Canada, both public and private enforcement operate concurrently, promoting the robustness of its capital markets (Puri 2012). While this chapter focuses on the private enforcement regime, it would be difficult to ignore the coinciding public regulatory developments for the companies subject to securities class actions in the dataset. Further, the focus of the statutory civil liability scheme on deterrence (largely the role of public enforcement) over compensation may have had an impact on the level of public enforcement. Is there an overlap in the cases pursued by public regulatory action and private enforcement? Very few companies were subject to both public enforcement proceedings and private class actions. Out of the 47

100   Plaintiffs’ counsel may be willing to take the risk discount by securing a lower amount earlier in exchange for less risk (there is a possibility that plaintiffs may get an even lower settlement amount later, as the cost of litigation increases and the value of the settlement decreases after taking into account the time value of money). 101   There has been considerable debate on whether public or private enforcement is more important for promoting investor confidence and fostering efficient capital markets (La Porta et al. 2006; Jackson & Roe 2009). Some scholars conclude that private enforcement is more valuable than public enforcement (La Porta et al. 2006), while others consider public enforcement just as important as private enforcement (Jackson & Roe 2009).

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504  Research handbook on representative shareholder litigation companies subject to class actions, 77 percent were not subject to any public enforcement activities, including informal investigations, while 85 percent were not subject to public enforcement proceedings. One argument that is often made is that plaintiffs’ counsel benefit from the efforts of public enforcement staff, so that when an investigation is announced, it prompts plaintiffs’ counsel to commence class actions. In investigations, securities regulators have a number of enforcement tools available to them that are not available to plaintiffs’ counsel. This includes the ability to compel information and documents from public companies. Public companies are granted a license to participate in the capital markets, and the securities regulators’ access to these tools allows them to ensure that the capital markets function smoothly. In private enforcement, plaintiffs must wait until the discovery stage to gather information and documents, unless defendants file affidavit evidence at the leave stage. Overall, there were few cases in the sample with an overlap between public regulatory action and private class actions. But, where there was an overlap, public enforcement activity almost always preceded private class actions. Of the companies in the sample subject to both public enforcement proceedings and private class actions, none of the class actions were preceded by the securities regulators’ statement of allegations. However, nearly all of them were preceded by some indication of public enforcement activity. This included public disclosure of a regulatory investigation made by the companies themselves or cease-trade orders by securities regulators for the same reasons underlying the class actions. One conclusion that can be drawn from this is that public regulatory action does indeed signal to plaintiffs’ counsel that there are potential misrepresentation or disclosure issues that would be ripe for class actions. That said, there were very few companies that were subject to both public regulatory action and private class actions. 7.1  Public Regulatory Actions A public regulatory action in Canada is preceded by an investigation. The OSC begins with an informal investigation, which can be prompted by multiple avenues, including investor complaints, market surveillance technology, and newspaper articles (Puri 2017). If OSC staff decide to move to the next stage, they launch a formal regulatory investigation and serve the company under investigation with a summons forcing them to testify. Typically, the OSC does not publicly disclose its investigations, although companies may choose to do so if the investigation would be considered material. Once the investigation is complete and if OSC staff find that the company under investigation has violated securities laws, the next step is to issue a non-public enforcement notice (the United States equivalent of a “Wells Notice”) to the company and/or its ­officers and directors. If no settlement is reached at this point, OSC staff commence public enforcement proceedings by issuing a Notice of Hearing and a Statement of Allegations. Settlements reached with OSC staff require the Commission’s approval and are eventually made public. The other provincial securities regulators in Canada have adopted a similar approach. Generally, public enforcement is driven by a host of factors, such as choosing cases that send a message to deter companies from similar violations and are in the public interest, but compensating harmed investors is not one of these. However, the decision to bring a private action is largely a function of whether the defendants will be able to

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Securities class actions in Canada  505 adequately compensate investors and their lawyers. Even though the Allen Committee and the CSA adopted deterrence as the primary objective of the statutory scheme, in practice, securities class actions are largely driven by plaintiffs’ counsel. Thus, there would not be much overlap between public and private enforcement. Out of the 47 companies subject to class actions, there was some degree of public enforcement activity against 11 companies (23 percent), ranging from cease-trade orders and informal investigations to public enforcement proceedings. As expected, companies were generally not subject to both the public and private enforcement regimes. Has the private regime’s focus on deterrence sent a signal to securities regulators to shift their focus from disclosure violations to other types of offenses?102 There has been a decreasing trend in the number of proceedings being commenced by Canadian securities regulators for disclosure violations, from 5 percent in 2011 to no proceedings in 2016.103 Is there a need for more public enforcement to tackle continuous disclosure violations to achieve optimal deterrence? Additionally, given that the market capitalization-based liability cap encourages plaintiffs and their lawyers to pursue larger companies, smaller companies may effectively be immune from private enforcement (Puri 2012). Therefore, public enforcement is particularly important with respect to disclosure by smaller companies, and initiatives such as the OSC’s recent Whistleblower Program may need to be further tailored to close this gap.104 Public enforcement proceedings (which are separate from cease-trade orders) relating to the same facts as the class actions were announced against seven of the 47 companies (15 percent) and/or their senior executives and directors. Of these proceedings, two were dropped: an OSC investigation into Imax Corporation’s accounting practices and a “Wells Notice” that had been issued to Manulife Financial Corporation (“Manulife”). Of the five proceedings that moved forward, two were brought by the OSC against Sino-Forest Corporation (“Sino-Forest”) and Greenstar Agricultural Corporation, and two were brought by the Alberta Securities Commission against Afexa Life Sciences Inc. (formerly known as CV Technologies Inc.) and Poseidon Concepts Corp. (“Poseidon”). The British Columbia Securities Commission brought the fifth proceeding against Southwestern Resources Corp. For 10 of the 11 companies that were subject to some degree of public enforcement activity, some indication of public enforcement activities preceded some or all of the corresponding class actions.105 Either the companies made the investigations or receipt 102   The OSC’s 2017–18 enforcement priorities include reducing regulatory burden in the public markets by lowering ongoing disclosure requirements. See OSC Notice 11-777—Statement of Priorities—Request for Comments Regarding Statement of Priorities for Financial Year to End March 31, 2018, www.osc.gov.on.ca/en/SecuritiesLaw_sn_20170323_11-777_rfc-sop-end-2018.htm. 103   Canadian Securities Administrators, 2012. “2012 Enforcement Report,” www.securitiesadministrators.ca/uploadedFiles/General/pdfs/CSA-2012-English-rev2014.pdf; Canadian Securities Administrators, 2016. “2016 Enforcement Report,” www.csasanctions.ca/CSA_AnnualReport2016_ English_Final.pdf. 104   OSC Notice of Policy Adopted under Securities Act, 2016. “OSC Policy 15-601 Whistleblower Program.” 105   Note: The only exception was Southwestern Resources Corp., which involved enforcement proceedings against the company’s CEO alone. For Poseidon, the public disclosure of a cease-trade order by the regulator preceded four out of the six class actions relating to the company.

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506  Research handbook on representative shareholder litigation of a “Wells Notice” public, or securities regulators issued cease-trade orders for the same reasons underlying the class actions. One conclusion that can be drawn from this data is that an indication of public enforcement activities, such as an investigation, can encourage class actions, even if they do not ultimately translate into public enforcement proceedings by the securities regulator. An indication of public regulatory action may signal to plaintiffs and their counsel that there are potential misrepresentation or disclosure issues that would be ripe for class actions. Imax, the first private action under the statutory civil liability scheme, is one example. It was preceded by an informal inquiry by OSC staff in June 2006 into the company’s “accounting policies and related matters.”106 Similar to the subject matter of the class action, the “primary focus” of the OSC investigation was “the Company’s application of multiple element arrangement accounting to its theatre installations and system agreements.”107 Three months later, investors brought a class action. In June 2011, Imax announced that OSC staff had ended their inquiry and “will be taking no further action.”108 Even though the class action started after public regulatory action, it still took nine years to settle. The class action was not resolved until December 2015, when the ONSC approved the parties’ $3.75 million settlement.109 Manulife is another example of how public regulatory action may prompt private class actions. The company was similarly subject to an OSC investigation before investors brought two class actions in Ontario and Quebec.110 In June 2009, Manulife received a “Wells Notice” from OSC staff regarding its “disclosure before March 2009 of risks related to its variable annuity guarantee and segregated funds business.”111 The OSC indicated in its preliminary conclusion that Manulife “failed to meet its continuous disclosure obligations related to its exposure to market price risk in its segregated funds and variable annuity guaranteed products”; Manulife responded to this.112 Just a month later, investors brought class actions in Quebec and Ontario. Manulife announced two years later that OSC staff would not be seeking “any orders from the OSC in connection with the enforcement notice delivered by staff in June 2009.”113 However, the class actions went on to be settled for $69 million almost eight years later, in 2017.114 106   Imax, 2010. Form 10-K at 23. The SEC initiated a formal investigation in parallel on or about September 3, 2010. 107   Press Release, Imax Corp., 2007. “Imax Announces Delay in Filing of 2006 10-K,” March 29, 2007, http://investors.imax.com/phoenix.zhtml?c=118725&p=irol-newsArticle&ID=979259#top. 108   See Alastair Sharop, 2011. “Imax Says SEC Dropping Accounting Probes,” Reuters Canada, http://ca.reuters.com/article/businessNews/idCATRE75S7VU20110629. The SEC investigation was also dropped at the same time. 109   Imax, 2015. Order Approving Settlement and Fees. “Marvin Neil Silver and Cliff Cohen and Imax Corporation, Richard L. Gelfond, Bradley J. Wechsler, Francis T. Joyce, Neil S. Braun, Kenneth G. Copland, Garth M. Girvan, David W. Leebron and Kathryn A. Gamble,” www. siskinds.com/cmsfiles/PDF/Securities/Imax/ORDER_OF_JUSTICE_BALTMAN.pdf. 110   Dugal v. Manulife Financial Corporation, 2011 ONSC 1785, 105 O.R. (3d) 364; Comité syndical national de retraite Bâtirente inc. c. Société financière Manuvie 2011 QCCS 3446, [2011] J.Q. no 9021. 111   Manulife, 2010. Annual Information Form at 59. 112  Ibid. 113   Manulife, 2011. Annual Information Form at 56. 114   Settlement Agreement, 2017. “Settlement Agreement between Ironworkers Ontario Pension

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Securities class actions in Canada  507 Sino-Forest is a unique example of how public regulatory action may prompt private class actions. The company’s disclosure of an investigation by OSC staff preceded all three class actions and a cease-trade order indicating an ongoing investigation preceded the final class action. In addition, the OSC took the unusual step of disclosing its investigation. The company announced on June 8, 2011 that OSC staff had “opened an investigation.”115 Quebec investors commenced a class action the next day, followed by investors in Ontario on July 20. In August 2011, OSC staff issued a cease-trade order banning all trading in the securities of Sino-Forest, indicating that they were “conducting an investigation into the activities and business of Sino-Forest and its subsidiaries and their management.”116 The order also required the chairman and CEO, as well as some senior executives, to “resign any and all positions” that they held in Sino-Forest or in “any other registrant” and prohibited them from becoming or acting as director or officer of any issuer. Investors in Saskatchewan commenced a class action three months later.117 Sino-Forest filed for bankruptcy protection under the Companies’ Creditors Arrangement Act in March 2012.118 The OSC staff issued a Notice of Hearing and Statement of Allegations against Sino-Forest, its former chairman and CEO, its former CFO, and four other senior executives two months later. In December 2012, OSC staff separately commenced public enforcement proceedings against Ernst & Young LLP (“EY”), who had been the auditors of Sino-Forest between 2007 and 2012. The allegations included that EY “failed to undertake their audit work on the Sino-Forest engagement with a sufficient level of professional skepticism.”119 OSC staff entered into settlement agreements with the CFO in June 2014 and EY three months later.120 For the remaining respondents, the

Fund Leonard Schwartz Marc Lamoureux and Le Mouvement D’éducation et de Defense Des Actionnaires (“Medac”) and Manulife Financial Corporation (“MFC”) Dominic D’Alessandro and Peter Rubenovitch,” www.manulifesettlement.com/sa. 115   Press Release, Sino-Forest. 2011. Sino-Forest Confirms Ontario Securities Commission Investigation, www.siskinds.com/cmsfiles/PDF/Securities/Sino/A100-149/A-126%20-%20Sino%20 Press%20Release%20-%20June%208,%202011%20-%20SF%20Confirms%20Ontario%20Securitie​ s%20Commission%20Investigation.pdf. 116   OSC Temporary Order, 2011. “In the Matter of the Securities Act R.S.O. 1990, c. S.5, as Amended and in the Matter of Sino-Forest Corporation, Allen Chan, Albert Ip, Alfred C.T. Hung, George Ho and Simon Yeung Temporary Order (Section 127(1), 127(5)),” www.osc.gov.on.ca/en/ SecuritiesLaw_ord_20110902_221_sino-forest.htm. 117   The class actions were filed against Sino-Forest, its former chairman and CEO, its former CFO, other senior officers and directors, auditors, and underwriters. The plaintiffs alleged that, among other things, the defendants misrepresented that Sino-Forest’s financial statements had been compiled in accordance with generally accepted accounting principles by materially misstating the company’s assets and results of operations. As of June 2017, the court had approved settlements with EY (approved on March 20, 2013); the former CFO (approved on July 24, 2014); the underwriters (approved on October 30, 2015); Sino-Forest’s independent directors (approved on March 29, 2016); and BDO Limited, as the former auditors, and certain Sino-Forest directors (both approved on November 16, 2016). 118   Office of the Superintendent of Bankruptcy Canada, 2015. CCAA Records Sino-Forest Corporation, www.ic.gc.ca/eic/site/bsf-osb.nsf/eng/br02791.html. 119   OSC Statement of Allegations, 2012. “In the Matter of the Securities Act R.S.O. 1990, c. S.5 as Amended and In the Matter of Ernst & Young LLP,” at para 2. 120   Both these settlement agreements were approved by the Commission on July 21, 2014 and October 3, 2014, respectively.

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508  Research handbook on representative shareholder litigation hearing on the merits commenced in September 2014, and the proceedings were ongoing as of June 2017. 7.2  Impact of No-Contest Settlements The relationship between public and private securities enforcement may be impacted by the terms on which public actions are settled, particularly whether they include an admission of liability. No-contest settlements of public actions (that is, settlements reached without companies admitting liability or any facts) can be a double-edged sword. On the one hand, no-contest settlements can be disadvantageous to plaintiffs because the admission of liability in public enforcement proceedings helps facilitate settlements of private class actions. On the other hand, no-contest settlements may incentivize companies to offer earlier and larger settlements to harmed investors, so that that they can go to the OSC with “clean hands.” Unlike the United States, Canada did not have the concept of no-contest settlements until 2014, when the OSC implemented its No-Contest Settlement Program. This program was driven by companies’ concerns that an admission of liability in enforcement proceedings could compromise their position in parallel private litigation, which prevented the efficient resolution of public actions (Puri 2012). Companies may qualify for no-contest settlements if they cooperate with OSC staff during investigations or self-report, and if their conduct was not abusive, fraudulent, or criminal (Puri 2017). Such settlements are particularly attractive to companies tackling concurrent or potential class actions. However, for plaintiffs and their lawyers, no-contest settlements are disadvantageous because the admission of liability in public enforcement proceedings potentially facilitates the settlement of class actions—although, as Philip Anisman has highlighted, even without admissions, settlement agreements in public enforcement proceedings can assist plaintiffs and their lawyers in obtaining leave (Anisman 2013). The OSC has only approved seven no-contest settlements to date, all in the financial services sector.121 Given that the companies in those cases significantly compensated the harmed investors, the OSC seems to be carefully implementing the program in very limited circumstances (Puri 2017). As noted in section 4, very few cases in the dataset named financial institutions as defendants. Perhaps because financial institutions proactively compensated harmed investors adequately, investors did not commence as many class actions against them as they did against companies in other industries, such as mining. The EY settlement in 2014 with OSC staff was the first no-contest settlement to be approved by the Commission. EY agreed to make a voluntary payment of $8 million “to

121   As of June 2017, the OSC has approved no-contest settlement agreements with the following companies: (1) EY in September 2014; (2) TD Waterhouse Private Investment Counsel Inc., TD Waterhouse Canada Inc. and TD Investment Services Inc. in November 2014; (3) Quadrus Investment Services Ltd in November 2015; (4) CI Investments Inc. in February 2016; (5) Scotia Capital Inc., Scotia Securities Inc., and HollisWealth Advisory Services Inc. in July 2016; (6) CIBC World Markets Inc., CIBC Investor Services Inc. and CIBC Securities Inc. in October 2016; and (7) BMO Nesbitt Burns Inc., BMO Private Investment Counsel Inc., BMO Investments Inc., and BMO InvestorLine Inc. in December 2016.

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Securities class actions in Canada  509 advance the Commission’s mandate of protecting investors and fostering fair and efficient capital markets.”122 Importantly, this was preceded by EY’s $117 million settlement in November 2012 of the Sino-Forest class action in which it was involved (the highest to date for statutory secondary market liability). This came shortly after OSC staff commenced public enforcement proceedings against Sino-Forest in May 2012.123 On the one hand, no-contest settlements may make it more difficult for plaintiffs to pursue private litigation, to the extent that plaintiffs’ counsel rely on liability admissions by defendants in enforcement proceedings. On the other hand, no-contest settlements may not necessarily be an obstacle for private enforcement. They may incentivize companies to offer earlier and larger settlements to harmed investors, so that that they can go to the OSC with “clean hands,” requesting a settlement where they do not have to admit liability or facts, and other mitigating factors.

8. CONCLUSION The introduction of the statutory civil liability scheme in 2005 has made it easier for investors to pursue secondary market misrepresentation claims. Several key findings have emerged in the past ten years. First, Canadian courts and provincial legislatures play a key role in interpreting procedural aspects of the legislation. Courts have gradually raised the bar for plaintiffs to obtain leave by making the “reasonable possibility” of success threshold more onerous, and introduced uncertainty in the application of limitation period provisions. The legislatures of five provinces have intervened and amended their respective legislation to introduce certainty for plaintiffs with respect to the events that toll the limitation period under the statutory civil liability scheme. On the defendants’ side, despite the caps on damages (5 percent of market capitalization), the data shows that plaintiffs and their lawyers tend to pursue relatively large, but not the largest, companies. This may suggest that the largest public companies have, or are perceived to have, stronger internal controls. In terms of industry sector, the data shows that a disproportionately high percentage of mining companies were subject to securities class actions. Finally, in addition to companies and their directors and officers, the data shows that gatekeepers, such as auditors, underwriters, and lawyers, were rarely, if ever, pursued by plaintiffs and their lawyers. On the plaintiffs’ side, retail investors were more likely to commence actions and be representative plaintiffs as compared to institutional investors. Plaintiffs’ counsel typically play a pivotal role in commencing class actions and will actively look for representative plaintiffs to lead actions. Additionally, institutional investors often face conflicts of interest in acting as representative plaintiffs due to their commercial relationships with the potential defendants. While not conclusive, the data also suggests that even though institutional investors are seldom representative plaintiffs and are not necessarily more 122   Settlement Agreement, 2014. “In the Matter of the Securities Act, R.S.O. 1990 c. S.5, as Amended and in the Matter of Ernst & Young LLP and in the Matter of Ernst & Young LLP (Audits of Zungui Haixi Corporation) Settlement Agreement between Staff of the Commission and Ernst & Young LLP,” www.osc.gov.on.ca/en/Proceedings_set_20140923_ernst-young.htm. 123   OSC staff commenced public enforcement proceedings against EY in December 2012.

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510  Research handbook on representative shareholder litigation likely to obtain settlements, their settlements are, on average, nearly three times greater than those obtained by retail investors. Finally, across the 74 cases in the sample, one law firm was involved in most of the cases, suggesting that a few plaintiff law firms have developed an expertise in securities class actions. In terms of the progression of cases, not a single case has been heard on the merits to date, and many cases were still ongoing as of June 2017. Of the cases that settled, more than half were certified at a later stage for the purpose of settlement, indicating that it is quite common for an action to reach a settlement without certification. Finally, there does not seem to be much direct overlap between the cases pursued by public regulatory action and private class actions. The majority of companies subject to class actions were not involved in public enforcement proceedings. It also appears that the number of proceedings commenced by Canadian securities regulators that involve disclosure violations have decreased, with no proceedings in 2016. This chapter focuses on providing ten years of data, but it also raises many questions that future studies should explore further. Overall, while the 2005 regime provides easier access for investors to seek compensation, barriers such as the leave requirement and caps on damages may counterbalance some of the effects of the regime. When the Allen Committee decided to prioritize deterrence over compensation, they did so under the presumption that deterrence would “reduce the need for investor compensation.” But after a decade of secondary market claims under this regime, has the prioritization of deterrence in fact translated into adequate compensation? Is there a need to strike a better balance between deterrence and compensation to enhance market discipline? With the current regime, there is a risk that companies may not even be effectively deterred in view of the limits on investors’ compensation. On the one hand, caps may provide companies with a framework to assess the costs and benefits of disclosure violations, fueling their risk appetite. On the other hand, caps can potentially encourage the settlement of class actions, since both parties have an expectation of the maximum payout. Defendants know their potential loss to the business, while plaintiffs know their potential maximum gain if the case goes to trial, providing a range that the parties can negotiate within. But given that the $1 million cap was determined over a decade ago, does it need to be adjusted to accurately reflect today’s market?124 Do the caps need to strike a better balance between investor compensation and the potentially crippling economic impact of unlimited damages on shareholders? Are there additional reforms that can better facilitate securities class actions for secondary market misrepresentations? Has the leave requirement gone too far? Should courts lower the bar for plaintiffs to obtain leave of the court to commence secondary market statutory liability actions? Or should the legislature amend the language in the statute to lower the threshold for obtaining leave or remove the requirement altogether? This is unlikely to replicate the American strike suits experience because Canada has a vastly different litigation atmosphere as well

124   For example, a chapter 13 bankruptcy under the US Bankruptcy Code has a debt eligibility threshold, which is periodically adjusted to reflect changes in the consumer price index. A similar approach could potentially be adopted to periodically adjust the caps on secondary market statutory liability.

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Securities class actions in Canada  511 as cost rules that discourage frivolous litigation.125 The CSA proposed the leave requirement in the first place due to the significant pressure from the issuer community.126 Finally, would an increased overlap between the cases pursued by public regulatory action and private class actions better facilitate class actions for secondary market liability? Do no-contest settlements positively influence private enforcement in ways other than the leave requirement? Further, while the lack of direct overlap between public and private enforcement may indicate that private enforcement fills the gap for investor protection where public enforcement falls short, private enforcement may not provide adequate compensation on its own. Is there value in making securities investigations against companies (not individuals) public if they meet a certain threshold? The Canadian private securities enforcement landscape has certainly shifted over the past ten years. Certain barriers to pursuing secondary market liability claims have been removed, while others have arguably been added. The balance between deterrence and compensation has also been a subject of continuous debate. With the many changes that have occurred, there now exists a decade’s worth of litigation that can be used to evaluate and further refine the current regime.

BIBLIOGRAPHY Anisman, P., J. Howard, W. Grover, & J.P. Williamson, Proposals for a Securities Market Law for Canada (Ottawa: Minister of Supply and Services, Canada, 1979). Anisman, Philip, 2013. “No-Contest Settlements and the SEC’s Recent Experience: Implications for Ontario (prepared at the request of Staff of the Ontario Securities Commission),” www.osc.gov.on.ca/en/SecuritiesLaw_ rpt_20130605_15-706_no-contest-settlements.htm. Branch, Ward K., Class Actions in Canada (Aurora, Ontario: Canada Law Book). Coffee, John C. Jr, 2006. “Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation,” 106(7) Columbia Law Review 1534. Condon, Mary, Anita Anand, & Janis Sarra, Securities Law in Canada: Cases and Commentary (Toronto: Emond Montgomery, 2005). Cox, James D., & Randall S. Thomas, 2005. “Letting Billions Slip Through Your Fingers: Empirical Evidence and Legal Implications of the Failure of Financial Institutions to Participate in Securities Class Action Settlements,” 58 Stanford Law Review 411. Cox, James D., & Randall S. Thomas, 2006. “Does the Plaintiff Matter? An Empirical Analysis of Lead Plaintiffs in Securities Class Actions,” 100(2) Columbia Law Review 101. Georgiev, George S., 2017. “Too Big to Disclose: Firm Size and Materiality Blindspots in Securities Regulation,” 64 UCLA Law Review 602. Jackson, Howell E., & Mark J. Roe, 2009. “Public and Private Enforcement of Securities Laws: Resource-Based Evidence,” 93 Journal of Financial Economics 207. La Porta, Rafael, Florencio Lopez-De-Silanes, & Andrei Shleifer, 2006. “What Works in Securities Laws?” 61 The Journal of Finance 1. Puri, Poonam, 1998. “Financing of Litigation by Third-Party Investors: A Share of Justice?” 36 Osgoode Hall Law Journal 515. Puri, Poonam, 2012. “Securities Litigation and Enforcement: The Canadian Perspective,” 27 Brooklyn Journal of International Law 3. Puri, Poonam, 2017. “When the OSC Comes Knocking,” Listed Magazine. Puri, Poonam, & Stephanie Ben-Ishai, 2003. “Proportionate Liability Under the CBCA in the Context of Recent Corporate Governance Reform: Canadian Auditors in the Wrong Place at the Wrong Time?” 39 Osgoode Hall Law Journal 36.

  Puri 2017; see, e.g., R.S.O. 1990, c. S-5, § 138.11.   CSA Notice, supra note 3, at 7389.

125 126

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Section C Other Modes of Enforcement

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28.  CSRC enforcement of securities laws: preliminary empirical findings Chao Xi

1. INTRODUCTION At the center of the ongoing debate over comparative securities regulation is the relative value of private and public enforcement for the development of securities markets around the world. One line of theory—which has been characterized as the “private enforcement primacy” thesis—argues that stronger private enforcement of investor protection, via both disclosure requirements and private liability rules, correlates with larger and deeper stock markets, and that public enforcement is much less relevant to financial outcomes (La Porta et al, 2006; World Bank, 2006; Djankov et al, 2008). That thesis is matched by a rival polar position holding that private enforcement is merely one of a number of mechanisms that can contribute to robust securities markets (Black, 2001) and that it has in fact played only a limited role in the development of some national markets, Italy (Ferrarini & Giudici, 2005) and the UK (Armour, 2009; Armour et al, 2009) being notable examples. Public enforcement, as measured by regulatory resources—it is argued from this perspective—is significantly and robustly associated with the breadth and depth of stock markets (Jackson, 2007; Jackson & Roe, 2009). In other words, public enforcement does matter. Most of the empirical evidence thus far put forward in the context of this debate concentrates either on the formal characteristics of securities laws and enforcement institutions (La Porta et al, 2006) or on such regulatory input as the staffing and budget resources of regulators (Jackson & Roe, 2009). There have been few attempts at the comparative measurement of enforcement outcomes, largely because of the considerable data collection difficulties involved (Coffee, 2007). This chapter represents a modest attempt to fill this important empirical gap by offering solid quantitative data on public enforcement outcomes in China. It is hoped that the attempt will facilitate future largescale cross-country empirical research encompassing China. By way of background, securities markets are a relatively recent market institution in the People’s Republic of China (PRC). First appearing in the early 1990s, the Chinese securities markets have expanded phenomenally. The market capitalization of domestic Chinese listed firms was in the tone of $512 billion in 2003. By the end of 2015, it had increased almost sixteenfold to reach $8.188 trillion (World Federation of Exchanges database, n.d.), making China’s securities markets the second largest in the world. The total number of domestic listed firms also rose significantly over the period, increasing from 1,285 in 2003 to 2,827 in 2015 (ibid). China’s stock markets are also gaining increasing significance in the country’s traditionally bank-dominated financial system (Allen & Qian, 2014; Pistor et al., 2015). The size of its securities markets as a share of GDP rose from just over 30 percent in 2003 to close to 75 percent in 2015 (World Federation of Exchanges database, ibid). 513

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514  Research handbook on representative shareholder litigation The burgeoning Chinese securities markets have long been plagued by market misconduct and securities law violations. Instances of fraud, abuse, and manipulation were at one point so rampant that the Chinese stock markets were dubbed as “worse than a casino” (Wu, 2001, cited in Green, 2004). Private enforcement of securities laws, by way of aggrieved investors bringing civil actions against wrongdoers, has been weak, owing to an array of legal and institutional constraints (Deng, 2005; Xi, 2006a; Guo & Ong, 2009; Palmer & Xi, 2009), with public enforcement thus significantly greater in amount and intensity. This chapter draws on a unique, hand-collected dataset comprising all 466 sanction decisions taken by the China Securities Regulatory Commission (CSRC), China’s primary securities regulator, during the period from 2006 through 2012. Its aim is to shed empirical light on an important component of the public enforcement of securities laws in China.1 The remainder of the chapter is structured as follows. Section 2 provides an overview of the CSRC enforcement process, and sets the stage for the discussions that follow. Section 3 presents the key statistical findings of the research, and discusses what those findings tell us about the nature of CSRC enforcement actions. Section 4 offers concluding remarks.

2.  OVERVIEW OF CSRC ENFORCEMENT PROCESS The CSRC is the Chinese equivalent of the US Securities and Exchange Commission (SEC), and is China’s primary enforcer of the country’s securities laws. It is vested under PRC law with the authority to investigate possible violations of securities laws and regulations and to discipline culpable firms and individuals. Before we proceed to an overview of the CSRC enforcement process,2 it is necessary to say a few words about the way in which the CSRC enforcement apparatus is structured. The CSRC carries out its enforcement efforts from both its headquarters in Beijing and its local offices throughout the country. CSRC headquarters sets up two internal divisions that share investigative authority: the Enforcement Bureau (jicha ju) and the Enforcement Contingent (jicha zongdui). The former plays a largely coordination-oriented role; the latter is tasked with carrying out investigations into alleged misconduct (Xi & Pan, 2017). At the local level, the country is divided into nine regions for regulatory purposes, and each of the CSRC’s nine regional offices houses an internal enforcement bureau. Further down the organization’s administrative hierarchy, it operates a local office in each of the country’s provinces, with each office typically having one or more divisions tasked with

1   The focus of this chapter is the enforcement actions taken by CSRC headquarters. The other important components of China’s public enforcement of securities laws include the local offices of the CSRC and the two official bourses, viz., the Shanghai Stock Exchange and Shenzhen Stock Exchange. This research was supported by a General Research Fund grant (CUHK-452913) from the Research Grants Council of the Hong Kong SAR. 2   The CSRC has developed a set of increasingly sophisticated rules to govern its enforcement process, including the 2008 CSRC Implementing Measures on Case Investigation and 2013 CSRC Opinions on Further Strengthening the Work of Inspection and Enforcement. Owing to space limitations, this part of the chapter does not cite or refer to specific rules within the CSRC regulations.

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CSRC enforcement of securities laws  515 securities enforcement. The CSRC’s Beijing headquarters focuses its efforts on the core areas of regulatory concern: violations of disclosure laws, market manipulation, insider trading, and so on. It also has jurisdiction over cases that are otherwise “complex, sensitive, or of a unique character.” CSRC’s local offices, in contrast, pursue only matters occurring within their respective territorial boundaries. 2.1  Filing, Investigation, and Review The CSRC’s formal enforcement process typically starts with what is called a “filing order.” The filing orders issued by CSRC headquarters or one of its local offices are generally based on the outcomes of a preliminary, informal review of the facts and circumstances, which determines whether further investigation is warranted. In other words, an informal investigation typically precedes a filing order, although there is no requirement for a filing to occur only after the completion of a preliminary investigation.3 A filing order can typically be initiated at CSRC headquarters in one of two ways: by the CSRC divisions responsible for day to day surveillance of the securities markets or by the two CSRC internal divisions tasked with the investigation. In both cases, the filing order must be endorsed by a member of the CSRC’s top administration (presumably of vice chairman rank or above). Filings can also be initiated and ordered directly by a top CSRC official. Further, regional and local CSRC offices can also issue their own filing orders on matters that fall within their territorial jurisdiction. Orders initiated at the local level are, however, subject to review, and they may be overturned or modified by the Enforcement Bureau at CSRC headquarters. The next step in the enforcement process is formal investigation. There is no separate order for a formal investigation, which, as noted, typically succeeds the issuance of a filing order. National legislation grants the CSRC a wide range of powers in the conduct of formal investigations:4 it can carry out visits to the sites of potential violative conduct with a view to taking evidence, and it can compel firms and individuals under investigation to answer queries and provide statements. The CSRC is also granted access to a variety of records, registrations, and other documents related to the matters under investigation. It is also vested with the authority to access trading accounts, bank accounts, and other financial accounts pertaining to the investigation and, where necessary, freeze and/or seize those accounts. Moreover, national securities laws also grant the CSRC the authority to halt trading in any security that is involved in a potential case of market manipulation or insider trading. When a listed firm learns that it has become the subject of a CSRC investigation, it is required by CSRC regulations to disclose that investigation. At the close of an investigation, the CSRC can take a number of actions in addition to, or as an alternative to, instituting formal enforcement proceedings, which are discussed in greater detail immediately below.5 The CSRC may refer cases which it considers particularly egregious to the criminal authorities (the Ministry of Public Security in particular)   Interviews with CSRC officials.   2014 PRC Securities Law, Art. 180. 5   There is an additional case review process conducted by the Enforcement Bureau. The manner in which an investigation is carried out, any factual findings, the determination of violative conduct, and the recommendation that sanctions be imposed, if any, are all subject to a 3 4

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516  Research handbook on representative shareholder litigation and/or other authorities. It also has the discretion to conclude or terminate a formal investigation if it determines that the gravity of the violative conduct is insufficient to warrant the commencement of enforcement proceedings. In that case, the CSRC can refer the matter to self-regulatory organizations (including the Shanghai Stock Exchange or the Shenzhen Stock Exchange) and/or to its own divisions tasked with day to day market surveillance. 2.2 Proceedings The CSRC can initiate formal enforcement proceedings against a regulated entity only via its in-house Administrative Sanction Commission (ASC). The potential alternative, bringing a civil action against the culpable firm or individual, is not available to the CSRC under Chinese law. The ASC acts on behalf of, and in the name of, the CSRC in enforcement proceedings. It is composed of a number of CSRC-appointed member “judges,” and is separate both organizationally and operationally from the CSRC divisions investigating possible securities violations. However, the ASC is not intended to serve as an adjudicator independent of the CSRC; to the contrary, it is appointed by, and answerable to, the CSRC that creates it. This stands in contrast with the notion of independence with regard to administrative law judges (ALJs) operating at the SEC. AJLs are supposed to be independent, and are largely insulated from SEC influence (Zaring, 2016). The underlying purpose of the ASC, in contrast, is to check and balance the CSRC’s investigative powers from within. In other words, the ASC’s role is to review the enforcement recommendations made by the CSRC’s internal investigation divisions and to make enforcement decisions on behalf of the CSRC. Accordingly, the ASC is not intended to be a neutral, third party arbiter; rather, it is part of the CSRC enforcement apparatus. ASC decisions are the outcomes of a trial-like procedure. Although it is beyond the scope of this chapter to provide a full account of that procedure,6 it is worth highlighting three important procedural rights afforded to defendants. First, regulated entities are entitled to a hearing before a panel of ASC member judges in a manner similar to courtroom hearings, and are entitled to representation. Second, regulated entities are also entitled to a prehearing notice laying out the factual findings, legal determinations, and sanctions, if any, to be imposed. Finally, an adverse decision by the ASC—in the name of the CSRC—can be appealed to the CSRC itself, which will review the ASC decision de novo, and an adverse determination by the CSRC can then further be appealed in the courts. Alternatively, defendants can appeal an ASC decision in the courts. 2.3 Sanctions China’s primary securities legislation empowers the CSRC to impose a wide variety of sanctions on regulated entities.7 The available sanctions fall broadly into three categories:

“­ substantive review.” In practice, this review process is often sidestepped to the extent that it now takes place only in limited circumstances. Interviews with CSRC officials. 6   For a fuller treatment of the ASC, see Xi and Pan (2017). 7   2014 PRC Securities Law, Chapter 11.

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CSRC enforcement of securities laws  517 warnings and orders to remedy misconduct; monetary sanctions, such as fines or disgorgement orders; and orders suspending or barring regulated entities from the securities industry or listed sector. These sanctions can be used singly or in combination. Warnings are the least severe type of CSRC sanction, and are often used in combination with other sanctions. In addition to warnings, the CSRC can order regulated entities to cease their violations of securities laws. It can also order defendants to take remedial actions to rectify those violations, such as the disposal of illegally obtained securities or the return of funds illegally raised from investors. Monetary sanctions can take two forms. First, the CSRC may order defendants to disgorge any ill-gotten profits or illicitly acquired revenues. Second, it may order defendants to pay a fine, the amount of which should fall into the range prescribed by the PRC Securities Law. Finally, the CSRC may prohibit defendants from offering securities services on either a temporary or permanent basis. Firms’ licenses and individuals’ qualifications may be temporarily suspended or permanently revoked. For individuals who have committed the more egregious violations, the Securities Law separately devises an even harsher form of sanction, namely, an industry ban,8 which bars them from engaging in securities business, or disqualifies them from serving as the directors, supervisors, or senior executives of listed firms, for a fixed period of time or indefinitely.

3.  DATA AND PRELIMINARY FINDINGS 3.1  The Data The dataset comprises all 466 official sanction decisions taken by the CSRC from 2006 to 2012. CSRC sanction decisions offer a considerable amount of information concerning enforcement actions, including the identities of violators, findings of fact, conclusions of law, and sanctions imposed. The length of sanction decisions ranges widely, from just a few hundred words to close to 20,000. Although some are little more than skeleton statements, others elaborate at length on the underlying jurisprudential considerations. The difference in length seems to depend on a number of factors, including the inherent character of the violation (for example, the complexity of the case, the number of violators involved) and other, more contingent factors (for example, the personal style of the ASC “judges” involved). The data were hand-collected by two teams of research assistants working independently of each other. The two teams checked each other’s work for inconsistencies, and all data were then verified by the project’s principal investigator. It is worth noting that CSRC sanction decisions come under two separate, and distinct, rubrics: administrative sanctions (xingzheng chufa) and industry bans (shichang jinru). This distinction is not to be confused with the three categories of sanction identified in the foregoing section. Instead, their differences appear to be a matter of path dependence. More specifically, CSRC decisions on administrative sanctions can be traced back to the founding years of the CSRC. By way of these decisions, the CSRC is able to make use   2014 PRC Securities Law, Art. 233.

8

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518  Research handbook on representative shareholder litigation Table 28.1  Relationships among sanction types and sanction decisions

Warnings and orders to remedy  misconduct Monetary sanctions Orders suspending or barring  regulated entities from the securities industry

CSRC Decisions on Administrative Sanctions

CSRC Decisions on Industry Bans

Yes

No

Yes Yes, but not inclusive of industry bans

No Yes, but industry bans only

Table 28.2  CSRC decisions on administrative sanctions and industry bans Year

CSRC Decisions on Administrative Sanctions

CSRC Decisions on Industry Bans

2006 2007 2008 2009 2010 2011 2012 Total

38 36 52 58 53 57 57 351

19 18 27 16 16 11 8 115

of almost all types of sanctions—with the exception of industry bans—against securities violations, as deemed appropriate. The industry ban, in contrast, is a relatively new tool in the CSRC’s regulatory toolkit. Rather than absorb it into the more established heading of administrative sanctions, the industry ban has been given standalone status. CSRC decisions on industry bans are considerably narrower in scope than other decisions, making use of a single type of sanction, for example, the industry ban. Table 28.1 depicts the relationships among the three categories of sanctions and the two rubrics of sanction decisions. During the period under investigation, the CSRC issued 351 decisions on administrative sanctions and 115 on industry bans. The annual numbers of CSRC decisions on administrative sanctions and industry bans, respectively, are reported in Table 28.2. It can be seen that the annual number of the former has risen over the study period, whereas that of the latter has declined sharply. 3.2  Violators: General The CSRC is vested with the statutory authority to take enforcement actions against a wide range of regulated entities and individuals. Regulated entities include issuers, listed firms and their controlling corporations, broker-dealer firms, investment advisory firms, financial advisory firms, credit rating institutions, and providers of securities services

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CSRC enforcement of securities laws  519 Table 28.3  Firms and individuals sanctioned by the CSRC Year 2006 2007 2008 2009 2010 2011 2012 Total

Sanctioned Firms 28 30 36 33 37 43 29 236

Sanctioned Individuals Administrative Sanction

Industry Ban

154 199 251 219 221 197 170 1,411

69 59 60 53 52 16 12 321

(accounting firms, auditing firms, and law firms that engage in securities business). Among the individuals regulated by the CSRC are the directors, supervisors, and senior executives of listed firms; securities practitioners; and accounting, auditing, and legal practitioners. The CSRC is also authorized to take enforcement actions against firms and individuals engaging in insider trading, market manipulation, and other kinds of misconduct. Table 28.3 shows the annual number of firms and individuals sanctioned by the CSRC between 2006 and 2012. In keeping with CSRC regulatory practice, as discussed previously, culpable individuals are divided into two separate subgroups: individuals subject to administrative sanctions and individuals subject to industry bans. There are some overlaps between the two, as some violations can result in an individual attracting both an administrative sanction and industry ban. For example, a trader who violates insider trading laws may be ordered to disgorge illicit profits and pay a fine, both of which are imposed by a CSRC administrative sanction decision. At the same time, he or she may also be barred from operating in the securities industry for a set period of time under a separate industry ban. Such a trader is counted twice in Table 28.3. Our statistics reveal 144 individuals who were disciplined by administrative sanctions and an industry ban at the same time. There appears to be no clear pattern with respect to the annual number of firms and individuals disciplined under the administrative sanctions rubric. The annual number of individuals barred from the securities industry and/or from serving as a director or officer of a public company exhibits a downward trend, however, declining sharply from 69 in 2006 to a mere 12 in 2012. 3.3  Violators: Firms Here, we first assess the types and characteristics of the culpable firms that attract CSRC sanctions. Table 28.4 offers a breakdown of the types of firms sanctioned by the CSRC during the period under investigation. It is clear from Table 28.4 that enforcing securities law violations perpetrated by listed firms is the CSRC’s top priority, with those firms constituting the largest cohort in every year from 2006 to 2012. Overall, listed firms account for close to half of all sanctioned

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520  Research handbook on representative shareholder litigation Table 28.4  Types of firms sanctioned by the CSRC Year

2006 2007 2008 2009 2010 2011 2012 Grand Total

Listed Companies

Broker-dealer Firms

Investment Advisory Firms

Accounting Firms

Others

N

%

N

%

N

%

N

%

N

%

22 22 14 11 15 14 14 112

78.57 73.33 38.89 33.33 40.54 32.56 48.28 47.46

1 0 2 0 0 0 0 3

3.57 0.00 5.56 0.00 0.00 0.00 0.00 1.27

1 0 3 6 6 10 6 32

3.57 0.00 8.33 18.18 16.22 23.26 20.69 13.56

1 4 7 5 3 2 2 24

3.57 13.33 19.44 15.15 8.11 4.65 6.90 10.17

3 4 10 11 13 17 7 65

10.71 13.33 27.78 33.33 35.14 39.53 24.14 27.54

Annual Total

28 30 36 33 37 43 29 236

firms in that period. The relative importance of such firms in CSRC enforcement efforts has, however, declined significantly over the years, accounting for well over 75 percent of the sample firms in 2006 but just over 30 percent in 2011. Accounting firms are also frequent targets of security law enforcement for such violations as fraud or misrepresentation in their reports. Although they represent more than 10 percent of all targeted firms, they seem to have drawn considerably less enforcement attention in recent years. The CSRC’s focus instead seems to have shifted to another group of regulated entities, viz., investment advisory firms, which in recent years have constituted approximately 20 percent of the sanctioned firm population. Broker-dealer firms, in contrast—which are frequent targets of securities enforcement action in the United States (SEC, various years)—are not frequently targeted by the CSRC. Only three broker-dealer firms in China were sanctioned during the period under investigation. The discrepancy may well have to do with the comparatively small number of listed broker-dealer firms in China—fewer than 20 in 2012. Having identified the various types of sanctioned entities, we now take a closer look at the sample listed firms. Our focus is on listed firms partly because public information is more readily available on these firms than on private firms. Of particular interest are two firm attributes, viz., firm size and ownership type, considered to be important determinants of securities regulation. Prior research in the US suggests that firm size is associated with enforcement action outcomes, with larger firms and their employees tending to fare better in SEC enforcement actions (Coffee, 2012; Gadinis, 2012). In light of such scholarship, we examine whether larger Chinese listed firms fared better than their smaller counterparts in the study period. We define larger firms as those included in the China Securities Index 300 (CSI 300) and its sub-index, the China Securities Index 100 (CSI 100). The CSI 300 is roughly equivalent to the S&P 500, and consists of the 300 Chinese A-share stocks with the largest market capitalization and greatest liquidity (China Securities Index Co Ltd, 2016a). Similarly, the CSI 100 comprises the 100 largest CSI 300 constituent companies, as measured by market capitalization (China Securities Index Co Ltd, 2016b). Table 28.5

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CSRC enforcement of securities laws  521 Table 28.5  Sanctioned CSI 300 firms and CSI 100 firms Year

2006 2007 2008 2009 2010 2011 2012 Total

Sample Listed Firms 22 22 14 11 15 14 14 112

Sanctioned CSI 300 Firms

Sanctioned CSI 100 Firms

N

% of Sample Listed Firms

% of Chinese Listed Firm Population

N

% of Sample Listed Firms

% of Chinese Listed Firm Population

5 4 3 1 2 2 1 18

22.73 18.18 21.43 9.09 13.33 14.29 7.14 16.07

19.93 18.79 18.66 17.01 14.2 12.78 12.14  

0 1 0 0 0 1 1 3

0.00 4.55 0.00 0.00 0.00 7.14 7.14 2.68

6.64 6.26 6.22 5.67 4.73 4.26 4.05  

presents the annual number of CSI 100 and CSI 300 firms sanctioned during the period under investigation. At first glance, CSI 300 and CSI 100 firms do not appear to have been frequently targeted, with just 18 and 3 such firms, respectively, subjected to CSRC administrative sanctions over the seven-year period. A closer look at the statistics, however, paints a rather more mixed picture. Take the CSI 300 firms, for example. Table 28.5 shows their share in the population of sanctioned firms, as compared to their share in the population of A-share listed firms. In the seven years under investigation, CSI 300 firms were, proportionately, underrepresented relative to smaller firms in four years (2007, 2009, 2010, and 2012) and overrepresented in three (2006, 2008, and 2011). The statistics on CSI 100 firms are more difficult to interpret, as a single action against such a firm can decisively swing the balance—as occurred, for example, in 2011 and 2012. However, it is perhaps fair to say that the statistics are less conclusive than they might initially appear with respect to whether large firms fare better than small firms. Ownership type is another important consideration in terms of the manner in which securities laws are implemented and enforced in economies with a strong state presence in the corporate sector (Hou & Moore, 2010). Accordingly, we are interested in determining whether state-owned firms fared better in CSRC enforcement actions during the study period than their non-state-owned counterparts. In keeping with a prior study in this area (Xi, 2015), we categorize the sample listed firms with reference to the identity of their ultimate controlling shareholders: the PRC central government and its agencies; Chinese local governments at various levels and their agencies; private individuals; or “miscellaneous,” such as a collective or firm without a single ultimate controlling shareholder. The data on the ultimate controllers of the sample listed firms were hand-collected. Table 28.6 provides a breakdown of the sample listed firms with respect to their ultimate controllers. Table 28.7 presents two sets of comparisons: first, the annual shares of state-owned firms in the sample listed firms, as compared to their annual shares in the entire population of A-share Chinese listed firms; second, the annual shares of central government-controlled firms in the sample listed firms relative to their annual shares in the Chinese listed firm population. The patterns are very clear. With the exception of

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522  Research handbook on representative shareholder litigation Table 28.6  Ultimate owners of sanctioned listed firms Year

2006 2007 2008 2009 2010 2011 2012 Total

State-owned

Non-state-owned

Central Government

Local Governments

Private Individuals

Miscellaneous

N

%

N

%

N

%

N

%

2 3 2 2 1 0 1 11

9.09 13.64 14.29 18.18 6.67 0.00 7.14 9.82

7 5 7 3 2 5 3 32

31.82 22.73 50.00 27.27 13.33 35.71 21.43 28.57

12 14 5 6 12 9 10 68

54.55 63.64 35.71 54.55 80.00 64.29 71.43 60.71

1 0 0 0 0 0 0 1

4.55 0.00 0.00 0.00 0.00 0.00 0.00 0.89

Sample Listed Firms

22 22 14 11 15 14 14 112

Table 28.7  State-owned sanctioned firms Year

2006 2007 2008 2009 2010 2011 2012 Total

State-Owned Firms*

State-Owned Firms Controlled by Central Government**

% of Sample Listed Firms

% of Chinese Listed Firm Population

% of Sample Listed Firms

% of Chinese Listed Firm Population

40.91 36.36 64.29 45.45 20.00 35.71 28.57 38.39

55.00 63.00 62.00 60.00 53.00 47.00 38.50  

9.09 13.64 14.29 18.18 6.67 0.00 7.14 9.82

12.89 10.33 − − 16.48 7.54 11.53  

Notes: *  Data on the annual numbers of state-owned listed firms are drawn from the Annals of State-owned Assets Supervision and Administration in China (2007), the official website of the China Association of Listed Companies (http://www.capco.org.cn/), and the China Securities Journal. **  Data on the annual numbers of state-owned listed firms controlled by the PRC Central Government are drawn from the Annals of State-owned Assets Supervision and Administration in China (2007), the Securities Herald, the Securities Daily, and other sources.

2008, state-owned firms fared significantly better, as a proportion, than their non stateowned counterparts, and central government-controlled firms were underrepresented in the five years for which official statistics are available. A note of caution is in order concerning the foregoing statistical findings. Although they are revealing, we must resist the temptation to infer a causal link between the attributes of Chinese listed firms and the outcomes of CSRC enforcement actions, for

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CSRC enforcement of securities laws  523 two main reasons. First, as presented, the statistics do not capture a number of other important determinants, one of the most important of which is the underlying firm misconduct, specifically whether there was any misconduct in the first place and, if so, how severe it was. In the absence of this information, it is difficult to establish causality between firm characteristics and enforcement outcomes. Second, the CSRC sanctions examined in this research are but the tip of the iceberg. The CSRC takes a large number of enforcement actions against regulated entities and individuals that are less formal (and visible) in nature, and thus are not captured in our sample. Also missing from our dataset is the vast body of enforcement actions taken by the local offices of the CSRC and the two official stock exchanges, which are, in general, less severe than CSRC sanctions. Further empirical research is necessary before any conclusions can be drawn on the determinants of securities enforcement in China. 3.4  Violators: Individuals Having dealt with the firms sanctioned by the CSRC, we now turn to culpable individuals. Our focus is the directors, supervisors, and employees of listed firms, information on whom is more readily available. By way of background, the corporate board structure under Chinese law comprises two boards: the board of directors and the supervisory board. However, that dual structure differs from the German two-tier system in an important way: in China, both boards are appointed by the shareholders’ meeting and are held accountable to it (Xi, 2006b; Gu, 2010; Wang, 2014). Directors, supervisors (that is, members of the supervisory board), and senior executives owe a fiduciary duty to the company, as well as a duty of loyalty (Howson, 2008, 2010). Under Chinese securities law, listed firms are liable for their violations of securities laws. The individuals who are directly responsible for those violations, be they directors, supervisors, senior executives, midlevel managers, or frontline employees, may also be held personally liable. Table 28.8 presents a breakdown of this cohort of culpable individuals, with nonindependent directors and members of senior management accounting for the lion’s share (over 75 percent). Independent directors were also often the target of CSRC securities enforcement during the study period, representing more than 15 percent of the culpable cohort. This finding is in conformity with the well-established jurisprudence developed by Table 28.8  Identities of culpable individuals Year

Non-Independent Directors and Executives

Independent Directors

Supervisors

Others

Total

2006 2007 2008 2009 2010 2011 2012 Total

119 160 163 116 132 116 89 895

14 34 44 24 30 25 17 188

0 0 2 5 2 8 8 25

30 14 5 16 10 3 3 81

163 208 214 161 174 152 117 1,189

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524  Research handbook on representative shareholder litigation Table 28.9  Corporate liability and individual liability Year

2006 2007 2008 2009 2010 2011 2012 Total

Firms & Individuals Cases

Firms Only Cases

17 21 14 11 14 13 13 103

5 1 0 0 1 1 1 9

Individuals Only Cases Firms

Individuals Involved

0 3 5 4 1 3 2 18

0 22 37 25 14 20 11 129

the Chinese judiciary, and embraced enthusiastically by the CSRC, stipulating that independent directors are not immune from directors’ liabilities (Clarke, 2006). Supervisors, in contrast, are largely absent—and are certainly underrepresented relative to the “others” category, which includes frontline employees and midlevel managers—offering some evidence in support of the conventional view that the Chinese supervisory board is, in practice, something of a figurehead, playing a minimal role in corporate governance (Xi, 2006b). An interesting question that immediately arises is whether the CSRC places greater emphasis on corporate than personal liability, displaying reluctance to hold liable the specific individuals responsible for the firm’s misconduct.9 Table 28.9, which provides a breakdown of CSRC actions against both firms and the individuals they employ, actions against firms alone, and actions against individuals alone, provides evidence to the contrary.10 In the overwhelming majority of cases (more than 90 percent), the CSRC took enforcement actions reflecting both corporate and individual liability. In other words, in very few cases (just 8 percent) did the CSRC take such actions against culpable firms alone. Interestingly, our dataset captures 18 cases in which the CSRC targeted only the individuals deemed responsible for the corporate wrongdoing in question, without also holding the firms that employed them liable. Further research is warranted to determine the explanation for these anomalies, that is, whether they can be explained by the underlying facts of the cases or by considerations beyond the merits of the cases, such as the ownership type and size of the firms concerned. 3.5  Violators: Barred Individuals As explained previously, industry bans fall into a separate rubric of enforcement actions within the CSRC enforcement program. Individuals targeted by industry ban orders  9   For the literature on corporate and individual liability in the U.S. context, see, e.g., Coffee (1981), Kaplow (1990), Arlen and Kraakman (1997), and Baer (2008). 10   This typology is drawn from Gadinis (2012).

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CSRC enforcement of securities laws  525 Table 28.10  Length of industry bans Year 2006 2007 2008 2009 2010 2011 2012 Total

2-Year Ban 3-Year Ban

5-Year Ban

7-Year Ban 10-Year Ban Lifetime Ban Total

N

(%)

N

(%)

N

(%)

N

(%)

N

(%)

N

(%)

0 0 0 1 0 0 0 1

0.00 0.00 0.00 1.89 0.00 0.00 0.00 0.31

5 21 10 11 15 3 3 68

7.25 35.59 16.67 20.75 28.85 18.75 25.00 21.18

24 13 13 18 18 6 4 96

34.78 22.03 21.67 33.96 34.62 37.50 33.33 29.91

0 0 1 0 2 1 0 4

0.00 0.00 1.67 0.00 3.85 6.25 0.00 1.25

18 15 16 7 9 4 3 72

26.09 25.42 26.67 13.21 17.31 25.00 25.00 22.43

22 10 20 16 8 2 2 80

31.88 16.95 33.33 30.19 15.38 12.50 16.67 24.92

69 59 60 53 52 16 12 321

Table 28.11  Proportion of longer and shorter industry bans Year

% of Industry Bans of 5 years or less

% of Industry Bans of 7 years or above

2006 2007 2008 2009 2010 2011 2012 Total

42.03 57.63 38.33 56.60 63.46 56.25 58.33 51.40

57.97 42.37 61.67 43.40 36.54 43.75 41.67 48.60

therefore constitute a subset of the data on culpable individuals in Table 28.2. Here, we take a closer look at the nature of the industry bans in the dataset as they pertain to individuals. As noted, individuals may be barred from operating in the securities industry and/or serving as directors, supervisors, or senior managers for a fixed period of time or indefinitely. In practice, the length of such bans ranges from two years to a lifetime. Table 28.10 provides a breakdown of industry bans by length, showing five-year (29.91 percent), ten-year (22.43 percent), and three-year bans (21.18 percent) to be the most common. However, permanent/lifetime bans are imposed by the CSRC surprisingly often (24.92 percent). As can be seen from Table 28.3, the annual number of individuals receiving an industry ban decreased dramatically over the period under investigation. Table 28.11 further documents the CSRC’s recent inclination to impose shorter, and presumably less consequential, industry bans, with the share of bans of five years or less increasing over time. This trend is puzzling. It seems not in congruence with the general upward trend in enforcement intensity suggested in Tables 28.2 and 28.3. There also appears to be no evidence showing that industry bans have been more frequently challenged in administrative and court proceedings in recent years, causing the CSRC to become more cautious in imposing them. Further empirical research is needed to determine the factors prompting the reduced reliance on industry bans.

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526  Research handbook on representative shareholder litigation Table 28.12  Violation types Year

2006 2007 2008 2009 2010 2011 2012 Total

Issuer’s Violation of Disclosure Rules

Insider Trading

N

(%)

N

23 25 21 14 16 16 17 132

45.10 56.82 31.34 21.88 26.67 26.67 26.98 32.27

0 2 3 6 10 10 14 45

(%)

Misuse Market Acquirer’s Appropriation of Third Manipulation Failure to of Funds and Party’s Disclose Securities Trading Shareholdings Account N

(%)

0.00 3 5.88 4.55 3 6.82 4.48 6 8.96 9.38 4 6.25 16.67 8 13.33 16.67 10 16.67 22.22 4 6.35 11.00 38 9.29

Others

N

(%)

N

(%)

N

(%)

N

(%)

6 7 4 5 2 5 8 37

11.76 15.91 5.97 7.81 3.33 8.33 12.70 9.05

1 0 1 8 5 6 11 32

1.96 0.00 1.49 12.50 8.33 10.00 17.46 7.82

9 1 8 7 4 0 0 29

17.65 2.27 11.94 10.94 6.67 0.00 0.00 7.09

9 6 24 20 15 13 9 96

17.65 13.64 35.82 31.25 25.00 21.67 14.29 23.47

Total

51 44 67 64 60 60 63 409

3.6  Violations: Types Statistics on the types of violations sanctioned also shed light on the overall trend in the CSRC’s enforcement focus. As Table 28.12 shows, the bulk of cases has consistently involved disclosure issues, wherein an issuer has failed to disclose material information or has disclosed false or misleading information, thereby violating securities disclosure rules. However, the share of actions against such cases has declined dramatically over time, falling from 60 percent of the CSRC caseload in 2007 to just over 20 percent in 2009. It is an open question whether this declining trend reflects the effectiveness of the CSRC’s clampdown on disclosure violations or simply a shift in focus to other types of violations. Two areas in which case numbers have climbed appreciably since 2009 are insider trading and acquirers’ failure to disclose shareholdings in target firms. The number of insider trading cases rose from none in 2006 to 14 in 2012, in keeping with the CSRC’s proclaimed focus on enforcing insider trading laws (Howson, 2012). The CSRC has also intensified its enforcement activities with respect to takeover laws. Chinese securities law contains a Williams Act-type disclosure requirement stipulating that a firm that has acquired 5 percent of the shares in a target firm, or increased its shareholding in that firm by 5 percent, must disclose all pertinent information.11 Enforcement actions against takeover disclosure violations increased from 1 in 2006 to 11 in 2012.

4.  CONCLUDING REMARKS Drawing on a dataset comprising all 447 CSRC sanction decisions taken from 2006 to 2012, this chapter presents preliminary empirical findings on an important component of China’s public securities enforcement activities: CSRC administrative sanctions and 11

  2014 PRC Securities Law, Art. 86.

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CSRC enforcement of securities laws  527 industry bans. In particular, it shows that the patterns of those efforts have shifted over time, from an initial focus on violations of disclosure rules to targeting a much wider spectrum of wrongdoing—insider trading and investment advisor violations, in particular. In enforcing China’s securities laws, the CSRC does not typically assume individual or corporate liability alone but frequently holds both parties liable, that is, considers both the culpable firms and the individuals responsible for the malfeasance in question. Industry bans are less frequently invoked to discipline individual wrongdoers than other types of sanctions, and when they are imposed they tend to be shorter in length and less consequential than they were in the past. Going forward, the fast-paced growth of the Chinese securities markets and increasing complexity of securities violations will pose new and ever more complex challenges for the CSRC. The changing patterns of CSRC enforcement activities during the period under investigation suggest that the CSRC has emerged as an adaptive regulator that is willing and able to develop new strategies and shift its enforcement priorities as market conditions evolve. The post-2012 securities markets in China have been marked by a significant period of market turbulence. Further examination of CSRC enforcement efforts since 2013 will help offer additional insights into the nature of public security law enforcement in China. Interestingly, as noted, the findings of the research presented in this chapter do not seem to offer conclusive evidence that CSRC securities enforcement is sensitive to any considerations beyond the merits of the cases pursued, such as the ownership type or size of the sanctioned firms. Further empirical research is thus warranted to explore the determinants of the public enforcement of securities laws in China in greater depth.

BIBLIOGRAPHY Allen, Franklin & Jun “QJ” Qian (2014), “China’s Financial System and the Law,” Cornell International Law Journal, 47, 499–554. Arlen, Jennifer & Reinier Kraakman (1997), “Controlling Corporate Misconduct: An Analysis of Corporate Liability Regimes,” New York University Law Review, 72, 687–779. Armour, John (2009), “Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment,” 71-119 in Rationality in Company Law: Essays in Honour of DD Prentice, edited by John Armour and Jennifer Payne, Oxford: Hart Publishing. Armour, John, Bernard Black, Brian Cheffins & Richard Nolan (2009), “Private Enforcement of Corporate Law: An Empirical Comparison of the United Kingdom and the United States,” Journal of Empirical Legal Studies, 6, 687–722. Baer, Miriam H. (2008), “Linkage and the Deterrence of Corporate Fraud,” Virginia Law Review, 94, 1295–1366. Black, Bernard S., (2001), “The Legal and Institutional Preconditions for Strong Securities Markets,” UCLA Law Review, 48, 781–856. China Securities Index Co. Ltd. (2016a), “CSI300 Index Methodology,” available at www.csindex.com.cn/ sseportal_en/upload/files/upload/000300hbooken.pdf. China Securities Index Co. Ltd. (2016b), “Methodology of CSI 100 Index,” available at www.csindex.com.cn/ sseportal_en/upload/000903hbooken.pdf. Clarke, Donald C. (2006), “The Independent Director in Chinese Corporate Governance,” Delaware Journal of Corporate Law, 36, 125–228. Coffee, John C., Jr (1981), “‘No Soul to Damn: No Body to Kick’: An Unscandalized Inquiry into the Problem of Corporate Punishment,” Michigan Law Review, 79, 386–459. Coffee, John C. Jr (2007), “Law and the Market: The Impact of Enforcement,” University of Pennsylvania Law Review, 156, 229–312. Coffee, John C., Jr (2012), “SEC Enforcement: What Has Gone Wrong?” National Law Journal, December 3.

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528  Research handbook on representative shareholder litigation Deng, Jiong (2005), “Building an Investor-Friendly Shareholder Derivative Lawsuit System in China,” Harvard International Law Journal, 46, 347–86. Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, & Andrei Shleifer (2008), “The Law and Economics of Self-Dealing,” Journal of Financial Economics, 88, 430–65. Ferrarini, Guido & Paolo Giudici (2005), “Financial Scandals and the Role of Private Enforcement: The Parmalat Case,” ECGI Working Paper Series in Law No 40/2005. Gadinis, Stavros (2012), “The SEC and the Financial Industry: Evidence from Enforcement against BrokerDealers,” Business Lawyer, 67, 679–728. Green, Stephen (2004), The Development of China’s Stock Market, 1984–2002: Equity Politics and Market Institutions, New York: Routledge Curzon. Gu, Mingkang (2010), Understanding Chinese Company Law, Hong Kong: Hong Kong University Press; 2nd edition. Guo, Li & Allan V.Y. Ong, (2009), “The Fledgling Securities Fraud Litigation in China,” Hong Kong Law Journal, 39, 697–718. Hou, Wenxuan & Geoff Moore (2010), “Player and Referee Roles Held Jointly: The Effect of State Ownership on China’s Regulatory Enforcement against Fraud,” Journal of Business Ethics, 95, 317–35. Howson, Nicholas Calcina (2008), “The Doctrine that Dared Not Speak its Name: Anglo-American Fiduciary Duties in China’s 2005 Company Law and Case Law Intimations of Prior Convergence,” 193–254 in Transforming Corporate Governance in East Asia, edited by Hideki Kanda, Kon-Sik Kim, & Curtis J. Milhaupt, New York: Routledge. Howson, Nicholas Calcina (2010), “Corporate Law in the Shanghai People’s Courts, 1992–2008: Judicial Autonomy in a Contemporary Authoritarian State,” East Asia Law Review, 5, 303–442. Howson, Nicholas C. (2012), “Enforcement Without Foundation?: Insider Trading and China’s Administrative Law Crisis,” American Journal of Comparative Law, 60, 955–1002. Jackson, Howell E. (2007), “Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications,” Yale Journal on Regulation, 24, 253–92. Jackson, Howell E. & Mark J. Roe (2009), “Public and Private Enforcement of Securities Laws: Resource-Based Evidence,” Journal of Financial Economics, 93, 207–38. Kaplow, Louis (1990), “Optimal Deterrence, Uninformed Individuals, and Acquiring Information about Whether Acts Are Subject to Sanctions,” Journal of Law, Economics, and Organization, 6, 93–128. La Porta, Rafael, Florencio Lopez-de-Silanes, & Andrei Shleifer (2006), “What Works in Securities Laws?” The Journal of Finance, 61, 1–32. Palmer, Michael & Chao Xi (2009), “The Globalization of Class Actions: China”, The Annals of the American Academy of Political and Social Sciences, 622, 270–9. Pistor, Katharina, Guo Li, & Zhou Chun, (2015), “The Hybridization of China’s Financial System,” 353–76 in Regulating the Visible Hand? The Institutional Implications of Chinese State Capitalism, edited by Benjamin L. Liebman & Curtis J. Milhaupt, Oxford: Oxford University Press. SEC, various years, Select SEC and Market Data. Wang, Jiangyu (2014), Company Law in China: Regulation in Business Organizations in a Transitional Economy, Cheltenham: Edward Elgar. World Bank (2006), Institutional Foundations for Financial Markets. World Federation of Exchange, World Federation of Exchange Database. Xi, Chao (2006a), “Private Enforcement of Securities Law in China: Daqing Lianyi Co v ZHONG Weida and Others (2004) Heilongjiang High Court,” Journal of Comparative Law, 1, 492–6. Xi, Chao (2006b), “In Search of an Effective Monitoring Board Model: Board Reforms and the Political Economy of Corporate Law in China,” Connecticut Journal of International Law, 22, 1–46. Xi, Chao (2015), “The Political Economy of Takeover Regulation: What Does the Mandatory Bid Rule in China Tell Us?” Journal of Business Law, 58, 142–64. Xi, Chao & Xuanming Pan (2017), “Public Enforcement of Securities Laws: A Case of Convergence?” 81–103 in Chinese Legal Reform and the Global Legal Order: Adoption and Adaptation, edited by Yun Zhao & Michael Ng, Cambridge: Cambridge University Press. Zaring, David (2016), “Enforcement Discretion at the SEC,” Texas Law Review, 94, 1155–1219.

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Index accounting restatements 2, 29, 32–3, 35–6 increase in 34 Qwest 34 WorldCom 34 Xerox 34 see also restatement framework actionable losses 88–8 consequential losses 89 as fundamental losses 88 market signaling 91–9 reputational damage 88 adequacy of representation 156, 172 badges of inadequacy 156 doctrinal standards 162–5 adequate care 168–9 appellate review 169 fast-filer presumption of inadequacy 166 inadequate representation 162–3, 165 meaningful discovery 168–9 quality of the pleadings 168 refining 166, 167 totality of circumstances test 166–7 as element of due process 158 evaluating 162, 169–71 benefits conferred through settlement 171 choice of forum in 170 in original litigation 170 timing and investment 169 requirement 157–9 sources of law 161–2 ALI Principles of Corporate Governance 101 American Rule 193, 194, 198, 353, 441 amicus curiae 143 appraisal 244–5 actions see appraisal actions arbitrage 243, 245, 251 forfeiture of rights of 245 legal developments 249–52 disclosure-only settlements in fiduciary duty class actions 249 in merits opinions 249, 250–51 statutory amendments 249–50 longstanding remedy 244 as replacement protection 244 as representative litigation 254–5 requirements 254 risk 248 statutes 244–5

appraisal actions 243–4, 267 consolidation of multiple suits 257–8 control of proceedings 257–9 fair value in 245 see also fair value /fiduciary duty class action differentiation 245 fiduciary nature of 256–7 judicial response to 243–4 mitigating risk of opting in 255–6 modern 246–9 multiple petitions 247 number of 246–8 only mergers triggering in Delaware 244 settlement costs sharing 262–5 disputes 259–60 with non-petitioners 261–2 with petitioners 260–61 recovery of fees and expenses 265–7 statutory framework of 259 values of dissenting shares 247–8 arbitration 184 backdating 60, 64–5, 127, 493, 494 bad faith 133, 469 intentional illegal acts as 101 board of directors centrality of 333 power 334 primacy of 343–4 brightline rule 105, 135 in Delaware 152, 153 business judgment rule 128, 129 in Delaware 98, 101 and dismissal recommendations 129–30 high presumption of propriety in 129–30 not covering illegal business decisions 101, 106 qualified deference 129 and structural bias 75, 129 business risk 92 Canada 482, 485–6 Canadian Securities Administrators 487 Class Proceedings Act (1996) 501 Companies’ Creditors Arrangement Act (1985) 507

529

M4633-GRIFFITH_t.indd 529

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530  Research handbook on representative shareholder litigation continuous disclosure regime deficient disclosure 486 enforcement 486–7 periodic disclosure 486 timely disclosure 486 non-contest settlements 508–9 Office of the Superintendent of Financial Institutions 499 Ontario Class Proceedings Act 492, 493 Financial Services Commission 499 Securities Act 487, 493 Securities Commission 499 Provincial-Territorial Council of Ministers of Securities Regulation Annual Progress Report (2016) 494 public enforcement 505–6 /private enforcement relationship 503–4, 505 public regulatory actions 504–8 enforcement, 504–505 investigations 504 non-public enforcement notices 504 Notice of Hearing 504 Statement of Allegations 504 secondary market class actions 483–4, 506 certification requirement 502 defendant companies 484 judicial interpretation of leave requirement 484 leave requirement 502 other defendants 484 plaintiffs 484–5 plaintiffs’ counsel 485 private and public enforcement 485 progression of cases 485, 501–3 secondary market statutory liability 487–8, 506, 509–11 burden of proof 487–8 caps on 495–500 case law see case law defendants 499–500 evidentiary requirements 490–91 gatekeeper role of courts 488–92 leave requirement 488–9, 490, 491–2 limitation period 492–5 no reliance requirement 487 plaintiffs 500–501 pocket shifting of damages 496 reasonable possibility threshold 489–90, 491 sectors involved 498–9 settlement 497 standing 500 securities class actions 482

M4633-GRIFFITH_t.indd 530

Sino-Forest class action 507, 509 TSX Committee on Corporate Disclosure (Allen Committee) 482–3 Final Report (1997) 483, 487 formation 487 Wells Notice 504, 505, 506 capitalization rate 84 case law Allapattah Services, Inc. v. Exxon Corp. 289, 290 ATP Tour, Inc. v. Deutscher Tennis Bund 75, 179, 180, 184, 186 Atzmon v. Bank Hapoalim Ltd. 231–2, 233, 234, 237 Barkan v. Amsted Indus., Inc. 205, 209, 214 Basic Inc. v. Levinson 12, 13, 14, 16 Blue Chip Stamps v. Manor Drug Stores 14, 89 Boilermakers Local 154 Retirement Fund v. Chevron Corp 178–9, 181, 182, 185, 195 C & J Energy Servs., Inc. v. Miami Gen. Empls.’ & Sanitation Empls.’ Ret. Tr. 215–16, 217, 218–19, 220, 221, 222–3 Chiarella v. United States 21, 22, 23 Copeland v. Fortis 355–60 Dirks v. SEC 21–2, 24–5 Eisen v. Carlisle & Jacquelin 122, 123, 126 Flanagan, Lieberman, Hoffman & Swaim v. Ohio Public Employees Retirement System 288, 298 Foss v. Harbottle 462 Goldstein v. Pinros Holdings Ltd. 233–4 Gorman v. Salamone 342, 343 Graham v. Olympus Corporation 362, 363, 367 Halliburton Co. v. Erica P. John Fund Inc (Halliburton II) 12, 13–16 decision, 16–18 Hazout v. Tsang Mun Ting 321–2 Hogg v. Cramphorn 419, 423, 432 In re Cendant Corp. Litigation 278, 294–5, 298 In re Appraisal of Dell Inc. 235, 248, 251, 258, 264, 266–7 In re Enron Corp. Sec., Derivative & ERISA Litig. 35, 288, 289, 293, 300 In re EZCORP Inc. Consulting Agreement Deriv. Litig. 73, 114, 173 In re Revlon, Inc. Shareholders Litigation 5, 135, 178, 196, 202, 204, 205, 207, 210, 211, 213–14, 225 In re Riverbed 110, 113, 115, 119 In re Royal Dutch/Shell Transport Sec. Litig. 358, 359, 368

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Index  531 In re Synthroid Marketing Litigation 291, 296 In re Trulia 4, 67, 110, 112, 113, 115, 119, 134, 136–7, 140–1, 142, 146, 150, 191–2 In re Wal-Mart Delaware Derivative Litigation 156, 161, 164 Ironworkers District Council of Philadelphia and Vicinity Retirement & Pension Plan v. Andreotti 132–3 Kital Holdings & Int’l Dev. Ltd. v. Maman 231, 232, 234, 235, 236, 238, 240 Mannix v. PlasmaNet, Inc. 261–2, 265–6 Mills Acq. Co. v. Macmillan, Inc. 208–9, 210, 211, 213, 221, 225 Morrison v. National Australia Bank Ltd 8, 354, 363, 365, 405–6 Omnicare, Inc. v. Laborers District Council Construction Industries Pension Fund 124 Paramount Communications Inc. v. QVC Network Inc. 204, 209–10, 211–13, 221 Pennoyer v. Neff 316–17 R v. Panel on Takeovers and Mergers ex p Datafin 427, 430 Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. 196, 202 Rosenbloom v. Pyott 130–31 Shaffer v. Heitner 318, 319, 323 Sharma v. Timminco Ltd. 493–4, 502 Silverman v. Motorola, Inc. 291, 295 Smith v. Van Gorkom 118, 202, 204–5, 337 Standard Iron Works v. Arcelormittal et al. 290–91 Teva see Teva Theratechnologies Inc. v. 121851 Canada Inc. 488, 490, 491–2 United States v. Newman 24, 25 United States v. O’Hagan 22–3, 24 Unocal Corp. v. Mesa Petroleum Co. 202, 203, 208, 213 Volkswagen litigation 360–61 Zapata Corp. v. Maldonado 101, 132 causation 85, 125 cash outflow 85–6 discount rate 86–7 expected return 87–8 causes of action 2, 408 common law fraud 39, 40 federal 71, 83 misrepresentation 81 private 40, 44, 369 securities fraud 12, 13–14, 35, 83 China Companies Law Article 470, 20.2

M4633-GRIFFITH_t.indd 531

Securities Regulatory Commission see CSRC stock markets 513–14 circularity 36, 37, 94 in FOTM class actions 47–8 of secondary market fraud gains and losses 51 of settlement payments 48, 86 class action abuses of 192 covered 17 FOTM see FOTM class action securities fraud see securities fraud class actions class conflict 96 Code of Federal Regulations 17 C.F.R. § 240.10b5-1 23 § 10b5-2 23 § 240.14e-3 23 § 243.100 (2015) 23 Rule 10b-5 (Private Right of Action) 2, 24 see also Rule 10b-5 private right of action collateral estoppel 156, 157, 164 collusion 164 common fund doctrine 193 competing claims 82–3 buyer-holders 82 prioritizing corporate claims 82–3 prioritizing direct claims of buyers 82 conflict of interest 9, 163, 306, 367, 378, 389 in derivative suits 75 direct 166 and shareholder litigation 460–61 corporate benefit doctrine 193 absence of 200 /common fund doctrine distinction 5, 193 as exception to American Rule 193 not widely recognized 193, 194, 196–7 corporate governance ALI Principles of 101 board’s centrality in 333 documents as contractual 182 limiting litigation through see limiting litigation market-oriented approach to 8–9, 415 mechanisms 341 reforms 61, 63, 68, 73 subnational regulation of 443 suits 442 tools 43, 50 corporate internal affairs see internal affairs doctrine

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532  Research handbook on representative shareholder litigation corporate law underproduction of 119–20 corrective justice 41–2 FOTM 41–2, 48–9 cost of equity 84 costs 19, agency 52, 61–2, 305, 306 deadweight 50, 51, 433–4 direct 44 enforcement 42 English rule 473–4 FOTM class actions 52–3 litigation see litigation costs overdeterrence 44, 53 private Rule 10b-5 44 PSLRA not reducing 29 reputational 42 riskbearing 49, 52 sharing 262–5 social 42, 49 counsel bidders, 307 dea, 307 litigation 307 plaintiffs’ 308 crosslisting 8, 372 failure of laws 378–9 Israel regulation 374–5 US regulation 374 weak enforcement of laws 375–6 CSRC Administrative Sanction Commission 516 administrative sanctions (xingzheng chufa) 517–18 Enforcement Bureau (jicha ju) 514 Enforcement Contingent (jicha zongdui) 514 enforcement process 514–15 conclusion 515–16 filing orders 513 formal enforcement proceedings 516 formal investigation 515 industry bans (shichang jinru) 517, 518 regulated entities 518–19 regulated individuals 519 sanctions 516–17, 519, 526–7 barred individuals 524–6 culpable firms 519–23 culpable individuals 523–4 monetary 517 remedy orders/warnings 517 suspension/barring of company 517 types of violations 526 damages collateral 91

M4633-GRIFFITH_t.indd 532

consequential 88, 90 crash 88 fundamental 94–95 measure of 80 reputational 88 de minimis requirement 249, 250 deal price 234, 235, 250, 305 Deepwater Horizon 93 defenses lockup 417 meaningful cautionary language 12–14 puffery 123–4 truth on the market defense 123 defining characteristic of corporate form 330 Delaware appointment of lead plaintiffs 150–52 bar 199 Code Title 10 § 366 (sequestration) 317–18 § 3104 (long arm) 316 § 3114 (implied consent) 316, 319 see also implied consent; long arm statute corporate charters 118 debtors’ rights cases 318–19 development of corporate law 119 disclosure settlements 140, 142–5 external decisions 146–7 distinction between equity and law courts 142 enhanced scrutiny 202–3 fairness hearings 142–3 fiduciary obligations 203 General Corporate Law litigation limits 180 § 142 342 § 109 342 § 220 (inspection rights) 111, 114 § 262 244 implied consent statute 319 constitutionality 320, 322–3 enactment 319 extension 319, 321–2 limitations 320, 322 personal jurisdiction under 321, 322 two-part test 319–20 jurisdiction 316, 326, 328–9 conspiracy theory of 327–8 implied consent statute see implied consent statute above long arm statute see long arm statute below over non-resident officers 337 landmark M&A decisions 202–3 see also mergers and acquisitions

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Index  533 leading jurisdiction for corporate law 110, 112 potential loss of status 115–16 long arm statute adoption 323 amenability to service of process 323, 324, 325, 326 asserting jurisdiction under 326–7 current application 323–4 extension 326 limitations 324 not source of personal jurisdiction 325 need to emphasize own decisions 152–3 nuisance claims 141–2, 146–7, 150 migration of from 152 public takeovers speed of adjudication 432 ratification of misconduct 137 slowing number of merger cases in 112 top destination for incorporations 112 demand requirement 3, 71, 76, 128–33, 461 demand-futility 130, 138 in direct actions 463 excused demand 128, 129 screening via see screening special litigation committees 132 weakening 129 derivative claims 58–9, 78, 81, 83, 89 Allergan 130–31 for backdating 64–5 bond requirement in 71 collateral estoppel in 172–4 escaping scrutiny 65 no perceived crisis 66–7 forum shopping in, 74 geographically dispersed 68 /merger litigation distinction 66, 67 new approach to 72 corporate self-help 74–6 increased judicial oversight 73–4 legislative 76–8 no judicial or legislative support for 67–8 no motivation for reform 68–9 numbers of 64 payment of expenses 71 primarily filed under state law 58 problems with 59–60 agency costs 61–2 few financial recoveries 60–61 lack of effectiveness 62–4 nonmonetary settlements 61 procedural hurdles 69–72 control of suit 71–2 difficulty filing suit 70–71 heightened procedural rules 70–71, 76 representative plaintiffs in 61–2

M4633-GRIFFITH_t.indd 533

settlements 65 superiority of 96 and varying procedural requirements 196–7 deterrence 42–4 direct actions 89, 92, 197, 459 advantage of 463 demand requirement in 463 /derivative claim distinction 197 direct claims 81, 197 buyers’ 82 precedence of derivative claims 82 stockholders’ 81 directors board see board of directors duties see directors’ duties independence 130, 131 legal obligations 186 /officers distinction 332–4 overlap 337 /shareholder power differential 185 as shareholder trustees 186 directors’ duties 449, 462, 472 fiduciary 100 see also fiduciary duties loyalty 101 obeying the law 99–102, 104–5 stockholder wealth maximization 100 directors’ liability 471 net loss rule 100 disclosure claims 159 whether direct or derivative action 197 disclosure settlements 138, 140, 143–5, 191 attorney’s fees 194–5 and corporate benefit doctrine 197–8 as deal tax 192 and forum selection clauses 192 judicial review of 191, 193 applicable law 195 application of internal affairs doctrine 195–6 authority to award attorneys’ fees 197–9 reasonableness of fees 199 only addressing disclosure claims 197 opposing 200 supplemental disclosures 199–200 Trulia materiality standard 145, 150, 191, 194, 200 as substantive law 196 discount rate 80, 83, 84, 86–7, 92 Federal Reserve 245 diversifying away loss 83, 87, 95 doctrines of repose 156, 157 due process 161, 328 adequacy-of-representation 158, 174

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534  Research handbook on representative shareholder litigation clause 299, 322 federal 173 rights 114 earnings game 34 enforcement continuous disclosure 486–7 costs 42 CRSC 514–15 see also CRSC modes of 10, 512 enhanced scrutiny 202–203, 204–6, 209, 214, 219 for illegality 100, 101, 104, 105 range-of-reasonableness test 223 entrepreneurial litigation 351–4, 368–9 in Asia 362 as controversial 352 counterreaction 367–8 definition 352 in Europe 354–5 by American law firms 357–8, 367 consolidation of claims 356–7 financing 357 Fortis litigation 355–60 opt-in principle 355 two-step strategy 360 using stichting as vehicle for 356–7, 358 Volkswagen litigation 360–61 future directions 368 globalization of 352, 353–4, 364–6 in Japan 362–4 in Korea 364 new players 366 potential for 365 reverse auctions 367 skepticism over 353 third party funders 366–7 unequal distribution 367 EU arbitration 452–3 arbitrability of derivative suits 453 arbitrability of securities disputes 452 bondholder/shareholder comparison 451 Brussels Ia Article 4 447 Article 7 No 1(b) 448 Article 7 No 2 447 Article 19 448 Article 24 No 2 446–7 Article 25(1)(a) and (c) 448 Article 31(4) 448 Article 63 447 consumer protection regime 453–4 rebuttable presumption of unfairness in 453

M4633-GRIFFITH_t.indd 534

derivative suits 445–6 choice of forum 445 default jurisdiction 445, 448 loser pays rule 446 Directive 93/13/EEC Article 3 and Annex 1(q) 453, 454 Article 6 453 Directive 2003/71/EC Article 14 452 Directive 2004/25 (takeovers) 419, 420 Directive 2007/36/EC (shareholder rights) 464–465 intracorporate litigation 445, 446 choice of court agreements 448–9 exclusive jurisdiction rule 446 matters outside exclusive jurisdiction 447–8 relevant connecting factors in 447, 448 primary/secondary market transaction differentiation 451 validity of jurisdiction agreements 451–2 Regulation (EU) 2016/301 Article 6(3) 450 representative litigation 454–5 securities litigation breach of the securities terms and conditions 450 choice of forum agreements 449, 450–51 default jurisdiction 449 fraud on the secondary market 450 prospectus liability 449, 450 tortious liability 449–50 tortious liability 447 Treaty on the Functioning of the European Union 445 /US differences on shareholder litigation 445, 454–5 intracorporate claims 457 securities claims 458 fair value 230, 241 burden of proof 245 calculation of 245 DCF method of valuation 230 and merger price 245 objective anchors in 231 consent of most of minority 232–3 consent of sophisticated offeree 237–9 consent of sophisticated shareholder 235 institutional/private shareholders 236 market price 231–2 negotiations 236–7, 239 prior deal 234–5 share price manipulation 233–4 when lacking objective anchors 239–41

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Index  535 Federal Civil Rules Advisory Committee 17, 77 Federal Rule of Evidence 706 200 Federal Rules of Civil Procedure Rule 23 15, 122, 351 commonality requirement 16 23.1 73 fee agreements presumption of reasonableness 294–5 overriding 295 fee awards 288–9 contingent 293 regulating see regulating fee awards see also fees feedback 86 fees contingent 287 in securities class actions 300–2 sliding scales 293–4 ex ante negotiations 299 ex post negotiations 299 retainers 298–9 sliding scales 300 terms 287–8 establishing upfront 297–9 see also fee awards feeshifting 71, 179, 180, 184, 281 banning 187 bylaws 249, 441 limited 77, 362 loser pays 354, 355, 357 fiduciary doctrine divergence in 336–41 weakness of 331 see also fiduciary duties fiduciary duties 187, 330–31, 334 care 335, 336, 337 directors’ 332, 335 /officers’ distinction 331–2 effectiveness 331 enforcing 331, 334–5 director preference in 339 evolution of 335 holding managers to account 331 loyalty 335, 336 officers’ 332, 335–6, 340–41, 344 absence of case law on 336–7, 339 and director preference 339 /directors’ distinction 331–2 procedural law preventing development of 337–9 purposes in corporate law 344–5 as unyielding 334 value of 345 see also directors; fiduciary doctrine; officers fiduciary duty class actions 248–49, 251–2

M4633-GRIFFITH_t.indd 535

first to file rule 196 foreseeability 322, 323, 328 forum forum non-conveniens doctrine 147, 442 shopping see forum selection forum selection 156, 183–4 parallel suits 63, 159 race to the bottom 159–60 FOTM class action 45–8, 53 compensatory damages in 46 definition 45 efficiency of 50 expanded liability in 46–7 incentives to settle in 47 no privity of dealing in 46 pre-trial dismissal 47 reliance in 125 settlement 47 circularity of 47–8 social function of corrective justice 48–9 costs of 52–3 deterrence 49, 53 discouragement of victim precautions 51–2 forced cost internalization 49–51 reduction of riskbearing costs 52 fraud on the market 12–13, 14–15, 16, 36 class action see FOTM class action secondary market fraud 48 social function of 48 fraud tax 282 frivolous litigation 110 deterring 110–12, 113–14 adequate investigation requirement 114 Section 220 actions 114 limiting see limiting litigation merit thresholds 111, 112, 113 and merger suits 113 multijurisdictional litigation 111, 114–15 private ordering solutions 176–7, 181 arbitration clauses 176 enforceability 177 fee shifting 177 forum selection clauses 176 limiting jurisdiction 176 minimum stake requirements 177 rationale for 177 and war chests 112 Germany Act on Model Procedures for Mass Claims in Capital Market Cases 360 appraisal rights 467 arbitrability in 452–3

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536  Research handbook on representative shareholder litigation rescission suits in 475–8 Berufskläger 475 Freigabeverfahren 477 number of 475–6 räuberische Aktionäre 475 settlement 476–7 similar function to shareholder class actions 477–8 types of shareholders resolution challenged 476 widespread 478 standing to sue in 472–3 good faith 117, 129, 132, 179, 218, 335, 489 hindsight bias 129, 163 illegality 98–9, 102–4 and advancing technology 103 as breach of fiduciary duty 101 and corporate law 98–9, 106–7 criminal and civil liability 98 director liability 99 drivers of change 102–3 greater scrutiny for 100, 101, 104, 105 no business judgment rule protection 104, 106 regulatory entrepreneurs see regulatory entrepreneurialism and self-driving cars 106 stockholder suits as supplemental law enforcement 105–6 and ultra vires doctrine 105 as violation of duty of loyalty 101 insider trading liability 22–3, 24 predicate breach of fiduciary duty requirement 2122 Insider Trading and Securities Fraud Enforcement Act (1988) 22 § 2 24 Insider Trading Sanctions Act (1984) 22 institutional investors 274 effect of 276–8 effectiveness of 276 hedge funds 275 increase in 222–3, 226 as lead plaintiffs 274 see also lead plaintiffs as litigation gatekeepers 15 pay to play 278–9 public pension funds 274–5 mutual funds not being 275 union pension funds 275–6 internal affairs doctrine enforceability of forum selection clauses 181

M4633-GRIFFITH_t.indd 536

litigation limits 181–3 scope of 182–3 international shareholder litigation 8 comparative 8–9 globalization of 8 Ireland Companies Act (2014) 424 public takeovers see public takeovers (Ireland) Takeover Panel Act (1997) 421, 429 Israel appraisal rights 230 in complete tender offers 229 only for ‘going private’ tender offers 229 case law 241 Companies Law amendment of 232 § 336 229 § 337 229–30 § 337(a) 230 § 338 230 /Delaware comparison 235 estimating fair value 230 see also fair value Italy appraisal rights 466 Article 34 legislative decree No 5/2003 453 corporate arbitration 453 judicial waiver 71 jurisdiction asserting 326–7 choice of 308–9 default 441–2, 449 Delaware 316, 326, 328–9 see also Delaware limiting 176 personal 316–17 extension of 322 subject matter 355 law firm quality 304 defense firms 311–12 gaps in knowledge 312–13 in M&A litigation 307 choice of jurisdiction(s) 308–9 selection of counsel 307–8 measuring in class actions 305–7 effect of agency costs 305, 306 by outcome 304–5 successful plaintiffs’ firms 310–11 lawmaking partnership 12–13, 16, 18, 26 advantages of in private securities fraud litigation 19

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Index  537 common objective 19 common objectives 24 conceptualizing 18–20 developing financial regulation 24–5 dynamic processes of 20–21 exploiting institutional competencies 20 and insider trading regulation 21–3 implications of 18, 24–6 open-textured original statute 19, 24 preventing agency capture 20 responsiveness 25 and the SEC 23–4 sequential adjustments 19 lead plaintiffs 32, 121, 271, 273, 284–5 authority 272 Delaware appointment of 150–51 effect of 274–6 on attorney’s fees 277–8 on settlement amounts 276–7 figurehead plaintiffs 281, 282 government-sponsored pension funds 272 having largest financial interest 271–2 individual investors 282 institutional investors 274 effect of 276–8 effectiveness of 276 hedge funds 275 mutual funds not being 275 pay to play 278–9 public pension funds 274–5 union pension funds 275–6 monitoring 273–4 reforms campaign contributions 280 fee arrangements 280–81 fee shifting 282, 284 repeat plaintiffs 280 standing 281–3 transparency 279 success of 272 legal origins 459 limiting litigation 176–7 arbitration clauses 177–8, 184 Delaware General Corporate Law 180 see also Delaware fee shifting 179–80, 184 forum selection 178–9, 180–81 history 177–81 ownership requirement 180 whether corporate internal affair 181–3 see also frivolous litigation; litigation limits litigants and law firms 6 officers and directors 7 plaintiffs 6–7 litigation

M4633-GRIFFITH_t.indd 537

costs see litigation costs frivolous see frivolous litigation funding 116–18 contingency fees 121 income smoothing 117–18 litigation finance companies 118 limiting see limiting litigation limits see litigation limits merger see merger litigation multijurisdictional 112, 159–60 see also forum selection representative appraisal as 254 see also appraisal vexatious see vexatious litigation litigation costs 126–8 effect on volume of litigation 126–7 procedural requirements raising 126 raising 126–8 substantive requirements raising 126 litigation limits 186, 187–8 and contract & consent 185–7 directors’ powers to enact 185 forum selection 183–4 unilaterally imposed 183 whether appropriate subject for private ordering 183–5 whether matter of corporate internal affairs 181–3 loss 95–6 actionable 88–9 see also actionable losses avoidable 83 causation 85 cash outflow 85–6 discount rate 86–7 expected return 87–8 component factors of 93–4 crash damages 88 diversifying away 83 fundamental 94–5 reputational 92 management buyouts 205, 209, 251, 306, 310 managers see directors; officers mapping shareholder lawsuits 459, 478 access to information 474–5 allocation of cost 473–4 allocation of risk 473–4 appraisal rights EU 466 France 467 Germany 467 Italy 466 US 466

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538  Research handbook on representative shareholder litigation closely held corporations 461 conflicts of interest 460–61 direct harm to shareholders 460–61, 463–6 in civil law jurisdictions 463–4 in concentrated ownership systems 465 France & Germany 463 nullity suits 465 rescission suits 464–5 UK 463 US 463 harm upon the corporation 460, 461–3 China 462 Continental Europe 462 UK 462, 463 US 461 institutional preconditions 471 oppression claims 467–8, 469 /inquiry proceeding comparison 470 publicly traded firms 461 rescission suits in Germany 475–8 Berufskläger 475 Freigabeverfahren 477 number of 475–6 räuberische Aktionäre 475 settlement 476–7 similar function to shareholder class actions 477–8 types of shareholders resolution challenged 476 widespread 478 standing to sue 471–3 China 473 France 472 Germany 472–3 Japan 472 Switzerland 472 UK 472 US 471 unfair prejudice claims 468–70 merger litigation 3, 58 appraisal actions 5–6 backlash against 66–7 black hat 141 ‘deal tax’ 66, 140–42 Delaware courts’ authority in 67 /derivative suits distinction 66 and forum selection 67 In re Trulia see case law judicial perspectives 4–5 merger tax 118–19 multijurisdictional 3–4 nuisance claims in 140, 141–2 post-Trulia 141 sorting of 141, 153–4 white hat 141

M4633-GRIFFITH_t.indd 538

mergers cashout 232 challenging 3, 66, 73, 178 crackdown on 244 deal tax on 73 freezeout 460 squeezeout 460 mergers and acquisitions 227 case law see case law current attitudes to 214–15 bidders’ contract rights 220 in Delaware Supreme Court 218–21 management-led single-bidder process 215–16 in Delaware Court of Chancery 216–18 shareholder voting 221 early attitudes to 204 defensive measures in merger agreements 207–10 asset lockups 208–9 no-shop clauses 207, 208, 209 termination fees 208 enhanced scrutiny 204–6, 209, 214, 219 connotation of multiple bidders 205, 206 management-led single-bidder processes 204–7, 209–10 multiple bidders 205 judicial preference for 206–7 primacy of fiduciary duties 210–11 over third party contract rights 211–13 shareholder voting in 213–14 hostile bids 205 reasons for changing attitudes to 222–6 failure of stockholder-led M&A litigation 223–5, 226 increase in institutional investors 222–3, 226 increased judicial comfort over defensive measures 225 severability in 225–6 targeted preliminary injunctions 210–11, 219–20 see also preliminary injunctions misappropriation theory 22–3, 24 misrepresentation 81, 87, 487, 520 experts’ liability 495 secondary market 482, 498, 500, 509 multijurisdictional litigation 3–4, 111, 114–15, 159–60, 183 negative value claims 354 Netherlands Act on Collective Settlement of Mass Claims (the Netherlands) 8, 358

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Index  539 New York Arbitration Convention (1958) 454 North Carolina Rules of Professional Conduct 198 Rule 1.5 199 nuisance claims 106, 115, 140–141, 144, 147, 283 and de minimis rule 249–50 provable losses 284 nuisance settlements 146, 148, 282 fees 154 migration outside Delaware 152 nunc pro tunc doctrine 494 officers accountability 341–4 via directors 341–2 proxy battles to remove 342–3 via stockholders 342–4 /directors overlap 337 /directors distinction 332–4 fiduciary duties see fiduciary duties malfeasance 340–41 powers 333–4 Oklahoma Code § 18-1126 71 overdeterrence 44, 53, 96 pay to play 278–9 policy considerations 16 policy objectives 23–4 preclusion 165, 167 addressing 162 claim 156, 161, 69 issue 111, 114, 165, 169, 174 preclusive effect 4, 157, 158, 161, 167, 171 preliminary injunctions 135–6 of future claims 282 as powerful tools 221 targeted M&A 210–11, 219–20 private ordering 439 dispute resolution provisions 439–40 choice of forum 440, 442 emergence of 440–41 fee shifting 441 mandatory arbitration 441 US approach 443–5 default rules in corporate governance 444 governing of content of corporate charters and bylaws 443–4 organizational documents can be treated as documents 444–5 Private Securities Litigation Reform Act (1995) 2, 13, 15, 47, 58, 117, 273 discovery bar 17, 126 effects of 127

M4633-GRIFFITH_t.indd 539

goals of 271 lead plaintiff provision 17 see also lead plaintiffs pleading standard 17, 29, 124, 126 response to abuses of securities class actions 273–4 screening effect 32 § 21D(a) 17 procedural rules 70 heightened 70–71, 76 control of suits 70, 71–2 cost sharing 77 creating difficulty filing suits 70–71 limited fee shifting 77 pleading standards 77 transsubstantive 70 proximate cause 88, 89, 90, 91 pseudo-foreign corporations 317 public character of corporate litigation 187 public takeovers 415–17 Ireland/UK/US differences 416, 437 Ireland/UK/US similarities 415–16 see also public takeovers (Ireland); public takeovers (UK) public takeovers (Ireland) regulatory regime 416–17 certainty of 432–3 deadweight costs 433–4 proactive approach to rulemaking 431–2 process advantages of 431 relative absence of litigation 434, 435 Takeover Panel 415, 427–31 adjudicatory speed 432 applying Rule 21 423–4 Board 428 Executive 428–29 432 expenditures 435–6 independence of 427–8 judicial review of decisions 430–31 powers 429 restrictions on 429–30 self-financing 435 statutory duties 428 statutory hearings 429 Takeover Rules 417, 420–21 disclosure of information 421–2 equivalent treatment 422–3 mandatory bid 422–3 no frustration principle 423, 424 substantive requirements 421–4 timescales 421 public takeovers (UK) City Code on Takeovers and Mergers 417, 419–20 disclosure of information 421–2

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540  Research handbook on representative shareholder litigation expanding scope of 423 General Principle 1 422 General Principle 2 422 General Principle 3 423 no frustration principle 423, 424 substantive requirements 421–4 timescales 421 defensive tactics 417–18 first appearance 417 Notes on Amalgamation of British Businesses 418–19 Panel on Takeovers and Mergers 415, 419, 424–7 adjudication process 425 Code Committee 424–5 decisions subject to review 426–7 Executive 425, 432 expenditures 434–5 judicial function 424 legislative function 424 monitoring compliance with City Code 424 powers of 424, 425–6 proactive approach to rulemaking 431–2 self-financing 435 on tactical litigation 423–4 regulatory regime 416–17 certainty of 432–3 cost of dispute resolution under 435 deadweight costs 433–4 process advantages of 431 relative absence of litigation 434 public takeovers regulatory regime 416, 417 race to laxity 373–4 crosslisting legislation in Israel 374–5 crosslisting legislation in US 374 as good thing 376–7 Teva case see Teva weak enforcement of crosslisting laws 375–6 see also crosslisting reasonableness 203 of fees 199 presumption of 294–5 range-of-reasonableness test 223 regulating fee awards 287–9 establishing fee terms upfront 297–9 in Fifth Circuit 296 mimic-the-market method 287–9, 290, 291–2, 302–3 percentage-based fees 290–93 in Ninth Circuit 296–7 setting terms 287 in Seventh Circuit 287

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in Third Circuit 288, 294–6 judicial assessments 295–6 presumption of reasonableness for ex ante fee agreements 294–5 securities-specific 294–6 regulation as revenue source 102–3 circumventing 103 securities 372–3 race to the bottom in see race to laxity regulatory entrepreneurialism 99, 102, 105 combating inefficient laws 103 potential of 106 reliance 125, 487 presumption of 16, 125 remedies aggregate litigation 354 appraisal 243 see also appraisal oppression 467–8, 469 unfair prejudice 468–9 required rate of return 84 res judicata 156, 157 respondeat superior liability 41–2, 43, 49 restatement framework 156, 163, 165 applying 174 interpreting 161, 171–172 Restatement (Second) of Judgments 162 restatement test 162 risk allocation 473–4 appraisal 248 -bearing 49, 92 business 92 materialization 93–4 Rule 10b-5 private right of action 39, 53 early 39–41 corrective justice in 41–2 costs of 44 deterrence in 42–4 evolution of 44 doctrinal innovation 44–5 FOTM Class Actions 45–8 see also fraud on the market Sarbanes–Oxley Act (2002) 15, 89 scienter requirement 14, 24, 31, 36, 88, 124, 126 screening via approval of settlement 133, 136–8 see also settlement causation 125 via demand requirement 128–33 see also demand requirement dismissal recommendations 130 for economic loss 125

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Index  541 heightened pleading requirement 124–5 materiality 123–4 motions to dismiss 134–5 preliminary hearings 122–3 preliminary injunctions 135–6 for reliance 125 Section 220 inspection rights 111 Securities & Exchange Commission 13 adoption of Rule 14e-3 24 exercise of authority 20 increasing threat of scrutiny 34 Securities Act (1933) 180 Securities and Exchange Act (1934) Rule 10b-5 13–14, 80 § 10(b) 39 § 10(b) 13, 14 § 10b-5 80 § 14, 309 § 21D, 88 securities fraud 12 actionable causes of loss 80–81 class actions see securities fraud class actions Enron, 33, 35 fraud on the market see fraud on the market as lawyer-driven litigation, 15 limitations on scope, 14 policy considerations in 14 private 13–14 importance of 15 limiting litigation abuse 14 limiting vexatious litigation in 15 as political hot potato 19–20 protecting investors 14 statute of limitations 15 severe 29–30, 33–5 increase in 34 WorldCom 33, 35 securities fraud class actions 1–2, 12, 37 abuses of 273 by bondholders 34 causation in 125 Cendant 33 as Congress/Court lawmaking partnership 12–13, 16, 18 as enforcement tool 17 and first internet stock bubble 33 as form of insurance 90–91 future implications 35–7 HealthSouth 33 impact of PSLRA 31–2, 37 accounting restatements 34, 35 lead plaintiffs in 32 lower fees in 300–302 pre-PSLRA 30–31 pretrial evaluations in 123

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private class actions 17 RiteAid 33 screening in 122–6 see also screening and securities fraud 29–30 severe fraud 33–5 see also securities fraud Sunbeam 33 as system for redistributing stockholder wealth 91 Securities Litigation Uniform Standards Act 13, 15 adoption of 17 Securities-Related Class Action Law (Korea) 364 Senate Committee on Banking, Housing, and Urban Affairs 30 separation of control 334 settlement 133–8 approval of 137–8 disclosure 138, 140, 142–5 see also disclosure settlement judicial preference for 192, 197 preclusive 160 weakness as screening process 136–7 severability 225–6 shareholder consent 185–6 derivative suits, 2–3 see also derivative claims /director power differential 185 not autonomous agents 186 power 185 rights 187 suits see shareholder suits shareholder suits class actions see class actions derivative see derivative claims externalities 121–2 individual 121 lawyer driven 121, 176 representative 121 screening 122–6 see also screening as vexatious 176 side payments 273 standing 89, 281–3, 471–3, 500 China 473 France 472 Germany 472–3 Japan 472 Switzerland 472 UK 472 US 471 stare decisis 16

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542  Research handbook on representative shareholder litigation stichting 8, 356 Stop Trading on Congressional Knowledge Act (2012) 23, 25 strike suits 489 Teva 377 aftermath 381–2 Brodet Committee 393 causes of action 408–9 class action 379–80 corporate avoidance of duty 378 Court as last resort 392, 407–8 Decision 381 executive remuneration disclosure 397–400, 404 failure of crosslisting laws 378–9 importance of individual disclosure 400–404 ISA reaction 380–81 Israeli court as only forum 405–6 Israeli disclosure rules 394–5 main arguments 386 continuation of violation of law 391 contradictory interpretation of duty to disclose 390, 404–5 disclosure obligations 387–8 failure to disclose directors’ compensation 389–90 failure to disclose intent to stop individual reporting 390–91 general 386–7 no self-created exemption from disclosure 391–2 reports after Dual Listment Law 388–9 reports before Dual Listing Law 387

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motion 385 to certify as class action 409–11 movants 406–7 no regulation 378 not reporting individual executive pay 377–8 remedies 411–13 US disclosure duties, expansion of 393–4 US disclosure rules 395–7 tramp corporations 317 two-tier plaintiffs’ bar investigation 148–9 methodology 149 results 149–50 UK Companies Act (2006) 419–20, 424 § 171 463 public takeovers see public takeovers (UK) shareholder primacy 418 ultra vires doctrine 99–100, 105 Uniform Interstate and International Procedure Act (1986) 323 US Berle-Means corporation 460 /EU differences on contractual agreements on shareholder litigation 445 non-public enforcement notices 504 public takeovers see public takeovers valuation, factors 84–5 vexatious litigation 14, 176 vicarious liability overdeterrence costs 53

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