Professor Bainbridge...on law, politics, religion, culture & food

The Demand Requirement in Derivative Litigation: Part IV

This is the fourth in a series of posts that collectively constitute a short monograph on the role of the demand requirement in derivative litigation. In this post, we turn to the policy question of when the board should be able to take control of a shareholder-initiated derivative lawsuit.

The Zapata court correctly identified the basic issue: If the corporation can consistently defeat bona fide derivative actions through procedural devices, much of the derivative suit’s supposed utility in punishing and deterring managerial misconduct will evaporate. On the other hand, the underlying cause of action belongs to the corporation and the corporation should be able to rid itself of nonmeritorious or even harmful litigation.[1] Subsequent decisions have recognized an even more serious concern: “the derivative action impinges on the managerial freedom of directors.”[2] Due regard therefore must be given “the fundamental precept that directors manage the business and affairs of corporations.”[3] In other words, shareholder derivative litigation presents the same tension between authority and accountability we have pervasively encountered throughout corporate law. Consequently, the question to be resolved is whether the derivative suit process deserves what the Zapata court referred to as its “generally recognized effectiveness as an intra-corporate means of policing boards of directors.”[4]

The significance of accountability concerns depends, at least in the first instance, on the nature of the defendant and of the claim. A board decision not to sue a supplier for breach of contract, for example, really is no different from a decision to enter into the contract in the first place. On the other hand, a board decision not to sue a fellow board member who has, for example, usurped a corporate opportunity is qualitatively different.

In supplier-type cases, accountability concerns have little traction. Consequently, it ought to be quite easy for the board to regain control over cases in which the shareholder-plaintiff sues some corporate outsider on a derivative basis. If the shareholder-plaintiff sues the board for breach of the duty of care, it likewise should be easy for the board to regain control over the litigation. If the board decided not to sue the supplier, for example, there probably was a reasonable justification for that decision. Even if there was not, the policies against judicial second-guessing of board conduct underlying the business judgment rule remain compelling. Indeed, in light of those policies, one could plausibly argue that shareholders should have no standing to bring derivative suits based on such claims.

In cases in which a director allegedly violated the duty of loyalty, however, accountability concerns seem more pressing. But do those accountability concerns trump the authority-based justification for deferring to decisions by a disinterested and independent board majority or committee? In a well-known article, Professors Coffee and Schwartz argued that ordinary business decisions and decisions not to pursue litigation are distinguishable.[5] Accordingly, they contended, the business judgment rule is irrelevant to judicial review of the committee’s decision. Rather, courts should aggressively review the merits of the case.

Coffee and Schwartz offered four principal justifications for their position. First, ordinary business decisions are made under time pressure and uncertainty. But so what? In our old friend, Shlensky v. Wrigley,[6] the board had something like 20 years in which to ponder its decision. Should the board therefore have been denied the protection of the business judgment rule? Given the time pressures associated with litigation, moreover, is there really that much difference between regular decisions and litigation decisions?

Second, Coffee and Schwartz argued, the business judgment rule’s main purpose is to shield directors from liability for honest mistakes. Directors who decide to dismiss derivative suits do not need such a shield from personal liability—or so Coffee and Schwartz opined. After Smith v. Van Gorkom,[7] however, one can plausibly imagine a scenario in which the committee members could be held liable if they were grossly negligent in failing to gather all material information reasonably available to them with respect to the prospective litigation.

Third, Coffee and Schwartz contended that courts have greater expertise in assessing the merits of litigation than they do with respect to typical business decisions. One problem with this argument is that judicial expertise, or the lack thereof, is only a small part of the case for judicial deference to board decisions. It is far from clear, moreover, the judges really have superior judgment with respect to such matters as the impact of litigation on firm morale or the amount of time defendants are likely to spend reading their liability insurance policies instead of working.

Finally, Coffee and Schwartz pointed out the potential for structural bias. (As discussed in the preceding post, structural bias refers to the possibility that SLC members, by virtue of their typical background as business executives will be biased in favor of the defendants.) Here, of course, we come to the nub of the matter. As illustrated by Zapata’s concern that SLC members will have a “there but for the grace of God go I” empathy for the defendants, concerns about structural bias pervade the law in this area. If structural bias is the main concern, Delaware law seems to get at the problem more directly than, say, does New York. Under Delaware law, demand will be excused where a majority of the board is either interested in the transaction or otherwise failed to validly exercise business judgment. Once demand is excused, Delaware courts take a close look at the merits of allowing the litigation to go forward, while New York courts are barred from doing so.

To be sure, Delaware law in this area could stand a good tweaking. The Aronson/Zapata framework continues to rely unduly on bizarrely worded standards that often fail to grapple with the real issue. The Delaware courts would do well to adopt a simpler standard, which asks whether the board of directors is so clearly disabled by conflicted interests that its judgment cannot be trusted.[8] If so, the shareholder should be allowed to sue. If not, the shareholder should not.

Or maybe not. In the first place, concern over structural bias can be taken too far. Indeed, “the structural bias argument has no logical terminus.”[9] If purportedly independent directors are likely to favor their fellow directors when the latter are sued, they are equally likely to do so in any conflict of interest situation. In the corporate takeover setting, for example, some commentators argue that nominally independent directors’ fears for their owns firm can render those directors unduly sympathetic to insiders’ job security concerns.[10] It is far from clear that structural bias can justify carving out special rules for derivative litigation, but not for other types of conflicted interest transactions.

In any event, one can concede both the importance of board accountability and the potential for structural bias without having to concede the utility—or even the legitimacy—of derivative litigation. In a seminal empirical study of derivative litigation, Professor Roberta Romano found that derivative litigation is relatively rare.[11] Of those cases that go to trial, shareholder-plaintiffs almost always lose. As is generally true of all litigation, however, most derivative suits settle. Only half of the settled derivative suits resulted in monetary recoveries, with an average recovery of about $6 million. In almost all cases, the legal fees collected by plaintiff counsel exceeded the monetary payments to shareholders. Romano further concluded that nonmonetary relief typically was inconsequential in nature.

Romano’s empirical analysis is consistent with our analysis of the relevant players’ incentives. A substantial percentage of derivative litigation likely consists of strike suits, which are settled for their nuisance value. Conversely, meritorious suits likely are settled too cheaply, albeit with inflated legal fees paid to plaintiff’s counsel. Because settlements typically are structured so that both any monetary payment and any legal fees are paid out of the corporate treasury,[12] derivative litigation necessarily tends to reduce the value of the residual claim.

Derivative litigation mainly serves as a means of transferring wealth from investors to lawyers. At best, derivative suits take money out of the firm’s residual value and return it to shareholders minus substantial legal fees. In many cases, moreover, little if any money is returned to the shareholders—but legal fees are almost always paid. Why would a diversified shareholder approve such a process?

If derivative litigation cannot be justified on compensatory grounds, can it still be justified as a useful deterrent against managerial shirking and self-dealing? In short, no. There is no compelling evidence that derivative litigation deters a substantial amount of managerial shirking and self-dealing. Certainly there is no evidence that litigation does a better job of deterring such misconduct than do markets. There is evidence that derivative suits do not have significant effects on the stock price of the subject corporations, however, which suggests that investors do not believe derivative suits deter misconduct.[13] There is also substantial evidence that adoption of a charter amendment limiting director liability has no significant effect on the price of the adopting corporation’s stock, which suggests that investors do not believe that duty of care liability has beneficial deterrent effects.[14]

A radical solution would be elimination of derivative litigation. For lawyers, the idea of a wrong without a legal remedy is so counter-intuitive that it scarcely can be contemplated. Yet, derivative litigation appears to have little if any beneficial accountability effects. On the other side of the equation, derivative litigation is a high cost constraint and infringement upon the board’s authority. If making corporate law consists mainly of balancing the competing claims of accountability and authority, the balance arguably tips against derivative litigation. Note, moreover, that eliminating derivative litigation does not eliminate director accountability. Directors would remain subject to various forms of market discipline, including the important markets for corporate control and employment, proxy contests, and shareholder litigation where the challenged misconduct gives rise to a direct cause of action.

If eliminating derivative litigation seems too extreme, why not allow firms to opt out of the derivative suit process by charter amendment? Virtually all states now allow corporations to adopt charter provisions limiting director and officer liability. If corporate law consists of a set of default rules the parties generally should be free to amend, as we believe it to be, there seems little reason not to expand the liability limitation statutes to allow corporations to opt out of derivative litigation.

To be sure, it seems unlikely that courts or legislatures will eliminate derivative litigation any time soon. In the meanwhile, courts should use the tools at hand to discourage derivative litigation as much as possible. As the Marx court put it, courts should be “reluctant to permit shareholder derivative suits.”[15] Only cases in which a majority of the board is disabled by conflicted interests from making impartial decisions on the merits of prospective litigation should courts allow a shareholder derivative suit to go forward.

--------------------------------------------------------------------------------

[1] Zapata Corp. v. Maldonado, 430 A.2d 779, 786-87 (Del. 1981).

[2] Pogostin v. Rice, 480 A.2d 619, 624 (1984).

[3] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

[4] Zapata Corp. v. Maldonado, 430 A.2d 779, 786 (Del. 1981).

[5] John C. Coffee, Jr., and Donald E. Schwartz, The Survival of the Derivative Suit: An Evaluation and a Proposal for Legislative Reform, 81 Col. L. Rev. 261 (1981).

[6] 237 N.E.2d 776 (Ill. App. 1968)

[7] 488 A.2d 858 (Del. 1985) .

[8] See Kohls v. Duthie, 2000 WL 1041219 (Del. Ch. 2000), in which Vice Chancellor Lamb noted that the Rales standard arguably provides a simpler and more directly relevant test than the Aronson standard. Id. at *5. (Recall that under Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993), the standard is whether the board could have properly exercised disinterested and independent judgment in assessing the demand.) See also Starrels v. First Nat’l Bank of Chi., 870 F.2d 1168 (7th Cir. 1989), in which Judge Easterbrook extensively argued for a test under which courts inquire “whether the board could make a valid business judgment in response to a demand. Id. at 1175 (Easterbrook, J., concurring).

[9] Michael P. Dooley & E. Norman Veasey, The Role of the Board in Derivative Litigation: Delaware Law and the Current ALI Proposals Compared, 45 Bus. Law. 503, 534 (1989).

[10] See Dynamics Corp. of Am. v. CTS Corp., 794 F.2d 250, 256 (7th Cir. 1986), rev’d on other grounds, 481 U.S. 69 (1987).

[11] Roberta Romano, The Shareholder Suit: Litigation without Foundation?, 7 J. L. Econ. & Org. 55 (1991).

[12] Some commentators assert that most out-of-pocket losses in derivative litigation are ultimately paid by liability insurers under D&O liability policies. See, e.g., Reinier Kraakman et al., When are Shareholder Suits in Shareholder Interests?, 82 Geo. L.J. 1733, 1745-46 (1994). If so, the cost of such suits still comes out of the residual claim in the form of insurance premiums.

[13] See Daniel R. Fischel & Michael Bradley, The Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis, 71 Cornell L. Rev. 261 (1986).

[14] See, e.g., Michael Bradley & Cindy A. Schipani, The Relevance of the Duty of Care Standard in Corporate Governance, 75 Iowa L. Rev. 1 (1989); Roberta Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 Emory L.J. 1155 (1990).

Marx v. Axers, 644 N.Y.S.2d 121, 124 (1996).

© Stephen M. Bainbridge, William D. Warren Professor of Law, UCLA School of Law, 2007