Reducing Shareholder Claims

A staggering percentage of mergers with values north of $100 million are being challenged in court by shareholders.
By: and | September 2, 2014

Shareholder derivative litigation continues to be prevalent, and, according to a recent study by Cornerstone Research, there has been a sharp increase in such claims during the past several years.

The trend is marked by the frequency of shareholder challenges to corporate decision-making in merger transactions.

These challenges typically involve assertions that corporate management violated fiduciary duties by failing to maximize shareholder value, failed to properly investigate or value the transaction, failed to adequately negotiate the deal, or failed to disclose the terms of the deal to shareholders.

Until recently, shareholder litigation tended to be seen following very large corporate transactions valued in the billions. During 2008, according to Cornerstone, shareholders filed litigation challenging 54 percent of merger transactions valued over $100 million. This percentage jumped to 86 percent in 2009, and has continued to steadily increase.

In 2013, shareholders filed litigation challenging a staggering 94 percent of all corporate transactions valued over $100 million.

This litigation landscape raises the potential that directors and officers will be exposed to significant liability in virtually every large corporate transaction.

Given the large number of public companies that are incorporated in Delaware, many shareholder actions are filed in the Delaware Chancery Court. In recent years, shareholder cases have become more fragmented, so shareholder litigation tends not to be confined to a single lawsuit in a single jurisdiction as was once often the case.

During 2013, 62 percent of the challenged transactions led to litigation in multiple jurisdictions with a single corporate transaction, on average, leading to five separate lawsuits in multiple jurisdictions.

Shareholder litigation is generally expensive to defend and introduces substantial uncertainties for a corporation and its management, especially when the litigation challenges a pending transaction. In many cases, it also may become necessary for the company to appoint a special litigation committee that, in turn, will engage attorneys and other professionals to independently investigate the factual and legal bases of the claims asserted by shareholders. These efforts also tend to be expensive.

Most shareholder actions are resolved through settlement, and most settlements involve non-monetary relief in the form of additional disclosures by the company or corporate governance changes with the only monetary component of the settlement being the company’s agreement to pay the plaintiffs’ attorneys fees.

The average fee award requested during 2013 was $1.1 million. Settlements involving other monetary payments by the company are not as common, but there are reported cases in recent years of substantial monetary payments in shareholder actions with several cases resolved for payments exceeding $100 million.

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This litigation landscape raises the potential that directors and officers will be exposed to significant liability in virtually every large corporate transaction.

Corporate governance statutes in Delaware (and other jurisdictions) have long allowed companies to limit this exposure to shareholder claims by including a provision in the corporate charter that broadly exculpates directors for breach of the duty of care, by indemnifying management at least for the cost of defending such claims, and by purchasing liability insurance.

Recent developments in the law now present additional strategies that a corporation should consider to further limit shareholder litigation risks.

Emerging Strategies to Limit Risk

Recent court decisions have upheld bylaw provisions that restrict shareholder litigation to a single jurisdiction such as Delaware, require shareholder claims to be arbitrated (rather than litigated), prohibit the company from paying the attorneys’ fees of its shareholders, and require an unsuccessful shareholder plaintiff to reimburse the cost of defending the litigation.

The rationale for these decisions is that courts have long enforced procedural restrictions on litigation if the parties have agreed upon them, and a corporation’s charter and bylaws must be treated as an agreement among the corporation and its shareholders.

Since a corporation is generally allowed by corporate governance laws in Delaware (and other jurisdictions) to delegate to its directors the power to adopt, amend or repeal its bylaws, the company’s shareholders are deemed to have agreed to any bylaws adopted by the directors in good faith pursuant to this delegated authority.

“Exclusive Forum” Bylaws

An “exclusive forum” bylaw requires shareholder litigation to be brought only in a specified jurisdiction — typically the corporation’s state of incorporation. This procedural requirement does not restrict what types of lawsuits may be brought by shareholders, only where shareholders properly may be bring them.

Joseph Finnerty III, partner, DLA Piper

Joseph Finnerty III, partner, DLA Piper

This restriction is important because it confronts the inevitable risks associated with multi-jurisdiction shareholder litigation by channeling litigation into a single jurisdiction, thus lowering litigation costs and streamlining the proceedings.

When the company is incorporated in Delaware, such a provision may ensure that the corporation is able to avail itself of a well-developed body of Delaware corporate law applied by a judiciary well versed in such matters. An “exclusive forum” provision cannot properly prevent shareholders from asserting claims, but it can ameliorate costly duplicative litigation.

The Delaware Court of Chancery recently upheld exclusive forum bylaws that were unilaterally adopted by the boards of Chevron and FedEx.

The Chancery Court rejected arguments that the forum selection bylaws were invalid because they were adopted unilaterally by the board without shareholder consent, and concluded that the board was properly delegated the power to adopt bylaws with shareholders’ full knowledge.

Following the decision, a state court in New York dismissed a shareholder lawsuit by enforcing a provision in the company’s bylaws that required the litigation to be filed only in Delaware.

Such bylaws have become increasingly common. Prior to the Chancery Court decision, over 250 public companies had adopted exclusive forum bylaws. Immediately following the decision, another 150 companies adopted similar bylaws.

Arbitration Bylaws

Another potentially cost-reducing bylaw is an arbitration bylaw. This requires any dispute brought by a shareholder to be resolved through binding and final arbitration.

Eric Connuck, of counsel, DLA Piper

Eric Connuck, of counsel, DLA Piper

Arbitration can limit costs and improve the quality of dispositions through the use of an expert arbitrator and simplified and streamlined dispute resolution procedures.

Courts in Massachusetts and Maryland recently upheld bylaw provisions that required shareholder claims to be arbitrated and precluded the arbitrator from ordering the company to pay attorneys’ fees to shareholders’ counsel.

These decisions relied upon the principle that where the corporate charter allows the board to unilaterally adopt, amend or repeal the company’s bylaws, the shareholders are presumed to have consented to the company’s bylaws — regardless of whether the shareholders in fact have even seen them. This conclusion was applied in these recent decisions to both sophisticated and “ordinary” shareholders alike.

Fee-Shifting Bylaws

Fee-shifting bylaws allocate risks in intra-corporate litigation by requiring an unsuccessful shareholder to reimburse defense costs to the company and its management.

Fee-shifting bylaws have the potential to deter litigation, but also may discourage meritorious claims due to the chilling effect of the potential for an award of attorneys’ fees being imposed against an unsuccessful shareholder.

As a result, fee-shifting bylaws are controversial but also have the greatest potential to discourage shareholder lawsuits by creating an economic disincentive to filing marginal claims.

Fee-shifting bylaws have recently been upheld by the Delaware Supreme Court and were held to be enforceable so long as they were adopted through appropriate corporate procedures and were not enacted for an improper purpose. The Delaware Supreme Court recognized such a bylaw may inevitably deter litigation, but ultimately concluded that an intent to deter litigation is not necessarily an improper purpose.

With shareholder litigation so prevalent, corporate management and risk managers must prepare for the inevitable costs of litigation.

By shaping the rules of the game, companies have at their disposal additional risk management tools that have the potential to greatly reduce costs and deter unnecessary litigation.

As the courts continue to uphold these measures and they become more and more successful, corporate boards should be willing to adopt these and potentially other defensive bylaws to manage shareholder litigation risk.

Joseph Finnerty III is a partner specializing in securities and business litigation at DLA Piper. Eric Connuck of counsel at the law firm, focusing on complex commercial matters.

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