Saturday, May 26, 2018
Risk factor disclosures are required under SEC rules, and encouraged under the PSLRA (which insulates from private liability forward-looking statements that are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement,” 15 U.S.C. § 78u-5). The theory is that investors, armed with adequate warnings, can make intelligent decisions about how to value a company’s securities.
Both the SEC in its guidance, and Congress when passing the PSLRA, emphasized that “boilerplate” warnings are not helpful; investors must be given specific, tailored information about the firm-specific risks that the company faces. For example, the SEC instructs firms, “Do not present risks that could apply to any issuer or any offering. Explain how the risk affects the issuer or the securities being offered.” 17 C.F.R. § 229.303. Meanwhile, in the PSLRA’s legislative history, the Conference Report states that “boilerplate warnings will not suffice.... The cautionary statements must convey substantive information about factors that realistically could cause results to differ materially from those projected.”
Scholars have documented that firm-specific risk warnings are helpful to investors. For example, a while ago I blogged about a study by Karen K. Nelson and Adam C. Pritchard documenting how risk factor disclosures may assist investors.
The difficulty is, how does one distinguish boilerplate risk factors from “meaningful” firm-specific ones? The impossibility of that task has frustrated several courts, with the First Circuit calling the PSLRA’s safe harbor a “license to defraud,” In re Stone & Webster, Inc., Securities Litig., 414 F.3d 187 (1st Cir. 2005), and the Second and Seventh Circuits expressing bewilderment as to how the adequacy of cautionary language is to be assessed, Slayton v. American Exp. Co., 604 F.3d 758 (2d Cir. 2010); Asher v. Baxter Int’l, 377 F.3d 717 (7th Cir. 2004).
Scholars have also assailed the judiciary for adopting unrealistic standards of how investors read and interpret corporate disclosures, and, in particular, for overestimating ordinary investors’ ability to digest corporate disclosures and correctly incorporate them into their decisionmaking. David A. Hoffman, The “Duty” to Be a Rational Shareholder, 90 Minn. L. Rev. 537 (2006); Stephen M. Bainbridge & G. Mitu Gulati, How Do Judges Maximize? (The Same Way Everybody Else Does—Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory L.J. 83 (2002); Stefan J. Padfield, Is Puffery Material to Investors? Maybe We Should Ask Them, 10 U. PA. J. Bus. & Emp. L. 339 (2008).
A new study by Richard A. Cazier, Jeff L. McMullin, and John Spencer Treu supports scholars’ intuition – and courts’ frustration – by demonstrating that standards generated by judges and the SEC appear to encourage firms to include lengthier, less informative risk disclosures in their SEC filings, despite the fact that long, boilerplate warnings may actually harm firms by increasing their cost of capital. In Are Lengthy and Boilerplate Risk Factor Disclosures Inadequate? An Examination of Judicial and Regulatory Assessments of Risk Factor Language, the authors demonstrate that in the event of a lawsuit, judges are more likely to find risk factors adequate if they are lengthier and more boilerplate. Moreover, the SEC is less likely to issue a comment letter if the risk factors match those of peer companies rather than identify firm-specific risks. In other words, the legal system encourages firms to adopt practices that are the opposite of what would benefit the market.
At this point, I just have to quote myself – sorry! – from an earlier blog post:
[A]ll of our measures of impact and harm and loss are, at this point, so far removed from reality as to border on complete legal fiction. Materiality is a construct from case law, with numerous additional doctrines piled on to it by courts without any heed for actual evidence of how markets behave. …. [W]hat we call “harm” and “damage” for the purpose of private securities fraud lawsuits have become so artificial that it no longer seems as though we’re even trying to measure the actual real-world effects of fraud. I believe private lawsuits are an essential supplement to SEC action but a system of fines or statutory damages would make so much more sense.
(As long as I’m plugging myself, I’ve also proposed having distinct damages and liability regimes for investors who can prove actual reliance, since I think the fraud on the market context often leads courts astray). But more immediately, here’s hoping the SEC takes notice of these findings and incorporates them into its practice.
Saturday, May 19, 2018
If you’re anything like me, you’ve spent the last few days procrastinating studying the drama unfolding at CBS. (If you’re not aware, here’s an article summarizing the state of play; the rest of this post assumes readers are familiar with the basic facts).
There’s a lot to chew on here, and I’m sure that as the case develops, there will be much more to say, but here are some off-the-cuff initial thoughts, in no particular order.
[More under the jump]
Monday, May 14, 2018
I always have loved the game of tag, and I love a challenge. More importantly, I love a conversation about business law . . . .
Last week, Steve Bainbridge posted a follow-on to posts written by Ann and me on the application of fiduciary duties to the private lives of corporate executives. As Steve typically does in his posts, he raises some nice points that carry forward this discussion. In a subsequent Tweet, Steve appears to invite further conversation from one or both of us by linking to his post and writing "Tag. You're it."
. . . to what extent should a board have Caremark duties to monitor a CEO's private life. Personally, I think Caremark is not limited to law compliance programs. A board presented with red flags relating to serious misconduct--especially misconduct in a sphere of life directly related to the corporation's business (think Weinstein)--has a duty to investigate. But, again, does that mean the board should hire private investigators to track the CEO 24/7?
I agree that a board's duty to monitor is not limited to compliance programs. Stone v. Ritter makes it plain that the duty to monitor arises from a director's obligation of good faith, situated within the duty of loyalty. Assuming no "intent to violate applicable positive law" or an intentionally failure to act in the face of a known duty to act (demonstrating a conscious disregard for his duties)," however, under Disney, a failure to monitor in this context likely would not rise to the level of bad faith unless the board "intentionally acts with a purpose other than that of advancing the best interests of the corporation"--which seems unlikely (although someone with more time and creativity than I have at the moment may be able to spin out some relevant facts). Of course, the Delaware Supreme Court could add to the Disney list of actions not in good faith . . . . But absent any of that, it is unlikely that a board of directors' failure to monitor an executive's private life will result in liability for a breach of the duty of loyalty.
Second, I want to pass on a further thought on the debate--one that is not my own. In an email message to me, co-blogger Stefan Padfield observed that corporate opportunity doctrine questions are fiduciary duty claims that extend into a fiduciary's private life--specifically, the fiduciary's usurpation of the opportunity for his or her private gain. He also noted that from there the leap is not as far as it may seem to conceptualizing other aspects of an executive's private conduct as being within the scope of his or her fiduciary duties to the corporation. This certainly provides more food for thought.
I want to thank Ann for stimulating all these ideas. Her original post raised a nice question--one that obviously provokes and has encouraged engagement in thoughtful conversation. While we have not yet resolved the issue, we have staked out some important ground that may be covered in extant or forthcoming cases. As Ann's and Steve's posts point out, there are a number of intriguing fact patterns at the intersection of executives' private lives and fiduciary duties that may force courts to wrestle some of this to the ground. I, for one, will be watching to see what happens.
Saturday, May 12, 2018
I've been hunkered down grading exams this week, so all I've got for you is this tale tail of a developing economy:
For the last five years or so, the campus of Colombia's Diversified Technical Education Institute of Monterrey Casanare has been home to a sweet black dog named Negro. There, he serves as a guardian of sorts, keeping watch over things as students go about their studies.
In return, Negro is cared for by the school's faculty, who provide him with food, water, attention and a safe place with them to pass the night.
But the dog has apparently decided that anything beyond that is up to him.
Early on in Negro's tenure at the school, he came to be aware of the little store on campus where students gather to buy things on their breaks; sometimes they'd buy him cookies sold there.
This, evidently, is where the dog first learned about commerce — and decided to try it out himself.
"He would go to the store and watch the children give money and receive something in exchange," teacher Angela Garcia Bernal told The Dodo. "Then one day, spontaneous, he appeared with a leaf in his mouth, wagging his tail and letting it be known that he wanted a cookie."
Negro had invented his own currency, but, of course, it was accepted.
He got a cookie — and it came with an epiphany.
Leaves can buy treats!
As you might expect, after the dog realized his money literally grows on trees, it's been a regular thing.
"He comes for cookies every day," Gladys Barreto, a longtime store attendant, told The Dodo. "He always pays with a leaf. It is his daily purchase."
Still more reliable than Bitcoin.
Monday, May 7, 2018
I was fascinated by Ann Lipton's post on April 14. I started to type a comment, but it got too long. That's when I realized it was actually a responsive blog post.
Ann's post, which posits (among other things) that corporate chief executives might be required to comply with their fiduciary duties when they are acting in their capacity as private citizens, really made me think. I understand her concern. I do think it is different from the disclosure duty issues that I and others scope out in prior work. (Thanks for the shout-out on that, Ann.) Yet, I struggled to find a concise and effective response to Ann's post. Here is what I have come up with so far. It may be inadequate, but it's a start, at least.
Fiduciary duties are contextual. One can have fiduciary duties to more than one independent legal person at the same time, of course, proving this point. (Think of those overlapping directors, Arledge and Chitiea in Weinberger. They're a classic example!) What enables folks to know how to act in these situations is a proper identification of the circumstances in which the person is acting.
So, for example, an agent’s duty to a principal exists for actions taken within the scope of the agency relationship. The agency relationship is defined by the terms of the agreement between principal and agent as to the object of the agency. The principal controls the actions of the agent within those bounds based on that agreement.
Similarly, a director’s or officer's conduct is prescribed and proscribed within the four corners of the terms of their service to the corporation. They owe their duties to the corporation (and in Revlon-land or other direct-duty situations, also to the stockholders). The problem then becomes defining those terms of service. For directors, a quest for evidence of the parameters of their service should start with the statute and extend to any applicable provisions of the corporate charter, bylaws, and board policies and resolutions more generally. For officers, the statute typically doesn’t provide much content on the nature or extent of their services. The charter may not either. Typically, the bylaws and board policies and resolutions, as well as any employment or severance agreement (the validity of which is largely a matter outside the scope of corporate law), would define the scope of service of an officer.
I have trouble envisioning that the scope of service (and therefore, reach of fiduciary duties) for a typical director or officer would extend to, e.g., private ownership of other entities and decisions made in that capacity. Yet, even where there is no technical conflicting interest or breach of a duty of loyalty, there is a clear business interest in having corporate managers—especially highly visible ones—act in a manner that is consistent with corporate policy or values when they are not “on the job.” While voluntary corporate policy or private regulation may have a role in policing that kind of director or officer activity (through service qualifications or employment termination triggers, e.g.), I do not think it is or should be the job of corporate law—including fiduciary duty law—to take on that monitoring and enforcement role.
Nevertheless, I remain convinced that better (more accurate ad complete) disclosure of (at least) inherent conflicts of interest may be needed so investors and other stakeholders can evaluate the potential for undesirable conduct that may impact the nature or value of their investments in the firm. As Ann notes, significant privacy rights exist in this context, too. There's more work to be done here, imv.
Thanks for making me think, Ann. Perhaps you (or others) have a comment on this riposte? We shall see . . . .
Saturday, May 5, 2018
Zohar Goshen and Sharon Hannes have just posted to SSRN an interesting paper, The Death of Corporate Law, arguing that markets and private ordering have begun to supplant adjudication as a mechanism for resolving corporate disputes because the increasing sophistication of investors has made private resolutions less costly.
There are many excellent insights in the piece, which furthers the taxonomy developed by Goshen and Richard Squire in Principal Costs: A New Theory for Corporate Law and Governance to add the costs of adjudication into the mix. Yet there may be some ways that the theory is incomplete. For example, the authors focus on the effect of shareholders’ rising “competence” – because of the concentration of investment in the hands of institutions – rather than on shareholders’ rising power, which (according to some) may not be accompanied by greater competence at all. Managers have acted to counteract that rising power (dual class stock regimes, delays in going public), which might represent an efficient bargain to which investors are agreeing (the authors’ view), or simply a forthcoming source of dispute.
But the other piece that’s missing, of course, is the role of securities law. Investors’ rising power and/or competence is not merely a function of markets; it’s a regulatory choice, due to everything from new CD&A disclosures and say-on-pay provisions to the expansion of Rule 14a-8 to permit its use for proxy access bylaws (and, heck, the existence of 14a-8 in the first place), to the loosening of restrictions of on investment in private funds. And what regulators giveth, regulators can taketh away. Thus, there are new efforts to, among other things, limit say-on-pay and shareholder proposals, and to regulate proxy advisors. There is even new Labor Department guidance meant to limit funds’ involvement in corporate governance (which I may or may not make the subject of another post).
At the same time, it's hard not to notice that we likely would be revisiting the old corporate disputes, but with respect to relationships between retail investors in funds and fund managers themselves, were it not for the fact that federal law occupies most of that space.
Point is, reports of corporate law’s death may be slightly, if not greatly, exaggerated. Perhaps another way of putting it is simply to note (as others have done) that the locus of regulation has shifted from flexible, ex post review to mandatory ex ante rulemaking.
Saturday, April 28, 2018
The #MeToo movement has shone a spotlight not only on sexual harassment, but also on the NDAs and arbitration agreements that allow it to flourish undetected for many years – until, in some cases, it finally explodes into a full-grown corporate crisis.
Part of the explanation is that victims choose to enter into settlements rather than conduct lengthy, expensive, and potentially humiliating court battles – which is understandable and a problem for which there is no obvious immediate solution.
But the other part of the explanation is that women (and men, who are harassed at lower rates but still may be targeted) are frequently forced to sign agreements to arbitrate claims confidentially as a condition of employment or the use of various services, and the Supreme Court – with its muscular interpretation of the Federal Arbitration Act – has held that states are virtually powerless to regulate these agreements. These agreements, it is well understood, are less about providing a venue for resolution of claims than about preventing claims at all, if for no other reason than most prohibit class actions. So until Congress is willing to modify the FAA (which, well, I’m not going to hold my breath), the situation continues.
Or does it?
Public pressure has now caused some companies to abandon their arbitration agreements. Microsoft ostentatiously announced it would no longer require them for sexual harassment claims. There was a bit of a tempest when it was discovered that Munger Tolles had them in their employment agreements; after some angry Tweeting – including requests for school-wide boycotts by elite law students and faculty – many firms agreed to withdraw them.
Uber’s user agreement with its riders has long contained an arbitration clause, and of course, we all know of the horror stories where Uber drivers are accused of assaulting passengers, sexually or otherwise. (Law Prof Nancy Leong reported a terrifying close call recently). It’s been my habit in my basic business organizations class to show students Uber’s user agreement, including the part on safety – where, to paraphrase, Uber instructs riders they should tell a friend where they’re going and sit near the car door in case they have to run.
Now, a group of women who allege they were sexually assaulted by Uber drivers have publicly released a letter to Uber’s board demanding that the board waive the arbitration clause. Their attorney argues that the board cannot claim it genuinely cares about women’s rights while forcing these claims into confidential arbitration.
Uber's been plagued by a tsunami of poor press recently, all casting a shadow on its hopes for an IPO next year. Given that, the women’s demand strikes me as a well-timed, savvy move. I don’t know if it can succeed – Uber may depend too heavily on keeping the misconduct of its drivers out of the spotlight – but on the other hand, as Twitter has demonstrated, there’s only so much silencing it can manage. I look forward to seeing whether these straws are what finally break the back of widespread arbitration clauses in consumer contracts.
Saturday, April 21, 2018
I tell my students that corporate waste technically may be a mechanism for defeating the business judgment rule in the absence of any other evidence of lack of compliance with fiduciary duty, but - as one Delaware decision put it - it's really more theoretical than real. See Steiner v. Meyerson, 1995 Del. Ch. LEXIS 95. When my students ask for some kind of real world example of waste, I tell them the facts of Fidanque v. American Maracaibo Co., 92 A.2d 311 (Del. Ch. 1952), where a corporation paid "consulting fees" to a 70-year-old former executive who had recently suffered a stroke that left him sufficiently incapacitated to be noticeable during his deposition.
I assumed that case was sui generis, but it turns out history has a way of repeating, this time in the form of Sumner Redstone's contract with CBS. As described in a recent opinion by Chancellor Bouchard, plaintiff stockholders of CBS adequately alleged that the Board made wasteful payments by refusing to terminate Redstone's $1.75 million contract as Executive Chair once his declining health left him unable to eat or speak, and by designating him Chairman Emeritus - at a $1 million salary - after he resigned from the Executive Chair position.
The decision strikes me as significant not merely because it presents a modern example of waste that I can now offer to my students - at a large, public company no less - but also because CBS is contemplating a merger with Viacom. Both companies are controlled by the Redstone family via supervoting shares, though they are - purportedly - negotiating the deal via independent committees. This kind of self-interested transaction was already vulnerable to legal challenge; how much stronger will that challenge be now that there's already evidence of a supine board willing to cater to Redstone?
Saturday, April 14, 2018
As most readers are likely aware, Donald Trump has no love for the Washington Post, which frequently publishes articles that cast him in a negative light. The Washington Post is owned by Jeff Bezos, who also is the founder, Chair, CEO, and largest shareholder of Amazon. Trump’s rage at the Washington Post in general and Bezos as its owner has led him to threaten Amazon, both publicly and privately, with suggestions that – for example – it should pay the Post Office more for shipping, that its taxes should be increased, and perhaps even that it should not have access to certain critical government contracts. Most recently, he even ordered a review of USPS finances, apparently as a mechanism for targeting Amazon. As a result, Amazon’s stock price has suffered.
Egan-Jones Proxy Services recently posted a comment on this state of affairs, ultimately arguing that Bezos’s responsibilities to Amazon’s investors include limiting the Washington Post’s coverage. As Egan-Jones put it, “Unless Mr. Bezos decides and is able to tone down, or better yet eliminate the content which is upsetting the President and his supporters he will continue to find he has created the most dangerous type of enemy for any type of company and its CEO, the politician… The job of a CEO is to act as a good steward for the funds investors have entrusted to him. The job of a CEO is not to promote a particular political path he or she may favor. Mr. Bezos needs to decide, does he wish to remain CEO of Amazon, or does he want to be a political player, Amazon’s investors deserve nothing less.”
Now, at this point I will say, from a pure policy perspective, I am horrified at the thought that any news organization could be bullied by a public figure into moderating truthful, newsworthy coverage. Additionally, by all accounts, Bezos has no input into the Washington Post’s editorial decisions. But putting these points to the side, I actually wish to explore the suggestion that a corporate fiduciary’s duty to shareholders extends to his private conduct, such that even entirely personal actions must be moderated if they might have an adverse effect on the corporation he oversees.
There can be no dispute that a corporate fiduciary’s personal information and behavior might be relevant to investors and to the quality of his/her stewardship. The health of corporate executives has frequently come under scrutiny (e.g., Steve Jobs, Sumner Redstone, Hunter Harrison); Martha Stewart’s private trading in an unrelated corporation ultimately impacted her own company; the private affairs of a partner could have company-wide repercussions; an executive’s drug habit may impact the company in unexpected ways; heck, even a CFO’s golfing habits may be relevant to the quality of corporate financial statements.
As a result, scholars – including Joan Heminway (hi, Joan!) – have tried to unpack the extent of a corporation’s duty to disclose directors’ and officers’ private facts, both under the federal securities laws, and under state fiduciary requirements, recognizing that due respect must be paid both to the informational needs of investors, and to the moral (and perhaps constitutional) rights of privacy possessed by corporate actors.
See, e.g., Joan Heminway, Martha’s (and Steve’s) Good Faith: An Officer’s Duty of Loyalty at the Intersection of Good Faith and Candor; Joan Heminway, Personal Facts about Executive Officers: A Proposal for Tailored Disclosures to Encourage Reasonable Investor Behavior; Ann M. Olazábal & Patricia Sánchez Abril, Celebrity CEOs: Disclosure at the Intersection of Privacy and Securities Law; Allan Horwich, When the Corporate Luminary Becomes Seriously Ill: When is a Corporation Obligated to Disclose That Illness and Should the Securities and Exchange Commission Adopt a Rule Requiring Disclosure?.
It’s an even knottier question when we extend that analysis not merely to disclosure, but to the original behavior. Do corporate fiduciaries have a duty to police their private conduct so as not to harm the company? And in this context, I use the phrase “private” not only to mean unknown to the public, but also to mean personal, unrelated to their jobs as fiduciaries.
When it comes to Bezos, for example, his ownership of the Washington Post is entirely separate from his control of Amazon. Amazon’s 10-K does not even mention the Washington Post, and its proxy statement only discusses the Post in order to disclose potential related-party transactions regarding advertising and digital services; they are entirely distinct companies.
It might therefore seem bizarre to declare that Bezos has a fiduciary duty to Amazon even when acting entirely in his unrelated capacity as owner of a newspaper. Yet the law already recognizes that for some executives, the personal and the professional are nearly impossible to disentangle; for example, I am reminded of corporate opportunity cases where an executive’s close relationship with his company made it impossible to distinguish opportunities presented to him in an individual capacity from those presented in a professional capacity – or, as the Delaware Supreme Court famously put it, “In the instant case Guth was Loft, and Guth was Pepsi.” We might therefore decide that certain controllers – like a Bezos, or a Musk, or a Zuckerberg, or a Gates, or a (formerly) Kalanick, or a Jobs, or a Stewart, or a Winfrey – are so intertwined with their companies, are such auteurs, that they cannot have private pursuits that are distinct from the companies they operate. All of their behavior may impact their companies, and thus all of their behavior must be scrutinized for compliance with the duties of care and loyalty.
Might the constitutional rights of privacy and free expression play a role here? Perhaps; fiduciary duties are obligations ultimately imposed and defined by the state. At the same time, though, there is no constitutional right to be a corporate CEO; unless fiduciary duties are viewed as the equivalent of an unconstitutional condition, there may be few limits to the state’s power to define standards of behavior.
Yet we might nonetheless decide that, as a matter of policy, executives must be granted space for private pursuits, if for no other reason than – as Joan points out – too many talented candidates may simply refuse the top jobs otherwise.
Saturday, April 7, 2018
On Friday, Elisabeth Kempf presented her new paper, co-authored with Oliver Spalt, at Tulane’s Freeman School of Business, Taxing Successful Innovation: The Hidden Cost of Meritless Class Action Lawsuits. Here is the abstract:
Meritless securities class action lawsuits disproportionally target firms with successful innovations. We establish this fact using data on securities class action lawsuits against U.S. corporations between 1996 and 2011 and the private economic value of a firm's newly granted patents as a measure of innovative success. Our findings suggest that the U.S. securities class action system imposes a substantial implicit “tax” on highly innovative firms, thereby reducing incentives to innovate ex ante. Changes in investment opportunities and corporate disclosure induced by the innovation appear to make successful innovators attractive litigation targets.
Using dismissal as a proxy for meritless – a point to which I will return – Kempf and Spalt find that firms that are granted valuable patents are more likely to be targeted by a class action lawsuit than other firms in the following year, and that the difference is driven by meritless lawsuits. The finding persists even controlling for firm size, sales growth, stock price returns, and volatility. They also find that these lawsuits disproportionately cause a drag on the firm’s stock price performance, constituting a hidden “tax” on innovation.
In many ways, I suspect the core finding of the paper is accurate, though I do question the ultimate conclusion, and I think that in future drafts – the version on SSRN is a very early one – other relationships should be tested.
To start, obviously the definition of “meritless” is a controversial one, and speaking as a former plaintiff-side class-action attorney, I do take issue with treating all dismissed cases as meritless ex ante. That said, the authors test using alternative measures of merit and reach the same results. The one I find particularly convincing is the test using the nature of the lead plaintiff, institutional versus individual – it’s not pretty, but in my experience, very often a good rule of thumb for the ex ante merit of a case is the identity of the lead plaintiff.
The authors also do not distinguish between Section 11 and Section 10(b) lawsuits, or control for circuits where lawsuits are filed (though they do control for location of firm headquarters). Section 11 lawsuits are easier to bring, and certain circuits have long had a reputation for imposing more stringent pleading standards – it is possible that a closer examination of these variables will lead to different or more nuanced conclusions.
The authors offer a number of explanations for their findings, including that innovative firms are more likely to make optimistic/forward looking statements, which they conclude attracts plaintiffs’ attorneys looking for an easy target. On this, I both agree and disagree. I do not agree that plaintiffs’ firms treat these statements as easy “gets” – the PSLRA and the safe harbor ensure that they are not, and every plaintiffs’ attorney knows that. But these statements may nonetheless influence the firm’s stock price, such that the firm is more likely to experience a stock price drop when the rosy predictions do not materialize.* And that drop is what will attract the attention of a plaintiffs’ firm, which may then latch on to the forward-looking statements and the – yes, puffery – if there’s nothing else to grasp.
Which brings me to my final observation. Much of the discussion at Prof. Kempf’s presentation focused on whether she could prove her ultimate point, namely, that securities lawsuits constitute a type of tax on innovation that may ultimately deter firms from innovating in the first place. Even if the paper is correct that securities fraud lawsuits do impose a tax on innovative firms, the question remains: will that tax deter innovation? Or will it deter overclaiming by innovative firms? Because if the latter, then – you know. Yay.
*The authors find that “innovative” firms are no more likely to experience a large stock price drop in reaction to a negative earnings announcement than other firms, but they have not – yet – tested to see whether these firms are more likely to experience a large stock price drop in reaction to other types of announcements.
Saturday, March 31, 2018
Another week, another Delaware Chancery decision in which a powerful, visionary minority blockholder is deemed to have “control” over a corporate board’s decision to acquire a company in which he has an interest.
In In re Oracle Corporation Derivative Litigation, which I blogged about last week, Larry Ellison’s control was enough to show that demand was excused for the purpose of a derivative lawsuit, while the court avoided the question whether Ellison should be formally deemed a controlling stockholder.
In In re Tesla Motors Stockholder Litigation, however, the question could not be avoided. That’s because – unlike in Oracle – the remaining stockholders voted in favor of the acquisition, which led the defendants to argue that the entire deal had been cleansed under Corwin v. KKR Financial Holdings LLC. Since Corwin does not apply to controlling stockholder transactions, Elon Musk’s status became critical.
Briefly, Elon Musk is the Chair, CEO, largest stockholder (22% at the time of the acquisition), and dominant face of Tesla. He was also one of the founders of SolarCity, along with his cousins. When SolarCity neared bankruptcy, Tesla acquired SolarCity at a significant premium to its market price. Though Musk formally recused himself from the Tesla board’s vote, he badgered the board into considering the acquisition (proposing it on three separate occasions within three months), hired the board’s financial and legal advisors, and ran the deal process. Meanwhile, the board voted to approve the deal without forming a special committee. (Sidebar: If the documents are made available under Wal-Mart Stores, Inc. v. Indiana Electrical Workers Pension Trust Fund IBEW, I cannot wait to find out what Wachtell – the board’s deal advisor – had to say about that.) Tesla shareholders sued, alleging that the transaction was a bailout of Musk’s company, paid for with Tesla’s assets.
The court, per VC Slights, concluded that, at least for pleading purposes, plaintiffs had alleged that Musk was a controlling shareholder. Slights rested his decision on Musk’s status as a visionary CEO, his substantial stockholdings, his close business and personal ties to Tesla board members who earned multi-million dollar salaries for their service, his domination of the process which led to the acquisition, the board members’ own ties to SolarCity, and SolarCity’s precarious financial position.
Slights recognized the awkwardness of his holding when compared with the Delaware Supreme Court’s recent conclusion in Dell, Inc. v. Magnetar Global Event Driven Master Fund Ltd that Michael Dell was not a controlling stockholder of the company that bore his name. Nonetheless, he justified his conclusion on the ground that the buyout in Dell involved several procedural protections (including the use of an independent special committee and Michael Dell’s pledge to cooperate with any buyer) that the Tesla board’s decision lacked.
But that reasoning collapses two separate ideas: whether someone has controlling shareholder status, which requires them to utilize heightened procedural protections to win business judgment deference, and whether a controlling stockholder has, in fact, employed such protections.
What both Tesla and Oracle really illustrate, then, is the inadequacy of pinning the level of judicial scrutiny to a bright line distinction between controlling and noncontrolling stockholder status in the first place. Yes, Musk was a large stockholder, but his stockholdings were the least important mechanism by which he dominated the board (and potentially influenced voting stockholders as well). We can call this yet more Corwin fall out: by heightening the significance of the stockholder vote only for transactions that fall into a specific category, the Delaware Supreme Court wound up placing pressure on the boundaries of that category.
What also stands out about the Tesla opinion – as with Oracle before it – is Delaware’s continued willingness to cast a gimlet eye on the webs of social and business relationships (especially with venture capital firms) that often tie boards together, particularly in tech companies. This is a point that Chief Justice Strine has been pushing, most recently at Tulane’s Corporate Law Institute, and what we are apparently seeing is that such relationships may not only evince a lack of independence, but may even count toward controlling shareholder status, as courts try to grapple with Corwin’s constraints.
Saturday, March 24, 2018
I am intrigued by VC Glasscock’s recent decision in In re Oracle Corporation Derivative Litigation, where he found that demand was excused with respect to a claim that Larry Ellison breached his fiduciary duties by functionally directing that the company acquire Netsuite, in which he owned a 39% stake.
First, the treatment of Larry Ellison: He only owns 27% of Oracle and, though he remains Chair of the Board, he no longer occupies the role of CEO. Nonetheless, the court was willing to draw the pleading-stage inference that he functionally has control of the company, such that both the outside and inside directors would fear for their positions if they crossed them. Yet at the same time, the court was unwilling to go so far as to formally designate him as a “controlling shareholder,” with all of the scrutiny that role would attract. In some ways, this is a welcome recognition that control is not simply an on/off switch: degrees of control may exist along a spectrum, and may compromise (nominally) independent directors’ judgment only so long as the relevant decision is not too extreme. At the same time, Delaware law tends to treat control status as binary, and in the past has only recognized the existence of control under a fairly narrow set of circumstances (cf. Corwin v. KKR, 125 A.3d 304 (2015), where the court refused to recognize KKR as a controlling shareholder of Financial Holdings, despite the fact that Financial Holdings was run by a KKR affiliate and existed to provide financing services to KKR).
Second, the treatment of the Board members: The court concluded that 6 board members were conflicted, in large part because – following Sandys v. Pincus and Delaware County Employees Retirement Fund v. Sanchez – nominally independent directors in fact were entangled in a web of business and social relationships with Ellison and Oracle that would likely hinder their ability to impartially consider whether to file suit against Ellison. None of these relationships would, by themselves, have disqualified any of the Board members (such as, for example, dependence on Ellison for participation in a cross-firm consulting initiative, and involvement in venture capital firms that look to Oracle as a potential acquirer), but the court found that the relationships collectively functioned to render the directors beholden to Ellison. This holding signals that going forward, corporate directors are taking a risk if they tolerate or encourage extensive relationships with each other outside of the boardroom.
Thirdly, the treatment of shareholder votes: In determining that one board member lacked independence from Ellison, the court took into account the fact that as a member of the compensation committee, he had ignored repeated shareholder “withhold” votes and shareholder votes to reject Oracle’s executive pay practices. In previous decisions, courts have refused to treat precatory shareholder votes on pay as having any legal significance, see Lisa Fairfax, Sue on Pay: Say on Pay’s Impact on Directors' Fiduciary. Duties, 55 Ariz. L. Rev. 1 (2013); it seems someone found a use for them. (I do wonder if there’s bitter with this sweet: Do approvals of "comically large" pay packages signal that directors’ actions have been approved by shareholders and therefore merit less judicial scrutiny?)
Finally, the court reserved judgment on the question whether In re Cornerstone Therapeutics Inc. Stockholder Litigation, 115 A.3d 1173 (Del. 2015) requires it to dismiss the complaint as to board members who lacked independence from Ellison for demand purposes, but against whom no claim had been stated regarding the underlying transaction.
All in all, it’s a fraught opinion and I look forward to seeing how it influences other decisions going forward.
Friday, March 16, 2018
It’s that time of year again! Tulane is hosting its 30th Annual Corporate Law Institute, a 2-day conference devoted to developments in corporate law, particularly mergers & acquisitions.
I was only able to attend some of the panels on the first day, but I very much enjoyed getting a sense of what lawyers – and judges – are thinking about these days. Below is a summary of some of the highlights that I found most intriguing:
[More after the jump]
Saturday, March 10, 2018
I’ve been consumed by the latest twist in Broadcom’s attempt at a hostile takeover of Qualcomm: the dramatic entrance of CFIUS.
For those who haven’t been following the saga, Broadcom, a Singaporean technology company, has been attempting to acquire San Diego-based Qualcomm for months. After its attempts at a friendly merger were rebuffed, it launched a proxy contest, proposing its own nominees to replace Qualcomm’s existing directors.
Qualcomm responded with what is apparently becoming de rigueur in contested proxy solicitations: in addition to setting up a website devoted to making its case to shareholders, it also promoted various tweets on the subject.
One intriguing aspect of Qualcomm’s argument has been that – as a leader in research and development – the merger would be bad for innovation and consumers. This point is reiterated on its website, which fascinates me because it assumes that investors as investors would be persuaded by an argument directed toward consumer wellbeing.
That may not have been the right tack; according to news reports, at least some large shareholders were poised to vote for Broadcom, giving Broadcom a fighting chance at a hostile takeover.
But the day before the crucial shareholder meeting, Qualcomm won a reprieve: the Committee on Foreign Investment in the United States (CFIUS) asked that the vote be delayed so that it could review whether the transaction posed a threat to national security.
CFIUS, Chaired by the Secretary of the Treasury and staffed with representatives of most major federal departments, is charged with reviewing proposed mergers and acquisitions in which a foreign entity proposes to gain control of a domestic one, to ensure that the transaction will not pose national security risks. It can intervene on its own accord when a transaction raises red flags or – more commonly – the parties can ask for pre-acquisition review to ensure that problems will not arise later. In this case, Qualcomm asked for the review, in an elegant example of the use of the regulatory system as a takeover defense mechanism that is sure to serve as a classroom example for decades. (Check out the wording of CFIUS’s letter: “Qualcomm is a global leader in the development and commercialization of foundational technologies… Qualcomm led the mobile revolution in digital communications technologies…” – did Treasury write this or Qualcomm’s PR department?)
CFIUS’s eleventh-hour appearance is quite the eyebrow-raiser. For one thing, it tests the outer boundaries of what counts as foreign control. And that’s not just because of the technical definition of what it means to be foreign – as the New York Times points out, Broadcom’s employees and properties are mostly located in the US, and the company has plans to relocate its headquarters to US this year – but because it’s unclear that Broadcom is, at this time, seeking “control.”
As its proxy filings indicate, Broadcom’s nominees for Qualcomm’s board have no prior relationship to Broadcom and mostly appear to be American. Broadcom is not a controlling shareholder, and its nominees will only gain board positions with the support of Qualcomm’s remaining (American) shareholders. Though of course Broadcom expects that eventually these directors will agree to allow Broadcom to acquire Qualcomm’s stock, that is by no means certain (remember Airgas??) and Broadcom has no legal power to compel them to do so. It is therefore a stretch to categorize the proxy fight itself as a “merger, acquisition, or takeover that is proposed or pending … by or with any foreign person which could result in foreign control of any person engaged in interstate commerce in the United States,” which is the only matter over which CFIUS has jurisdiction. Indeed, this precise point apparently troubled Sec. Mnuchin.
The other stunner is the national security risk that CFIUS identifies, namely, the fact that Broadcom’s investment strategy involves cutting R&D spending, which might hobble Qualcomm’s efforts to develop 5G technology. As CFIUS itself concedes, this is the investment strategy of many – American – private equity firms, and is unrelated to Broadcom’s (nominally) foreign status; it is simply the fact that Broadcom happens to be foreign that gives CFIUS jurisdiction to insert itself into the dispute. Steven Davidoff Solomon calls this an example of “realpolitik,” namely, an acknowledgement that China – our main competitor in the 5G space – has a government policy of assisting private development of technology.
Broadcom has responded to all of this with pledges to continue spending on R&D and even to sponsor a new initiative dedicated to training American engineers, but my bottom line reaction is that if the US is so concerned about keeping American tech companies competitive, it might reconsider all those new immigration policies that are scaring talent away to other countries.
Edit: Jinx, buy me a Coke - after I typed this post up, a Qualcomm shareholder filed a lawsuit in Delaware arguing that by inviting CFIUS to review the deal using spurious arguments of foreign control, Qualcomm directors violated their fiduciary duties. I can't say I have high hopes for the suit's chances, at least to the extent it rests on CFIUS's actions, but I did find one detail interesting: the original CFIUS order apparently required that the shareholder meeting be postponed and proxies cease being accepted or counted; CFIUS then modified the order to call for an adjournment of the meeting and to permit proxies to be solicited. The plaintiff contends this was done at Qualcomm's urging, to permit it to continue to try to lobby shareholders to change their votes.
Saturday, March 3, 2018
George Geis at the University of Virginia has just posted Traceable Shares and Corporate Law, exploring the implications that blockchain technology will have on various aspects of corporate law that – until now – hinged on the presumption that when one person buys a share of stock in the open market, there is no prior owner who can be identified. The ownership history of a particular share cannot, in other words, be traced.
That lack of traceability has a lot of important effects. For example, it means that if a company issued stock pursuant to a false registration statement, but also issued additional stock in another manner, plaintiffs may not be able to bring Section 11 claims because they cannot establish that their specific shares were traceable to the deficient registration. In the context of appraisal, it has led to questions of whether petitioners who obtained their shares after the record date have an obligation to show that the prior owners of the shares did not vote in favor of the merger (an impossible task). If blockchain technology makes it possible to trace the owners of a share from one transfer to another, these areas of law may be dramatically altered.
The most intriguing part of the paper, however, is where Geis goes further, and inquires whether traceability could cause us to rethink fundamental corporate doctrines. For example, he points out that fraud-on-the-market doctrine is often criticized because some shareholders may benefit from the fraud – in the form of rising share prices – but do not have to pay any damages if they sell before the crash. He provocatively suggests that with traceable shares, subsequent purchasers might have claims against the transferors – which might then incentivize selling shareholders to more closely attend to matters of corporate governance.
I find the proposal fascinating, because it would function, essentially, as a kind of targeted veil-piercing. Though I doubt legislatures and courts would have much appetite for such a rule, it makes for an interesting thought experiment to imagine how it might play out. Presumably, such a rule would not depend on inside information – insider trading prohibitions already would permit disgorgement in those circumstances – so we have to assume the selling shareholders were relying on public information when making their trades. I also assume such liability would be more palatable when imposed on institutional investors of a certain size than on retail investors. Would institutions have a defense if they showed they tried to be good corporate stewards, objected to, say, pay packages that encouraged risk-taking and the like? Especially if they could also show they used an index strategy and so engagement was their only tool to monitor their investments?
One downside, of course, would be potential losses to market efficiency. If shareholders cannot gain by selling stock of companies that they believe are overvalued, prices will become less informative. Indeed, the act of selling out may be exactly the best way to exert pressure on management to govern more responsibly.
In any event, I think Geis is correct when he predicts that traceable shares are in our future – and we may have to rethink a lot of corporate law as a result.
Saturday, February 24, 2018
At this point, drawing inferences from corporate jet usage is its own mini-genre in the business literature. There was David Yermack’s famous Flights of Fancy, which found that companies underperform when the CEO makes use of the company jet for personal business (often, apparently, golfing-related business); other studies have found that corporate jet use can enhance firm value, or detract from it, depending on whether the company has weak corporate governance, and that public firms have larger jet fleets than firms owned by private equity funds, suggesting the excessive fleet size is due to agency costs in public firms.
(And these studies, naturally, were conducted before everyone knew about GE’s now-discontinued practice of having its CEO travel with a jet and a spare.)
Now there’s a new contribution to the genre: Corporate Jets and Private Meetings with Investors, by Brian J. Bushee, Joseph J. Gerakos, and Lian Fen Lee.
The authors begin with the previously-documented phenomenon that when investors have the opportunity to engage in private meetings with corporate management, their trading improves. Regulation FD prohibits management from providing these investors with nonpublic material information, but somehow – whether through outright violations of the rule or simply subtle cues that the investors can synthesize with their own information – these meetings benefit investors who are fortunate enough to have the opportunity to participate in them.
The rest of the world, however, usually doesn’t know when these meetings are taking place. If they occur at a publicized conference researchers can deduce their existence, but otherwise, there’s no obvious way to tell.
The authors figured out that they could deduce when private meetings were taking place by tracking corporate jet usage. They found that when the corporate jets were used to rapidly fly to multiple cities where their investors are based, there are increases in the level of local institutional stock ownership, and detectable market reactions (which the authors attribute to investors acting on what they believe to be improved private information). The authors also found that these trips were more likely to occur when the firm was undergoing various conditions that might increase investors’ demand for information.
The part that I find interesting, though, is that evidence was mixed as to whether institutions were actually benefitting from these meetings in the form of trading gains – and they were more likely to do so when the trips were taken to large cities with finance industries rather than to other locations. The authors don’t say it, but that piece makes me wonder if there’s a distinction in investor sophistication at play; all investors are not created equal, and some institutions may be better able to make use of the information revealed in private meetings than others.
Saturday, February 17, 2018
The possibility lurking in Dell, Inc. v. Magnetar Glob. Event Driven Master Fund Ltd, 2017 WL 6375829 (Del. Dec. 14, 2017), has now materialized.
For those of you just joining us, in Dell and DFC Glob. Corp. v. Muirfield Value P’rs, L.P., 172 A.3d 346 (Del. 2017), the Delaware Supreme Court threw some cold water on the practice of appraisal arbitrage. The two decisions suggest that in an appraisal action, courts should not try to conduct their own valuation of a company except in unusual circumstances; instead, where the deal was negotiated appropriately, the deal price itself represents the best evidence of fair value.
That alone would be enough to discourage would-be appraisers, absent evidence of significant dysfunction in the process by which the deal price was reached, but the decisions went further: both contained extensive endorsements of the efficient markets hypothesis and the accuracy of market pricing. In the context of the opinions themselves, the market price discussions were puzzling, because they played little role in the Court's actual analysis. In both cases, the Court ultimately suggested that the deal prices - which were above market price - were appropriate. At the same time, however, in neither case did the defendants argue that the deal price included value arising from the merger itself (which is unavailable in an appraisal action) - a point that the DFC court in particular highlighted.
That left open the possibility that in future cases, defendants would be able to successfully argue that the market price of a publicly traded company is the best evidence of its value, and that any premium above that amount represents value arising out of the merger. Such an argument would leave appraisal petitioners with, at best, market price - which is usually a figure less than the deal price, rendering the appraisal remedy itself not worth pursuing for most publicly-traded companies. Worse, it would do so even in situations where there were significant problems in the deal negotiations. After all, no matter how hair-raising the process by which the deal price was reached, if that price was above market price - and if market price is evidence of the standalone fair value of the target as a going concern - then appraisal provides no remedy.
Well, that's what just happened. In Verition Partners Master Fund, Ltd., et al. v. Aruba Networks, Inc., C.A. No. 11448-VCL, memo. op. (Del. Ch. Feb. 15, 2018), VC Laster concluded that after Dell, he had no choice but to accept the market price as the best evidence of the target's fair value - even in the face of evidence that the acquirer made an employment offer to the target's CEO while negotiations were continuing (in violation of a prior agreement with the target, and without the Board's knowledge), and in the face of evidence that the target's financial advisors were trying to curry favor with the acquirer. As a result, he awarded the dissenters the pre-deal market price of $17.13 per share, a figure significantly below the merger price of $24.67 per share.
It appears that unless the Delaware Supreme Court steps in to say this isn't what it meant in Dell and DFC, going forward, appraisal arbitrageurs will have to show both that there were dysfunctions in deal negotiations, and that there were significant reasons to distrust the pre-deal market price, before they can hope to come out ahead. That'll be quite an uphill climb.
Saturday, February 10, 2018
Socially responsible investing is all in the news these days, as several large asset managers and advisors have publicly declared commitments, of one kind or another, to pressuring portfolio companies to act in socially responsible ways.
Commenters debate whether these managers genuinely believe social responsibility will improve value at portfolio companies, or whether they are trying to appeal to the preferences of clients who themselves favor socially responsible investing, either as a mechanism for improving value, or, more probably, as a matter of, essentially, “taste.” If you’re going to invest an index fund, for example, you may as well invest in the one where you believe your dollars will also be used to push for your preferred agenda – even if little is actually being done in that direction.
The reason it’s so difficult to suss out anyone’s exact motive, of course, is that it’s tough to admit – as an asset manager or any kind of institutional investor – that you’re interested in anything other than financial returns. Not simply because of the publicity you’ll generate, but because it’s not clear how far fiduciary obligations allow fund managers to go in pursuing social goals.
(This is, of course, one of the ways in which reductionistic fiduciary duties strips out the real concerns of the ultimate humans the duties are designed to benefit).
Which is why I found the letter by Jana Partners announcing its new social activism fund – and targeting Apple – so intriguing. In a partnership with the California State Teachers Retirement System (who is not, at least yet, an investor in the fund), Jana is urging Apple to institute stronger parental controls on the iPhone. Now, there’s been a lot of commentary about Jana’s motivations - is Jana truly trying to profit via social activism? Or is this a loss leader so that it can cultivate relationships with kinds of institutions it needs to support its more traditional activist campaigns?– but what intrigues me are the interests of CalSTRS.
Because the letter spends most of its time talking about how better controls will ultimately prove profitable for Apple and thus Apple’s shareholders, but concludes by pointing out that the issue is “of particular concern for CalSTRS’ beneficiaries, the teachers of California, who care deeply about the health and welfare of the children in their classrooms.”
In other words, the subtext is that CalSTRS’ interest is for teachers as teachers – not necessarily for teachers as shareholders.
This is hardly the first time a pension fund has shown its hand in this way, but it does highlight how funds are even more constrained than businesses in terms of openly pursuing socially responsible goals, and the delicate tapdance they sometimes do around that fact.
Saturday, February 3, 2018
All circuits agree that loss causation can be shown via “corrective disclosures” – some kind of explicit communication to the market that prior statements were false, followed by a drop in stock price.
However … there has been an alternative theory that plaintiffs can use to show loss causation, even without an explicit corrective disclosure. The theory is usually described as “materialization of the risk.” It requires the plaintiff to show that the fraud concealed some condition or problem that, when revealed to the market, caused the stock price to drop, even if the market was not made aware that the losses were due to fraud. For example, a company may report a slowdown in sales, causing its stock price to fall, while concealing the fact that the slowdown was due to an earlier period of channel stuffing. By the time the channel stuffing is revealed, it may communicate no new information about the company’s prospects, so the stock price remains unmoved. Under a materialization of the risk theory, the price drop upon disclosure of the fall in sales would be sufficient to allege loss causation.
To be sure, very often cases fall along something more akin to a spectrum, with district courts demanding more or less of a connection between the disclosure and the underlying fraud before permitting plaintiffs to proceed; nonetheless, the broad guidance offered at the circuit level influences those determinations. Thus it was significant that, for a time, three circuits – the Fifth, Sixth, and Ninth – were reluctant to recognize “materialization of the risk” theory, and required plaintiffs to clear the more restrictive “corrective disclosure” hurdle.
In July 2016, as I previously described, the Sixth Circuit joined the majority of circuits and endorsed “materialization of the risk” theory. That left just the Fifth and the Ninth Circuit on the side of corrective-disclosure-only, with a case then-pending before the Ninth Circuit that directly presented the question.
That decision has just been released. In Mineworkers’ Pension Scheme, et al v. First Solar Incorporated, et al, the Ninth Circuit, as well, held that “A plaintiff may also prove loss causation by showing that the stock price fell upon the revelation of an earnings miss, even if the market was unaware at the time that fraud had concealed the miss…. This rule makes sense because it is the underlying facts concealed by fraud that affect the stock price. Fraud simply causes a delay in the revelation of those facts.”
The per curiam opinion stated that the matter had already been resolved by an earlier Ninth Circuit case, which … I, ahem … dispute, but regardless, it’s apparently settled now.
By my count, that leaves the Fifth Circuit standing alone. Your move, Fifth Circuit.
Saturday, January 27, 2018
The Delaware Supreme Court finally issued its decision in Cal. State Teachers Ret. Sys. v. Alvarez, and it appears we don’t have one neat trick for dealing with races to the courthouse in derivative litigation after all.
As I’ve discussed in previous blog posts, Delaware has a substance and procedure problem. Namely, it uses its own court procedures as supplemental mechanisms to substantively police the behavior of corporate actors, but those procedures don’t apply in non-Delaware forums. That leaves Delaware vulnerable to being undercut by other states – and encourages an unhealthy race to the courthouse in other jurisdictions.
As I explained before, in the context of derivative cases, “Delaware’s recommendation that derivative plaintiffs seek books and records before proceeding with their claims simply invites faster filers to sue in other jurisdictions – and invites defendants to seek dismissals against the weakest plaintiffs, which will then act as res judicata against the stronger/more careful ones.”
That’s what happened in Alvarez. While the Delaware plaintiffs spent years litigating a books and records request, defendants won a dismissal for failure to plead demand futility against a competing plaintiff group in Arkansas. The Chancery court then held that the dismissal was res judicata against the Delaware plaintiffs.
On appeal, the Supreme Court remanded with a curious request: to determine whether the dismissal violated the Delaware plaintiffs’ federal Due Process rights. The reasoning, first articulated by VC Laster in In re EZCORP Inc. Consulting Agreement Deriv. Litig., 130 A.3d 934 (Del. Ch. 2016), was that until a court concludes demand is futile, the plaintiff has no right to bring suit on the corporation’s behalf, and therefore acts individually. Laster analogized to the Supreme Court’s decision in Smith v. Bayer Corp., 564 U.S. 299 (2011), which held that a named plaintiff in a class action cannot bind the class until after certification.
On remand the Chancery court couldn’t quite bring itself to hold that federal Due Process was violated, exactly, but did suggest that the Delaware Supreme Court adopt a rule prohibiting preclusion in these circumstances, in part because such a rule would further public policy.
That decision was appealed back up to the Delaware Supreme Court, which has now rejected the recommendation. The Supreme Court concluded that a derivative case is unlike a class action, because in a class action, pre-certification, the named plaintiff is suing on his or her own behalf, bringing a claim that he or she is entitled to bring individually. By contrast, in a derivative action, the stockholder plaintiff never has the right to bring a claim individually; the claim always belongs to the corporation. Thus, even absent demand futility, the plaintiff must be viewed as standing in the corporate shoes. By this reasoning, derivative plaintiffs are in privity with each other, and there is a sufficient alignment of interests to satisfy Due Process.
In short, absent a showing of inadequate representation by the first plaintiffs, res judicata applies.
The Delaware Supreme Court did have a curious footnote though and I wonder if it provides an opening in future cases. The Court noted that had Delaware plaintiffs attempted to intervene in the Arkansas action – or, failing grounds to intervene, at least filed a statement of interest or sought to participate as amici – they might “have a more compelling argument before this Court that the Arkansas Plaintiffs failed to adequately represent them.” We’ll see if anyone tries to take advantage of that going forward.