Wednesday, October 4, 2017

Revising How to Handle Derivative Claims (or Not)

Yesterday, Professor Bainbridge posted "Is there a case for abolishing derivative litigation? He makes the case as follows: 

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 claim, there seems little reason not to expand the liability limitation statutes to allow corporations to opt out of derivative litigation.

I think he makes a good point.  And included in the market discipline and other measures that Bainbridge notes would remain in place to maintain director accountability, there would be the shareholder response to the market.  That is, if shareholders value derivative litigation as an option ex ante, the entity can choose to include derivative litigation at the outset or to add it later if the directors determine the lack of a derivative suit option is impacting the entity's value.  

Professor Bainbridge's post also reminded me of another option: arbitrating derivative suits.  A friend of mine made just such a proposal several years ago while we were in law school: 

There are a number of factors that make the arbitration of derivative suits desirable. First, the costs of an arbitration proceeding are usually lower than that of a judicial proceeding, due to the reduced discovery costs. By alleviating some of the concern that any D & O insurance coverage will be eaten-up by litigation costs, a corporation should have incentive to defend “frivolous” or “marginal” derivative claims more aggressively. Second, and directly related to litigation costs, attorneys' fees should be cut significantly via the use of arbitration, thus preserving a larger part of any pecuniary award that the corporation is awarded. Third, the reduced incentive of corporations to settle should discourage the initiation of “frivolous” or “marginal” derivative suits.

Andrew J. Sockol, A Natural Evolution: Compulsory Arbitration of Shareholder Derivative Suits in Publicly Traded Corporations, 77 Tul. L. Rev. 1095, 1114 (2003) (footnote omitted). 

Given the usually modest benefit of derivative suits, early settlement of meritorious suits, and the ever-present risk of strike suits, these alternatives are well worth considering.

ADR, Corporate Finance, Corporate Governance, Corporations, Delaware, Financial Markets, Joshua P. Fershee, Litigation, Securities Regulation | Permalink


As far as I'm concerned we already arbitrate derivative claims. In Delaware, courts sit without a jury, judges are experts in the area, and matters are handled very quickly. Because derivative claims involve the whole corporation they should be public, so there's no benefit to privacy. I don't see what arbitration would offer that Delaware doesn't. Modern arbitration, by the way, is increasingly expensive, and often doesn't have things like dismissal and summary judgment.

Posted by: Ann Lipton | Oct 4, 2017 6:47:34 AM

I hear you on arbitration. I am not at all sure it is the best solution at this point, but I do think even adding the option facilitates a discussion that is worth having. Every time I teach derivative suits, I feel like it ends up being similar to veil piercing. I am just not at all clear the cases are leading to especially efficient or equitable outcomes. It may be that litigated cases are less indicative of what the law is facilitating through negotiation and settlement, though, too.

Posted by: Joshua Fershee | Oct 4, 2017 7:16:33 AM

The problem for me is that derivative suits allow a single shareholder to substitute his or her judgment for that of the elected board. A democratic solution would be to submit derivative claims for shareholder approval before they can be brought. If a majority of shareholders (perhaps only disinterested ones?) do not want to pursue the claim, why should the dissenter be allowed to pursue it?

If there's merit and some chance of significant recovery, I'd expect large shareholders to vote to pursue it.

Posted by: Frank Snyder | Oct 4, 2017 8:25:38 AM

Post a comment