Our legal system is one of our society’s crowning achievements. But for all of its grandeur, our legal system is not without its flaws. Among other things, our system encourages litigiousness that all too often involves frivolous suits and lawyers’-fee driven litigation, including the recent phenomenon of multi-jurisdiction derivative litigation driven by plaintiffs’ lawyers competing to get control of the dispute in order to try to capture the fee.
Two separate opinions this past week – one out of the Seventh Circuit and one from the Delaware Court of Chancery – harshly criticized these kinds of practices. Both of the opinions were entered in shareholders’ derivative lawsuits, too. Though both of the cases are sharply critical of fee-driven plaintiffs’ lawyers’ practices, only one of the cases resulted in the dismissal of the suit. Interestingly, in the Delaware case, owing to the Court’s disdain for the practices of “fast-filing” plaintiffs’ firms in parallel California proceedings, the Delaware case will be going forward.
The Allergan Case in Delaware
In September 2010, Allergan pled guilty to a criminal misdemeanor for misbranding its Botox product and paid a total of $600 million in civil and criminal fines. Various plaintiffs’ firms filed multiple derivative suits both in federal court in California and in Delaware. The California cases went forward more quickly, while in Delaware, at least one of the plaintiffs sought to pursue a books and records action against the company, in order to obtain further information pertinent to the company’s board. The Delaware plaintiff used the information and documentation to amend its complaint. The California plaintiffs ultimately also obtained the same information and documentation and supplemented their complaint as well.
The defendants moved to dismiss the California action on the ground that the plaintiffs had not made a demand on the Allergan board to pursue the claims, nor had they established demand futility. The California court granted the defendants’ motion to dismiss. The defendants then sought to have the Delaware action dismissed, arguing that the collateral estoppel effect of the California dismissal was preclusive of the demand futility issue.
In a massive and muscular June 11, 2012 opinion (here), Delaware Chancery Court Vice Chancellor Travis Laster firmly rejected the suggestion that the California court’s prior ruling compelled him to dismiss the Delaware action. He relied on two grounds in rejecting the argument that the California judgment is preclusive; first, he found that the California judgment was preclusive only as to the individual California shareholder plaintiffs, and second, he found that the California plaintiff did not adequately represent Allergan.
Both of these lines of analysis are interesting and so I discuss both below, but it is the inadequate representation issue that is the main interest to this blog post.
Vice Chancellor Laster first held that question of whether or not pre-suit demand is futile is controlled by the internal affairs doctrine and therefore governed by the law of the state of incorporation – in this case, Delaware. It should not, he said, be governed by potentially different rules across “twelve different circuits, fifty states and the District of Columbia, Puerto Rico and the other territories.”
He held further that under Delaware law a shareholder seeking to pursue a derivative claim on behalf of a corporation represents only his own individual interest until it is established that he has the right to pursue the claim. Because the California plaintiff was found not to have the right to pursue the claim, the California court’s judgment is preclusive only the California plaintiff alone, not on all other shareholders or the corporation (that is, the California plaintiff is not in “privity” with the other shareholders).
As an independent basis for rejecting the preclusive effect of the California judgment, Laster held that the California plaintiffs did not adequately represent Allergan. In concluding that the California plaintiff had not provided adequate representation, Laster launched a lengthy disquisition of the motivations and actions of the specialized plaintiffs’ shareholder bar and the specific actions taken on this case.
These specialized firms face a competitive environment where they often can only control the case and capture the fee if they are the first-to-file. The first-filed rule “incentivizes the plaintiffs’ lawyers to file as fast as possible in an effort to gain control of the litigation.” These firms, facing first-to-file pressure “rationally eschew conducting investigations and making books and records demands, fearing that any delay would enable to gain control of the litigation.” As he put it, “No role, no result, no fee.”
For the “fast-filing lawyers” their lawsuit “has the dynamic of a lottery ticket,” since in most cases their hastily prepared complaint will risk dismissal. However “in the rare case, fate may bless the fast-filer with something implicating the board,” which will make the case likelier to survive the motion to dismiss and improve the settlement value of the case exponentially.
“A fast-filer” can “readily build a portfolio of cases in the hope that one will hit.” Filing a derivative claim “is relatively cheap” and search costs are minimal. Indeed, derivative plaintiffs “often piggyback on the efforts of other specialized plaintiffs’ firms.” The lawyer’s “most difficult task will be finding a suitable plaintiff.’
The “first-to-file” regime “disserves stockholder interests across multiple dimensions.” It prevents plaintiffs’ lawyers from “acting optimally” and “forces defendants to respond to multiple complaints in multiple jurisdictions” but at the same time gives defendants litigation advantages, because the hastily filed complaints are more likely to be dismissed. Noting Delaware’s courts’ resistance to the first-to-file regime, Laster commented that “a state that ritualistically favored defendants might embrace such a regime, but Delaware has a long history of striving to balance the interests of stockholders and managers to craft an efficient corporation.”
Laster found that the California proceedings demonstrate all of the shortcomings with the race-to the courthouse phenomenon:
By leaping to litigate without first conducting a meaningful investigation, the California plaintiffs’ firms failed to fulfill the fiduciary duties they voluntarily assumed as derivative action plaintiffs. Rather than seeking to benefit Allergan, they sought to benefit themselves by rushing to gain control of a case that could be harvested for legal fees. In doing so, the fast-filing plaintiffs failed to provide adequate representation.
Moreover, the California plaintiff’s shortcomings were not later redeemed when the California plaintiff belatedly asked for and received the fruits of the Delaware plaintiff’s books and records action. Laster concluded that “rather than representing the best interests of the corporation, the California plaintiffs sought to maximize the potential returns of the specialized law firms who filed the suit on their behalf.”
Having rejected the defendants’ suggestion that the California court’s determination was preclusive on the issue of demand futility, Laster then went on and rejected the basis on which the California court had determined that demand was futile. He said that he found the California court’s analysis “unpersuasive.” He concluded that the Delaware plaintiffs, pleading with the benefit of the results of their books and records action, had established that demand was excused as futile.
The Seventh Circuit’s Decision in the Sears Case
Following the 2005 merger of Kmart and Sears, the merged company board included two individual directors who also served on the boards of other companies that competed with Sears. Two Sears shareholders filed a derivative lawsuit alleging that the two directors’ interlocking directorships violated the Clayton Act. Sears moved to dismiss the suit on the grounds that the plaintiffs had not made a pre-suit litigation demand on the Sears board. Northern District of Illinois Judge Ronald Guzman denied the motion to dismiss. Faced with the prospect for further litigation, Sears agreed to a settlement of the case that consisted of agreements for one of the two directors to step down and for the defendants not to object to the plaintiffs’ attorneys’ fee request of $925,000.
Sears shareholder Theodore Frank moved to intervene in the case in order to object to the settlement. Judge Guzman denied Frank’s request to intervene. Frank appealed the denial of his request to intervene. In a June 13, 2012 opinion written by Chief Judge Frank Easterbrook for a three-judge panel of the Seventh Circuit (here), the appellate court ruled that Frank’s motion to intervene had been improperly denied. That determination would seem to represent all that the appellate court was called upon to do. But the Court did not stop there; it went on to add a few choice words about the case (and perhaps about the District Court as well).
The district court’s reason for denying Frank’s motion to intervene, the Seventh Circuit said, is “unsound.” The district court denied the motion because the existing plaintiffs adequately represented Frank’s interests. But as the Seventh Circuit said, “that the plaintiffs say they have the other investors’ interests at hear does not make it so.” The Seventh Circuit emphasized that its case decisions encourage liberal allowance of intervention.
“We could,” the Court said, “stop at this point and leave the parties to slug it out In the district court.” But, “this litigation is so feeble that it is best to end it immediately.” The only goal of this suit “appears to be fees for the plaintiffs’ lawyers.” It is “impossible to see how the investors could gain from it – and therefore impossible to see how Sears’ directors could be said to violate their fiduciary duty by declining to pursue it.” The court went on to note how unlikely it is that a consumer or regulator would pursue any claim based on the interlocking directorates.
It is “an abuse of the legal system to cram unnecessary litigation down the throats of firms whose directors serve on multiple boards, and then use the high costs of antitrust suits to extort settlements (including undeserved attorneys’ fees) from the targets.”
In short, the Court said, “the suit serves no goal other than to move money from the corporate treasury to the attorney’s coffers, while depriving Sears of directors whom its investors have freely elected.”
Discussion
In both of these two decisions, the courts criticized derivative actions motivated by plaintiffs’ attorneys’ desire to collect a legal fee but otherwise to the detriment of the company involved. To the extent the views expressed in these opinions represent an evolving judicial view of how some plaintiffs’ firms are conducting business, they could represent a troubling threat to the business model of at least certain parts of the plaintiffs’ bar
But though there are similarities of perception and expression between these two cases, there are some very important differences between the two cases as well. For example, as a result of the Seventh Circuit’s opinion, the Sears case, which was to have continued to go forward in the district court (owing to the fact that the proposed settlement had for unrelated reasons come apart), will now not be going forward. By contrast, owing to Vice Chancellor Laster’s opinion, the Allergan case, which seemed like it was over as a result of the California court’s opinion, will now be going forward in Delaware.
The Seventh Circuit was concerned that the district court had allowed a fee-driven frivolous suit to go forward (and it certainly does seem as if its opinion in the Sears case is a very carefully aimed slap at the district court); Vice Chancellor Laster seems concerned that as a result of inadequate actions of fee-driven plaintiffs’ lawyers proceeding in another jurisdiction, a potentially meritorious case was being threatened with being shut down.
The key may be Laster’s insight that the hastily prepared “first to file” complaints actually benefit the defendants, as the cobbled together complaints are easier to get dismissed – which is what happened in California. Laster also seemed troubled that the Delaware plaintiffs, who were in his court and who had proceeded deliberately, could have deprived of the benefit of their labors owing to the hasty actions of the inadequately prepared California plaintiff.
An important context for Vice Chancellor Laster’s opinion is the ongoing problem of multi-jurisdiction litigation and the jurisdictional competition that has ensued. Laster seems to have just about had it with courts in other jurisdictions presuming to interpret and apply Delaware corporate law and making a mess of it. You can imaging him shaking his head in disgust as he notes, first, the plaintiffs’ lawyers rushing to file actions in other jurisdiction’s court and making a hash of it, and then the courts in those other jurisdictions making a further mess of the situation.
It will not be lost on any plaintiffs’ lawyers in the room that the outcome of Laster’s opinion is that a case that appeared dead will now be going forward. It is as if to say to the plaintiffs’ bar, go ahead, rush off to those other courts and file your actions if you want, maybe the lottery ticket will produce a winner. But take your time and prepare appropriately, and file your suit in Delaware, and you will receive a full and fair hearing. Laster expressly contrasts Delaware with a (supposedly hypothetical) state “that ritualistically favored defendants.” Delaware, he said, “has a long history of striving to balance the interests of stockholders and managers to craft an efficient corporation law.” The message to the plaintiffs ‘ bar seems to be that Delaware’s courts are open for business – and its courts are not going to be put off by competing litigants pushing ahead on other courts.
Maybe I am reading too much into Judge Laster’s opinion. But it sure seems like there are some things for defendants to worry about here. Not just the fact that the case is going forward after being dismissed in California. It is this case, taken in combination with other developments – such as the massive plaintiffs’ award in the Southern Peru case—that seemingly would give corporate defendants cause for concern. The question for defendants is what to make of these developments and what they might mean as Delaware tries to protect its turf in the jurisdictional competition.
There is still the problem of the lack of recognition given to the California court’s ruling on the demand futility issue. As Alison Frankel said in her June 12, 2002 article in her On The Case blog (here) discussing Laster’s ruling, Laster’s collateral estoppel analysis could prove to be “very controversial.” The principles of judicial efficiency militate very heavily in favor of a presumption that issues are decided only once. Anything that seemingly gives litigants a second bite at the apple flies in the face of these principles.
The prospects of multiple, competing demand futility determinations is potentially troubling. Multi-jurisdiction litigation may be the result of the actions of a competitive, fee driven plaintiffs’ bar, but it is not going to go away any time soon. It is already a serious problem. But if courts stop giving effect to determinations made in other courts, the problems of multi-jurisdiction litigation could get a whole lot worse.
All of that said, it is very encouraging to see courts actively worrying about problems caused by frivolous and fee-driven litigation. If these opinions do represent an evolving judicial perception about the motivations driving certain kinds and categories of litigation, the environment for that type of litigation has become decidedly more hostile. And as Justice Laster’s opinion shows, eliminating the abuses would be a good thing not just for defendants, but also for plaintiffs that proceed responsibly.