Over the past fifteen years, there has been a steady progression of corporate scandals, from Enron to options backdating to the excesses that led to the global financial crisis. These debacles were followed by waves of shareholder litigation. However, according to one legal scholar, the shareholder lawsuits all too often concentrate on enforcing legal duties on and imposing liabilities on the board of directors of the involved companies, to the exclusion of the officers whose misconduct led to their companies’ problems. As a result, the enforcement mechanism that shareholder litigation represents has not been effective in deterring corporate officer misconduct.
In a February 2, 2015 blog post on the CLS Blue Sky blog entitled “Legal Agency Costs: Our Preference to Sue Directors” (here) Oklahoma Law School Professor Megan Shaner contends that in pursuing shareholder litigation, plaintiffs’ lawyers tend to focus on director-specific actions. As also set out in greater detail in her longer scholarly article entitled “The (Un)Enforcement of Corporate Officer Duties” (here), Professor Shaner says that, despite the many high profile examples of officer misconduct, there is a near absence, even in Delaware, of case law discussing officers’ fiduciary duties. This suggests that these duties are not being enforced, at least by way of bringing lawsuits for violations. Shaner contends that in the absence of a functioning enforcement mechanism to hold officers accountable, the fiduciary duties imposed on officers will not have their intended constraining effect. She proposes several reforms to shareholder derivative litigation procedure, in order to remove possible impediments and disincentives for shareholder enforcement of officer fiduciary duties.
Shaner begins her longer article with a discussion of how over time a “culture of deference” to the actions and decisions of corporate officers has evolved. Senior corporate officials have, she contends, “all but subsumed” the board of directors’ role at the central corporate decision-maker. This in turn has led to all too many situations in which senior managers have put their interests ahead of those of the corporation. She cites as examples of this the Enron scandal, the options backdating scandal, and the events at Lehman Brothers and other firms the led to the financial crisis.
Shaner says “the recurring theme of officer malfeasance winding its way through the past fifteen years should not be ignored.” These events, she says, “raise corporate governance concerns and questions about perceived shortcomings in the current system of checks and balances on management power intended to deter misconduct and hold misbehaving managers accountable.”
Our legal system imposes fiduciary duties on corporate directors and officers. However, Shaner contends, the majority of decisions regarding the fiduciary duty doctrine has developed in the director context. There is “surprisingly little case law of commentary on the exact nature and scope of officer fiduciary duties.” The lack of officer fiduciary duty case law “raises questions regarding the effectiveness of the enforcement scheme.” It is, she says, not the fiduciary duties themselves but rather “the failure to enforce those duties as a constraint on officer power that has contributed to these instances of disloyalty and corruption.”
Shaner sees a direct link between the absence of fiduciary duty enforcement against corporate officers (as opposed to directors) and the recurrence of corporate scandals. The enforcement of legal obligations not only provides the means for punishing failures to discharge legal obligations, it also has “the corresponding benefit of incentivizing compliance with rules and regulations.” In order for fiduciary duties to have their “intending constraining effect on officer conduct – deterring misconduct and encouraging compliance ex ante as well as detecting and sanctioning misconduct ex post – it is important that the mechanisms in place to enforce those duties function effectively.”
Because, in the current corporate environment boards often lack the incentive and informational means to monitor management effectively, shareholders often provide the most effective monitoring of corporate officers and enforcing officer fiduciary duties. The primary enforcement mechanism available to stockholders, she says, is the derivative lawsuit. However, procedural rules often create significant hurdles for shareholders seeking to pursue derivative litigation.
Specifically, the demand requirement – taken together with the business judgment rule standards for the assessment of boards’ responses to shareholder litigation demands and the high standards associated with pleading demand futility – – mean at a minimum that the derivative lawsuit process is complex, lengthy and expensive, and ultimately very difficult to pursue successfully.
Shaner proposes reevaluating derivative litigation burdens in an effort to ensure stockholders have a meaningful enforcement mechanism available. In proposing derivative litigation procedural reforms, Shaner acknowledges “abuses by the defendants’ and plaintiffs’ bar, imposition of high litigation costs on the corporation, [and the] limited actual impact on promoting desirable behavior and agency costs.” Nevertheless, Shaner contends, the derivative lawsuit plays an important role in corporate governance, because “it is the most powerful tool available to stockholders in checking management power.”
In order to improve the ability of shareholders to monitor and enforce officer fiduciary duties, Shaner proposes two derivative litigation procedural reforms. First, she suggests that the demand requirement should be modified to excuse the demand requirement in certain circumstances and, second, that the role of the special litigation committee should be limited.
With respect to the demand requirement, she recommends excusing the demand requirement for stockholders that have one percent interest in the corporation, which she says would allow long-term holders of a corporation’s stock to file a derivative lawsuit without first having to satisfy the demand requirement. She proposes further that the extent of the ownership requirement would ratchet down as the length of the period of the shareholder’s ownership increases.
Shaner also proposes to limit or eliminate the role of the special litigation committee. She suggests that there should be a stronger presumption in favor of continuing derivative litigation lawsuits and a more searching judicial inquiry into special litigation committee, with a heavier burden on a committee to justify dismissal. She suggests as an alternative that the board’s ability to make use of a special litigation committee could disappear when the suit is brought by shareholders holding a certain percentage of the corporation’s stock pursues the suit.
In conclusion, Shaner contends that “reevaluating and relaxing derivative lawsuit requirements for stockholders will improve enforcement incentives and aid in ensuring that officers are being held accountable for their fiduciary obligations.”
Shaner’s blog post is interesting and her longer article is scholarly and well-written, and I recommend both. However, while I recommend the articles, I must respectfully dissent from at least some parts of her analysis. In my view, the last thing the American economy needs is more litigation or litigation against more people.
First, I must admit my biases. The way I see it, our litigation system is the creation of lawyers – lawyers acting as legislators, lawyers acting as judges, lawyers acting as law school professors, lawyers acting as, well, lawyers. Not too surprisingly, the one group that litigation regularly and reliably rewards is the lawyers. From time to time there are meritorious lawsuits. All too often, however, litigation is a costly and burdensome waste of time, money and effort.
In my view, the ex post rationalization for derivative litigation is only arguable at best. The ex ante rationalization is even weaker. (By the way, why can’t legal scholars just say “before” and “after” like normal human beings?) Reducing her position to its bare essentials, Professor Shaner basically contends that there would be less corporate officer misconduct if there were more litigation against corporate officers, which would happen if it were easier to sue corporate officers. Her proposal is built on the presumption that more litigation against officers would deter officer misconduct. Personally, I think the conjecture that more litigation against officers would deter officer misconduct is speculative at best.
Let’s take a look at the record. After the era of corporate scandals such as Enron and WorldCom, there was a flood of litigation. A few short years later, we were treated to the unedifying spectacle of the options backdating scandal. The flood of litigation following the corporate scandals didn’t do anything to prevent or deter the subsequent backdating scandal. And by the same token, there was a massive amount of litigation following the options backdating scandal – almost all of it filed as shareholder derivative litigation – yet only a short time later, the global financial crisis followed. There were over 160 options backdating-related derivative lawsuits, but they did nothing to reform corporate behavior in the run up to the financial crisis.
The massive amounts of shareholder litigation following each of these scandals seem to have had little deterrent effect. The successive scandals happened just the same. Moreover, given the scale and nature of each of the succeeding scandals, I think it has to be seriously questioned whether the later misconduct could have been avoided if only a few more officers had been named as defendants in the earlier lawsuits. (And I should add here as an aside that in almost all of the more than 160 shareholder derivative lawsuits that were filed in the wake of the options backdating scandal, many of the corporate officers who received the backdated options were named as individual defendants. Their inclusion as defendants had no impact on the subsequent corporate misconduct that led up to the global financial crisis.)
I have spent much of the last twenty years since I left the active practice of law interacting with corporate officers and directors. I have to say that the deterrent effect from the threat of shareholder litigation is far weaker than legal academia assumes. Most directors and officers believe they will never get sued in a shareholder lawsuit. They look at the conduct that led to the scandals and to the lawsuits, and they say, I would never do anything like that, so I will never get sued. I will agree that those who have gotten caught up in litigation before take a different view, although even there many come away from the litigation convinced only that the system is flawed. Some former litigants are receptive to counsel on how to avoid future lawsuits, and so in that sense the shareholder litigation may have the kind of motivating and incentivizing effect that Shaner believes it to have. Overall the effect is far less than Shaner assumes.
I agree with Shaner that shareholder oversight may be the best way to avoid corporate officer misconduct. However, there are better ways to encourage and achieve shareholder oversight than through even more shareholder litigation against even more defendants. The solution (or at least a solution) may be through the involvement of more engaged activist shareholders.
Coincidentally, the cover story in last week’s Economist magazine addressed this very topic. In the February 7, 2015 magazine’s leader, entitled “Capitalism’s Unlikely Heroes: Why Activist Investors are Good for the Public Company” (here), the magazine discussed the increasingly effective new generation of activist investors that increasingly are a “force for good.” These activist investors have stepped forward to “fill a governance void,” which in turn has forced previously passive index fund and public pension fund investors to “become more active and more forward-looking.” According to the magazine’s longer cover article, activism is “a breath of fresh air in the stuffy, complacent world of the big American corporation.” Moreover, analysis shows that activist investor involvement has led to “a sustained, if modest, improvement in operating performance and better shareholder returns.”
Shareholder oversight through activism has advantages over oversight through litigation. Because an activist campaign cannot prevail without the support of other shareholders, there are natural mechanisms in place to constrain the process. There is less of a problem with agency costs and the kind of agency co-option that can happen in litigation when the lawyers take over the process.
Shaner does acknowledge — in the second paragraph of footnote 196 of her article — that “the emergence of institutional and activist shareholders as active participants in corporate governance has compensated for some of the collective action problems” that constrains shareholder oversight. However, in the text of her article, she says – explaining her preference for reformed derivative litigation as the preferred tool to improve shareholder oversight of corporate officer misconduct – that “the lack of economic incentives and other time, money and resource constraints continue to deter individual, institutional and activist shareholders alike, from engaging in consistent, meaningful monitoring of management.”
The recent Economist article is less skeptical about the promise and possibilities of activist shareholder involvement. Given the excesses to which shareholder litigation is prone, I would much rather see efforts to improve shareholder oversight focus on the proactive involvement of shareholders, rather than through further expansion of our litigation system.
To be sure, shareholder activism has its critics. The Economist article quotes the prominent corporate lawyer Martin Lipton as saying that activist shareholders are “having a serious impact on the economy and are an aggressive deterrent to investment, research and development and employee training.” The methods of many activist investors are not immune to excess, and can lead to even well-performing companies being targeted. But, again, because the activist investors can only succeed with the support of other shareholders, there are natural checks in the system against the worst of these effects. And the checks on activist shareholders are much more effective and direct than the checks on shareholder litigation excess.
I agree with Professor Shaner that more needs to be done to try to prevent corporate officer misconduct. Where she and I diverge is that I am against any proposed solution that will lead to more rather than less shareholder litigation. Litigation will not suddenly become a more effective deterrent mechanism if there is more of it or if corporate officers are named as defendants more frequently. Improved monitoring through increased shareholder involvement is a more promising method of trying to prevent corporate officer misconduct than is increased or expanded shareholder litigation, and it is less likely to lead to the inefficiencies and excess to which shareholder litigation is prone.