Shareholder derivative lawsuits are notoriously difficult for claimants. In order to pursue a derivative suit, a shareholder plaintiff must overcome numerous procedural and pleading hurdles. Even when cases survive the initial obstacles, the ultimate outcome often consists of little more than the payment of the plaintiff’s attorney’s fees with slight benefit to the company in whose name the claim was ostensibly was pursued. In light of these considerations, UCLA law professor Stephen Bainbridge has a modest proposal: Eliminate derivative litigation altogether. In a brief October 3, 2017 post on his ProfessorBainbridge.com blog (here), Bainbridge suggests that we just do away with the whole inefficient process. Bainbridge raises a number of interesting points, but, as discussed below, while I agree with some of his concerns, I am not sure I agree with his proposed solution.
In support of his proposal, Bainbridge cites three main points. First, Bainbridge asserts that while “derivative litigation is relatively rare,” shareholder plaintiffs “almost always lose.” The relatively few cases that survive settle, and “in almost all cases the legal fees collected by plaintiff counsel exceeded the monetary payments,” with nonmonetary relief typically “inconsequential in nature.”
Second, the primary beneficiaries of derivative litigation are the claimants’ attorneys, with strike suits settled for nuisance value and meritorious cases “settled too cheaply, albeit with inflated fees paid to plaintiffs’ counsel.” Meanwhile, the company on whose behalf the suit ostensibly was filed must fund monetary payment and legal fees out of the corporate treasury. In other words, derivative litigation “mainly serves as a means of transferring wealth from investors to lawyers.” Little money is returned to shareholders, while “legal fees are almost always paid.” Why, Professor Bainbridge asks, “would a diversified shareholder approve such a process?”
Third, there are better means that derivative litigation to deter managerial misconduct. There is, Professor Bainbridge says, “no evidence that litigation does a better job of deterring such misconduct than do markets.”
In light of these considerations, Professor Bainbridge suggests that “a radical solution would be elimination of derivative litigation.” Derivative litigation, he says, “appears to have little accountability effect.” Eliminating derivative litigation would not eliminate director accountability; directors would remain subject to “various forms of market discipline,” including “markets for corporate control and employment, proxy contests, and shareholder litigation where the challenged misconduct gives rise to a direct cause of action.”
In recognition that some observers might find the complete elimination of derivative litigation “too extreme,” why not, Bainbridge asks, “allow firms to opt out of the derivative suit process by charter amendment?”
With over three and a half decades of experience observing D&O litigation, I am well acquainted with the problems Professor Bainbridge cites. I have seen derivative suits that are inefficient or even wasteful, where the only beneficiaries are the lawyers.
Yet for all of the excesses, I am not prepared to go all the way and say that the entire derivative litigation system should be dumped. Saying that derivative litigation is rarely beneficial or useful is not the same as saying that it is never beneficial or useful.
I think it is fair to point out that the legal scholarship on which Professor Bainbridge relies in support of his assertion that shareholder derivative litigation rarely produces a company benefit – that is, an article by Yale Law School Professor Roberta Romano – was written in 1991. There have been some important developments since Professor Romano wrote her article 26 years ago.
As I have documented on this blog (most recently here), there have been several massive shareholder derivative lawsuit settlements in recent years that have produced very substantial benefits for the companies on whose behalf the lawsuits were filed, including at least six shareholder derivative lawsuits that resulted in settlements in the nine figures. And that is not even counting the $2.876 billion judgment entered in June 2009 against Richard Scrushy in the HealthSouth shareholders’ derivative lawsuit, or the $1.263 billion award in the Southern Peru Copper Corporation Shareholder Derivative Litigation.
Another consideration that I think should also be taken into account is that the costs associated with derivative litigation are managed and transferred through D&O insurance. Many of the large settlements discussed above were funded in whole or in part by D&O insurance. The defense fees and sometimes the plaintiffs’ fees are paid for D&O insurance. My point is that the costs of shareholder derivative litigation involve a more complex mechanism than Professor Bainbridge arguably takes into account.
To be sure, the insurance itself has its cost, but companies would have to buy D&O insurance whether or not derivative litigation exists, and I can say because I have run a D&O underwriting facility that the possibility of derivative litigation is a relatively small factor in the overall pricing scheme, particularly for public companies. I suspect that if shareholder derivative litigation were eliminated tomorrow, the impact on public company D&O insurance pricing likely would be far less substantial than some might assume. (Supply and demand is a far more significant factor.)
I have a more fundamental issue with Bainbridge’s thesis. I disagree with Professor Bainbridge’s suggestion that shareholder derivative litigation has little or no deterrent effect. To the contrary, I think a great deal of boardroom time and energy level is spent on trying to take steps to avoid litigation or trying to make sure that processes are followed correctly and thoroughly so that if the board has to defend its actions in litigation that its actions will withstand scrutiny. I have been in many board rooms, and I can say that directors do indeed frequently consider the risk of derivative litigation and guide their conduct accordingly.
It is worth noting that in the end, Bainbridge does pull his punches a little bit. After throwing out his “radical solution” of eliminating derivative litigation altogether, he suggests that if this proposal is “too extreme,” that perhaps companies could opt out of derivative litigation with charter amendments.
The idea of litigation management bylaws has been one of the fashionable notions in recent years. Forum selection bylaws, once a mere suggestion, are now mainstream. Fee-shifting by-laws, for a time another trendy proposal, have fallen by the wayside, at least for now. Another idea that has surfaced recently is the idea of a bylaw provision requiring shareholder disputes to be arbitrated. Bainbridge’s proposal for a charter amendment provision eliminating shareholder derivative litigation certainly is of a piece with these other ideas.
I have no idea whether or not a charter amendment eliminating the possibility of derivative litigation is even a realistic idea from a legal perspective. I suppose the argument might be that prospective shareholders could decide the value they attach to the availability of derivative litigation, and if they believe it is an important corporate governance mechanism, they can choose not to invest in a company that disallows derivative litigation.
To the extent there is now going to be a debate about the idea of allowing companies to adopt this type of charter amendment, I think the debate will be of greater value if all of the considerations relevant to the question of whether or not derivative litigation has social value are considered, including in particular the actual derivative litigation outcomes that have taken place in recent years; the actual impact of D&O insurance; and the way that boards of directors actually conduct their affairs.