After the U.S. Supreme Court’s March 2018 decision in the Cyan case that state courts retain concurrent jurisdiction for ’33 Act liability actions, one idea that circulated was that companies could avoid securities class action lawsuits in state court by adopting a charter provision designating a federal forum for these kinds of suits. Unfortunately, in December 2018, Delaware Chancery Court Vice Chancellor Travis Laster held in Sciabacucchi v. Salzburg that under Delaware law federal forum provisions are invalid and ineffective, as discussed here. The Sciabacucchi decision, which is now on appeal, is the subject of a comprehensive critique in a recent article by Stanford Law Professor Joseph Grundfest, entitled “The Limits of Delaware Corporate Law: Internal Affairs, Federal Forum Provisions, and Sciabacucchi” (here). Professor Grundfest argues that Sciabacucchi was wrongly decided and that a under a “straightforward” application of applicable Delaware statutory law, federal forum provisions are valid and permitted.
It is important to note at the outset, as Professor Grundfest acknowledges in footnote one in his paper, that Grundfest himself developed the concept of the federal forum provision and drafted the federal forum provision language that was in dispute in the Sciabacucchi case. Indeed, in the parties’ pleadings in Sciabacucchi, the use of federal forum provisions was referred to as the “Grundfest solution,” and so Grundfest’s interest in these issues is, as he acknowledges in the footnote, “paternal.”
Background on State Class Action Securities Litigation
Professor Grundfest opens the substantive portion of his paper with a review of the problems that state court securities actions create. First, as his paper statistically demonstrates, state court securities class action litigation, which actually began to accumulate even before Cyan, has grown significantly since the case was decided, to the point that now 76 percent of Section 11 cases are brought either in state court alone or in parallel state and federal actions.
Plaintiffs, Professor Grundfest notes, have significant incentives to “migrate” their cases to state court, as state court pleading standards are more plaintiff-friendly; as state courts do not uniformly apply the discovery stay in federal court; and as there is no process in state court for consolidating duplicate proceedings.
Plaintiffs’ attraction to state court arguably is statistically justified, as between 2011 and 2018, the dismissal rate for state court Section 11 actions was only 19 percent, while the dismissal rate in federal court was 45 percent. Increased likelihood of surviving dismissal and increased uncertainty has meant that state court securities suits at higher values than do comparable federal court actions. Among other things as a result of these considerations, the cost of D&O insurance for IPO companies has risen materially in the wake of Cyan, as Professor Grundfest’s paper details statistically. Readers of this blog will find the paper’s discussion of the D&O insurance issues particularly interesting.
Background on Litigation Management Bylaws
The idea for companies to adopt bylaw provisions specifying a federal forum arose out of the larger discussion in recent years for companies to manage their litigation risks by adopting litigation management bylaws. In 2013, then-Chancellor Leo Strine Jr. held (as discussed here) in the Chevron case that corporations can adopt bylaws designating a preferred forum for litigation “relating to the internal affairs of the corporation.” A 2014 Delaware Supreme Court decision in the ATP Tour case (discussed here) also upheld the validity of a bylaw provision shifting fees to an unsuccessful litigant in a shareholder claim. However, in 2015, the Delaware legislature enacted a provision barring fee-shifting bylaws, while codifying the right of Delaware corporations to designate Delaware as the preferred forum for shareholder disputes.
The Sciabacucchi Case
With the idea circulating that companies should adopt federal forum provisions, a number of IPO companies adopted bylaws designating a federal forum “for the resolution of any complaint asserting a cause of action under the Securities Act of 1933.” Among the IPO companies adopting these kinds of provisions were Blue Apron, Stitch Fix and Roku. Matthew Sciabacucchi bought shares in all three companies. He then filed an action in Delaware Chancery Court seeking a judicial declaration that the companies’ federal forum provisions are invalid.
In December 2018, Vice-Chancellor Laster granted Sciabacucchi’s motion for summary judgment, holding under Delaware law the provisions are invalid and unenforceable. In reaching this ruling, Vice-Chancellor Laster said that while Delaware law permits companies to adopt a forum selection clause for “internal affairs” claims, owing to what Laster describes as “first principles” Delaware law “does not authorize a Delaware corporation to regulate external relationships.” A ’33 Act liability action, Vice-Chancellor Laster said, “is external to the corporation,” as “Federal law creates the claim, defines the elements of the claim, and specifies who can be a plaintiff or a defendant.”
While Delaware law has certain authority on internal matters related to the company’s organization, that authority “does not extend to its creation’s external relationships.” The state’s authority, Laster said, does not extend, for example, to tort claims asserted against the company.” A state’s corporate charter “cannot bind a plaintiff to a particular forum when the claim does not involve right or relationships that were established under Delaware law.” Since that is what the federal forum provisions do, they are therefore “ineffective and invalid.”
Professor Grundfest’s Critique
Professor Grundfest’s paper presents a multi-part attack on Vice-Chancellor Laster’s ruling in Sciabacucchi. As an initial matter, Grundfest challenges Laster’s reliance on sweeping “first principles” to invalidate the federal forum provision. Under these “first principles,” Laster said, when “the claim exists outside the corporate contract, it is beyond the power of corporate law to regulate.” The implications of this suggestion, Grundfest says, “reach far beyond the four corners of Federal Forum Provisions and articulate a novel principle that would constrain all of the past and future Delaware corporate law.”
The further problem with the “first principles” analysis is the suggestion that without these constraints, Delaware might interpret its own laws to allow regulation, say, of tort or contract claims. The “easy answer to these concerns is that none of them could arise in the context of federal forum provisions, and other forum provisions are not at issue. Delaware, Grundfest says, “can address those concerns if and when those provisions arise in a real case or controversy.”
The Sciabacucchi decision, Grundfest contends, is “highly contestable.” Among other things, Grundfest argues that the decision is against controlling U.S. and Supreme Court precedent. Laster concluded that that the federal forum provision is “contrary to the federal regime,” while disregarding the U.S. Supreme Court’s 1989 decision in Rodriguez de Quijas v. Shearson/American Express, Inc., which, Grundfest asserts, the Court “conclusively establishes that plaintiffs have no immutable right to litigate Securities Claims in state court and enforces a contract of adhesion prohibiting state court litigation of Securities Act claims.” Yet, Grundfest notes, Sciabacucchi nowhere mention the Rodriguez claim. Moreover, Grundfest notes, by invalidating a federal practice governing a federal claim that is consistent with federal law, Sciabacucchi “imposes a restraint on federal practice that appears nowhere in federal law,” and “creates an unprecedented intrusion by Delaware law into the federal space.”
A further “problem” with Sciabacucchi is that it assumes that Securities Act plaintiffs are never existing stockholders to whom fiduciary duties are owed – a proposition, Grundfest notes, for which the Sciabacucchi opinion offers no factual support. In fact, Professor Grundfest notes, numerous SEC filings show that existing holders purchase additional shares in both IPOs and follow-on offerings, and these purchasers are owed fiduciary duties in connection with the statements made in the registration statements.
Sciabacucchi’s “internal affairs” analysis is also “problematic” as it “diverges from precedent” to “invent a materially narrow definition” of the term “internal affairs.” Both U.S. Supreme Court and Delaware’s definition of internal affairs are broader and more encompassing, yet Sciabacucchi “offers no rationale for its divergence from controlling precedent.”
The decision’s application of its “divergent definition” of “internal affairs” is “additionally problematic” in its conclusion that Securities Act claims are “always external.” However, Delaware precedent establishes that an act can simultaneously be an internal violation of Delaware law or violate a federal law. Indeed, Grundfest argues, the “due diligence” defense to Section 11 claims necessarily entails a close inquiry into the actions and awareness of board members, all matters that are “entirely internal.”
The court’s decision is also “problematic” from a policy perspective. If the board processes that caused the filing of a defective registration statement are external, then “a host of boardroom functions” previously considered internal become “amenable to regulation by sister states.” This “trajectory” is “inimical to Delaware’s interest in regulating the internal functioning of Delaware-chartered entities.” Moreover, Sciabacucchi’s “first principles” analysis, and its implied constraints on legislative action “veers Delaware’s judiciary into the Legislature’s lane, as well as into the federal lane.”
All of these problems, Grundfest suggests, can be avoided by a “straightforward” interpretation and application of Delaware’s statutory law. A textualist reading of the statutes avoids “all of the concerns that inspire the invention of a divergent ‘internal affairs’ definition.” Sections 102(b)(1), 115, and 202 of the DGCL “unambiguously support the validity of Federal Forum Provisions and nothing in Sciabacucchi suggests Federal Forum Provisions are inconsistent with the plain text.” The statutory text also answers the concern about the possibility of charter provisions seeking to address, for example, tort or contract law. Sections 102 and 115 both refer to provisions relating to directors, officers, and shareholders “in their capacities as such,” which would take out the concern about charter provisions spilling into a host of other matters.
Grundfest’s paper is massive and detailed. It is always a challenge attempting to summarize anything as vast and sweeping as this paper and it is a particular challenge to do so within the constraints of the blogging format. I hope my summary here does justice to Grundfest’s extensive effort.
While Grundfest’s arguments are numerous and extensive, several basic things stand out. The first is that he thinks that Vice-Chancellor Laster really got it wrong in Sciabacucchi. In Grundfest’s view, the decision disregards important federal and Delaware precedent and relies on assumptions of fact that are “demonstrably incorrect.”
The other thing that is clear is that Grunfest continues to believe that federal forum provisions are a good idea and are permissible under Delaware statutory law. I should note here that in the interests of brevity, I telescoped Grundfest’s affirmative case that the text of the relevant Delaware statutes supports companies’ adoption of federal forum provisions. It is in the nature of his paper that his critique of Sciabacucchi predominates the presentation.
There is no mystery about the timing of Professor Grundfest’s paper. As I noted at the outset, Sciabacucchi is on appeal to the Delaware Supreme Court, and the parties have just entered the briefing phase of the appeal. Having originated and propagated the idea of federal forum provisions, Grundfest clearly has an interest in seeing his intellection creation survive legal scrutiny. His paper clearly bespeaks the fervor of his commitment to his project. The paper is a legal missile aimed at the Delaware Supreme Court.
It will of course be very interesting to see how the appeal turns out. The larger problem for everyone is that the possibility of state court securities litigation has created a huge mess, adding complexity, confusion, and cost for companies and for their D&O insurers. We can also certainly hope that the Delaware Supreme Court concludes that federal forum provisions are permissible.
However, unless and until that happens, the problems arising from the possibility of state court securities litigation will continue, causing all of the problems and concerns that Grundfest’s paper notes. For that reason, I continue to believe that the best approach would be for Congress to act and address this situation. SLUSA was clearly intended to force all securities litigation into federal court. However, Congress made a hash of things when it modified the jurisdictional provisions of the ’33 Act, and that is how the U.S. Supreme Court wound up concluding in Cyan, notwithstanding SLUSA, that state courts retain concurrent jurisdiction for Section 11 claims. While federal forum provisions are a good idea, the best thing would be for Congress to go back and clean things up.
One final note. Grundfest’s paper is massive and could even be daunting for some. Just in case readers of this blog don’t manage to make their way through the text to see it, the insurance practitioners who read this blog will be particularly interested in the statistical analysis in Section II of Grundfest’s paper. The paper not only sets out interesting statistical information about state court securities litigation filings and resolutions, but it also lays out interesting and detailed information about how Cyan has affected the D&O insurance market for IPO companies. I am sure that many readers will find it well worth their time to work their way through both the litigation statistics and the insurance pricing information.
Special thanks to the several readers who sent me a link to Professor Grundfest’s paper.