One of the more distinctive developments in the capital markets in recent years has been the rise in the number of very large private companies. These companies are sometimes referred to as “unicorns,” as if they are very rare creatures — but the reality is that worldwide there over 1,230 of them. Because the rise of so many large private companies is relatively recent, many of the legal principles and procedures relevant to these companies are just forming – giving rise to what University of Illinois Law Professor Verity Winship describes as the “gaps between private-market reality and legal structures that were designed for public companies.”
Among the “uncharted areas” is shareholder litigation; in a new paper, Professor Winship considers what shareholder litigation has meant in the context of these unicorn companies. What she found is that shareholder litigation involving these companies is rare, and that the procedural mechanisms available to investors are limited, at least by comparison to the mechanisms available to public company investors. Professor Winship describes her paper in an April 25, 2024, Harvard Law School Forum on Corporate Governance post entitled “Unicorn Shareholder Suits” (here). The paper itself can be found here.
The starting point for Professor Winship’s consideration of shareholder litigation involving unicorns is a principle, recognized in the literature, that the rights of shareholders basically involve three things – the right to vote, the right to sell, and the right to sue.
In order to consider what this right to sue means for investors in the context of these very large private companies, Professor Winship conducted a study of shareholder litigation involving unicorns. She began her analysis with a list of unicorn companies as of the end of 2016. She then set out to identify shareholder litigation involving any of these companies filed during the period January 1, 2015, and March 31, 2020. From this exercise, she made a number of interesting determinations.
First, she found that shareholder suits are relatively rare. Even using what she called a “generous” definition of shareholder suits, she found that only 6% of the companies on the 2016 list were sued during the five-year study period, which she contrasted with the annual rate of litigation frequency for public companies that approaches 4%.
Second, she found that while the numbers are low, a few themes emerge from the litigation that was filed. Among other things, “the litigants, forum, and claims vary, with no obvious substitute for federal securities class actions.” The suits are “predominantly brought in state court based on state-law contract and fiduciary duty claims.”
Among the cases Professor Winship’s analysis did identify are a number of lawsuits that I have discussed on this site, including, for example, investor lawsuits involving WeWork (here) and pre-IPO Uber (here). Although it is not among the cases identified in her study (because the company was not on the 2016 list she used), Professor Winship also refers throughout her paper to the investor lawsuit filed against Theranos, discussed here.
Having determined that shareholder litigation involving unicorn companies is relatively rare, she then considered the reasons why the litigation is so rare. She identifies what she describes as a “potent mix of procedural limitations,” as well as “the structure of private company investment, and cultural constraints in the relationship among VCs and private companies.” There are also the fundamental characteristics of the private companies themselves: “the absence of a market price, contractual shareholders, limited information, and founder-investor-employee dynamics.”
The absence of a readily determinable market price may be particularly significant, not only because it eliminates the predominance of common issues required to bring a class action, but also because the fact that a private company’s shares do not trade on an efficient market means that no “fraud on the market” presumption is available.
Professor Winship also notes that many of the investors in the private companies invested at different times, under different circumstances, and often under various types of contractual agreements. This investment structure also reduces the likelihood of claimants being able to establish the predominance prerequisite to establishing a plaintiff class.
In addition, because these private companies are by definition not reporting companies, there is a dearth of publicly available information upon which prospective claimants or even enforcement agencies might draw.
Finally, she also notes that the incentives to sue are very different in the unicorn context compared to the public company context. In particular, there is a widely perceived “founder-favoring culture where shareholder litigation would be wildly out of place.”
However, as Professor Winship notes, as these very large companies develop and mature, the ownership structure may start to change. Investor populations may shift to encompass employees and retail and later state investors. Under these circumstances, “the stakes are high because fraud does not go away just because less information is available about it; it may be even more prevalent behind private companies’ (figurative) closed doors.” The cozy relations between founders and start-up investors may even “disable many of the usual pressures to create governance structures that might prevent or correct misconduct.’
Professor Winship does briefly consider procedural avenues that aggrieved investors may be able to pursue in the absence of the availability of a federal securities class action alternative. Among other things, she notes that there may be state law substantive theories claimants may pursue that do not depend on a showing of reliance. There may also be legal theories where presumptions of reliance may be established without the need for a showing that the defendant company’s shares traded in an efficient market. The availability of information requests, such as through books-and-records actions, may help fill in information for prospective litigants and could have salutary governance effects as well.
Professor Winship closes her paper with a conclusion that there is much further work to be done. As she puts it, there is a “continuing need to map and address the gap between U.S. regulatory structures and the world of startups, tech unicorns, and other innovations – good and bad – that reflect a fundamental shift in how businesses raise money.”
Discussion
I found Professor Winship’s thoughtful paper interesting. Her study of securities litigation involving unicorn companies will be of particular interest to this site’s readers, especially those involved in underwriting or counseling large private companies. Though I was not surprised by her conclusion that litigation involving unicorn companies is rare, I think it is worth noting that some of the cases that were filed and that she did identify involve high-profile cases that will be familiar to this site’s readers.
There was one aspect of Professor Winship’s analysis that did trouble me. It was my sense in reading her paper that she presumed that it was a problem that it was not as easy for unicorn investors to sue as it is for public company investors to sue. Or at least that it ought to be easier for unicorn investors to sue than it currently is.
Here is the point where I have to declare my biases. I have spent the last four decades involved one way or the other with corporate and securities litigation. I have worked on quite a number of cases that were meritorious. I have worked on more cases that were dubious at best. And I have worked on far too many cases over the years that were a waste of everyone’s time on the planet. I am wary of any suggestion that that anything needs to be done in the United States of America to make it easier for people to sue each other. I will add to that that while it may be difficult for unicorn investors to sue, it is obviously not impossible. As the WeWork, pre-IPO Uber and even Theranos cases mentioned above show, aggrieved investors have managed to find a way.
There is another point here, and that is that the fact that the risk of securities litigation is less for private companies than it is for public companies may in fact be among the several reasons that some companies prefer remaining private rather than going public. Professor Winship does acknowledge this possibility in her paper, albeit primarily in a footnote (that is, footnote 275, where she acknowledges that “for some observers, the barriers to shareholder litigation against large private companies may be a feature rather than a bug.”)
I have a further thought along those lines, which is that as a society, we may want to allow more space for these start-up ventures, even if they are big, by comparison to the greater constraints we impose on public companies. Investors know, or ought to know, that they are investing in highly speculative, unproven ventures. There is a level of risk investors necessarily accept in investing of these kinds of ventures that differentiates their investment categorically from the kind of investment an investor makes in a publicly traded company.
All of that said, I do recognize that investors do not, and should not be expected to, surrender all rights. Everyone has a right to expect not to be defrauded. A look at what happened at Theranos is both sobering and a reminder of how badly things can go wrong. When considering these kinds of situations, it is easier to take Professor Winship’s point that it may be that the capital markets may have moved faster than the legal mechanisms that are available to ensure the integrity of the markets. It may well be that, as she suggests, that further work needs to be done to consider the procedural mechanisms that are available to aggrieved investors. This is particularly true once the interests of retail investors are considered.
I suspect that in the short run, efforts to address these concerns will need to be taken at the state level. (I don’t see the current Congress, or the one likely to be elected in November, getting its act together to address these kinds of issues.) There is a potentially productive and probably interesting conversation that could be had about what kinds of procedures and mechanisms might be need to ensure that large private company investors are protected. To that extent, I salute Professor Winship for trying to get this conversation started.