Facebook IPO derivative ruling: a cure for multiforum madness?
Every company considering an IPO owes a hearty thanks to U.S. District Judge Robert Sweet of Manhattan for his decision Wednesday to dismiss four shareholder derivative suits against Facebook board members. Sweet’s painstaking 70-page opinion includes holdings that are great for Facebook’s defense of a parallel securities class action over its disclosures to IPO investors, but the judge also reached precedent-setting conclusions on standing and ripeness that will help other derivative defendants ward off IPO-based claims in state court. Facebook’s lead lawyers, Andrew Clubok of Kirkland & Ellis and Richard Bernstein of Willkie Farr & Gallagher, certainly deserve credit for coming up with innovative arguments to establish valuable precedent in IPO cases.
I believe Sweet’s ruling may have application beyond IPO derivative suits, though. The decision could represent a way for defendants to address the proliferation of derivative suits that are inevitably filed in multiple state courts after M&A deals are announced.
First, a refresher on the allegations and procedural background of the Facebook derivative suits. The complaints allege that under the direction of Facebook’s board, the company failed to make adequate disclosures to IPO investors about Facebook’s revenue projections and challenges in adapting to smart device usage. (If those sound an awful lot like securities class action claims, that’s because the derivative suits parallel a securities case against Facebook that is also before Judge Sweet.) Three derivative suits were filed in state courts in California. A fourth was filed in federal court in Manhattan. Defendants removed the three California cases to federal court in San Francisco. Then, before shareholders could litigate motions to remand them to state court, the Judicial Panel on Multidistrict Litigation transferred all of the derivative litigation to Sweet in Manhattan federal court.
Facebook made a number of arguments about why the derivative suits should be dismissed, most of which Sweet agreed with. In findings that will probably turn out to be the most useful for the company, the judge said that Facebook “repeatedly made express and extensive warnings” about the challenge of increased use of mobile devices and that the company was not obligated to disclose internal revenue projections. Sweet’s conclusion about the adequacy of Facebook’s warnings will help the company’s defense in the ongoing securities class action. And according to Facebook defense lawyers Clubok and Bernstein, all IPO issuers should be relieved by Sweet’s strong language on the disclosure of internal projections, in which the judge cited “courts throughout the country” that have “uniformly agreed” such internal calculations aren’t material.
“An opposite ruling on disclosure would have changed at least two decades of IPO practice,” Bernstein told me. “It would have been a revolutionary change.”
The judge also implicitly endorsed the legitimacy of forum selection clauses in certificates of incorporation, though he denied Facebook’s motion to dismiss the derivative suits on forum selection grounds. Sweet ruled that Facebook had adequately disclosed its clause, which mandates that shareholders must sue in Delaware Chancery Court. He said the clause didn’t apply to the IPO derivative suits (none of which was filed in Delaware) because the company did not file its certificate of incorporation until three days after the IPO, so its forum selection restrictions didn’t bind IPO purchasers. But according to Clubok and Bernstein, the judge’s analysis of the validity of the clause, even though it’s dicta, is significant in a relatively undeveloped area of the law.
Even more importantly for future IPO derivative defendants, Sweet found that shareholders who buy in an IPO cannot meet standing requirements for derivative claims. As the judge explained, derivative plaintiffs, who bring suit on behalf of the corporation itself, must be able to show that they owned stock at the time of the board misconduct they’re alleging. Here, Sweet said, shareholders were complaining that Facebook directors breached their duties when they withheld inside information from investors in offering materials. But none of the investors who filed a derivative suit was a shareholder before the IPO, when those disclosure decisions were made. So, according to Sweet, none has standing to assert a derivative claim.
That’s a broadly useful holding for defendants, according to Clubok, who argued the dismissal motion for Facebook. “The ruling holds that those who buy stock after an IPO can’t use a derivative suit to complain about pre-IPO conduct,” he said.
But there’s more: Sweet also said that federal courts have discretion to consider threshold issues like standing and forum selection even before they determine whether they have jurisdiction over derivative suits, which, after all, typically assert state-law causes of action. The Facebook derivative suits presented unusual procedural circumstances, since they were consolidated and transferred to federal court before remand was litigated. Sweet’s conclusion that he could rule on standing, demand futility and ripeness without deciding jurisdiction, Clubok said, is hugely significant – especially in tandem with the judge’s analysis of standing.
The combination, according to Clubok, is going to block plaintiffs from undermining the Securities and Exchange Commission’s power to regulate IPOs through the back door of state court derivative claims. “IPOs are less likely to be second-guessed by state court juries if companies follow the rules set forth by the SEC,” he said.
Obviously, Sweet’s ruling on shareholder standing in IPO derivative cases won’t help defendants in M&A derivative suits, but I believe his reasoning on the power of federal courts to decide threshold questions could. Typically, after a deal is announced, shareholders file multiple suits in Delaware or other state courts (and sometimes in federal court as well). Companies usually don’t mind litigating in Delaware, but what drives them crazy is defending essentially the same claims by multiple sets of plaintiffs in multiple state courts outside of Delaware. Under the template of the Facebook derivative cases, though, there’s nothing to stop them from removing state-court suits to federal court and then, before shareholders can litigate remand motions, citing Sweet and moving to dismiss on demand futility. (Sweet found demand futility to be among the threshold issues he had discretion to decide without ruling on jurisdiction.) I’ve heard arguments that one way to solve the problem of multiforum derivative litigation would be to give the JPMDL the power to consolidate cases raising issues of federal law, even when they’re not filed in federal court. Sweet’s holding on the discretion of federal courts in early-stage derivative litigation would be all the more powerful if that were to happen.
One final point about Sweet’s ruling: The judge agreed with Facebook’s innovative argument that shareholders’ derivative claims weren’t ripe because they were based only on the premise that the company would be found liable for securities violations in the parallel class action. That’s another broad holding that, according to Bernstein, should be useful to defendants in other derivative suits that attempt to piggyback on securities class actions.
Sweet gave the Facebook derivative plaintiffs leave to file an amended complaint, but it’s hard to see how they’ll get past the formidable obstacles his ruling raises. The plaintiffs didn’t respond Wednesday to a Reuters request for comment.
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