‘Skin in the game': justifying restrictive minimum-stake-to-sue bylaws

November 17, 2014

The life insurance settlement company Imperial Holdings, as I told you last week, appears to be the first public corporation to adopt a bylaw requiring investors to provide written consent from at least 3 percent of all shareholders before they can sue the company. But it almost surely won’t be the last. Phillip Goldstein of Bulldog Investors, who is the board chairman at Imperial, sits on the boards of two other public corporations whose shareholders will vote on virtually identical minimum-stake bylaws at annual meetings in December: the Mexico Equity and Income Fund and the Special Opportunities Fund. Goldstein told me he expects shareholders at both funds to accept the provisions, just as he expects Imperial’s shareholders to endorse the board’s adoption of the minimum-stake bylaw at their annual meeting this spring.

The vast majority of shareholders, Goldstein said in an interview, should welcome these bylaws. As he envisions them, minimum-stake-to-sue bylaws will stop investors without much financial interest in the outcome – and the lawyers who represent them – from hijacking deals and forcing companies to spend money to defend meritless cases. “The bylaws are like a cooling-off period,” Goldstein said. “We’re saying, ‘Slow down, get support from other shareholders.'”

Goldstein emphasized that minimum-stake bylaws aren’t intended to block all shareholder suits. That’s the last thing he wants: As an activist investor, he said, he relies on the threat (and sometimes the fact) of litigation as leverage against recalcitrant boards. The problem is when “somebody with a $1,000 investment sues on behalf of the entire company,” he said. “It’s nutty.”

However nutty, the phenomenon is well documented. Earlier this year, for instance, law professors Adam Pritchard of the University of Michigan and Jessica Erickson of the University of Richmond co-authored “Frequent Filers,” a paper about individual shareholders (including relatives and employees of securities class action lawyers) and even purported institutional investors who have each filed multiple suits against companies in which they own negligible stakes. That study, in turn, relied in part on Erickson’s 2013 paper, “The New Professional Plaintiffs in Shareholder Litigation,” in the Florida Law Review. Erickson found data indicating that so-called “repeat plaintiffs” filed more than 700 M&A class actions and derivative suits between 2002 and 2012. She identified more than 60 such plaintiffs who had filed an average of 11 suits apiece.

Erickson said some of these repeat plaintiffs have relatively large holdings in the companies they sue, but that several own just small stakes. (Except in federal-court securities fraud class actions, shareholders are not required to disclose their holdings in order to sue companies or directors.) In one case Erickson cited, a repeat plaintiff owned just nine shares of the targeted company.

Goldstein said he wanted to devise a bylaw that would require shareholders “to have skin in the game” in order to sue. None of the other restrictive bylaws that have recently been in vogue accomplished that, he said. Forum selection clauses are mere housekeeping, in Goldstein’s view. Mandatory arbitration clauses can stick a company with bad precedent that’s tough to appeal, he said. And fee-shifting provisions to make shareholders pay defense costs when they lose “are overkill and look bad,” Goldstein said, especially when they’re advanced by an activist investor like him.

“We were looking for a more surgical approach, something that would cut out the cancer of frivolous lawsuits without eating into healthy tissue,” Goldstein said.

Before Imperial’s board voted to adopt its minimum-stake suit, he told me, he called Institutional Shareholder Services to discuss the provision. ISS had three concerns, according to Goldstein. It didn’t want companies to adopt minimum-stake bylaws without a shareholder vote; it wanted to know the mechanics of how shareholders would deliver consent to the company; and it wanted to hear whether Goldstein was suggesting that his proposed 3 percent threshold should apply to large cap corporations as well. (I emailed an ISS spokesman to confirm Goldstein’s account. ISS declined to comment on the specifics and pointed me to ISS’s recently updated policy recommendations on bylaws to restrict shareholders’ litigation rights. The recommendations frown on boards amending bylaws or charters without shareholder approval.)

Goldstein said he agreed with ISS that shareholders should approve the minimum-stake bylaw, which is why the provision is up for a vote next month at the two funds, which are both incorporated in Maryland. If Imperial shareholders vote against the bylaw when they meet this spring, he said, he will ask the board to rescind it. Goldstein also agreed that a 3-percent threshold might be too high for shareholders in a company with billions of shares on the market. (He told me he picked 3 percent because that’s the threshold for shareholders who want to have their board nominees included in corporate proxy materials.) Obviously, Goldstein said, there’s nothing magic about 3 percent, so bigger companies with broader shareholder bases can tailor their own minimum-stake bylaws.

Meanwhile, according to him, Imperial is already poised to receive a tangible benefit from the minimum-stake bylaw. After reaching a 2012 non-prosecution agreement with the U.S. Justice Department and a $12 million settlement with shareholders (for conduct that predates Goldstein’s involvement with the company), Imperial pays more than $1 million a year in insurance for its directors and officers. Goldstein told me that Imperial’s insurers have told the company that the premiums will be cut as a result of the new bylaw.

So will minimum-stake bylaws be struck down by courts? Law professors Pritchard and Erickson – who proposed in their “Frequent Fliers” study that states enact minimum-holding requirements for shareholder litigation – offered different answers to that question. Pritchard said the provisions should hold up, at least with regard to M&A class actions based on state law and shareholder derivative suits. The bylaw Goldstein designed would deter meritless “deal tax” suits, Pritchard said, without chilling real cases that big investors are willing to stand behind. In that sense, the minimum-stake provision is less drastic than fee-shifting and mandatory arbitration clauses, which wipe out good and bad cases alike.

Erickson, however, said that minimum-stake bylaws make her nervous. There’s an obvious conflict of interest if boards adopt them without shareholder consent, since directors would be defendants in the suits they’re acting to ward off, she said. Erickson also said that 3 percent is a high bar in the United States, where stock ownership is widely dispersed, and courts aren’t likely to want to determine appropriate thresholds on a company-by-company basis. Finally, she said, distinguishing between large and small shareholders may trouble judges: “Do we really want to look at mom and pop investors and say, ‘You don’t get to come in the door?'”

(Reporting by Alison Frankel)

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