Ugly-duckling shareholder derivative suits are poised for swandom

January 2, 2015

Even if you believe that shareholder litigation is an effective means of compensating investors for corporate misconduct, you have to wonder about derivative suits.

Unlike securities fraud class actions, in which representative shareholders sue on behalf of investors who claim to have traded on the basis of corporate lies, derivative suits are filed by shareholders standing in the shoes of the corporation itself. These cases typically allege that directors and officers breached their duties. They are procedurally tough – shareholders have to show either that they demanded action from the board or that a demand would have been futile – and often dismissed, because shareholders have to overcome the presumption in Delaware and most other jurisdictions that boards exercise their business judgment in the best interests of corporations. In Delaware Chancery Court, judges don’t even want plaintiffs’ lawyers to file derivative suits until they’ve examined corporate books and records to see if there’s any basis for their allegations.

Once in a while, a derivative suit gets past all of the obstacles and ends with a big-dollar settlement or judgment. But here’s the thing: Shareholders don’t get the money. Remember, these cases are brought on behalf of the corporation itself, so whatever directors and officers agree to pay – usually settlements are covered by their directors’ insurance policies – goes to the corporation. Plaintiffs’ lawyers get a cut, of course. But shareholders’ benefits are only indirect. Sure, settlements often include corporate governance reforms that are presumably good for investors, and resolving litigation might boost share prices. That’s not the same as receiving cash.

You can see why it’s easy to be skeptical about derivative litigation, especially in the era of ubiquitous M&A “deal tax” suits. But the end of 2014 may have been a turning point for derivative suits – not just in how seriously defendants view their exposure in the cases but also in how settlements are structured.

Let’s look first at the risk to defendants in derivative litigation. The videogame company Activision Blizzard agreed in November to pay $279 million to settle a Chancery Court derivative suit related to its stock buyback from Vivendi. That’s the biggest derivative settlement ever, topping News Corp’s $139 million settlement in 2013 of claims that directors failed to avert its hacking scandal. (The plaintiffs’ lawyers who reached the Activision deal, according to a stipulation filed last month, want $72.5 million for their record-setting result.) Meanwhile, according to a Nov. 30 piece in The Wall Street Journal, the mining company Freeport-McMoRan reached a preliminary agreement to pay more than $130 million to settle allegations that board members were conflicted in the $9 billion purchase of two affiliates in 2013.

Two of the three biggest-ever derivative settlements, in other words, have come in the past two months. (In two other cases, against former HealthSouth CEO Richard Scrushy and against the board of Southern Peru Copper, courts entered judgments of more than $1 billion each.) Kevin LaCroix at the D&O Diary wrote last month that defendants and their insurers can no longer disregard the risk posed by derivative litigation. “For many years, D&O insurers have considered that their significant severity exposure consisted of securities class action lawsuits,” LaCroix said. “The undeniable reality now is that in at least some circumstances, derivative suits increasingly represent a severity risk as well.”

To me, the most intriguing development in derivative litigation isn’t just that defendants may be increasingly likely to pay more than $100 million to resolve claims against board members, but that settlements may actually deliver hard cash to shareholders. The Wall Street Journal had a terrific scoop last month on the structure of the preliminary Freeport-McMoRan settlement, reporting that most of the money will be distributed to investors via a special dividend.

As of Friday afternoon, Freeport and the plaintiffs still hadn’t filed settlement papers in Delaware Chancery Court, so we don’t know exactly how the dividend will be paid. But it’s an ingenious answer to the argument that cash payments in derivative suits are like transferring money from one corporate pocket to another, dropping some of it along the way to plaintiffs’ lawyers. Paying the money to shareholders sends a much stronger message of board accountability.

It’s been 20 years (can you believe it?) since Congress passed the Private Securities Litigation Reform Act of 1995 in order to restrict shareholder fraud class actions. As I’ve said before, the rise in derivative suits was an unintended consequence of that change in the federal securities laws. Derivative litigation has probably kept some plaintiffs’ firms afloat in the past 10 years, but it hasn’t accomplished a whole lot for most shareholders. Quite the contrary: The proliferation of deal tax cases has inspired companies to change bylaws or charters to curtail shareholders’ rights to sue for corporate wrongdoing. Forum selection, fee-shifting and minimum-stake-to-sue provisions can all be traced to the rise in derivative M&A litigation.

I’m hoping that the Freeport settlement, which should be filed any day now, provides a model for giving shareholders – and not just plaintiffs’ lawyers – an actual cash benefit from derivative litigation. We call these cases shareholder suits. Wouldn’t it be great if they really were?

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