Once again, there are demands to reform corporate litigation. (See, e.g., Kevin LaCroix, “Time for Another Round of Securities Class Action Litigation Reform,” The D&O Diary, Oct. 23, 2018.) But once again, the Delaware courts are leading the way to cure the problems that litigation critics complain of most. Recent Delaware Court of Chancery decisions are yet another example of that leadership. We begin to show how that is being done, by outlining the perceived problems.
The critics focus on two types of corporation litigation they claim are serious problems: so-called merger objection lawsuits; and event-driven securities litigation. The principal objection to merger objection lawsuits is that they only allege a proposed merger is improper because the proxy statement asking for stockholders’ approval is inadequate, the alleged problem is then “cured” by defendants’ immaterial supplemental disclosures and the case is dismissed after the plaintiffs lawyers are paid off with a substantial fee. That seems to be tolerating a strike lawsuit that really accomplished nothing but a fee for the lawyers.
The principal objection to event-driven securities litigation is that they are based on a failure to disclose that the company was subject to a serious risk that eventually occurred, depressing the company’s stock price. The critics argue these suits are based on a risk the company did not anticipate and thus could not have disclosed. Thus, such claims lack proof of scienter and again are just lawyer-driven fee generators with fees paid to avoid the costs of defense.
Delaware Addresses the Merger Objection Lawsuit
By 2016, the Delaware Court of Chancery effectively curbed the abuses in merger objection litigation in Delaware. In re Trulia Stockholders Litigation, 129 A.3d 884 (Del. Ch. 2016), held that complaints alleging disclosure violations “cured” by unsubstantial supplemental disclosures did not confer a real benefit on stockholders and did not warrant a fee award. As a result, these suits have virtually disappeared in Delaware courts. Moreover, if the current trend of following Delaware’s lead continues in federal court, these merger objection suits may end there too. See, e.g., In re Walgreen Stockholder Litigation, 832 F.3d 718 (7th Cir. 2016).
While hard data is difficult to obtain, a recent pleading filed in Rosenfeld v. Kindred Healthcare, D. Del. C.A. 1:18-cv-00260-RGA, states that since Jan. 1, 2016, 178 such merger objection cases were filed in the U.S. District Court for the District of Delaware involving 98 transactions. Of those transactions subject to suits, 69 involved prompt settlements following supplemental disclosures. A second pleading in that case indicates fee awards are usually “agreed to.” It appears that the plaintiffs attorneys were able to negotiate a voluntary fee from the defendant corporations to get rid of the litigation. While that may seem like an abuse of the legal system, at least one federal court has held it lacked the power to sanction plaintiff’s lawyers for bringing such an unmeritorious litigation. (SeeRosenfeld v. Time (S.D.N.Y. 2018).)
So long as the federal courts do not constrain these suits, they will be filed in federal courts. That may be why the same file-settle-dismiss-get paid practice has not occurred in the Delaware courts. We hope that is more due to the reluctance of Delaware lawyers to sanction such a practice. But in any case, the solution would seem to be for corporate defendants to simply not agree to pay for those settlements.
Delaware Addresses Event-Driven Litigation
While Trulia is well known, two recent decision deserve even more attention for their potential impact on event-driven litigation. Wilkin v. Narachi, (Del. Ch. 2018), involved a failure of Orexigen Therapeutics Inc. to successfully market a new drug. When the final unsatisfactory test results for that drug were announced, Orexigen’s stock prices dropped 22 percent in one day. Litigation followed. The essence of the ensuing derivative suit was that the Orexigen directors had failed to disclose the drug’s problems. The court dismissed the complaint, using a fairly typical analysis of when a derivative complaint may be filed absent a prior demand on the board of directors.
But Wilkin’s analysis importance lies in how it treated the allegations the directors were liable for failing to disclose the Orexigen drug’s problems. Briefly, the court held that for the directors to be liable, they must have “knowingly” disseminated false information. This holding was “to ensure that [Delaware] law was not discordant with federal standards,” (Wilkin at 39-40). In short, in Delaware scienter must be pleaded with some factual support.
This then raises the question what sort of factual support does Delaware law require to show scienter when a company suffers harm when a previously undisclosed risk occurs? The short answer is there must be a “red flag” warning the board that risk is likely. The other recent court of Chancery decision in Marchand v. Barnhill, (Del. Ch. 2018), confirms this is a high test to meet by a plaintiff. Just arguing the board should have known of the risk is not good enough.
The facts in Marchand are important. For as the opinion notes, the corporate harm involved wide-spread contamination at the famous ice cream maker, Blue Bell. The contamination was widely known within Blue Bell lower management, but not at the board of directors’ level. Fortunately for the Blue Bell board, it had a monitoring system in place to report contamination. While that system failed, the board was entitled to rely upon it to avoid liability in this derivative suit. Had Marchand been a securities disclosure suit in federal court, it is doubtful the complaint would have been dismissed. The lower-level employee knowledge of contamination would have been sufficient to support a claim of scienter under federal securities law. See, e.g., Southland Securities v. Inspire Insurance Solutions, 365 F.3d 353, (5th Cir. 2004), and In re Omnicare Securities Litigation, 769 F.3d 455 (6th Cir. 2014), commented on in Kevin M. LaCroix, Guest Post: “Corporate Mismanagement Become Event-Driven Securities Litigation,” The D&O Diary, Oct. 21, 2018.
Together then, Wilkin and Marchand teach that under Delaware law the failure to disclose an unknown risk to the corporation is not actionable. As a result, event-driven complaints based on such non-disclosures will not succeed. That effectively addresses the problem of such suits proliferating. That does not solve that problem for federal litigation. But, once again, Delaware is leading the way to litigation reform.
Of course, these Delaware decisions involve derivative suits that sought to impose liability on directors. The federal securities lawsuits are generally class actions against the corporate itself, alleging failures to disclose. Nonetheless, it seems initially odd that a corporation should be liable for some disclosure violations under federal law while its directors have no individual liability for the underlying corporate damages under Delaware law. See comment, John C. Coffee Jr., “Securities Litigation in 2017: ‘It Was The Best Of Times, It Was The Worst Of Times,’” The CLS Blue Sky Blog, March 19, 2018. The different results in these two types of suits is justified by the different public policies that seek to enforce. Federal securities laws are intended to protect investors. Delaware corporate law is intended to encourage service on boards of directors by protecting innocent board members.
Nonetheless, these Delaware decisions may impact how the federal courts interpret the scienter and causation requirements of the federal securities laws. By limiting liability absent notice of corporate problems, the Delaware courts enforce the role that requiring real proof of scienter should play in securities litigation.