One feature of the recent changing mix of corporate and
securities litigation has been the rise in the filing of follow-on derivative
lawsuits in the wake of securities class action lawsuit filings. As Wilson Sonsini
partner Boris Feldman recently
noted, "like a moth drawn to a candle," the derivative bar watches class
action filings and "just cannot resist cribbing the class action complaints,
even though the company's setback does not suggest any breach of fiduciary
duty."
The rise in the number of follow-on derivative lawsuits
seems to be attributable to the efforts of smaller or newer plaintiffs' firms
to try to get a piece of the action. The problem with these kinds of cases is
that they just compound the defendant company's litigation expense and threaten
distraction from or even prejudice to the company's defense in the class action
suit - all as a result of a derivative action supposedly brought on the
company's behalf.
One way to try to reduce at least some of the potential
evils associate with these follow-on suits would seem to be to stay the
derivative suit until the securities suit has concluded. In many cases, the
derivative plaintiffs agree to a stay. The question whether the court itself
should order a stay of one of these follow-on suits was addressed in a January
27, 2012 Delaware Chancery Court opinion (here)
in a derivative action involving SunPower Corporation.
The litigation arose after SunPower announced that it
would have to restate its prior financials due to the underreporting of
expenses at its Philippine manufacturing operations. Following these
announcements, the company and several of its directors and officers were named
as defendants in securities
class action lawsuits (later consolidated) in the Northern District of
California. The consolidated class action case was initially dismissed without
prejudice, but the class action plaintiffs' amended pleading survived the
defendants' renewed motion to dismiss. The court's December 19, 2011 denial of
the defendants' renewed motion to dismiss can be found here.
Following the filing of the securities class action
lawsuits, additional plaintiffs filed five derivative lawsuits in California
state court, seeking indemnification from the individual defendants for any
expenses the company incurs in the class actions. Those five California
derivative actions were stayed by agreement.
However, yet another plaintiff filed a separate
derivative action in Delaware Chancery Court, after having first exercised his
rights to inspect the company's books and records. The Delaware plaintiff
contended that his access to confidential company documents has shown that the
company had incurred million of dollars of costs, even before the class action
lawsuits were filed, due to the accounting issues with the company's Philippine
operations.
The defendants moved to stay the Delaware plaintiffs'
action, arguing that proceeding with the derivative suit would prejudice the
company's defense in the securities suit. The defendants also argued that
because the relief the Delaware derivative plaintiff seeks is largely
contingent on the outcome of the securities suit, it would be premature for the
derivative suit to proceed. The derivative plaintiff argued that because his filings
were under seal, the defendants overstated the prejudice, He also argued that
the because of the $8 million in expenses the defendants had already incurred
in connection with the restatement, there were noncontingent damages ripe for
adjudication.
In granting the defendants' motion for a stay, Vice
Chancellor Donald F. Parsons, Jr. concentrated on the overlap between the
factual allegations in the class action lawsuit and in the derivative lawsuit.
Both actions accused the individual defendants of having knowledge of the
alleged wrongdoing or having ignored red flags. But, Parsons noted, the
derivative plaintiff "makes these arguments on behalf of the corporation
while the Securities Class Action plaintiffs make them against
SunPower."
Parsons said that "it is not practical for two actors ...
to pursue divergent strategies in two simultaneous actions on behalf of the
same entity." As a result, "simultaneous prosecution of both actions"
would be "unduly complicated, inefficient and unnecessary." The prosecution of
the derivative suit would involve "taking actions designed to refute the merits
of the Company's defense of the Securities Action and vice versa." This creates
a "significant risk that the prosecution of [the derivative suit] will
prejudice SunPower." Parsons notes there is also a significant risk of
inconsistent rulings.
Parsons also rejected the plaintiffs' argument that the
derivative suit was ripe for adjudication because at least a portion of the
claimed damages are not contingent. Because the fill extent of the alleged
damages cannot be known until the class action is resolved, "the wisdom as a
practical matter of treating the indemnification claims as unripe until the
liability for which the indemnification is sought is determined is plain."
Because the derivative claims cannot be adjudicated in full, the sensible
ordering of events is for the class action to go first.
Accordingly, Parsons ordered the derivative suit to be
stayed indefinitely, allowing the plaintiff to seek to have the stay lifted
upon the earlier of the final dismissal of the securities class action or
December 31, 2012.
Discussion
As discussed in a January 27, 2012 memorandum from the
Morrison Foerster law firm (here),
Vice Chancellor Parsons ruling provides "the clearest articulation to date of
the danger follow-on derivative actions poste to corporations on whose behalf
they are supposedly brought." The ruling, according to the memo, "should prove
a valuable guide to courts" trying to manage simultaneous derivative and class
action litigation in the future.
The larger context for the problems Vice Chancellor
Parson addressed is the increasing proliferation of conflicting litigation
surrounding any type of corporate event. The phenomenon of multiple class
action lawsuit filings following a stock drop has long been part of the
corporate and litigation scene. These kinds of cases are more easily
consolidated and managed. What has changed is increasing numbers of follow on
derivative lawsuits, often, as here, filed in multiple jurisdictions, and which
are not so easily consolidated or coordinated.
Just to quantify this problem and to provide a little
bit of historical context, in its 2011
securities class action litigation report, NERA Economic Consulting
reported that the number of settled securities class action cases that were
accompanied by parallel derivataive lawsuits has grown dramatically in recent
years. NERA reports that prior to 2002 (when the Sarbanes-Oxley Act was
enacted) the number of settled cases that were accompanied by a parallel
derivative action ranged between 11 and 22 percent a year. However, from 2007 through
the first half of 2011, the range was from 56 to 65 percent.
The threat of prejudicing the defense of the securities
class action lawsuit is only one of the problems associated with the increase
in follow-on derivative litigation. The proliferation of multiple simultaneous
suits in multiple jurisdictions imposes a costly and vexatious burden on the
companies involved. The SunPower case provides a good illustration of these
problems. The Delaware derivative plaintiffs alleges that the company "is largely
self-insured so that expense, settlements or damages in excess of $5 million in
these actions will not be recoverable" under insurance. The costs associated
with the derivative plaintiffs' action simply add to this burden. As
NERA noted in its year-end securities litigation report, in commenting on
the phenomenon of folllow-on derivative lawsuits, "to the extent [the
individual defendants] have indemnification agreements or continue to hold
board or management positions, derivative litigation may prove expensive for
the issuer."
Unfortunately for the company, the derivative action has
merely been stayed, not dismissed, which raises the question of what will
happen in the future. The likelihood is that the class action lawsuit will
settle at some point. (Yes there is a chance that it will be resolved on
summary judgment, and an even smaller chance that it will be resolved at trial,
but the greatest likelihood is that it will be settled.) Given the apparent
limited amount of insurance available, the class action settlement will likely
be modest. And if the case settles, the stipulation undoubtedly will include
the usual defense disclaimers of liability or wrongdoing.
At that point, the stayed derivative litigation will
finally be ripe. But at that point, the remaining insurance will almost
certainly be gone. The derivative plaintiffs, without the benefit of any
factual findings in the class action suit, will have to try to establish
liability, forcing the individual defendants to incur additional defense
expenses (which almost certainly would be advanced to the defendants under the
company's indemnification provisions), all to try to extract some payment out
of the personal assets of the individual defendants. Given these factors, it
seems highly probable that any ultimate recovery in the derivative suit - and
therefore any benefit to the company - would be slight. But in the meantime,
the company and its senior management are forced to endure the burden and
expense of continued, redundant litigation.
There may be (infrequent) occasions where this kind
of liltigation-about-litigation is not burdensome, vexatious and wasteful.
Nevertheless, it is very hard to observe the expansion of this kind of
follow-on derivative litigation with anything but alarm. If, as seems
likely at least for now, this kind of litigation is going to continue to
increase, it is going to be increasingly important for courts to develop rules
of the road, if for no other reason to make sure that these suits do not
further harm the very companies on whose behalf they supposedly are brought.
That is the reason I think Vice Chancellor Parsons ruling is important, because
it represents a practical recognition that the courts are going to have to
police things to prevent the whole process from getting out of control.
I know that the plaintiffs' attorneys behind these cases
will argue that the cases are necessary to protect companies from the expenses
the corporate defendants are forced to incur when alleged management misconduct
leads to shareholder litigation. Other observers might perhaps more accuratey
characterize these cases as nothing more than a vehicle by which the
plaintiffs' firm involved is seeking to extract a fee. I would argue that
a better way to address the cost of litigation problem is
through a prudent risk management approach including a comprehensive program of
D&O insurance. If the company has an appropriate D&O insurance program
in place, the class action litigation costs would not fall on the company, and
there would be no even theoretical need for (or indeed any justification for)
these types of follow-on lawsuits in most circumstances.
At least from the allegations Vice Chancellor Parsons
recites in his opinion, it appears that this company carried only nominal amounts
of D&O insurance. The amount and extent of litigation in which this company
has become involved underscores the fact that in this day and age, well-advised
firms should carry more than minimal amounts of insurance. Indeed, this case
shows that in a changing litigation environment, traditional notions of limits
adequacy may no longer be sufficient. The possibility that companies may have
to be prepared to fund a multi-front defense suggests that companies may need
more insurance than in the past in order to be fully protected.
A Dated Debate: We
generally refer to the year 1901 as "nineteen-oh-one." Similarly, 1909 is
"nineteen-oh-nine." But we refer to 1910 as "nineteen-ten" not
"nineteen-and-ten." My point here is that conversational conventions eventually
tend toward to simplest and most economical expression.
In our current century, 2001 is referred to as "two
thousand and one." 2009 is referred to as "two thousand nine." I suspect the
convention will shift as the century progresses. For example, when we finally
reach 2020 (if we do in fact make it that far), I feel quite certain the year
will be referred to as "twenty-twenty" and not as "two thousand twenty."
Similarly, 2021 will be "twenty-twenty-one," not "two thousand twenty one."
Which brings me to the current year, 2012. Why do we
refer to it as "two thousand twelve" rather than "twenty twelve"? I am not sure
why, but "twenty twelve" is not in widespead usage. I feel quite certain that
eventually we will all shift to the "twenty - " formulation, just as a century
ago, usage shifted to the "nineteen -" custom.
Maybe it won't be until 2020, but the "twenty
-"nomenclature will eventually be the conversational way to refer to years
during the current century. It may be too late now to change the way we refer
to the current year, but it still may be possible to make some progress on this
now.
As part of our forward-looking mission here at The
D&O Diary, we would like to propose that we all get an early start on
the rest of the century. Specifically, and with next year still a good eleven
months off, we would like to respectfully suggest that everyone make a mutual
commitment to refer to next year as "twenty-thirteen" rather than as "two
thousand thirteen." Why wait until 2020 to get on with the future?
I am sure many of you are wondering why I am so concerned
about this. Here at The D&O Diary, we consider it part of our job to
worry about these things so you don't have to. Now remember, its "twenty
thirteen," not "two thousand thirteen." O.K., everybody back to work.
Read
other items of interest from the world of directors & officers liability,
with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.
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