A Small Step Toward Curbing the Follow-On Derivative Suit Curse

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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