Conventional wisdom is that shareholder derivative suits are dead. Yet this death knell is decidedly premature. The current conception of shareholder derivative suits is based on an empirical record limited to suits filed in Delaware or on behalf of Delaware corporations, leaving suits outside this sphere in the shadows of corporate law scholarship. This Article aims to fill this gap by presenting the first empirical examination of shareholder derivative suits in the federal courts. Using an original, hand-collected data set, my study reveals that shareholder derivative suits are far from dead. Shareholders file more shareholder derivative suits than securities class actions, the area of corporate litigation that has received nearly all of the scholarly attention. By writing off shareholder derivative suits, scholars have missed the distinct role that these suits play in corporate law, particularly in the area of corporate governance. Unlike traditional litigation, remarkably few of the suits in my study ended with monetary payments. Instead, these suits more commonly ended with corporations agreeing to reform their own corporate governance practices, from the number of independent directors on their boards to the method by which they compensate their top executives. These settlements reflect the rise of a new type of shareholder activism, one that has gone undocumented in the legal literature. Corporate governance has moved into the courtroom, and this development has important, and potentially troubling, implications for corporate law.
TABLE OF CONTENTS INTRODUCTION I. STUDY DESIGN AND METHODOLOGY II. EMPIRICAL ANALYSIS OF FEDERAL DERIVATIVE SUITS A. The Unseen Importance of Derivative Suits B. Surveying the Complaints 1. Mapping the Complaints 2. Detailing the Parties a. Derivative Plaintiffs b. Plaintiff Corporations c. Defendants 3. Analyzing the Allegations C. Procedural Hurdles in Derivative Suits 1. Demand in the Federal Courts 2. Special Litigation Committees D. Four Paths to Resolution 1. Judgment 2. Involuntary Dismissals 3. Voluntary Dismissals 4. Settlements a. Private Company Settlements b. Public Company Settlements III. ASSESSING CORPORATE GOVERNANCE IN THE COURTROOM A. The Promise of Redress B. The Limits of Reform C. The Possibility of Deterrence CONCLUSION
Conventional wisdom is that shareholder derivative suits play a small, and dwindling, role in corporate law. Once the cornerstone of corporate law, (1) these suits are now viewed as relics of an older time, rendered obsolete by more modern means of policing corporate misconduct such as high-stakes securities class actions, sweeping government investigations, and the stringent listing standards of the national stock exchanges. As the tools for monitoring corporate managers multiply, scholars have all but abandoned shareholder derivative suits. In the world of corporate law scholarship, shareholder derivative suits are not just "forgotten," (2) they are "dead." (3)
As a result, few scholars have deemed these suits worthy of empirical analysis. Over the last fifteen years, there have been just two studies of shareholder derivative suits. (4) Although both made crucial contributions to our understanding of these suits, the empirical focus in these studies was on suits filed in Delaware state court or on behalf of Delaware corporations. (5) There remains no comprehensive examination of shareholder derivative suits in the federal courts, where most corporate litigation is centered.
This dearth of empirical data comes at a particularly bad time. As the financial markets have experienced tremendous upheaval, corporate law has been besieged with calls for reform. (6) Scholars and politicians alike have called for a restructuring of market regulations and renewed oversight of private litigation. (7) If shareholder derivative suits are to play any role in these efforts, it should not be based on an incomplete snapshot of this area of the law.
This Article aims to bridge that gap by presenting the first empirical analysis of shareholder derivative suits in the federal courts. My study is based on a hand-collected and original dataset of full case records from complaint through final judgment. (8) In contrast, many studies of litigation examine only reported decisions available through Westlaw or Lexis. (9) As others have recognized, such studies suffer from a selection bias because fewer than 5 percent of decisions are available through these databases. (10) Moreover, neither Westlaw nor Lexis allows scholars to track entire case records, which means that most litigation research is based on a single snapshot of the studied cases rather than a comprehensive review of the entire case record. (11) As scholars are increasingly recognizing, (12) litigation research must be done on the ground, studying case records from start to finish.
From this in-depth examination of shareholder derivative suits, three important conclusions emerge. First, contrary to the conventional wisdom, shareholder derivative suits are anything but dead. Shareholders actually file more shareholder derivative suits than securities class actions, (13) the area of shareholder litigation that has received nearly all of the scholarly attention. (14) Corporate law scholarship has missed this fact because most shareholder derivative suits are filed in federal court and nearly half are filed on behalf of companies incorporated outside of Delaware. (15)
Second, corporate governance reform has moved into the courtroom. Remarkably few of the suits in my study ended with the corporation receiving a meaningful financial benefit. Instead, shareholder derivative suits more commonly end with the parties agreeing to corporate governance settlements. In these settlements, corporations agree to reform their corporate governance practices, from the number of independent directors on their boards to the method by which they compensate their top executives. These settlements have not been studied at all in the legal literature. The rise of shareholder activism in the courtroom has simply flown under the radar of corporate law scholarship.
Third, there is significant reason to question the wisdom of corporate governance's move from the boardroom into the courtroom. Drawing on business and finance literature, this Article demonstrates that corporate governance settlements often fail to live up to their potential because they include reforms that are unlikely to benefit corporations or their shareholders. (16) Yet despite the minimal benefits to corporations, the plaintiffs' attorneys studied still received substantial fees, confirming the view that "[t]he real incentive" to file shareholder derivative suits "is usually not the hope of return to the corporation, but the hope of handsome fees to be recovered by plaintiffs' counsel." (17) By writing off shareholder derivative suits, scholars have missed the problematic role that these suits continue to play in corporate law.
This Article proceeds in three parts. Part I explains the design and methodology of the study. Part II sets out the empirical results of the study, examining the shareholders who file derivative suits, the companies named in the suits, the types of claims alleged, and, most importantly, the resolution of these suits. Part III adds a normative component, drawing on business and finance scholarship to evaluate corporate governance settlements and concluding that many of these settlements do little to enhance corporate value. In the end, "corporate governance at gunpoint" may not be the best strategy for reform. (18)
I. STUDY DESIGN AND METHODOLOGY
This Part explains the methodology of the study and provides an overview of its significance and limitations. Before turning to this discussion, however, a brief explanation of the role of derivative suits and securities class actions in corporate law is warranted. Derivative suits and securities class actions are the procedural mechanisms to enforce two different branches of corporate law.
Derivative suits are the procedural mechanism to enforce state fiduciary duty law. (19) In a derivative suit, the corporation is the functional plaintiff--that is, the real party in interest--and the allegations are that the corporation's current or former officers and directors breached their fiduciary duties to the corporation. (20) Any recovery in a derivative suit is returned to the corporation. (21) In a derivative suit, despite the fact that the suit is brought in its name, the corporation's role is limited because shareholders, whom I will call derivative plaintiffs, file these suits on behalf of corporations. (22) The law gives shareholders this power because corporate officers and directors, who normally decide whether corporations should file lawsuits, are often implicated in the alleged wrongdoing and cannot be trusted to make unbiased decisions regarding the merits of these suits. (23)
Securities class actions are the procedural mechanism to enforce the federal securities laws. (24) In a securities class action, the plaintiffs are shareholders alleging that a corporation and its individual officers and directors violated the federal securities laws by making false or misleading public statements. (25) Any recovery in the lawsuit goes to the corporation's shareholders. (26)
Although derivative suits and securities class actions are both key procedural tools in corporate law, scholars have focused nearly all of their attention on securities class actions, studying these suits from every angle. (27) As a result, scholars now know almost everything there is to know about securities class actions, but next to nothing about derivative suits. (28) The time has come to explore the unexplored side of shareholder litigation.
To understand the role of derivative suits in the federal courts, this study examined the full case records of derivative suits filed in federal district courts over a twelve-month period in 2005 and 2006. (29) The cases were identified by searching the "Dockets" database in Westlaw, which includes the dockets of cases in the federal district courts. (30) The search was limited to dockets that included any variation of the term "derivative." (31)
This search produced a list of 478 cases. I then culled from this list cases that were not shareholder derivative suits, cases that were filed before the relevant time period, duplicate cases, and cases that were filed under seal. Two hundred ninety-one cases remained after these suits were culled from the study. I then culled an additional 109 cases that were consolidated by court order. If a suit from my study was consolidated with other suits, I tracked the consolidated suit, even if some of the constituent suits that made up the consolidated suit were not filed during the relevant time period. On the other hand, if two or more suits were filed on behalf of a single plaintiff corporation, but these suits were not consolidated, I tracked each suit separately. This sorting process led to a total population of 182 cases. (32)
I then reviewed the entire case record, from original complaint to final judgment, for all 182 suits using the Public Access to Court Electronic Records (PACER) system. (33) Data from the case records were coded into a specially designed database. (34) I coded more than 200 variables for each suit. These variables included nearly every substantive aspect of the suits, from the parties, to the claims, to the motions and orders and ultimate resolution of the suits. This in-depth review makes this study the most comprehensive examination of derivative suits that has ever been conducted.
This search methodology has certain limitations. First, although the search likely uncovered nearly all derivative suits filed in federal court during the relevant time period, it is impossible to guarantee that the search uncovered all such cases. This limitation is unavoidable in litigation research. The documents in the PACER system are not text searchable and, therefore, there is no perfect way to capture all cases of a given type. Nonetheless, unlike the dockets of other types of cases, the dockets of derivative suits typically note that the case is a derivative suit on the docket itself, usually by specifying that the shareholder sued derivatively on behalf of the plaintiff corporation. Accordingly, a search of the dockets database likely uncovered most, if not all, of the federal derivative suits filed during the relevant time period.
Second, the dataset includes a number of cases that may not reflect the typical derivative suit. Specifically, 40 of the 182 cases (22 percent) involved allegations that the defendants backdated or otherwise repriced stock options. A company backdates stock options when it dates stock options prior to the date that the company actually granted the options. By backdating stock options, companies can manipulate, and generally increase, the value of these options, a practice that often violates accounting and tax rules and can make the company's public disclosures false or misleading. (35) These suits occupied the front pages of newspapers when the scandal broke, (36) but they are different in several important ways from the other suits in the study. Specifically, these suits, which I will call stock option suits, were filed exclusively against large public companies, they disproportionately settled, and these settlements resulted in more value for the plaintiff corporations than the settlements in many of the other suits. (37)
Despite their unique characteristics, these suits reflect an important facet of shareholder litigation. In any given year, most derivative suits are what I term "classic" derivative suits. These suits turn on traditional allegations of corporate wrongdoing, including accounting irregularities, false public statements, or abuse of control by a controlling shareholder. A significant number of derivative suits, however, are more episodic, reflecting the financial crisis du jour. In 2003-2004, for example, derivative plaintiffs set their sights on mutual funds, alleging that these funds had engaged in illegal "market timing" by allowing key clients to profit by placing trades after business hours. (38) In 2005-2006, the time period covered by this study, these episodic suits focused on stock option backdating. From 2008 to the present, there has been an explosion of derivative suits relating to the subprime lending crisis and the resulting credit crunch. (39)
A study of derivative suits that did not include these episodic suits would miss an important facet of shareholder litigation. I have accordingly included both types of suits in my study but noted below when the stock option suits differ significantly from the classic suits. With these points in mind, we turn to the findings of the study.
II. EMPIRICAL ANALYSIS OF FEDERAL DERIVATIVE SUITS
This Part sets out the results of the study. These results demonstrate that derivative suits are a much bigger player in the world of shareholder litigation than scholars have recognized. The study also uncovers the sharp resemblance between derivative suits and other types of shareholder litigation, a resemblance that has gone unnoticed in the legal literature. The results are divided into four sections. The first section analyzes the number of derivative suits in the federal courts, highlighting the long-overlooked role of these suits in corporate law. The next three sections proceed chronologically through the lifecycle of litigation. The second section focuses on the complaints, analyzing the parties on both sides of the litigation as well as their allegations. The third section focuses on the procedural hurdles in derivative suits, hurdles that waylay many shareholders in their effort to vindicate corporate claims. The final section focuses on the resolution of derivative suits, providing a foundation for the reevaluation of the role of derivative suits in countering corporate misconduct.
A. The Unseen Importance of Derivative Suits
An initial look at the data demonstrates that derivative suits play a far larger role in corporate law than previous empirical studies have recognized. Conventional wisdom is that derivative suits are bit players in corporate law, (40) and this view has been confirmed by the few empirical studies in this area. (41) In their study of derivative suits filed in the Delaware Court of Chancery in 1999 and 2000, Randall Thomas and Robert Thompson found that shareholders filed approximately forty derivative suits per year during this time period. (42) The other major study of derivative suits over the last fifteen years, conducted by Kenneth Davis, examined reported decisions of derivative suits available on Westlaw and Lexis. (43) This study examined a total of 294 suits filed over more than seven years, or again approximately 40 suits per year. (44) Thus, the existing empirical literature has unearthed a relatively small number of derivative suits, leading scholars to conclude that "the number of derivative suits has declined markedly in recent years." (45)
My study found that derivative suits have not disappeared--they have simply moved into the federal courts. During the twelve-month period covered by my study, shareholders filed a total of 182 suits in the federal courts. (46) This figure is more than four times higher than the number of derivative suits found by prior studies and more than four times higher than the number of derivative suits filed in the Delaware Court of Chancery. (47) The federal courts are now the center of a significant percentage of corporate litigation, a fact that the focus on state courts has caused scholars to miss.
Even more importantly, my study reveals that derivative suits may well outnumber other types of shareholder litigation, a finding that is again directly contrary to the conventional wisdom. The relatively low number of derivative suits found in prior studies has led scholars to conclude that, "compared to federal securities class actions, or to state court acquisition-oriented class actions, derivative suits are running a weak third in terms of their importance to shareholders." (48) My study challenges this conclusion. Adding the 182 suits in my study to the approximately 40 suits filed per year in the Delaware Court of Chancery yields an approximate estimate of more than 220 derivative suits filed each year. (49) Moreover, this number does not include derivative suits that are filed in other state courts--suits that are currently beyond the reach of litigation researchers because few state court dockets are searchable. In contrast, shareholders on average file fewer than 200 securities class actions per year, fewer than the number of derivative suits. (50) Shareholders file approximately 110 state court acquisition-oriented class actions each year, again fewer than the number of derivative suits. (51)
As this comparison demonstrates, the sheer numbers do not justify the scholarly neglect of derivative suits. Scholars have written off derivative suits based on the small number of these suits in the Delaware Court of Chancery, overlooking the fact that derivative suits have moved into the federal courts. Derivative suits are not dead. Shareholders are still filing them and corporations are still fighting them--the legal academy simply has not known it.
This insight, however, is only the start of the inquiry. Once it is clear that derivative suits are a much more important part of shareholder litigation than previously recognized, the next question is what role these suits play. This question requires an in-depth examination of the suits themselves--an examination conducted in light of empirical evidence from other types of shareholder litigation. We begin this inquiry by looking at the various parties involved in the litigation, from the shareholders to the corporations to the individual officers and directors.
B. Surveying the Complaints
My analysis of shareholder derivative suits begins at the beginning of the suits themselves. I first explore the geography of shareholder litigation. I then turn to the complaints, examining the shareholders who typically file these suits and their allegations.
1. Mapping the Complaints
The suits in my study were spread throughout the federal courts, with at least one suit filed in every judicial circuit. As the figure below indicates, however, a disproportionate number of suits were filed in district courts in the Second and Ninth Circuits.
In all, 26.7 percent of the suits were filed in the Ninth Circuit, while 24.7 percent were filed in the Second Circuit. (52) These percentages are nearly twice the percentages of civil cases filed in each of these two circuits more generally. (53) The concentration of suits in these two circuits is not especially surprising. District courts in New York and California have traditionally been hotbeds of corporate litigation, as empirical studies of securities class actions have demonstrated. (54)
2. Detailing the Parties
a. Derivative Plaintiffs
Turning to the derivative complaints, the first question is who are the shareholders who are filing these lawsuits? My study found that derivative plaintiffs are rarely corporate insiders. Only 15 of the 182 cases (8.2 percent) involved a derivative plaintiff who also served as a director or officer of the plaintiff corporation, and all 15 involved private companies. Moreover, although derivative plaintiffs rarely disclosed their precise ownership interest in the plaintiff corporations, few shareholders appeared to own a significant stake in these corporations. Accordingly, even if they were victorious, their individual recoveries were minimal. What then is their motivation for filing these lawsuits?
The answer turns on the role of institutional investors and other activist investors in shareholder litigation. Institutional investors have long been the preferred plaintiffs in shareholder litigation, as the example of securities class actions makes clear. Prior to 1995, securities class actions were widely viewed as a prime example of lawyer-driven litigation, with shareholders playing little or no role in directing the litigation. (55) Corporations were often forced to pay nuisance settlements rather than incur the high costs of litigation, a phenomenon that Congress concluded would "wreak havoc on our Nation's boardrooms and deter capital formation." (56) Congress sought to end these practices by enacting the Private Securities Litigation Reform Act of 1995, or PSLRA. (57) The PSLRA encouraged institutional investors, such as banks or other financial institutions, to serve as lead plaintiffs by creating a strong presumption that the lead plaintiff in a securities class action should be the shareholder applicant with the largest financial stake. (58) Congress hoped that institutional investors, who have to answer to their own constituencies, would pursue more meritorious litigation and therefore end the abuses that had plagued this area of the law. (59)
By and large, however, the empirical evidence has not borne out these expectations. In a study of 260 post-PSLRA settlements between 1995 and 2002, James D. Cox and Randall S. Thomas found that the PSLRA did increase the percentage of institutional investors serving as lead plaintiffs, but their influence has not lived up to the heady congressional expectations of the 1990s. (60) Approximately 40 percent of the post-PSLRA cases included at least one institutional plaintiff, (61) up from less than 10 percent before the enactment of the PSLRA. (62) Only 17.6 percent of the total study, however, included a financial institution--the classic institutional investor envisioned by Congress (63)--as a plaintiff. (64) Moreover, these financial institutions were not banks or mutual funds, but rather public or labor pension/retirement funds. (65) The study found, however, that the presence of institutions as lead plaintiffs in securities class actions had a small, but measurable, impact on settlement value, raising settlements 0.04 percent for every I percent increase in provable losses. (66)
Derivative suits, by contrast, have largely escaped legislative scrutiny. There are no statutes comparable to the PSLRA's lead plaintiff provisions encouraging institutional investors to file derivative suits. Surprisingly, however, institutional investors are still quite common in federal derivative suits. (67) Of the 141 derivative suits filed on behalf of public companies, 47 (33.3 percent) involved some kind of institutional plaintiff. (68) Moreover, in 27 of these cases (19.1 percent of the public company suits), there was at least one financial institution named as a plaintiff, a greater percentage than Cox and Thomas found in their study of securities class actions. Once again, these financial institutions were almost all public or labor pension/retirement funds, rather than more traditional financial institutions such as banks or mutual funds. (69) These figures demonstrate that financial institutions such as pension and retirement funds are actually more common as plaintiffs in federal derivative suits than securities class actions, at least during the period covered by this study. This fact is counterintuitive, given that securities class actions tend to draw far higher settlement awards and thus return more bang for the buck for investors willing to lend their name to the suits.
A further examination of the data, however, indicates that institutional investors were far more likely to serve as plaintiffs in the stock option suits than in the more classic derivative suits in my study. Financial institutions served as plaintiffs in 37.5 percent of the stock option cases, but only 11.9 percent of the classic public company derivative suits. As explained in more detail below in Part II.D, these cases are the most meritorious suits in the study, at least if merit is determined by the relief obtained by the plaintiff corporation. (70) Accordingly, it appears that, just as in securities class actions, institutional investors in derivative suits are drawn to the bigger, higher-quality cases.
Derivative suits also have their fair share of repeat players, another characteristic common in securities class actions. The vast majority of plaintiffs in my study appeared in only one of the study cases. Twenty-one plaintiffs, however, appeared in more than one. Of these twenty-one repeat players, eighteen appeared in two cases, three appeared in three cases, and one plaintiff (the Alaska Electrical Pension Fund) appeared in five cases. All of these repeat players appeared in public company suits.
Interestingly, several shareholders in my study have made frequent appearances in the world of shareholder litigation even outside the time period covered by my study. Steven Staehr filed just one suit in my study, but according to the Wall Street Journal, he is a "frequent filer" of shareholder derivative suits and has filed "at least seven other shareholder suits" over the past five years. (71) Another plaintiff, Robert L. Garber, who filed two suits in my study, testified in a deposition last year in New York federal court that he has filed more than twenty-five shareholder derivative suits. (72) Following his deposition, the court determined that Mr. Garber was "appallingly ignorant of the many derivative actions that have been filed in his name" (73) because he did "not exert himself to become informed about the litigations in which he serves as named plaintiff unless his performance is being closely examined." The court also noted that Mr. Garber's law firm "initiated this litigation and entirely controlled it." (74) As the court noted, "[t]he very abuses that led to the reform embodied by the PSLRA permeate the world of derivative litigation as well." (75)
There were even more repeat players among the law firms involved in the suits. My study reveals that a fairly small group of plaintiffs' law firms file the vast majority of the suits. Three firms--Coughlin Stoia Geller Rudman & Robbins, Robbins Umeda & Fink, and Federman & Sherwood--each appeared in more than thirty of the suits. Three other firms appeared in ten or more of the lawsuits. (76) Indeed, the ten most common plaintiffs' firms in the study were involved in nearly 75 percent of the public company suits. (77) None of these firms was involved in any of the private company suits. These figures reveal a cadre of plaintiffs' firms responsible for a significant percentage of derivative suits filed on behalf of public companies.
This phenomenon will not surprise those familiar with other types of shareholder litigation because securities class actions are also dominated by a small group of law firms. (78) What may be surprising, however, is how little overlap there is between the law firms involved in derivative suits and the law firms involved in securities class actions. Only two of the ten most represented law firms in my study appeared as one of the top ten plaintiffs' law firms in securities class actions in 2006, 2007, or 2008. (79) Many of these firms file securities class actions but are much smaller players in this category of suits, (80) suggesting that derivative suits may serve as a launching pad for firms that aspire to the more lucrative practice of securities class actions. (81)
As the above analysis demonstrates, institutional investors are just as active in derivative suits as in securities class actions, and there is an active plaintiffs' bar in derivative suit litigation just as in securities class actions. The examination now turns to the plaintiff corporations, the entities at the heart of these suits.
b. Plaintiff Corporations
Commentators have suggested that the real value of derivative suits is in policing managers of smaller public companies. (82) Such companies do not reap as much benefit from other enforcement mechanisms because they are too small to be named in most securities class actions and too big to take advantage of contractual protections common in smaller, privately held companies. (83) Yet the data in my study suggest that derivative suits are disproportionately filed against large public companies. Out of the 182 cases in my study, 141 (77.5 percent) were filed against public companies. These 141 cases involved a total of 126 different corporations. (84) Another 41 suits were filed against a total of 45 private companies. (85)
As Figure 2 indicates, the vast majority of the 126 public company plaintiffs trade on large public exchanges. Fifty-eight companies (46.0 percent) trade on the New York Stock Exchange (NYSE). Another 60 companies …