Do Derivative Lawsuits Still Matter?

In the world of directors’ and officers’ liability, securities class action lawsuits dominate the dialogue. Securities lawsuits generate headlines and produce eye-popping settlements. There are even websites (refer here and here) devoted exclusively to providing the latest information about securities lawsuits. The same cannot be said for derivative lawsuits, but it has not always been that way. At least until 30 years ago or so, shareholders derivative lawsuits were the main vehicle for defining the duties of corporate directors and officers and establishing the standards of corporate governance.

A November 2007 law review article by Wisconsin Law School Dean Kenneth B. Davis, Jr., entitled "The Forgotten Derivative Suit" (here), takes a detailed look at the diminished role of derivative lawsuits and examines the ways in which derivative lawsuits nevertheless still matter.

The author begins with the view that until the mid-70s, courts, acting through derivative lawsuits, provided the principal means of corporate oversight. Over the last three decades, this role has shifted, principally to independent Board directors but to others as well. In analyzing derivative litigation’s changing role, the author refers to historical analysis and prior research as well as to his own survey of 294 opinions involving derivative suits brought in federal and Delaware courts and involving Delaware corporations and issued between 2000 and the first quarter of 2007.

In Dean Davis's view, the two most important causes for the declining significance of derivative lawsuits is the judicial development of the demand requirement (and corresponding deference to independent directors) and the development of exculpatory statutes relieving directors of financial responsibility for many actions. These factors, the author finds, "have combined to marginalize the derivative suit for cases not involving self-dealing or other palpable breaches of the duty of loyalty."

In addition, a number of developments "began to supplement and supplant the derivative suit with respect to both of its recognized roles – compensation and deterrence." As for compensation, "securities and other class actions now perform many of the functions previously associated with the derivative suit." In addition, regulatory mechanisms (especially the SEC’s enforcement program) and the threat of criminal prosecution ‘have evolved to challenge the derivative suit’s reputation as the chief regulator of corporate management." Moreover, as a result of a more vigorous business press and the publicity surrounding recent corporate scandals, "the stigma of corporate misconduct" also provides significant deterrence even in the absence of formal action. All of these mechanisms fulfill functions the derivative lawsuit would have provided in the past.

The author takes a particular look at the recent wave of options backdating derivative lawsuits (about which refer here), which he notes are "consistent with the critique that derivative suits simply piggyback on what the government (or perhaps the media) has already uncovered and investigated." In this circumstance, the derivative lawsuit can contribute to deterrence only if the government lacks resources and if the plaintiff is willing to follow through. He notes that "too often, however, the economic pressures facing the plaintiffs’ attorney, coupled with the defendants’ access to indemnification and insurance, leads to a quick and non-pecuniary settlement that supports the award of attorneys’ fees but imposes little if any monetary cost on the individual defendant." (The latter point was underscored in the Wall Street Journal’s November 19, 2007 article, here, discussing the outcomes of many of the options backdating cases.)

Notwithstanding these limitations on the continued meaningfulness of derivative lawsuits, there are still circumstances, the author concludes, when derivative lawsuits are likeliest to be valuable. The first involves "misconduct at smaller companies, whose shares are less actively traded" or not publicly traded at all, and where the misconduct "will be more likely to escape the awareness and the interest of governmental agencies and the media." The second involves "cases seeking the return of a substantial benefit" which "pose a greater threat of personal loss to individual defendants." In cases "challenging transactions between the corporation and those who control it" (which would tend to involve both smaller companies and personal benefit, both of the previously identified factors), "the derivative suit continues to make its most important contributions, both as a source of compensation and deterrence for the corporation’s minority shareholders and as a public good."

The author, who clearly has devoted much time to studying and thinking about derivative lawsuits, bemoans their diminished role. He notes that:

There is no field manual, code of conduct, formal training or licensing body to spell out what directors ought to do in a specific situation….[Courts’] opinions are … the raw material for a dialogue across the business and legal professions as to what should be expected of directors….One effect of the stricter demand requirements has been to reduce the volume of case law available to perform this culture shaping role.

As someone who has spent most of my professional career involved with directors’ and officers’ liability issues, I have always felt that derivative lawsuits are underappreciated, understudied, and poorly understood. Part of the reason for this is that there is relatively little centralized information about derivative lawsuits, especially by comparison to securities class action lawsuits. Dean Davis’s article goes a long way toward helping to explain the role and significance of derivative lawsuits, and provides useful supporting data. The article helps to fill a significant void in the world of directors’ and officers’ liability.

Special thanks to Dean Davis for providing me with a link to this excellent article.