Archive for April, 2010

Two Types of Shareholder Litigation

There are two types of shareholder litigation.[1] Direct suits are actions brought by shareholders to redress harms inflicted on the shareholders directly typically by corporate officers. The derivative suit, in contrast, enables shareholders to obtain redress for harms inflicted on the corporation.[2] Although, the individual shareholder initiates the derivative suit, the action is brought on the corporation’s behalf and the corporation, not the shareholder, receives any recovery.


The Critical Distinction Between Both Types of Suits

The critical distinction between derivative suits and direct actions turns on the party who suffers the harm, a difficult distinction to make in most factual situations.[3] To maintain a derivative suit, the shareholders must allege that they have suffered injury to their interests because of injury to the corporation. The test applied by the court focuses on the nature of the injury and the claim is considered derivative if the corporation’s interests have been injured. The claim is considered direct if the interest of the shareholder that has been damaged.[4] Determining who has suffered the injury may be relatively straightforward in some cases; there are many situations where determining who has suffered the injury is ambiguous. For instance, where a minority shareholder alleges a breach of the duty of loyalty by a controlling shareholder, it is not clear whether the injury to the minority shareholder is direct or indirect. Since the decision of the Delaware Chancery Court in In re Caremark, Inc establishing that corporate directors have a fiduciary duty to establish monitoring systems to prevent, and when necessary correct, criminal misconduct on the part of corporate employees and agents, the potential for the use of derivative or direct suits in regulating bribery by corporations has increased. The recognition of the directors’ responsibility to establish monitoring systems opens the opportunity for shareholders to bring derivative actions alleging breach of a fiduciary duty.


Incentive Structure for Shareholder Litigation Against Bribery

The potential for both types of suit to curtail bribery by corporate offices is curtailed by the incentive (collective action) problems suffered by both types of suits. In view of the dispersed ownership characteristic of public corporations, most shareholders have a limited amount invested in any given corporation. It is therefore not cost effective for most shareholders to investigate and litigate specific instances of wrongdoing by corporate officers.[5] This problem has been partially ameliorated by allowing representative suits such as class actions. Nonetheless, in the direct suit, the fact that plaintiff’s recovery is limited to his damages creates a disincentive for the plaintiff to litigate corporate officers engaging in bribery. Similarly, there is a disincentive for the plaintiff to bring derivative suits because the recovery is for the benefit of the corporation and the plaintiff benefits only indirectly.[6] Although representative actions resolve one set of collective action problems, they do so at a price: they can create high agency costs and generate an entirely new set of collective action problems.[7] The major criticism of shareholder litigation is that the reduction of agency costs has intensified the collective action problems that are associated with any type of group litigation.


In the context of bribery by corporations, resolving one set of costs does not heighten the other set of costs. On the contrary, the use of shareholder litigation to curb bribery by corporations’ highlights the deterrence function performed by both derivative and direct suits. The central dilemma faced by the prospective role of shareholder litigation in regulating bribery by corporations is the tension underlying the proper balance between the positive management agency cost reducing effects of shareholder litigation against the collective action problems associated with shareholder litigation.[8] The most apparent error courts make is elevating compensation over deterrence in defining the mission of the derivative suit.[9] Many features common to the conduct of direct and derivative suits detract from the positive role of shareholder litigation in curbing misconduct by corporate officers.


The Misapplication of Shareholder Litigation

The social utility of shareholder litigation has also been affected by the view that shareholder suits are private suits intended to compensate injured investors. A recurring fallacy in the debate over shareholder litigation has been the preoccupation with the compensatory rather than punitive aspects of shareholder suits thus serving to obscure the suits’ expression of social values.[10] The academic debate, consistent with the compensatory goal, has been inclined to measure the value of shareholder suits by reference to the size of financial compensation.[11] By finding, as they do, that shareholder suits fail in their compensatory mission, these studies support a negative view of the social value of shareholder litigation. The special attention devoted to the goal of compensation by shareholder litigation actions tells us very little about the goal of deterrence generally. The focus of shareholder litigation is to address the problem of redistribution in a private contract, rather than the norm enunciating characteristics of these actions. In this view, compensating shareholders is a private matter, whereas deterrence is of public concern. The more squarely the objectives of shareholder suits are geared towards a compensatory function, the weaker the role these suits play in the condemnation of the misconduct underlying the shareholder actions. To the extent that suits are perceived as addressing purely private injuries, instead of being understood to address violations of the public interest in ways that cause private harms, the perception will be that derivative suits are but a subset of the standard commercial dispute between two warring financial interests. The extent to which shareholder litigation should play in role deterring wrongful conduct by corporate officers may be latent in existing doctrine, but plenty of room remains for serious consideration of these implications.


Indemnification Insurance – Another Hurdle

In addition to the lack of incentive by shareholders to litigate, corporate officers, and directors are shielded from most exposure to liability for damages through indemnification and insurance.[12] The availability of indemnification and insurance insulates corporate officers from most financial responsibility. Although these indemnification and insurance policies do not cover officers who are liable for wrongdoing such as bribery, there is a tendency for corporate officers to settle rather than incur liability from litigation. The settlement agreements can be drafted to insure conduct of the corporate officers meet the requirements for coverage. In fact, the vast preponderance of shareholder suits that survive pre-trial motions result in settlements, not judgments on the merits.[13] The deterrence effect of shareholder litigation for the misconduct of corporate officers would appear to be dampened by the prevalence of settlements within the bounds of available insurance from the carrier rather than the corporate officers.

[1] The case of Jones v. H.F. Ahmanson & Co., 460 P.2d 464, 470 (Cal. 1969) provides a detailed judicial exposition of the nature of derivative suits and distinguishes direct suits from derivative suits.

[2] Prunty, B [1957]: “The Shareholders’ Derivative Suit: Notes on Its Derivation”. In Vol. 32 New York University Law Review, 980 at 981-984 traces the historical development of derivative suits.

[3] Glenn G. Morris, [1995] Shareholder Derivative Suits: Louisiana Law, 56 La. L. Rev, 583 at 586-88.

[4] See Welch, J [1984]: “Shareholder Individual and Derivative Actions: Underlying Rationales and the Closely Held Corporation”. In Vol. 9 Journal of Corporate Law, 147 at 154.

[5] Empirical studies of derivative suit settlements suggest that attorneys, not shareholders, are the principal beneficiaries. See Romano, R [1991]: “The Shareholder Suit: Litigation Without Foundation?”. In Vol. 7 Journal of Law Economics and Organization, 55 at 63-65.

[6] See Cox, J [1999]: “The Social Meaning of Shareholder Suits”. In  Vol. 65 Brook. Law Review, 3 at 6.

[7] See Macey, J & Miller, g [1991]: “The Plaintiffs’ Attorney’s Role in Class Action and Derivative Litigation: Economic Analysis and Recommendations for Reform”. In Vol. 58 University of Chicago Law Review, 1 at 8 n.6.

[8] Thomas, R & Hansen, R [1993]: “Auctioning Class Action and Derivative Lawsuits: A Critical Analysis”. In Vol. 87 North Western University Law Review, 423 at 427 recognise that collective action problems inherent in any effort to organise a large group of individuals into a common project.

[9] Some commentators have suggested that deterrence is the major reason for and principal effect of derivative suits. See Schwartz, D [1986]: ‘In Praise of Derivative Suits: A Commentary on the Paper of Professors Fischel and Bradley’. In Vol. 71 Cornell Law Review, 322 at 331.

[10] Cox for instance, has suggested that in the determining the primary purpose of the derivative suit, the goal of compensation has prevailed over deterrence. See Cox, J [1982]: ‘Searching for the Corporation’s Voice in Derivative Suit Litigation: A Critique of Zapata and the ALI Project’. In Duke Law Journal, 959 at 990.

[11] See for example Fischel, D & Bradley, M [1986]: “The Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis”. In Vol. 71 Cornell Law Review, 261 and Romano, R [1991]: “The Shareholder Suit: Litigation Without Foundation?”. In Vol. 7 Journal of Law Economics and Organization, 55. However, an earlier study provides a slightly more optimistic report. See Jones, T [1980]: “An Empirical Examination of the Resolution of Shareholder Derivative and Class Action Lawsuits”. In Vol. 60 Boston University Law Review, 542.

[12] See Kraakman, R [1984]: “Corporate Liability Strategies and the Costs of Legal Controls”. In Vol. 93 Yale Law Journal, 857 at 861-62. He describes the scope to which officers and directors may be insulated from liability by indemnification and insurance.

[13] A 1992 study of 98 corporate and class action suits in the Delaware Chancery Court over a two and a half year period found that more than 95% of the preferred settlements were approved and approximately two-thirds of the attorneys’ fee applications were granted in full. See Berger, C & Pomeroy, D [1992]: “Settlement Fever”. In Sept.-Oct. Business Law Today, 7.


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Fiduciary duties of directors and bribery

The regulatory regime for the internal organisation of the corporation in the US has traditionally been an exclusive function of State law. The State of Delaware in the US is the domicile of choice for most of the publicly listed corporations and the destination where most corporations incorporate in the US. The provisions of the Delaware statute focus on defining the duties and responsibilities of the directors and the relative rights of shareholders to constrain the actions of directors. These duty-based controls, such as the fiduciary duties imposed by statutes to constrain managerial discretion are monitored through the exercise by shareholders of their legal remedies to bring proceedings. The Delaware statute imposes very little by way of accountability obligations on the directors and officers of the corporation. For instance, there are no requirements regarding the qualification or independence of directors or obligations defining the duties of the corporate officers.[1] The statute establishes a set of default rules that can be changed by corporate organisers to fit their preferences, but has relatively little to say about the standards that directors and officers must adhere to or practices they must follow. Consequently, the standards accountability for directors in the discharge of their corporate responsibilities comes from non-legislative sources. These sources include listing standards such as those provided by the NYSE LSE and fiduciary duty obligations developed by the courts.

Statutory Framework for the Liability of Directors

The broad framework for the duties of the directors and officers of the corporation is laid out in the Delaware Corporate Law Statute. The statute provides that all the powers of the corporation should be exercised by or under the direction of the board of directors.[2] Despite the broad ambit of the powers given to the board of directors, there are statutory limitations to the powers of directors by the power of shareholders to vote, sue, and sell their stock. For instance, shareholder voting is required, not just to elect directors, but also as a prerequisite to mergers and similar transactions after directors have proposed them.[3] Other constraints on the powers of the directors are factual. For instance, despite the powers of shareholders to vote, sell, and sue, these powers are selectively utilised with very little impact on the control of the corporation.[4] Although shareholders can elect directors, they do not act for the corporation.[5] The Officers of the corporation act for the corporation on behalf of the directors as agents.[6] Although the officers of the corporation exercise the majority of the actions taken on behalf of the corporation, the provisions of the statute clearly subordinates the officers to the directors of the corporation.[7]

Fiduciary Duties Developed by the Court

Beyond the statutory provisions, the accountability of directors is governed by fiduciary duties imposed by the courts. Directors and Officers of corporations must comply with three basic categories of duties: the duty of care, duty to monitor, and the duty of loyalty. The duty of care applies to board decisions that do not involve conflicts of interest. The duty of care requires that the directors of the corporations discharge their duties in the honest belief that their actions are taken in the best interests of the corporation.[8] The scope of the duties of Directors includes the obligation to make decisions based on informed business judgment.[9] Directors are also obliged to be diligent in gathering and considering information that is material, or merely relevant, prior to making a decision, and should exercise reasonable care in the attention they give to the performance of their general responsibilities.[10] For many years, the courts described this duty in a manner that appeared to hold directors and other managers to the negligence standard.[11] The standard of the scope of the duty of care of the corporation’s directors is determined by the contours of the business judgement rule. The business judgment rule protects decisions made in good faith, on a fully informed basis, and in the best interests of shareholders. The court will presume that the decision of the directors was taken in the best interest of the shareholders unless the plaintiff rebuts this presumption. Rebutting the presumption does not result in per se liability.[12] Rather, rebutting the presumption shifts the burden to the directors to show the fairness of the transaction.[13] Rebutting the presumption requires a showing of gross negligence.[14] The business judgment rule and the high standard required to establish a breach of the duty of care ensures that directors are insulated from liability to the corporation or its shareholders as long as the actions taken is can rationally be related to a business purpose of the corporation.

Judicial Activism legislative restrictions

The Delaware courts have on occasion sought to expand the scope of the duty of care owed by directors. These attempts have however been restricted by the Delaware legislature through statute. In the case of Smith v. Van Gorkom, the Delaware Supreme Court expanded the scope of duty of care of directors by allowing a rebuttal of the business judgement rule when the officers and directors had not engaged in fraud or taken the decision for personal gain or bad faith.[15] In this case, the directors approved the sale of the corporation at a two-hour meeting, without advance notice and without seeing the final written agreement. According to the court, bad acts amounting to gross negligence brought judicial oversight over the transaction.[16] In effect, the court lowered the threshold for the duty of care from the very high gross negligence standard. The Delaware State legislature responded to the expansion by incorporating a provision that waives monetary damages for breaches of the duty of care into the corporate law statute.[17] The effect of the statutory provision is that in the absence of a violation of the duties of loyalty, good faith, or intent to harm the corporation or its shareholders, directors are now exculpated from private monetary liability for failures to adhere to their duty of care.

The Duty of Care and Bribery

The current scope of the duty of care is insufficiently developed to impose liability on directors in situations where officers engage in bribery. Under the standards of the duty of care established by the Courts, directors have no special obligations with regard to verifying the information supplied by officers of the corporation. In Solash v. Telex Corp. the court held that directors fulfil their duty of care by reviewing management supplied information in the standard manner, as long as they are unaware, and in the exercise of due care would not have been aware, of facts or discrepancies signalling the need for additional information.[18] The principal argument that has been advanced in favour of limiting the duty of directors is that requiring directors to verify information supplied by management would be inefficient and might create an adversarial relationship between directors and officers.[19] This limitation, combined with the business judgment rule and passage of Section 102(b)(7) limits the scope of the duty of care to regulate bribery by corporation. While the duty of care applies to decisions that do not involve conflicts of interest, the duty of loyalty primarily applies in situations where the directors have a financial interest in transaction. The existence of the conflict raises the possibility that the directors or corporate officers are engaging in self-dealing at the expense of the shareholders.[20] Similar to the duty of care, the duty of loyalty is restricted by the business judgement rule and the same gross negligence standard is used to determine whether directors are in breach of the duty.

The Duty to Monitor and Bribery

The duty to monitor actions of the officers of the corporation is another fiduciary duty that has broad potential to impose liability on directors for the actions of corporate officers engaging in bribe transactions. The Delaware Courts have imposed a specific duty on the part of directors to monitor the business affairs of the corporation. Under the duty of care, directors are not accountable for corporate wrongs in the absence of specific knowledge.[21] In the case of In re Caremark, the Delaware Court of Chancery sought to impose a fiduciary obligation on directors to put in place and monitor procedures to keep them informed about the activities of the corporation.[22] The case involved a derivative action against the corporation’s directors by the shareholders. The defendant, Caremark, was engaged in patient care.[23] The corporation derived most of its revenue from Medicare and Medicaid reimbursement. Under the Anti-Referral Payments Law, Caremark could not provide remuneration for the referral of patients by physicians. In violation of the prohibition, the officers of Caremark paid for referrals. The corporation eventually pled guilty to criminal charges. The shareholders argued that the directors had breached their duty to monitor by inadequately supervising the conduct of the corporate officers. Although the parties settled the proceedings, the Court in approving the settlement was of the opinion that if again faced with the issue, it would not follow an interpretation of the red flag test, which protected directors in all but overtly suspicious circumstances.[24] The Court indicated that the duty of oversight might require boards of directors to have monitoring and reporting systems to provide the board with “timely, accurate information sufficient to allow management and the board . . . to reach informed judgments concerning both the corporation’s compliance with law and its business performance”.[25]

Limitations of the Duty to Monitor

The application of the duty to monitor to the regulation of bribery by corporations is limited. First, the Caremark decision was taken in the Delaware Court of Chancery. Neither the decision nor its rationale ever received approval by the Supreme Court of Delaware. Second, the scope of the duty is limited by the fact that the directors would only be liable in the event of a systematic failure of procedures put in place to deter bribery. The standard requires that directors put in place procedures that keep them informed but did not cover the quality of the procedures instituted. There was thus very little incentive for directors to inform themselves by putting in place procedures to ensure that problems came to their attention. The directors had little incentive to seek other sources of information, which could increase their oversight obligations and legal exposure. [26]

Duties of other Corporate Officers

Corporate officers, as agents of the corporation, also have fiduciary duties to the corporation and shareholders similar to the duty owed by directors. Even though the relation between the officers and the corporation is governed by the contractual terms of the employment agreements, as fiduciaries, they owe several duties to the corporation that exist independently of contract.[27] Breach of these duties affords the corporate principal a host of remedies, including a tort action against the agent for losses caused by the breach.[28] The fiduciary duty of the corporate officer particularly relevant to the regulation of bribery is the officer’s duty of loyalty. This duty requires the agent to act solely for the benefit of the corporate principal.[29] The scope of the duty of loyalty is broad and precludes the officers from taking actions adverse to the corporation, or on behalf of one with interests adverse to the principal without consent, not competing with the principal, providing an accounting to the principal for profits.[30] The agency status of officers seems to have been more significant to the issue of whether, in a particular case, officers had the power to affect the corporation’s relationship with third parties than to the issue of the fiduciary duties owed by officers, as agents to the corporate principal. Relatively little litigation asserting breach of fiduciary duty claims against officers has been brought either by boards of directors or, derivatively, by shareholders. The scope of the fiduciary duty of corporate officers in the context of bribery has been limited by the fact that until the passage of an amendment the Delaware statute in 2004, the Delaware Chancery Court did not have personal jurisdiction over officers of corporations.[31]

[1] See Del. Code Ann. tit. 8, 141(b) (2001 & Supp. 2002) provides that the certificate of incorporation or bylaws may prescribe other qualifications for directors. See also 142(a) (2000) which provides that the corporation “… shall have such officers with such titles and duties as shall be stated in the bylaws or in a resolution of the board of directors which is not inconsistent with the bylaws … .”.

[2] Del. Code Ann. tit. 8, 141(a) provides that all corporate power “shall be managed by or under the direction of a board of directors”.

[3] Del. Code Ann. tit. 8, 141 (2001 & Supp. 2002).

[4] Thompson, R [1999]: “Preemption and Federalism in Corporate Governance: Protecting Shareholder Rights to Vote, Sell, and Sue”. In Vol. 62 Law & Contemporary Problems, 215, at 216.

[5] Del. Code Ann. tit. 8, 141(a) (2001) provides that the power of a corporation lies with the board of directors and officers who may be elected by the shareholders.

[6] Del. Code Ann. tit. 8, 142 (2001) outlines the duties and powers of officers selected by the directors.

[7] Most sections of corporation law codes are directed to the role of shareholders rather than to corporate officers. The main provisions directed toward corporate officers include Del. Code Ann. tit. 8, 142, which refers to officers and defers to the corporations bylaws or board resolutions as to what officers might do, how they are chosen, and how vacancies are filled, except for minimal default provisions, such as the provision that officers may resign at any time. Other provisions include Section 143, which addresses loans to employees and officers, and section 145, which includes officers, along with directors and others, as persons whom the corporation may indemnify.

[8] Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

[9] Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985)

[10] Aronson, 473 A.2d at 812 (Del. 1984).

[11] See Gelb, H [1998]: “Director Due Care Liability: An Assessment of the New Statutes, 61 Temple Law Review, 13 at 16,  who notes that there are few reported cases in which directors have been held liable for mere negligence.

[12] McMullin v. Beran, 765 A.2d 910, 916-17 (Del. 2000).

[13] See the cases of  Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1162 (Del. 1995) and Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993).

[14] See the case of Brehm v. Eisner, 746 A.2d 244, 264 n.66 (Del. 2000) where the court noted that decisions reached through a grossly negligent process will not be protected by the business judgement rule.

[15] 488 A.2d 858 (Del. 1985).

[16] 488 A.2d at 864, 867-69.

[17] Del. Code tit. 8, 102(b)(7) (1988).

[18] Fed. Sec. L. Rep. (CCH) P93, 608, 97,727, 1998 WL 3587 (Del. Ch. 1988).

[19] Coffee, J [1977]: “Beyond the Shut-Eyed Sentry, Toward a Theoretical View of Corporate Misconduct and Effective Legal Response”. In Vol. 63 Virginia Law Review, 1099 at 1108.

[20] Brown, J [1991]: “Discrimination, Managerial Discretion and the Corporate Contract”. In Vol. 26 Wake Forest Law Review, 541, at 652.

[21] See Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (1963), where the court noted that absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to expect exists.

[22] In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).

[23] Caremark, 698 A.2d at 971.

[24] Caremark, 698 A.2d at 970

[25] Caremark, 698 A.2d at 970.

[26] The Court stated that good faith attempts to monitor management would not result in liability and that good faith would not be established through isolated examples of oversight failure, but only through sustained or systematic failure. Caremark, 698 A.2d at 970.

[27] Restatement (Second) of Agency 1 (1958).

[28] Id. 399.

[29] Id. 387.

[30] Id at 389-90, 391-92, 394, 393 and 388.

[31] Del. Code Ann. tit. 10, 3114 (2003).

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