The Structure of Stockholder Litigation: When Do the Merits Matter?

The following post comes to us from Minor Myers, Assistant Professor at Brooklyn Law School, and Charles Korsmo, Assistant Professor at Case Western Reserve University School of Law.  It is based on their recent paper, “The Structure of Stockholder Litigation: When Do the Merits Matter?,” which is forthcoming in the Ohio State Law Journal and is available here.

We offer a novel perspective on an old question in corporate law: Do the merits matter in stockholder litigation? In short, we find that the merits appear to matter very little in an important type of stockholder litigation—fiduciary duty class actions challenging mergers—and that the seeming irrelevance of the merits largely stems from the structural features of that type of litigation.

One persistent challenge confronting any attempt to answer that question has been the impossibility of directly assessing the merits of fact-sensitive claims that allege fraud or breach of fiduciary duty. Investigators have been forced to use highly imperfect proxies for merit, such as the presence of an accounting restatement, a parallel SEC inquiry, and so forth. We examine stockholder class actions that challenge proposed mergers, the dominant form of stockholder suit today. Merger claims offer two major advantages in asking whether the merits matter. First, we can directly observe the paramount merits issue of claims attacking proposed takeovers instead of relying on some proxy. While such claims are couched in terms of violations of fiduciary duty, the only issue of genuine consequence to a typical stockholder will be the adequacy of the merger consideration, which we can observe directly. The second advantage of studying merger litigation is that stockholders have two distinct types of legal remedies available to them: filing a class action alleging fiduciary breach or seeking stockholder appraisal. The fiduciary class action involves a class comprised of all shareholders, lead plaintiffs with small holdings, and plaintiffs’ attorneys who control the claims. Appraisal litigation, by contrast, has none of these features. We exploit these differences to test whether the structure of the litigation affects the merits of the claims. If the fiduciary class actions differ from appraisal in the incidence and intensity of litigation, the most natural inference is that the difference is attributable to the difference in structure.

In a fiduciary class action, the claims by default proceed on behalf of the entire stockholder class. All of the major species of stockholder litigation—not just fiduciary class actions but also derivative suits and federal securities claims—are brought in a representative capacity, initiated and managed by professional plaintiffs’ attorneys. The actual named plaintiff is typically an unimportant player in the litigation, exercising little oversight over the prosecution or settlement of the claims. This relationship—between the stockholders on whose behalf the claims are brought and the plaintiffs’ attorneys who control those claims—has long been viewed as the root problem in stockholder litigation. Plaintiffs’ attorneys may bring claims that are not in stockholders’ best interests or forego aggressive litigation of meritorious actions in favor of a quick settlement that provides generous attorneys’ fees. The enduring question is whether this relationship attenuates the connection between the merits and litigation.

The structure of appraisal claims offers a stark contrast. Each stockholder must affirmatively opt in to the appraisal claim by meeting certain procedural requirements. As a result, an attorney representing a small stockholder cannot bring an appraisal claim in the hopes of gaining representative status for a larger class and, accordingly, a larger potential recovery. The stockholder must hire the attorneys, not the other way around. In addition, Delaware’s appraisal statute makes no provision for allocating the plaintiff’s attorney fees to the defendant. Consequently, plaintiffs’ attorneys can receive payment only from the actual plaintiffs, either directly or out of a genuine monetary recovery. If the pathologies associated with standard stockholder litigation are caused—or at least exacerbated—by the ability of plaintiffs’ attorneys to secure large fees even in the absence of genuinely valuable recovery to the shareholder plaintiffs, we would expect to see these pathologies significantly reduced in the appraisal context. In addition to a much-reduced agency problem, an appraisal proceeding presents the shareholder with a genuine risk of financial loss that is absent from other shareholder litigation because the court may ultimately determine fair value to be less than what the shareholder would have received in the merger. Unlike plaintiffs in fiduciary class actions, appraisal petitioners have real skin in the game.  Taken together, these features mean that Delaware appraisal actions present a unique type of stockholder claim where the merits ought to matter a great deal. Because the crucial merits issue is the same in takeover litigation and in appraisal—the adequacy of the merger consideration—we can use appraisal as a benchmark against which to measure the merits of takeover litigation.

Until very recently, appraisal has not attracted much attention.  In our previous Article, “Appraisal Arbitrage and the Future of Public Company M&A,” we present a full picture of contemporary appraisal activity and argue that commentators have underestimated its social utility. Here, we use the differing structures of appraisal and fiduciary class actions to investigate the role of legal merit in conventional stockholder litigation.

We examined appraisal-eligible mergers between 2004 and 2013.  To determine whether the merits matter, we compared the characteristics of deals that resulted in fiduciary duty class actions to those that did not. The size of the merger premium should be correlated to the magnitude of the potential damages and also to the probability of a breach of fiduciary duty. If the merits matter, we would therefore expect to observe an inverse relationship between the size of the merger premium and the likelihood of a fiduciary class action challenging the merger. That is, shareholders should be more willing to challenge a merger where they are set to receive a small premium over the market value of their shares, and less likely to do so where they would receive a large premium.

We also examine the relationship between the overall size of the deal and the likelihood of a fiduciary duty class action. While the size of the deal is generally correlated to the potential damages available, the deal size should be—at most—approximately as relevant to the merits as the size of the merger premium. If, however, the incidence of class action litigation is driven by plaintiffs’ attorneys searching for deep pockets, we would expect a far stronger positive relationship between deal size and the likelihood of a claim. Consistent with this expectation, we find that fiduciary duty class actions challenging mergers are strongly associated with deal size and that deal size has far greater explanatory power than the merger premium. Our findings suggest that the merits count for little in the decision to bring suit and that such actions are frequently brought primarily for their nuisance value.

To test this conclusion, we also examine the incidence of appraisal actions. We find that appraisal activity—unlike fiduciary litigation—is not correlated with deal size. This finding supports the conclusion that the usual correlation between deal size and shareholder litigation is driven by agency problems and asymmetric litigation risks, which are largely absent in the appraisal context. We also examine the merger premium for deals that attracted an appraisal petition versus those that did not. In contrast to the results for fiduciary duty class actions, we find that there is a strong correlation between the merger premium and the likelihood of an appraisal claim. Mergers with smaller premia are more likely to attract appraisal actions, precisely as we would expect if the decision to seek appraisal is based on the merits of the underlying claim.

In sum, our findings show that the merits matter in the incidence and intensity of appraisal actions. This stands in stark contrast to the fiduciary class action litigation, where deal size is the strongest predictor of litigation, with far greater influence than the adequacy of the merger premium. These results represent the most conclusive evidence yet that the merits matter little in at least one important class of stockholder litigation. The contrasting example of appraisal litigation involving the same universe of transactions makes the conclusion all the more compelling.

Our results demonstrate that appraisal claims are overwhelmingly meritorious. Recent developments in Delaware suggest appraisal claims may in fact be too meritorious. Readers may recall the dust-up earlier this year over fee-shifting bylaws, which ended with a joint resolution that called upon the Corporation Law Section of the Delaware bar to examine that issue. Tucked at the end of that resolution was an additional request: that the Section also examine the “statutes and court rules governing the exercise of appraisal rights.” The need for such a reexamination is not apparent to us. Some defense-side firms have issued memos full of hand-wringing over appraisal activity, and it is perhaps too cynical to worry that the resolution was an invitation to snuff out what appears to be the most socially useful form of stockholder litigation. In light of our findings, appraisal is the type of stockholder litigation least in need of reform. If anything, other forms of stockholder litigation could be made to function better by borrowing the structural features of appraisal.