As reported by Cornerstone Research, Advisen and others, the frequency and volume of shareholder derivative and class action lawsuits challenging mergers and acquisitions of U.S. public companies have skyrocketed in recent years. In 2007, only 53 percent of all M&As valued at $500 million or more encountered legal challenges by the target's shareholders in the form of multiple derivative and/or class action lawsuits against the target's board of directors. By 2011, the rate of M&A objection suits had practically doubled: Nearly all (96 percent) of the larger M&A deals and the vast majority (85 percent) of smaller combinations (valued between $100 million to $500 million) faced an average of four separate shareholder lawsuits per deal, with some transactions attracting more than 15 lawsuits, according to Cornerstone's "Recent Developments in Shareholder Litigation Involving Mergers and Acquisitions." In light of this rapid growth, M&A objection suits now represent more than 25 percent of all securities suits filed, up from 8 percent in 2004, according to Advisen's "Securities Suits Remain Off Recent Highs."
Given this new reality where no M&A deal, no matter the terms and decision-making process, is immune from M&A objection suits boards of directors of potential M&A targets must be prepared to face an onslaught of shareholder claims. One important tool in the board's arsenal is the special litigation committee (SLC). As explained in more detail below, when a shareholder makes a written demand on the target's board to assert claims on behalf of the corporation in the form of a derivative action, the directors can appoint an SLC to fulfill their obligation to investigate and evaluate the claims. So long as the SLC can demonstrate that it acted independently and in good faith, a court will give deference to the SLC's "business judgment" as to whether or not claims should be brought against the company. While shareholders of Delaware corporations often try to circumvent the demand requirement by alleging demand futility, shareholders of companies incorporated in Pennsylvania do not have this option and must make a written demand on the board to file suit. Therefore, before announcing an M&A deal, the target's board should be apprised of the SLC process so it can effectively respond to a shareholder demand letter.
M&A Objection Suits: The New Reality
In cookie-cutter fashion, most M&A objection suits filed in 2010 and 2011 alleged that, in approving the M&A deal, the target company's directors agreed to a price that is too low, conducted a flawed sales process and made misleading disclosures, all in breach of their fiduciary duties owed to shareholders. Typical process claims included allegations that the directors failed to conduct a sufficiently competitive auction; imposed restrictive deal protections that discouraged additional bids; incorporated terms reflecting various conflicts of interest (e.g., executive retention, change-of-control payments to executives); and/or failed to disclose sufficient information regarding the sale process, the reasons for the board's actions, financial projections and/or the financial advisers' fairness opinions. Because such claims are governed by the law of the state of the company's incorporation, not federal law, plaintiffs attorneys often file these actions in state court either the state of incorporation or, if different, the state where the company resides.
In 2010 and 2011, the majority of M&A objection suits were filed within two weeks after a deal's announcement and, in most cases, the parties settled the shareholder claims before the deal closed. Cornerstone points out that these findings show a significant change from the outcomes observed a decade ago, where 59 percent of the M&A objection suits filed in Delaware Chancery Court were dismissed and only 28 percent settled. In addition, only a few of the M&A objection suits filed in 2010 and 2011 resulted in payments to shareholders in stark contrast to suits filed a decade ago, where half the settlements included cash awards. Most of the recent cases examined by Cornerstone settled for additional disclosures, and some settled for changes in merger terms, though none included a higher bid for the target. Although most of the settlement reports reviewed by Cornerstone did not disclose the amount of plaintiffs attorney fees, of the reported attorney fees, 43 percent were $500,000 or less and only 23 percent were $1 million or more.
In most circumstances, target companies have little incentive to fully defend M&A objection suits because the sooner they can resolve the litigation, the sooner they can close the deal. Additionally, the acquiring company often pushes for a settlement to enable the deal to close. Given this high likelihood of a quick settlement, plaintiffs lawyers are nearly guaranteed a financial return (in the form of attorney fees) on a minimal investment of time and resources. Unlike the Private Securities Litigation Reform Act of 1995, which Congress enacted to curb the filing of "strike suits" that once plagued public companies, no federal legislation currently exists to restrain this new form of attorney-driven litigation, because the claims arise under state, not federal, law.
Shareholder Demand Letters
Where the target company is incorporated under Delaware law, a shareholder may either make a written demand on the board of directors to file suit against some or all of the directors on the company's behalf (usually in the form of a "demand letter"), or, alternatively, file a derivative complaint that pleads "with particularity" facts showing that demand on the board would be "futile." (See Del. Ch. Ct. R. 23.1; Fed. R. Civ. P. 23.1.) A shareholder who makes a written demand instead of filing a derivative action on behalf of the company concedes that such demand is not futile and that a majority of the board is sufficiently independent to investigate the issues raised by the demand and decide how to respond. Consequently, the board's ultimate decision whether to file suit will be protected by the "business judgment rule" as long as the board makes the decision with due care, in good faith and in the company's best interests. (See, e.g., Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).)
Where the target is a Pennsylvania company, the complaining shareholder must make a written demand on the board of directors to file suit against the board and does not have the option of pleading demand futility. (See Cuker v. Mikalauskas, 692 A.2d 1042, 1049 (Pa. 1997) (adopting §7.03 of the American Law Institute Principles of Corporate Governance).) Moreover, the board can assert the business judgment rule in defense of its decision not to sue; and, if the court "makes a preliminary determination that a business decision was made under proper circumstances ... then the business judgment rule prohibits the court from going further and examining the merits of the underlying business decision."
Special Litigation Committees
Generally speaking, a corporation's decision whether to assert claims against any of its officers and/or directors is entrusted to the business judgment of the company's board of directors. Accordingly, if and when a shareholder "demands" that a company's board conduct an investigation of alleged misconduct, the board must review the challenged activities and respond to the demand.
Despite the fact that a demanding shareholder concedes the independence of a majority of the board, it is considered best practice for the board to appoint an SLC to review and investigate the facts underlying the alleged misconduct. The board should appoint as members of this committee directors who are clearly independent with respect to the alleged misconduct. It is well-established law that merely being sued does not, by itself, disqualify a director from being disinterested for service on the SLC. While Delaware law does not mandate a minimum number of committee members, Pennsylvania requires that the SLC have at least two members. Because a single-member SLC will receive heightened scrutiny, it is considered best practice to have at least two members, even in Delaware.
To form an SLC, the board must pass a resolution that clearly defines the scope of the committee's authority. The board should authorize the SLC to investigate and evaluate the claims presented by the shareholder demand or asserted in a pending action. In addition, the board should give the SLC authority to retain and be advised by independent outside counsel and, where applicable, to retain and be advised by other independent advisers whose expertise the SLC believes is necessary for assisting in its review of the issues and in formulating its conclusions.
General Delaware Requirements
Whether an SLC's decision to pursue (or terminate) derivative litigation is independent or not depends on the "totality of the circumstances." Delaware courts generally examine the following factors when applying the "totality of the circumstances" test, as in In re Oracle Securities Litigation, 852 F. Supp. 1437, 1441 (N.D. Cal. 1994):
"(1) a committee member's status as a defendant, and potential liability; (2) a committee member's participation in or approval of the alleged wrongdoing; (3) a committee member's past or present business dealings with the corporation; (4) a committee member's past or present business or social dealings with individual defendants; (5) the number of directors on the committee; and (6) the structural bias of the committee."
In order to prevail on its decision, the SLC must persuade the court, under a summary judgment standard, that "(1) its members were independent; (2) that they acted in good faith; and (3) that they had reasonable bases for their recommendations," according to the opinion in In re Oracle Derivative Litigation, 824 A.2d 917, 928 (Del. Ch. 2003). If the SLC meets this burden, then the court is free to defer to the SLC's decision or may, in its discretion, apply its own business judgment as to whether derivative litigation should be pursued.
General Pennsylvania Requirements
In Pennsylvania, the court will make a preliminary determination as to whether an SLC's decision not to bring suit in response to a shareholder demand (or to terminate pending litigation) was made under the "proper circumstances" delineated under American Law Institute Principle §7.09. These circumstances include: (1) whether the SLC is composed of two or more disinterested and independent people; (2) whether it was assisted by counsel of its choice; (3) whether it prepared a written report; (4) whether it conducted an adequate investigation; and (5) whether it rationally believed its decision was in the best interests of the corporation. (See LeMenestrel v. Warden, 964 A.2d 902, 912-13 (Pa. Super. 2008); Fundamental Partners v. Gaudet, 2011 Phila. Ct. Com. Pl. LEXIS 373, at *2-3 (Nov. 23, 2011).) If the court determines that the decision was made under proper circumstances, "then the business judgment rule prohibits the court from going further and examining the merits of the underlying business decision," the court held in Cuker.
Managing Influx of Suits
Although there may be nothing that Congress can do to curtail this new version of the securities strike-suit, boards of M&A targets can at least manage the inevitable influx of M&A objection suits by forming SLCs when confronted with shareholder demands to file derivative litigation. So long as the SLC meets the legal requirements delineated above, its business judgment whether to pursue a derivative lawsuit in response to a demand should receive judicial deference.
This article was previously published by The Legal Intelligencer.
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