On October 24, Kevin LaCroix’s D&O Diary discussed a report called “The Trial Lawyers’ New Merger Tax,” published by the U.S. Chamber Institute for Legal Reform. The report proposes several legislative approaches that would funnel all shareholder lawsuits challenging mergers to the seller corporation’s state of incorporation. Kevin has been a leading commentator in the discussion of the M&A-case problem. I started to write a reply to his October 24 post but my reply became too involved for a simple comment. So, I decided to turn it into a post here.
I doubt I need to convince many people, including a great many plaintiffs’ lawyers, that the explosion of M&A cases is a problem. The problem, of course, is not that shareholders bring lawsuits challenging mergers. Challenges to transactions based on problematic processes, such as the one at issue in Smith v. Van Gorkom, have improved corporate decision-making. Rather, the problem is that virtually every acquisition of a public company draws a lawsuit, even though very few transactions are actually problematic, and most cases are filed very quickly, before plaintiffs’ lawyers could possibly have enough information to decide whether the case might have merit.
The result is spurious and wasteful litigation. But very few cases present significant risk, so the vast majority of cases present a simple nuisance that can be resolved through painless additions to the proxy statement and a relatively small payment to the plaintiffs’ lawyers. Although companies that are sued bemoan the macro M&A-case problem, each individual company understandably focuses on its own case, and the vast majority conclude that it’s best to settle it rather than defend it to the bitter end. Collectively, however, the M&A-case problem is significant and needs to be addressed.
Everyone suffers from the M&A-case problem. Public companies being acquired now expect to be sued, regardless how favorable the transaction and how pristine the process, and are paying higher D&O insurance premiums. D&O insurers collectively have suffered the full brunt of the problem through payment of defense costs and settlements. Plaintiffs’ securities lawyers who don’t bring M&A cases, or who bring them more thoughtfully than others, suffer from guilt by association. Defense lawyers’ law practices have benefited from the increase in M&A cases, but I for one – and I’d bet that the vast majority of my peers would agree with me – would prefer to defend more legitimate M&A cases or other types of matters than the type of M&A cases I’m addressing.
I believe there are two sets of related root causes of the M&A-case problem:
- There are too many plaintiffs’ lawyers who bring M&A cases, and too many lawyers file cases over the same transaction with too little coordination among the cases.
- Too few cases are weeded out on a motion to dismiss, before the time to settle arrives. This is due to a number of factors and dynamics, including pleading standards, expedited discovery, and the timing of the transaction.
These sets of causes are intertwined. Companies are willing to settle because they want certainty that the deal will close on time. They need to settle to ensure certainty, even if the case lacks merit, because too few cases are dismissed. They are able to settle because they usually can do so quickly and cheaply. This is so because few of the plaintiffs’ M&A firms are set up to vigorously litigate even a small percentage of the cases they file; instead, these law firms take a low-intensity, high-volume approach. Such firms can survive in the M&A-case “market” because of the two root causes: (1) there is too little coordination of the cases – which means that firms often obtain some recovery just by filing a case – and (2) too few cases are weeded out at the dismissal stage – which means that companies must settle to obtain certainty that the deal will close on time.
All of the foregoing adds up to make the M&A litigation business an attractive one for certain plaintiffs’ lawyers. That attraction increases the number of plaintiffs’ lawyers trolling for cases, which in turn leads to more filings.
Solutions to the M&A-case problem flow from the two root causes.
- If multiple cases filed over the same transaction were better coordinated, there would more regularly be a meaningful competition for the lead plaintiff. Some firms, such as those with greater ability to vigorously litigate cases, would start to dominate. Firms that did not often win lead-plaintiff competitions would bring fewer cases.
- If more cases were dismissed, only the firms with the resources to risk investing time in a case that might be dismissed would bring cases, and those firms would tend to bring strong enough cases to survive a motion to dismiss.
Together, these solutions would mean that there would be fewer M&A cases, and the cases that are brought would tend to be the result of more careful screening by more sophisticated firms with more resources at risk.*
The U.S. Chamber Institute for Legal Reform’s report, echoing a recommendation by a panel of the Association of the Bar of the City of New York, identifies several federal legislative fixes that would funnel M&A cases to the seller’s state of incorporation. The report focuses on addressing the expense associated with competing litigation in multiple forums and the risk that a bad ruling in just one of the cases can scuttle the transaction. This cost and risk, the report says, gives the plaintiffs the settlement leverage that creates the M&A-case problem.
Although I would characterize the plaintiffs’ leverage differently (for the reasons discussed above), I agree that funneling cases to the seller’s state-of-incorporation would significantly address the problem, for a very simple reason: more M&A cases would be filed in Delaware, and litigation in Delaware would produce needed reforms in at least the cases filed there.
Most public companies are incorporated in Delaware, including almost two-thirds of all Fortune 500 companies. Yet a recent study by Marcia Mayer of NERA and my former Wilson Sonsini partner Doug Clark showed that, over a set of 277 litigated transactions, only 33 percent were filed in Delaware and only 20 percent were filed only in Delaware. Thus, if M&A cases against Delaware corporations were forced into Delaware, it necessarily would yield an increase in filings in Delaware.
I am confident that several things would follow:
- Plaintiffs’ firms would file fewer M&A cases against Delaware corporations, because plaintiffs’ lawyers are more reluctant to file bad cases in Delaware or try to overreach on their request for attorneys’ fees. Most of the worst M&A cases are filed outside of Delaware – a statement that is unscientific but I’d wager is correct and is probably an understatement.
- M&A cases filed in fewer forums would tend to reduce the number of plaintiffs’ firms that file M&A cases.
- Because of their vast experience with shareholder challenges to mergers, Delaware courts are attuned to the M&A-case problem, and could manage and resolve cases in ways that would tend to minimize or solve the problems.
- If M&A cases nevertheless remained a problem, Delaware would be receptive to legislative and rule changes that would help.
- Corporations would likely incorporate in Delaware in even greater numbers.
Two final thoughts:
First, if I had to choose, I would say that the plaintiff-coordination cause is probably the most significant cause of the M&A-case problem. Leadership status in M&A cases is still influenced heavily by the race-to-the-courthouse problem that led to the lead-plaintiff provisions of the Private Securities Litigation Reform Act. A race to the courthouse fosters a lack of pre-filing investigation. Choosing counsel based on the plaintiff’s or the plaintiff’s firm’s bona fides would result in domination by several strong and disciplined plaintiffs’ firms and reduce the number of firms that routinely file.
These plaintiff-side issues affect the dismissal issue. In a securities class action, the leading plaintiffs’ firms are sometimes receptive to candid requests for voluntary dismissal based on the evidence. M&A plaintiffs’ counsel generally are not. There are at least three reasons: (1) such a request takes place early in the litigation, before any plaintiffs’ firm is in charge – which means that defense counsel must convince several firms to dismiss; (2) the merits matter less to M&A plaintiffs’ firms, for the reasons discussed above; and (3) a securities class action plaintiffs’ lawyer wants to avoid an investment of hundreds of thousands of dollars on a bad case – but high-volume M&A firms’ investments are so small that they don’t mind taking a win-some-lose-some approach, and as discussed above, even really bad cases usually end up yielding some payday.
Second, the maxim “be careful what you wish for” applies here. Litigation of more M&A cases in Delaware would reduce the number of M&A cases and tend to improve the “quality” of the cases that are filed. But that would come at a price: the cases that are filed generally would be harder to settle quickly and cheaply.
* The lead-plaintiff and pleading-standard provisions of the Private Securities Litigation Reform Act have accomplished this to a significant extent in securities class actions.