Every Transaction in Which a Public Company Sells All or a Meaningful Portion of Its Business Should Be Approached as Though It Will Give Rise to Litigation.
By Steven F. Carman and Chauncey M. Lane
It is more than a 90 percent likelihood in the mergers and acquisitions universe – within hours after a public company announces a sale of some or all of its business, a lawsuit is filed alleging violations of securities laws by the company, alleging breaches of fiduciary duties by its board, and seeking class status for the aggrieved (though yet unknowing) stockholders.
Virtually identical complaints are then filed by other law firms. Those law firms spend most of their time on the matter trying to convince the assigned judge that they, and they alone, are well-positioned to obtain stockholder relief. Once the judge has selected a lead law firm for the stockholder class, that firm reads the target company’s preliminary proxy and demands a dozen or two meaningless changes in disclosure.
The defendants (both the corporation and its board members) agree with the law firm to make a small handful of the requested disclosure changes. Importantly, the law firm then demands outrageous compensation for the “valuable service” it has rendered to stockholders before agreeing to accept some percentage of the amount requested.
The two parties reflect that arrangement in a draft settlement agreement that, importantly for the defendants, includes a waiver of rights any non-objecting stockholder may have to individually challenge the transaction or to sue the board. The judge approves what has been agreed to, the stockholders’ lawyer gets paid, and the transaction proceeds to closing. The whole process having devolved into negotiation of a “transaction tax” payable to the plaintiff’s bar for the privilege of timely completing a corporate transaction.
The good news is that several state courts are refusing to play their designated role in this well-choreographed dance. Led, as is frequently the case, by an opinion in Delaware, courts are refusing to approve these “disclosure only” settlements. That is, settlements in which the stockholders’ law firm has: (i) negotiated disclosure changes described as generally “of trivial value,” and (ii) then obtained far less trivial compensation.
In early 2016, the Delaware Chancery Court expressed a preference for stockholders’ claims of deficient disclosure to either be litigated to resolution or made moot rather than be the subject of a settlement agreement. Further, the court articulated a heightened standard for approval of a proposed settlement, requiring that any agreed upon supplemental disclosure to stockholders be “plainly material.”
Breach of Fiduciary Duty
The court seemed to be discouraging stockholders from alleging a breach of fiduciary duty by board members unless they were ready to prove that allegation. In part, the court implied that immaterial additional disclosure would not be accepted as a cure for the breach initially alleged.
Not surprisingly, this decision was well received by those representing public companies, their board members, and the insurance companies who were frequently on the hook for at least a portion of the settlement payment. Several other states have now adopted the standard articulated in Delaware and some evidence suggests that the “transaction tax” is being paid less often and in smaller amounts. Most recently, a New York trial court issued an opinion strongly supportive of the Delaware standard and encouraged New York appellate courts to adopt that standard lest New York develop “a reputation for attracting and countenancing worthless strike suits.”
While it is tempting to conclude that these decisions will result in the demise of the “transaction tax,” logic suggests that will not be the case. Plaintiff firms do not go away, they adapt. And in this case, early indications are that adaptations will include:
- Dropping claims of a breach of fiduciary duty by board members and focusing exclusively on alleged disclosure deficiencies under the federal securities laws, thereby assuring access to potentially less skeptical federal judges, or in some cases, prompting SEC enforcement actions before SEC administrative law judges who are not bound by state or federal common law.
- Bringing claims, when possible, in other states that have explicitly rejected the reasoning in the Delaware case, an option recently reinforced by the U.S. Supreme Court in a decision finding that state courts can continue to hear certain securities class actions brought under federal law.
- Focusing on smaller transactions where it might be easier to identify material deficiencies in disclosure.
In addition, as the SEC issues new pronouncements on disclosure topics, the issues covered are likely to become a popular basis for claims of inadequate disclosure. As an example, the SEC’s articulated focus in 2016 on the inappropriate use of non-GAAP financial measures in public company disclosure was soon followed by the inclusion of claims in stockholder complaints that use of such non-GAAP financial measures in proxies was both material and misleading.
Recognizing the issue it had created, in late 2017 the SEC issued guidance limiting its objection to the disclosure of non-GAAP financial information when that disclosure merely reflects information provided to a company’s financial advisor to facilitate the work of that advisor.
The lesson from all of this is that every transaction in which a public company sells all or a meaningful portion of its business should be approached as though it will give rise to litigation. The processes and procedures that courts have historically reviewed and respected should be carefully followed.
Disclosure should be accurate and complete. The announcement of every transaction should be preceded by appropriate litigation preparation. While litigation may nonetheless result, at least the company will be well positioned to resolve it quickly and the “transaction tax” will be minimized.
Public companies should however find solace in the long-standing requirement that plaintiffs plead fraud allegations with specificity – a requirement that has proven to be a formidable opponent to the plaintiff’s bar, particularly in federal courts where plaintiffs must also establish fraudulent intent.
Steven F. Carman is a partner at Husch Blackwell LLP. Now serving as leader of the firm’s Energy and Natural Resources industry team, Carman has structured mergers and acquisitions, strategic alliances and capital formation transactions in excess of $7 billion. [email protected], 512-370-3451.
Chauncey M. Lane is a partner at Husch Blackwell LLP. As a member of the Energy and Natural Resources team, he assists with buy-side and sell-side mergers, divestitures, asset acquistions, going-private transactions, debt and equity offerings, corporate governance and corporate restructurings. [email protected], 214-999-6129.