Courtesy of Richard A. Booth
Most securities fraud class actions under SEC Rule 10b-5 involve revelation of negative information about the defendant company that should have been disclosed earlier – bad news that (allegedly) has been covered up by company agents. The standard remedy in such cases is out-of-pocket damages (OOPs). But this measure of harm is inherently ambiguous. Some courts interpret it as price inflation at the time of purchase.[1] Others interpret it as the difference between the price paid and the price at which a stock settles after corrective disclosure.[2]
Although it might seem that these formulations are synonymous, the latter includes not only the difference in price that would have been paid if the truth had been known at the time of purchase, but also any additional difference that might be caused by the disclosure of the truth. For example, the market may conclude that the company is likely to become the target of an enforcement action or private securities litigation, and thus that the company is likely to suffer increased legal expenses (including possible fines and settlements). In addition, the company may suffer an increased cost of capital because the market perceives added risk that information about the company may be unreliable. These additional factors and possibly others – what I call collateral damage – will also be reflected in the decrease in price that occurs immediately upon corrective disclosure.
While the Supreme Court quite clearly ruled in Dura Pharmaceuticals, Inc. v. Broudo that price inflation alone is not enough to establish loss causation – holding that a plaintiff must show that market price reacted to disclosure of the truth – that decision begs the bigger question of how much of the loss can be said to be caused by the misrepresentation.
Calculating OOPs
The question of how to calculate OOPs has become even more important with the growth in event-driven securities fraud class actions. For example, following the Deepwater Horizon explosion and spill, investors who had bought BP stock during the run-up to the event argued that BP (as operator of the rig) had misrepresented its safety practices and thus had deceived the market into underestimating the risk inherent in its business. When the explosion and spill occurred, the market allegedly discovered that BP had covered up some of the risks. Stock price fell, and plaintiffs sued to recover their losses. When the smoke cleared (so to speak), BP stock had lost about half of its value. Market capitalization had declined from about $120B to about $60B. In the end, BP paid out about $60B in direct expenses relating to the event. In other words, it could be argued that the entire decrease in BP stock price was attributable to collateral damage. While ordinarily the business judgment rule (in possible combination with an exculpatory charter provision) would preclude stockholder recovery for such loss, fraud-period buyers would undoubtedly argue that their losses flowed from price inflation – even though subsumed within the $60B loss suffered by the company. In short, it matters a lot how we measure damages in a securities fraud class action.
It seems quite clear that collateral damage is harm suffered by the company that should be the subject of a derivative action – for the benefit of all stockholders – and not a direct (class) action. The clear implication is that OOPs should be measured as price inflation at the time of purchase, that is, price inflation narrowly defined net of any collateral damage.
Indeed, because FRCP Rule 23 – which governs class actions – requires that a class action for damages be superior to any other means of resolving a dispute, Rule 23 itself requires that collateral damage be addressed in a derivative action simply because it can be so addressed.
Although there is little doubt that the law requires collateral damage to be litigated in a derivative action, there is no doubt that this result is a radical departure from the prevailing practice. In a securities fraud class action, the company pays and buyers recover. In a derivative action, the company recovers from the individuals responsible for the loss – presumably directors and officers. It is equivalent to a pick-six in football. Indeed, in the Deepwater Horizon case, it could be that investors who bought BP stock during the alleged fraud period would have little or no claim remaining since it appears that the entire loss is derivative in nature.
Arguably, the problem with a derivative remedy is that the defendant directors and officers are likely to hide behind the almost bullet-proof business judgment rule and thus avoid any liability. Nevertheless, it turns out that a derivative action for collateral damage will lie whenever a meritorious claim can be stated under Rule 10b-5. In other words, it appears that state corporation law is perfectly congruent with federal securities law.
State Law Remedy
Two developments in the state law of fiduciary duty have coalesced to provide a state law remedy in any case in which a claim will lie under Rule 10b-5.
The first such developmentis the recognition that fiduciary duty includes a duty of candor that applies even in the absence of a request for stockholder action (such as ratification).[3] That is, the duty of candor extends beyond the well-recognized state law duty of disclosure that applies in the context of a stockholder vote.[4] It applies whenever management speaks: If management speaks, it must speak the truth. To do otherwise is a breach of fiduciary duty and is actionable under state law. But in order to state such a claim, the plaintiff must plausibly allege that the corporation suffered harm as a result and that management acted with scienter. Neither of these requirements is problematic. If the company has suffered no harm, there is no need for a derivative action. And because scienter is required to state a federal claim for fraud under Rule 10b-5, the need to plead scienter to maintain a state law claim for breach of fiduciary duty merely matches the federal pleading hurdle.
The second such development is the recognition that in cases alleging a breach of fiduciary duty, a fiduciary who acts contrary to the interests of the corporation – and does so with scienter– loses the protection of any exculpatory charter provision under DGCL 102(b)(7),which extends only to actions taken in good faith. But scienter implies bad faith.[5] Moreover, the same standard applies to establish demand futility in the context of a derivative action.[6]
The upshot is that a state law derivative action can be maintained in any case in which a securities fraud class action can be maintained under Rule 10b-5. In other words, whenever a claim will lie under Rule 10b-5, it will also lie under the state law of fiduciary duty so long as some sort of harm to the corporation can be pleaded.
Admittedly, this congruity assumes that the definition of scienter is the same under state corporation law as it is under federal securities law. But scienter is scienter—whether one is in federal court or state court. Indeed, the federal courts borrowed the scienter standard from the common law of fraud as developed by state courts. Moreover, since a state law claim for breach of fiduciary duty in this context will arise under the duty of candor, the issue of scienter arises in connection with speech by corporate agents. Whatever scienter might mean in other situations, it is difficult to see how the definition of scienter could possibly differ as between state law and federal law as applied to speech.[7]
To be sure, the quantum of the remedy in a derivative action will be different from that of a securities fraud class action even though the same facts are involved. On the one hand, a derivative award will not include a decrease in stock price from the correction of price inflation as narrowly defined. The corporation itself has no claim for price inflation.[8] On the other hand, the award will reflect the loss suffered by all of the stockholders and not just those who bought during the fraud period. Moreover, it seems likely that the calculation of damages will be based on the actual costs of fraud suffered by the company. But this difference militates further for a derivative remedy: It is much easier to quantify the cost of fraud by reference to fines, legal bills, and such, than by reference to the stock price, which can be affected by all sorts of extraneous factors.
Finally, aside from simplifying the litigation process by providing for unitary corporate recovery, derivative actions avoid the circularity inherent in class actions while also addressing the problem of excessive deterrence by providing a perfectly tailored action against individual wrongdoers.[9]
Practical Problems
Although the case for litigating collateral damage claims as derivative claims is compelling, the practical problem is how to induce the parties or the courts to do the right thing. The problem is one of market failure. No one has an incentive to advocate for derivative actions. CEOs are unlikely to argue that they should be personally liable. And plaintiff attorneys stand to generate bigger fees with securities fraud class actions. Both sides understand that the corporation has insurance for such claims, and insurers are happy to profit from selling such insurance. Indeed, they seldom even participate in the defense of securities fraud class actions. So no one has much incentive to escape this broken system.
In theory, a court could act on its own motion to treat such claims as derivative. The parties do not get to decide the nature of the claim.[10] But it seems unlikely that a federal court – where securities fraud class actions must be litigated – would order a large part of the claim to be treated as derivative since it is unclear that the corporation would have standing to maintain a derivative action under federal law.[11]
One possible solution to the problem is for individual corporations to adopt bylaws under DGCL 115, requiring that any claim made in a securities fraud class action under Rule 10b-5 that canbe treated as derivative must be so treated and must be litigated first. Notably, the Delaware Supreme Court in Salzberg v. Sciabacucchi has upheld a similar provision – a so-called federal forum provision (FFP) – requiring any claim under the Securities Act of 1933 to be litigated in a federal court sitting in Delaware.[12]
To be sure, the provision at issue in Salzberg required such claims to be litigated in federal court. But nothing in the reasoning thereof suggests that a bylaw requiring litigation of derivative claims in the Delaware Court of Chancery would be invalid.Indeed, the argument for enforcing such a bylaw is much stronger than the argument for enforcing the FFP accepted by the Salzberg Court.[13] A corporation, as an elaborate contract, is quite free to specify how it will be governed internally, subject to any mandatory rules imposed by the state of incorporation. In other words, a corporation is largely free to specify how disputes between and among its owners and itself will be resolved.
Conclusion
Irrespective of whether corporations adopt bylaws such as the one proposed above, there is no doubt that much of the loss suffered by buyer-stockholders in the typical securities fraud class action is derivative in nature and should be litigated as such. Moreover, doing so would be a vast improvement over the extant regime, which is widely agreed to provide excess deterrence by overcompensating buyers who effectively pay themselves out of corporate funds, causing further loss to legacy stockholders.
[1] See, e.g., Ludlow v. BP, PLC, 800 F.3d 674 (5th Cir. 2015).
[2] See, e.g., Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005).
[3] See Malone v. Brincat, 722 A.2d 5 (Del. 1998). Note that the Malone court was itself quite candid in noting that the duty of candor could provide a remedy for legacy holders following passage of the Securities Litigation Uniform Standards Act (SLUSA) of 1998, which was intended to curtail the growth of securities fraud class actions under state law, which growth was itself a reaction to the tightening of federal standards and procedures embodied in the Private Securities Litigation Reform Act (PSLRA) of 1995. In essence, SLUSA provides that federal securities law preempts all direct stockholder causes of action under state law state law that are based on deception (except for actions relating to stockholder voting). SLUSA also contains an express exception for state law derivative actions – the so-called Delaware Carve-Out. Exchange Act 28(f)(5)(c); 15 USC 78bb(f)(5)(c).
[4] See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).
[5] See Stone v. Ritter, 911 A.2d 362 (Del. 2006). See also Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007); American International Group, Inc. v. Greenberg, 965 A.2d 763 (Del. Ch. 2009).Although the Stone court does not use the word scienter, the court cites Guttman v. Huang,which does so with gusto. See Stone,911 A.2d 362, 369-70(quoting Guttman v. Huang,823 A.2d 492, 506 (note 34) (Del. Ch. 2003)).
[6] See Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006)(noting that it is critical in a case of BOD inaction to overcome an exculpatory charter provision in order to excuse demand). See also Rattner v. Bidzos, No. 19700, 2003 Del. Ch. LEXIS 103 (Sept. 30, 2003); In re Tyson Foods, Inc. Consolidated Shareholder Litigation, 919 A.2d 563 (Del. Ch. 2007); Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007) (all stating that a showing of scienter will suffice to overcome the presumption of propriety as to unconflicted directors).
[7] See generally Richard A. Booth, Scienter in State Law Securities Litigation (forthcoming).
[8] The traditional view is that corporation has no interest in the trading of its own stock. See Brophy v. Cities Serv. Co., 31 Del. Ch. 241, 70 A.2d 5 (Del. Ch. 1949).
[9] See Richard A. Booth, Sense and Nonsense About Securities Litigation, 21 U. Penn. J. Bus. L. 1 (2018).
[10] See, e.g., Smith v. Waste Management,Inc., 407 F.3d 381 (5th Cir. 2005). Cf. Bangor Punta Operations, Inc. v. Bangor & A. R. Co., 417 U.S. 703 (1974) (dismissing claim on theory that it should have been litigated as a derivative action and plaintiff would have been ineligible to do so).
[11] But see Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71 (2006), where the Court did exactly that. On the other hand, Exchange Act §16(b) expressly contemplates a derivative action in parallel circumstances, suggesting that the courts might be sympathetic to a Rule 10b-5 action by the company.
[12] Salzberg v. Sciabacucchi, No. 346, 2019; 2020 Del. LEXIS 100 (Mar. 18, 2020). Although the 1933 Act is a federal law, a claim arising thereunder can be filed in either federal or state court and cannot be removed to federal court if filed in state court.See Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018) (holding that SLUSA did not repeal concurrent federal and state jurisdiction under the Securities Act of 1933).
[13] In Salzberg, the Court of Chancery had ruled that the provisions in question were unenforceable because a claim under the 1933 Act is not a matter of corporate internal affairs and thus is not a proper subject for a charter provision under DGCL 102. Sciabacucchi v. Salzberg, C.A. No. 2017-0931-JTL, 2018 Del.Ch.LEXIS 578 (December 19, 2018), rev’d, Salzberg v. Sciabacucchi, No. 346, 2019; 2020 Del. LEXIS 100 (Mar. 18, 2020).This is no mere technicality. A corporation – as a legal person – cannot write the laws that apply to it any more than an individual can do so. Accordingly, the Chancery Court held that the 1933 Act is an external law regulating how corporations may sell securities to outsiders. Nevertheless, the Delaware Supreme Court disagreed, ruling that the Chancery Court had applied an unduly narrow definition of internal affairs.
