Litigation Discovery and Corporate Governance: the Missing Story About the "genius of American Corporate Law"

• Publication year: 2014

Litigation Discovery and Corporate Governance: The Missing Story About the "Genius of American Corporate Law"

Érica Gorga

Michael Halberstam

LITIGATION DISCOVERY AND CORPORATE GOVERNANCE: THE MISSING STORY ABOUT THE "GENIUS OF AMERICAN CORPORATE LAW"

Érica Gorga^* Michael Halberstam^**

Abstract

Strikingly absent from the entire corporate governance and corporate litigation debate is a unique feature of American civil procedure that deserves special attention: the modern civil discovery regime. This Article attempts to fill this gap. We argue that modern discovery—first established by the Federal Rules of Civil Procedure in 1938—has had a profound impact on the evolution of shareholder litigation, corporate governance, and the culture of corporate disclosure in the United States.

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This Article shows that (1) litigation discovery, and its threat, have driven and structured the process of corporate shareholder litigation; (2) the information generated by discovery has stimulated the development of case law defining shareholder rights and managerial duties; (3) the episodic legal demands for detailed corporate internal information (and the threat of discovery) have induced incremental improvements in corporate governance practices, including more exacting decision procedures, internal monitoring, recordkeeping, and disclosure; (4) highly developed, continuously evolving discovery practices have established templates for independent corporate internal investigations by boards and regulators; and (5) discovery has given regulators steady insight into changing corporate internal practices and patterns of wrongdoing to which regulators have responded with broad legal and regulatory changes. This Article concludes that litigation discovery serves, inter alia, as a form of ex post disclosure, which complements and enforces ex ante disclosure under the federal securities laws.

These observations have important normative implications for legal transplants and the enforcement debate. Among other things, this Article cautions against legal transplants of U.S.-style securities disclosure, aggregate litigation mechanisms, and other enforcement mechanisms without considering appropriate tools for investigating corporate internal wrongdoing ex post, and points to problems in the empirical literature on U.S. shareholder litigation outcomes. It also questions current proposed reforms to the federal discovery rules.

Introduction............................................................................................1386

I. The Role of Discovery in U.S. Corporate Governance........1397

A. The Elephant in the Board Room ............................................. 1397
B. The Example of the Disney Company Shareholder Derivative Litigation.................................................................................. 1401

II. The U.S. Information-Forcing Regime......................................1406

A. New Deal Origins of Modern Discovery.................................. 1406
B. The New Tools of Modern Discovery....................................... 1408
C. The Devolution of Judicial Authority onto Private Parties...... 1415
D. The Influence of Federal Rules of Discovery on State Civil Procedure: The Case of Delaware........................................... 1417

III. Consequences of Discovery for U.S. Corporate Governance Institutions............................................................1419

A. Shareholder Litigation ............................................................. 1420

1. Cases That Go to Trial ....................................................... 1426

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2. Cases Resolved at Summary Judgment .............................. 1431
3. Cases Settled Prior to Summary Judgment........................ 1434
4. Cases That Go Through "Some" Discovery...................... 1440
5. Cases That Are Dismissed or Settled Prior to the Motion to Dismiss Based on a Corporate Internal Investigation by a Special Litigation Committee ..................................... 1444

B. Discovery Has Shaped Internal Corporate Governance .......... 1453
C. How Discovery Informs Legal Change .................................... 1455

1. The Development of Fiduciary Duty Doctrines .................. 1455
2. The Development of DGCL Section 220 Case Law............ 1458
3. Regulatory Changes and Federal Law Reform .................. 1461

D. Litigation Discovery Complements and Enforces Securities Disclosure—Discovery as Ex Post Disclosure......................... 1462

IV. Objections and Replies................................................................1465

A. The Special Hurdles to Discovery in Shareholder Actions ...... 1467
B. The FRCP's Retreat from Liberal Discovery Since the 1970s . 1470
C. Dysfunctions of Discovery1472
D. The Costs of Discovery............................................................. 1476

V. Policy Implications for Comparative Corporate Governance...................................................................................1479

A. The Enforcement Debate ......................................................... 1479
B. Exporting U.S. Corporate Governance and Securities Laws ... 1482

1. How Well Does Disclosure Work Without Litigation Discovery?.......................................................................... 1485
2. Exporting Aggregate or Representative Litigation Mechanisms to Europe ....................................................... 1487

C. Reforming Discovery in the United States ................................ 1492

Conclusion................................................................................................1494

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"As stated by the Supreme Court in Hickman v. Taylor, 'Mutual knowledge of all the relevant facts gathered by both parties is essential to proper litigation.' Such, however, is not the basis of procedural policy in any other country in the world."

—Geoffrey C. Hazard, Jr.¹

INTRODUCTION

Professor Romano's seminal work, The Genius of American Corporate Law, inspired an international debate on corporate governance and influenced the research agendas of law, economics, and finance scholars for over two decades. Romano's book offered an explanation for the curious American exceptionalism in financial markets development based on the counterintuitive theory that the competition among states for incorporations generated a "race to the top" in state legal regimes governing corporate internal affairs.² She famously argued that the creation of a market for legal rules allowed firms to select corporation codes with better corporate governance devices to mitigate agency costs.³ The genius of American corporate law, according to Professor Romano, relied on the consequences of federalism for the evolution of American corporate and securities laws while much less successful institutional frameworks were implemented in other countries.⁴

Ever since Romano first articulated her theory of the genius of American corporate law, researchers have attempted to analyze, identify, and compare across national legal regimes and economies precisely what legal variables have been responsible for resolving (or failing to resolve, as it were) the agency-cost problems between shareholders and managers inherent in the structure of large public firms. This comparative enterprise has been highly consequential in that the legal variables so identified have, in turn, been deemed "preconditions" to the highly developed capital markets in the United

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States that other nations across Europe, Asia, and Latin America ought to emulate.⁵

By now the corporate governance debate has, with mixed success, explained national differences as depending variously on corporate ownership structures,⁶ minority shareholder protections,⁷ stock exchange rules,⁸ mandatory disclosure regimes, and liability standards,⁹ as well as much broader explanations, including differences in social and cultural norms,¹⁰ political histories,¹¹ historic legal origins of national legal systems,¹² and, more recently, varying levels of "intensity" in the enforcement of corporate and securities laws.¹³

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The enforcement literature has studied differences in levels of public and private enforcement.¹⁴ It has also revisited various aspects of derivative and class action litigation from a more comparative perspective with the express intent of paying closer attention to procedure. Professor Bernard Black and coauthors, for example, surveyed procedural rules that affect the adjudication of directorial and managerial liability claims in the United States, Russia, France, Germany, Austria, Korea, and the United Kingdom.¹⁵ But Black and coauthors mostly confine their survey to analyzing who can file a claim, what the available filing mechanisms are, and how attorneys' fees and litigation costs are allocated among the litigants.¹⁶ In a separate study on private enforcement, Professor Coffee argues that U.S. aggregate litigation rules establish a "unique" system of "entrepreneurial litigation."¹⁷ In particular, the "intensity" of such enforcement by "private attorneys general" is generally considered to be a distinctive feature of the U.S. system.¹⁸ But Coffee, like the rest of the literature, confines his analysis to a relatively narrow discussion of class action rules and the incentives created in the class action context by the American rules on fee shifting and contingency fees.¹⁹

Similarly, academic and jurisprudential debates in the corporate law literature about exporting U.S.-style aggregate litigation to European and other countries have concentrated on such rules as shareholder standing requirements, fee shifting, contingency fees, and class action rules. But the

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enforcement debate has ignored how private litigants might obtain information about corporate internal wrongdoing in civil law systems in Europe, Asia, or Latin America.²⁰

The extensive...