A necessary gatekeeper: the fiduciary duties of the lead plaintiff in shareholder derivative litigation.

AuthorKoopmann, Amy M.
  1. INTRODUCTION II. BACKGROUND A. The Historical Development of the Shareholder Derivative Action B. Representative Litigation C. Comparing Shareholder Derivative Actions and Class Actions 1. Shareholder Derivative Actions a. Direct Versus Derivative b. The Demand Requirement 2. Class Actions D. Fiduciary Duties Generally E. Lead Plaintiff Fiduciary Duties in the Context of Class Action Litigation F. The Private Securities Litigation Reform Act of 1995 G. Litigation Costs III. ANALYSIS A. Current Gatekeeping Functions Do Not Prevent Plaintiffs from Filing Detrimental Shareholder Derivative Actions 1. Special Litigation Committees, Demand Requirements, and High Pleading Standards are Inadequate Gatekeepers Because of Timing 2. The Lead Plaintiff is in a Better Position than the Plaint's Attorney to Police the Course of the Litigation a. Problems with Relying on Plaintiffs' Attorneys to Police Derivative Litigation B. Institutional Investors Provide a Source of Lead Plaintiffs with Knowledge of the System and the Likelihood of a Claim's Success C. Why Settle a Worthless Suit? D. Bringing a Worthless Suit Breaches a Lead Plaint's Fiduciary Duties to the Corporation and Other Shareholders by Wasting Corporate Assets IV. RECOMMENDATION A. State Legislatures Should Enact a Statutory Framework Addressing Lead Plaintiff Fiduciary Duties 1. Require a Plaintiff Filing a Derivative Action to Provide Notice to Shareholders Who May Then Move to Serve as Lead Plaintiff 2. Allow the Court-Appointed Lead Plaintiff to Dismiss the Case 3. Introduce Incentives for Institutional Investors to Serve as Lead Plaintiffs a. The Statutory Scheme Should Fully Compensate Lead Plaints for Their Time and Efforts b. The Statutory Scheme Should Award Bonuses Based on Who Pays the Settlement and for Significant Governance Reforms i. The Statutory Scheme Should Allow Courts to Award a Bonus When the Actual Defendants Contribute to the Settlement ii. The Statutory Scheme Should Allow Courts to Award a Bonus for Significant Governance Reforms iii. Incentives Independent of the Proposed Statutory Scheme 4. Clearly Impose Fiduciary Duties on Shareholder Derivative Action Lead Plaintiffs a. Borrow from Current Statutory Fiduciary Duty Frameworks b. Borrow from Case Law Defining Fiduciary Duties c. Leave Room for Court Discretion 5. Sanction Lead Plaints Who Violate Their Fiduciary Duties V. CONCLUSION I. INTRODUCTION

    Fraudulent behavior by corporate directors is not a new problem (1) and neither is the derivative action--the tool often used to address this problem. (2) In 1957, one commentator noted that "[i]n 1832 it must have appeared, as it does today, that the individual stockholder was in need of a means of invoking judicial power to curb managerial abuse." (3) This statement is just as true in 2009, as is apparent from the managerial and director abuses that continue to plague corporations.

    Although the shareholder derivative action provides a useful tool to address the important problem of director misconduct, the action has faults that can prevent it from accomplishing this goal. Shareholder derivative litigation is representative litigation, meaning that the person who brings the suit represents others' interests. (4) A major weakness of representative litigation in general is that the agent controlling the litigation often does not have the same interests as the principal. (5) In the case of shareholder derivative actions, a meritless suit brought by a plaintiff without the corporation's best interest in mind can become a significant drain on the corporation's and its shareholders' resources. For better or worse, it is extremely difficult to win a derivative action because of the procedural hurdles in place. (6) Since these barriers make success so unlikely, plaintiffs should be particularly conscientious of the merits of a case.

    This Note examines lead plaintiffs' fiduciary duties in derivative actions, including the duty to refrain from bringing meritless suits. Part II explains the historical development of shareholder derivative actions, representative litigation problems, the differences between shareholder derivative actions and class actions, fiduciary duties--both generally and in the context of class action lead plaintiffs, and the various costs associated with litigation. Part III analyzes why lead plaintiffs owe fiduciary duties in shareholder derivative actions and why bringing meritless suits breaches those duties. Part IV recommends that legislatures and the judiciary take action to delineate and enforce shareholder derivative lead plaintiff fiduciary duties.

  2. BACKGROUND

    Courts developed the derivative action to fill a void they saw in shareholders' ability to protect their investments. (7) Many courts and scholars, however, have criticized the derivative form. (8) Importantly, shareholder derivative actions require other shareholders to rely heavily on the lead plaintiff in the action to represent both the shareholders' and the corporation's interests. (9) This reliance is necessary, given the representative nature of a derivative action, (10) but can lead to problems when shareholders do not feel that the lead plaintiff adequately represented their interests. In order to better understand derivative litigation's unique procedures, the following section examines its development.

    1. The Historical Development of the Shareholder Derivative Action

      The derivative action developed in courts of equity. (11) Its origin "lies in judicial recognition of a new wrong or maladjustment for which pre-existing legal procedures proved more or less inadequate." (12) Developed in both United States and English courts, the first U.S. "classic derivative action[] where [a court permitted] a shareholder ... to sue to compel the directors to restore corporate assets taken in violation of their fiduciary duty" (13) was Taylor v. Miami Exporting Co., (14) an Ohio case. (15) Several other plaintiffs throughout the country followed suit by filing derivative actions. (16)

      Many of the procedural hallmarks of the derivative action that exist today developed in these early cases. (17) Courts required the corporation to be a party to the litigation in order to prevent the possibility of a double recovery in an action later brought by the corporation. (18) Also, any recovery would go to the corporation as opposed to the individual that brought the suit. (19) This made "[t]he corporation's role in these actions ... that of a passive recipient of the proceeds as the most logical and convenient mode of aggregate recovery." (20) Accordingly, "[w]hen a shareholder sued the management he sued on a right belonging to shareholders." (21) The United States Supreme Court recognized derivative actions in 1855. (22) Despite criticism, shareholders continue to use derivative actions in an attempt to enforce officers' and directors' fiduciary duties. (23)

      In the 1970s, it became increasingly difficult for a plaintiff to succeed with a derivative action. (24) While courts previously viewed derivative actions as a useful regulation device, procedural barriers such as special litigation committees (25) make their current efficacy questionable. (26) Additional hurdles arose from legislation, as in Congress's passage of the Private Securities Litigation Reform Act (PSLRA). (27)

    2. Representative Litigation

      Both class action and shareholder derivative suits are representative litigation. (28) In representative litigation "the named parties represent others similarly situated." (29) The lead plaintiff therefore takes on an important role:

      Representational capacity assumes that the role of acting on behalf of another is a basis for imposing fiduciary obligations on the person who assumes the representational role and, in varying degrees, for binding the represented person to the consequences of the representative's acts.... Such a plaintiff in a class or derivative action has undertaken to act on behalf of the class or the corporation and is treated as a fiduciary, but is not subject to the control of the class or corporation. (30) Appointing a single lead plaintiff or small group of lead plaintiffs is necessary given the significant number of individuals whose rights representative litigation implicates. Ideally, the lead plaintiff takes charge of the litigation for the class, or in a derivative action, for the corporation. (31)

      Representative litigation presents some serious problems. Describing representative litigation in the context of class actions, one academic noted:

      As individual claims are often small, class members have little incentive to monitor their agent. They also lack the expertise that would enable them to do so. The unmonitored agent can therefore engage in at least two types of problematic behaviors. First, class counsel may do too little, settling the class members' claims for less than their real value in exchange for quick and substantial fees (a sell-out or sweetheart deal). Second, class counsel may do too much, filing meritless cases in the hopes of extracting nuisance fees (a strike suit). (32) Plaintiffs' counsel has significant incentive to engage in these problematic practices when acting as the agent to a class or in a derivative action. (33) This Note addresses both of the above scenarios, but focuses on the second scenario, in which class counsel files meritless cases in hopes of extracting nuisance fees.

    3. Comparing Shareholder Derivative Actions and Class Actions

      The differences between class actions and derivative actions are not always apparent to shareholders. (34) Although class actions and derivative actions both developed as equitable remedies and are "representative" actions, (35) important distinctions exist between the two. (36) These differences include who is injured, who receives the recovery, and who is involved in the decision to bring the action. (37)

      1. Shareholder Derivative Actions

        Since the corporation is the...

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