Priya Cherian Huskins Contributor Shareholders should, of course, be able to hold public companies and their directors and officers liable if they mislead investors when going public. But what happens if the litigation becomes less about accountability and more about plaintiffs taking advantage of the legal system?
In the past several years, we’ve seen a surge of frivolous securities class actions against newly public companies in state courts. These lawsuits allege misstatements and omissions in the S-1 registration statement. Aside from costly and time-consuming litigation, the end result has also been brutal pricing for directors and officers (D&O) insurance—the very insurance that protects directors, officers, and the companies they serve from this type of litigation.
Recently, a landmark Delaware Supreme Court decision, the appeal of Sciabacucchi v. Salzberg, offered a solution to companies facing these frivolous securities class actions in state court. I’ll cover three takeaways from that decision, but first, some background. When shareholders believe an IPO’s registration statement is inaccurate, they can sue under Section 11 of the Securities Act of 1933. One example of this might be if a company failed to mention in their registration statement that they were having problems with their products, and that customers were starting to turn to a competitor. If that information later came out and caused the company’s stock price to drop abruptly, shareholders might sue.
It used to be that Section 11 claims were brought exclusively in federal courts. But because the statutory language was unclear, in 2014, we started to see more Section 11 suits in state courts—especially in California. State courts present extra challenges for corporations facing Section 11 suits:
Compared to federal courts, state court Section 11 cases are more likely to survive dismissals, even with weaker pleadings.
Unlike in federal court, state court plaintiffs can immediately start asking for documents and witness interviews, which drives up the cost of litigation quickly.
Some state courts, such as those in California, have a strong reputation for being friendlier venues for plaintiffs in securities class actions.
Initially, not all state courts allowed Section 11 suits. Notably, New York state courts decided these suits should be brought in federal court. Because the court circuits differed in opinion, the U.S. Supreme Court eventually weighed in. In March 2018, the Supreme Court ruled in Cyan, Inc. v. Beaver County Employees Retirement Fund that all state courts could hear Section 11 suits.
It’s no surprise then, that a surge of Section 11 suits in state courts followed. According to data analysis from Woodruff-Sawyer, there was a 79 percent increase in these cases from 2018 to 2019.
In addition, some companies experienced parallel filings. This is when a company is sued both in state and federal courts for the same set of allegations. Parallel Section 11 filings rose 208 percent between 2018 and 2020. This has resulted in terrible pricing for public company D&O insurance, particularly for IPO companies. The costs and the self-insured retentions (akin to a deductible) more than quadrupled in a short period of time.
For instance, the cost of $10 million in D&O insurance at the start of 2018 was less than $500,000 on average. That shot up to closer to $2 million by the end of 2019. Deductibles went from an average of $2.5 million to $10 million in the same time frame.
These insurance prices have been unaffordable for many small and mid-cap IPO companies. In the short term, companies have bought lower limits, which means that their directors and officers, as well as company balance sheets, are less protected. In the longer term, the increasing costs threaten to choke the IPO pipeline. (If they can’t afford to cover their risks, why go public?)
In an effort to get back to normal, some companies adopted what’s referred to as the “Grundfest Solution.” The “Grundfest Solution” (named after Professor Joe Grundfest of Stanford Law School) involves placing in a company’s charter documents choice of forum provisions that specify shareholders may only bring Section 11 claims in federal court. But no such luck—at least not initially in Delaware. At the end of 2018, in Sciabacucchi v. Salzberg, the Delaware Chancery Court struck down this solution as invalid under Delaware law. Luckily, the defendant appealed and was met with resounding success. In March 2020, the Delaware Supreme Court delivered a landmark decision: Delaware companies are permitted to adopt the federal choice of forum provisions.
This decision could put an end to frivolous Section 11 securities class actions in state court. Here are two important implications of the Sciabacucchi decision:
1. Delaware-incorporated companies headed for an IPO (or direct listing) should put the choice of forum provisions in their charter documents. We now have a high degree of confidence that if a company were to have a Section 11 claim in a Delaware state court, it will be dismissed. Of course, that same case may be brought to federal court instead, but such a case would be subject to the federal court’s higher pleading standard. This would make it harder for frivolous cases to survive a motion to dismiss.
2. D&O insurance rates for IPO companies and others will not snap back right away. We do not yet have a case of a state court dismissing a Section 11 case for lack of jurisdiction due to federal forum provisions. You can still expect that insurers will want to see these provisions in charter documents, at least for IPO companies. Insurers will likely view a company lacking these provisions to be riskier than a company that has them. The impact of Sciabacucchi on Section 11 suits in state court is something to watch closely. By all accounts, it’s a big win for companies who would otherwise face expensive, duplicative Section 11 litigation in multiple courts.