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E-MailC.N.V. Krishnan is Professor of Banking and Finance at Case Western Reserve University Weatherhead School of Management; Steven Davidoff Solomon is Professor of Law at University of California Berkeley School of Law; and Randall S. Thomas is John S. Beasley II Chair in Law and Business at Vanderbilt Law School. This post is based on their recent paper, and is part of the Delaware law series; links to other posts in the series are available here.
Special litigation committees (SLCs) are controversial. They are supposed to dispassionately consider the merits of derivative litigation brought by shareholders against the company and some of its officers/directors, but they are composed of board members from the same company/board that is being sued. As a result, some shareholders and academics complain that these SLCs always seek to dismiss the shareholders’ cases and operate solely to protect directors from liability.
In An Empirical Study of Special Litigation Committees: Evidence of Management Bias and the Effect of Legal Standards, we empirically test the effectiveness and use of SLCs, the recommendations that they make in their reports, and how legal rules on the judicial review of those report affect case outcomes. We do so using a hand collected final sample of 384 publicly available SLC events spanning the 26-year period Jan 1, 1990 through Dec 31, 2015. In our analysis we find consistent evidence of pro-management SLC bias. We also find that the law and judicial oversight matters. In cases litigated in Delaware, or in courts applying Delaware law to matters involving Delaware companies, the courts tend to exercise their own business judgment and be less deferential to SLCs, while cases in certain states with more deferential legal standards governing court scrutiny of SLCs are more likely to favor management interests.
The initial value of our paper is in providing a comprehensive descriptive look at SLCs. While fiduciary litigation is ubiquitous, we find that SLCs are not common. In our sample, we find that on average there are around 15 SLCs deployed per year, of which 75% are created in cases involving public companies. Moreover, the claims in the suits in which SLCs are used are varied. While a high percentage of the cases where they are involved contain broad allegations of breach of fiduciary duties, about one third of the cases allege a specific breach of the duty of loyalty (DOL), and another third allege a claim of waste.
After providing a descriptive look at SLCs and when they are utilized, we next examine what SLCs actually do. SLCs file a report with the court in a majority (60%) of all of the cases in which they are involved. In about 43% of all cases (73% of the cases in which an SLC report is filed), the SLC recommended dismissal of the litigation. In 12% of all cases (20% of the cases in which a report is filed), the SLC recommended either pursuing the case, settling the case, or pursuing some claims while settling others. Thus, in the majority of cases, SLCs appear to side with management in seeking dismissal.
We present descriptive statistics on how SLCs report recommendations compare to the outcome of a case. On average, 46% of all SLC-associated suits are dismissed by the court, which is roughly comparable to the percentage of cases in which the SLC recommends dismissal. In an additional 40% of all of the cases the parties settled the litigation with the average value of the settlement award at around $24.5 million (median around $6 million). However, as mentioned above, the SLC recommended settlement, pursuit of litigation, or both in only 12% of all cases, suggesting a strong bias in SLCs against pursuing these apparently valuable cases.
However, we find evidence that SLC actions are highly determinative of litigation outcomes. In univariate analysis, cases were eventually dismissed (settled) at a significantly higher (lower) rate where the SLC compiled a report to dismiss as compared to cases where the SLC did not. In multivariate analysis, an SLC report recommending case dismissal is significantly and positively associated with the probability of case dismissal, and significantly and negatively associated with probability of case settlement, after controlling for lawsuit reasons, legal standards, and time fixed effects. This evidence supports the claim that SLC reports significantly affect eventual case outcomes. We also find evidence that when SLCs recommend dismissals for breach of DOL and general breach of fiduciary duties, these recommendations for dismissal result in a higher probability of case dismissal, lower probability of settlement, and lower probability of high value settlement.
While our findings show evidence of management bias, they may also be interpreted as a consequence of differing cases in these areas being resolved by SLCs. More specifically, it may be that defense attorneys utilize SLCs to dismiss inferior cases. Thus, their recommendations to dismiss indeed results in higher dismissal rates and lower probabilities of settlement and high value settlement. To further account for this issue, we adopt the strategy of examining SLC utilization under different legal standards and jurisdictions. It can be presumed that, generally, cases in which SLC’s are utilized are the same across jurisdictions and law or that if there are differences they are due to the jurisdictions and law themselves, not the case quality itself. By exploiting these differences, as well as controlling for the lawsuit reasons themselves (a proxy for case quality) and time fixed effects as outcomes may vary by time, we control for any endogeneity and can confirm our findings.
We examine the impact of legal standards in different states on SLCs. We first examine Delaware cases. We find that Delaware incorporation is significantly and negatively (positively) associated with the probability of case dismissal (settlement), while the presence of multiple suits (an indicator of a major case) is significantly associated with the probability of a case being settled. These results offer one explanation for defense counsels’ preference for using SLCs in cases brought outside Delaware involving Delaware companies.
We next exploit the differing standards for judicial review of SLCs’ actions by categorizing SLC cases under the different legal standards: Delaware, and three other standards utilized by other states. We find that in states with the lowest level of judicial review, SLCs are more likely to recommend dismissal of a case, and are more likely to have a case dismissed as opposed to settled and less likely to have a settlement with a high settlement value. In univariate results, both the rates of SLC reports recommending case dismissal and actual case dismissals are the lowest amongst all jurisdictions in Delaware suits. These results are evidence that judicial scrutiny matters for SLC.
We further examine this point by looking at Delaware cases before and after the Oracle case, which arguably tightened the standards for director independence. We find that, in the post-Oracle period, in Delaware cases, breaches related to DOL and options backdating cases are significantly and positively (negatively) associated with settlements (dismissals), and multiple suits are significantly and positively associated with settlements. These results reinforce the importance of judicial standards of review for SLC outcomes.
Our findings highlight that, contrary to prior studies, there is evidence of SLC pro-management bias. We further find that legal standards matter—in states with the lowest level of judicial review outcomes are more likely to be favorable for defendants. Defense lawyers appear to exploit these differences to obtain dismissals at a higher rate in multi-jurisdictional litigation. Our results point to skepticism concerning the role of SLCs and provide evidence for increasing judicial review of SLC conduct.
The complete paper is available for download here.
