Federal Forum Provision Possible Impact on D&O Insurance

Since the Cyan decision in 2018, plaintiffs have gone hog-wild over state court Section 11 suits. The victory last week in the Delaware Supreme Court in the Sciabacucchi case (pronounced “Sha Ba Cookie”) provides a hopeful path forward for the issuer community. Here are some thoughts on how the decision may impact the D&O insurance world.

What is This All About?

Shareholder claims involving a public offering (of equity or debt) can be brought pursuant to Section 11 of the Securities Act of 1933. A U.S. Supreme Court decision in 2018 confirmed that Section 11 claims may be brought in Federal or state court. Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S. Ct. 1061 (2018). State court is generally a favorable forum for plaintiffs. Historically, state judges have been reluctant to toss out meritless Section 11 claims that would not have survived scrutiny in Federal court.

In response to Cyan, many companies began to include a Federal Forum Provision (“FFP”) in their Articles of Incorporation. The Provision specified that a shareholder could only bring a Section 11 claim in Federal court. (Professor Joseph Grundfest of Stanford Law School was the principal proponent of such provisions. If you are interested in more detail about them, look at his article.)

No such provision is required for after-market shareholder class actions, brought under Section 10(b) of the Securities Exchange Act of 1934. By statute, those claims can only be brought in Federal court.

Plaintiffs sued in the Delaware Court of Chancery to invalidate the Provisions. Plaintiffs prevailed in the trial court, but lost on appeal. The decision—in which my firm, Wilson Sonsini, represented the prevailing parties—is here.

What Impact Will the Decision Have on Pending Claims?

You might analyze this separately depending on several considerations.

For cases pending against companies that do not have a FFP, the Delaware decision won’t make a difference. It is unlikely that a court would dismiss a pending suit based on an adoption now by a defendant company of an FFP.

For cases pending against companies that do have an FFP in place, aggressive action is warranted. Those companies probably should move immediately to dismiss the cases in state court based on the Provision. Even if the state court previously declined to rule on the validity of the FFP—or ruled against it—a jurisdictional issue can be raised at any time. Some state court judges may prove to be hostile to the FFP, even after the Delaware decision. That is why the petition for writ of mandamus was created.

Some plaintiffs with Section 11 claims solely in state court may offer “fire sale” settlements in light of Sciabacucchi. A company can choose to waive its FFP (under the terms of the typical clause) if it chooses to do so. This means that a company should be able to settle a Section 11 claim in state court if it decides to take that path.

Does the Decision Preclude Further Litigation Over the Validity of FFP’s?

No. The Sciabacucchi decision rejected a facial challenge to the validity of such Provisions. Plaintiffs lawyers might bring “as applied” challenges to the clauses. Such challenges should not succeed, but this underscores the importance of getting the language and the process right. Plaintiffs are likely to attack the process by which a board of directors adopted the Provision. Well-counseled companies should not just copy-and-paste what another company did.

Some plaintiffs might attack the FFP’s as invalid under Federal law, trying to bootstrap the Cyan decision. The Delaware Supreme Court rejected such a challenge at pages 43 to 46 of the decision. The analysis is persuasive, but might be relitigated by plaintiffs in other courts.

Should Companies that Don’t Have an FFP Adopt One Now?

For private companies contemplating an IPO when the markets return to normal: absolutely. The Provision will give them substantial protection against post-IPO Section 11 suits in state court.

For companies that are already public, the answer is: probably yes. We believe that a Federal Forum Provision adopted post-IPO should be effective, but this is an issue that will be heavily litigated in the coming years. The Provision could protect you with respect to future registered offerings, whether of debt or equity, or in connection with an M&A transaction. You should be aware that the first few companies adopting Federal Forum Provisions in this context may well be the subject of declaratory-judgment suits seeking to invalidate them. We view that downside risk as modest.

The D&O industry can incentivize issuers to adopt Federal Forum Provisions by providing premium discounts to companies that do so.

What Else Can Companies Do to Combat Non-Meritorious Section 11 Suits?

Wholly apart from the FFP approach, another way to fight frivolous suits under Section 11 is to take advantage of the statute’s stringent “tracing” requirements. Here is an article discussing a possible approach. Issuers have been slow to adopt this approach, perhaps because they are rarely repeat players in the Section 11 world. That is not true for D&O insurers, who may wish to incentive their insureds to explore modifications of IPO lockup agreements to reduce dramatically damages in Section 11 suits.

Does the Decision Empower Companies to Require Arbitration of Shareholder Claims?

Probably not. Past efforts by some companies to impose mandatory-arbitration clauses on shareholder lawsuits have been unsuccessful and highly controversial. In Sciabacucchi, the Supreme Court suggested (though it did not resolve) that shareholder arbitration clauses present very different considerations.