Private Enforcement of Shareholder Rights: A Comparison of Selected Jurisdictions and Policy Alternatives for Brazil

Introduction

The OECD recently published a report Private Enforcement of Shareholder Rights: A Comparison of Selected Jurisdictions and Policy Alternatives for Brazil, which is the joint project with Brazil’s Securities and Exchange Commission (Comissão de Valores Mobiliários-CVM) and the Ministry of Economy. Building on a comparative review of ten countries—Brazil, France, Germany, Israel, Italy, Portugal, Singapore, Spain, the US and the UK—the report recommends a range of actions to address weaknesses in the frameworks for derivative suits and corporate arbitration in Brazil. The policy alternatives offered for Brazil seek to strike a balance between, on the one hand, adequate incentives for investors to find redress for infringement of their ownership rights and, on the other hand, avoiding frivolous litigation that may drain valuable resources from companies.

The recommendations in the report, for instance, address procedural barriers that minority shareholders must surpass before filing derivative suits. Likewise, the report proposes a change in the cost allocation for unsuccessful lawsuits in order to allow effective private enforcement through derivative lawsuits. The report also proposes a new transparency regime for corporate arbitrations, taking into account the particularities of conflicts involving shareholders’ rights in public companies.

Besides the OECD’s analysis and recommendations in the first chapter of the report, there are three other chapters prepared by consultants commissioned by the OECD. Chapter 2 (authored by Martin Gelter) compares nine jurisdictions’ frameworks for the use of derivative litigation. Chapter 3 (co-authored by Andre Luis Monteiro and Renato Beneduzi) compares the same group of jurisdictions plus one additional country on frameworks for the use of corporate arbitration. Chapter 4 (Guillherme Setoguti) focuses in detail on Brazil’s legal and regulatory framework in these areas.

Key points on derivative litigation

In all jurisdictions, the legal framework for shareholder derivative litigation must perform a difficult balancing act. Directors and officers not facing sanctions for violating their duties of care or loyalty will likely have insufficient incentives to comply with these (except e.g. reputational incentives affecting capital markets or managerial labor markets). The proper plaintiff to enforce such claims is the corporation, but often the alleged wrongdoers (directors, officers, and controlling shareholders) influence the decision-making process leading to a liability suit. Creating a mechanism for (minority) shareholders to initiate litigation seems like an obvious solution to address this problem. However, shareholders’ incentives to sue look weak in many jurisdictions. When the corporation is harmed, shareholders suffer only a reflective loss because of the loss of the value of their interest. Minority shareholder plaintiffs only benefit from a suit in proportion to their shares in the company, while the remaining benefits accrue to others after investing time and expenses into litigation.

Facilitating minority shareholder litigation, however, also engenders the possibility of abuse. A small likelihood of success, combined with negative publicity resulting from litigation, may mean that the corporation and its executives could spend time and money more usefully. Moreover, directors and officers are usually in the best position to gauge advantages and disadvantages of litigation. An entrepreneurial litigation culture, such as the one existing in the US, can sometimes take (or appear to take) an abusive turn when lawyers are the main financial beneficiaries from a settlement. The decision to sue, and decisions made in pursuit of a derivative claim such as a settlement may therefore not be in the best interest of the corporation and its shareholders. When balancing managerial agency cost and litigation agency cost, legal systems therefore need to create the right level of deterrence.

A certain level of litigation agency cost may be acceptable to generate sufficient activity in the enforcement of directors’ duties that will reduce managerial agency cost. A key incentive for derivative actions is the possibility that attorney’s fees may depend on the outcome of the lawsuit, which is a very common practice in the US. In Brazil, there are also few limitations on contingent and conditional fees and, in fact, instead of reimbursement of attorney’s fees, the law provides for a contingent award to the winning plaintiff’s attorney (20% in the case of derivative lawsuits against controlling shareholders and between 10% and 20% when directors and officers are the defendants). Many other jurisdictions limit or prohibit contingency or conditional fee structures.

The jurisdictions reviewed in the report have established various procedures aimed at protecting corporate directors and officers (and, in some cases, controlling shareholders) against non-meritorious litigation. Some countries require the shareholder meeting to be involved in the decision to allow the initiation of a lawsuit on behalf of the company (only Brazil and, in certain cases, Spain among the nine surveyed countries) while other jurisdictions permit it (Germany and Italy). Such a process has few advantages because it introduces delays and generally shareholder meeting are not likely to initiate litigation in firms with concentrated ownership. Another mechanism we see in several jurisdictions are minimum ownership thresholds for a derivative claim, which still exist in Brazil, Germany, Italy, and Spain. These are based on the idea that a shareholder with a relevant economic interest in the corporation’s equity is unlikely to sue for an illegitimate reason. However, in many cases it is difficult for a group of shareholders to coordinate efforts and therefore surmount those thresholds as they range between 1% and 5% in the countries covered in the report.

The most promising mechanism is a pre-screening procedure inspired by the demand requirement in the US. In Delaware, plaintiff shareholders rarely make demand that the board bring a suit and move directly to a claim of demand futility that will effectively decide whether a derivative claim can move forward. Other jurisdictions have similarly introduced pre-trial procedures, including Israel (which also has a demand requirement), the UK, and Singapore, where plaintiffs have to ask the court for leave to pursue a derivative suit, and Germany, which has introduced a “lawsuit admission procedure” for derivative suits.

There are two interesting differences between jurisdictions regarding such procedures. First, while the law is complex in all surveyed jurisdictions, in the US and in Israel the court’s decision to admit a suit tends to turn to a greater extent on the question whether board members were sufficiently disinterested or independent to decide about the merits about the suit. In Germany, Singapore, and the UK, there is a greater emphasis on the prima facie merits of the case, and on whether the suit would be in the best interests of the corporation.

Second, the function of the demand requirement differs to a certain extent between jurisdictions. In the United States, the demand stage of derivative litigation is particularly significant because litigation will only later move into discovery. In other jurisdictions, early-stage procedures often have an effect on how litigation risk is allocated among the parties. In most jurisdictions, losing plaintiffs carry the financial risk of having to pay court fees and other litigation expenses in case of losing the dispute, which is often a significant disincentive for a minority shareholder to initiate a derivative action. The obligation to reimburse the litigation costs of the winning party is the general rule in Brazil, France, Germany, Italy, Singapore, Spain and the UK. A pre-trial procedure serves not only to evaluate whether the claim is non-meritorious, but also as a cut-off point after which the corporation (for whose benefit the derivative suit is brought) must bear litigation cost (this is the rule in Germany and Israel). Sometimes, the initial amount in dispute based on which costs are measured are capped in the pre-trial stage, and/or the corporation must bear the cost of litigation if the suit is admitted by the court.

Due to the time and costs that a litigation process may incur, derivative action will often end in a settlement. Such possibility may also be relevant to the shareholder considering the initiation of a lawsuit. Therefore, some countries have rules to clarify that the shareholder may settle the suit on behalf of the company and establish procedures to manage the conflicts of interests of the shareholders as a whole and the representative plaintiff (e.g., in Germany, Italy and Spain, the settlement must be reviewed by the shareholders meeting; and in Delaware, Israel, Singapore and the UK, the court must approve the settlement).

One last issue impacting the feasibility of derivative actions is the asymmetry of information between, on one side, minority shareholders and, on the other side, managers or controlling shareholders. No other system in the survey has developed a system that would provide advantages to plaintiffs comparable to those provided by discovery in the United States. A few countries, such as Israel and the UK, have created special rules for derivative suits allowing courts to instruct companies to disclose certain information during the pre-trial stage.

Key points on arbitration

Brazil and Spain are the only jurisdictions among the 10 covered in the report that have opted for arbitration as a means of resolving corporate and securities disputes involving publicly listed companies. The Brazilian Company Law not only recognizes that the articles of incorporation may include mandatory arbitration clauses, but the adoption of such a clause is also a condition for companies to be listed in the local listing segment with the highest standards of corporate governance (“Novo Mercado”). This growing reliance on arbitration for resolution of corporate disputes stems from the (i) slow pace of the Brazilian judicial system in conducting proceedings, and (ii) some judges’ lack of good knowledge of corporate law issues.

Possibly because of the properties of inertia, corporate arbitrations in Brazil are protected by confidentiality restrictions in the same way that commercial arbitration traditionally has been. Confidentiality of arbitration proceedings involving shareholders’ ownership rights, however, create a number of challenges: (i) shareholders who might be affected by decisions of the arbitrators do not have the opportunity to intervene in the proceeding; (ii) arbitral decisions lose their reputational effects, which might be important to deter mismanagement and abuse; (iii) market participants lose an important source to understand what their duties as managers and controlling shareholders effectively mean in concrete cases.

Publicity of the main phases of an arbitration proceeding is a necessary condition for the existence of large multiparty arbitrations involving the enforcement of shareholders’ rights. Especially in the case of publicly listed companies, shareholders may find it difficult to coordinate efforts to hire a law firm and file the request for an arbitration proceeding and, therefore, it is necessary that the shareholders are promptly informed in regards to the filing of the request in order for the greatest number to intervene. This is the rule, for example, for proceedings initiated in one arbitration institution in Germany and two others in the US (in Germany, the rules mentioned here are for non-listed companies, since disputes over collective rights of minority shareholders of publicly held companies are not arbitrable in mentioned country).

Arbitration involving collective interests of shareholders could follow either an opt-in system (where shareholders need to adhere as parties to the proceeding) or an opt-out one (where every shareholder is considered represented by the plaintiff if the shareholders do not pronounce otherwise within a deadline at the beginning of the proceeding). The opt-out system is considered advantageous for the goal of fostering collective arbitrations because—for psychological and practical reasons—it results in a greater number of shareholders being represented in the dispute and, therefore, bound by the arbitration award (it has arguably been one of the main reasons why class actions are so common in the US). Of course, an opt-out system would only be fair if the initiation of an arbitration proceeding is efficiently publicised to all shareholders and if they have sufficient time to analyse the claim and decide whether it would be in their interest to stay as a party.

In any case, none of the 10 jurisdictions covered in the report have an opt-out collective arbitration system for corporate disputes, which one could refer to as “class arbitration”. What does currently exist are some multiparty arbitrations initiated by shareholders who brought together a claim to an arbitral institution, but who do not represent any other shareholder that did not formally accept to be a party.

The full report is available for download here.