Preliminary Procedures in Shareholder Derivative Litigation: A Beneficial Legal Transplant?

Shareholder derivative suits, which shareholders bring to enforce claims of the corporation, are a perennial subject of debate. While it is often seen as a nuisance in jurisdictions where it is frequent, such as in the United States, derivative suits are notably scarce in many countries. In principle, derivative suits can have a beneficial impact by creating incentives for a corporation’s directors and officers to comply with their legal duties. Enforcement of fiduciary duties may reduce agency costs and increase investors’ confidence. However, derivative suits sometimes exhibit the problem of litigation agency cost: Plaintiffs or, more likely, their lawyers, may pursue goals different from those of shareholders collectively and may attempt to coerce the company into a settlement benefiting themselves. The international debate about derivative suits has been important enough for the OECD to make it a significant part of a reform recommending reforms for shareholder litigation in Brazil.

Demand futility and the need for balance

My paper, which is based on the part of the OECD report that I prepared, explores the significance of preliminary procedures as a mechanism to balance the goals of enforcing corporate law and screening out non-meritorious litigation at an early stage. By “preliminary procedures,” the paper refers to court decisions early in the process to decide whether a derivative suit should go forward or whether the board’s prerogative to litigate on behalf of the corporation should be respected.

The comparative literature has explored several levers for derivative suits, such as standing requirements (e.g., minimum percentage thresholds for plaintiff shareholders) or the structure of cost rules, such as the reimbursement of the winner’s litigation cost and the availability of contingency fees. In the past 30 years, several jurisdictions have adopted preliminary procedures as a screening mechanism, including Germany, Israel, Singapore, and the UK. However, the original model is the law of the United States, specifically Delaware, where preliminary procedure evolved not be legislative design but rather the case law of the Chancery Court and Supreme Court. US law generally requires that plaintiffs first demand that the board enforce the claim. According to the Delaware Supreme Court, “[b]y electing to make a demand, a shareholder plaintiff tacitly concedes the independence of a majority of the board to respond” (Spiegel v. Buntrock, 571 A.2d 767 (1990)). Consequently, plaintiffs rarely bring a demand to the board. The court’s decision about demand futility based on the plaintiff’s pleadings has de facto turned into a preliminary stage universally used in Delaware cases. In United Food v. Zuckerberg (262 A.3d 1034 (2021)), the Delaware Supreme Court refined its test for demand futility. In short, the court must assess each directors’ possible conflict of interest individually; if at least half of directors have a conflict, demand is futile.

The international trend toward preliminary procedures

In the UK, Singapore, Israel, and Germany, legislatures introduced preliminary procedures by statute that play a similar role as a gateway to litigation. Some of these reforms were linked to a new model for the directors’ duties. In the UK (from 2006) and Singapore (from 1994 and expanded to publicly traded firms in 2014), the changes were linked to the introduction of a new derivative mechanism that avoided the (somewhat restrictive) requirements of the historical case of Foss v. Harbottle of 1843. Plaintiffs must ask for the court’s “permission” or “leave” to bring a derivative claim (UK Companies Act, s. 261 and 262, Singapore Companies Act, § 216A(3)). Germany changed its enforcement model in 2005, reduced the ownership thresholds for bringing a suit, and concurrently introduced an “admission procedure” for derivative suits (§ 148 Aktiengesetz). Thus, what would otherwise have been a broad expansion of derivative suits was mitigated by new procedural obstacles.

Pre-trial procedures can be considered a legal transplant. The effects of legal transplants are not always the same as in the jurisdiction of origin. In Delaware, the requirement to plead demand futility establishes a barrier against the lawsuit moving into the burdensome discovery stage, which is less of a concern in other jurisdictions. The paper argues that preliminary procedures have the potential to overcome hurdles against derivative litigation in jurisdictions where they have not become a meaningful governance instrument. In many countries, derivative litigation has traditionally been inhibited by procedural disincentives resulting from the distribution of litigation costs. In striking a balance between “too many” and “too few” derivative suits, there are several levers that policymakers could adjust to make the instrument more attractive, including cost and fee rules that reward successful plaintiffs or their lawyers, e.g., through contingency fees. Preliminary procedures provide an opportunity to remedy some issues hindering derivative suits, specifically the measurement of court fees (which plaintiffs sometimes must advance) and litigation cost. In jurisdictions applying the “English rule” (or “loser pays rule”), unsuccessful plaintiffs may have to reimburse defendants for some of their cost, which creates a strong disincentive against representative forms of litigation. The court’s decision can serve as the cutoff point for the risk of having to bear litigation costs for potential plaintiffs. We already see that some plaintiffs limit the reimbursement risk at that stage.

Making preliminary procedures successful legal transplants

So far, most jurisdictions that introduced preliminary procedures for derivative litigation have not yet seen a substantial uptick in private enforcement of corporate law, primarily because of flaws in the system’s design. The paper suggests two major design elements to make a preliminary procedure effective. First, shareholders should not be saddled with a risk of bearing costs that deters them from litigating. Instead, the risk of paying litigation costs should be limited to the preliminary procedure. Second, in several countries, preliminary procedures often require shareholders to provide evidence (even if only prima facie evidence) that the suit is likely to prevail or is otherwise “in the interest of the corporation.” Outside shareholders are typically not well-positioned to support the substance of a claim to such a degree at an early stage. Instead, as in Delaware, the emphasis of the preliminary stage should be on conflicts of interest of directors that make it unlikely that they pursue a claim.

Conclusion

The paper thus argues that a well-designed system has the potential to turn derivative suits into an effective corporate governance mechanism. Such a system would permit courts to control potentially abusive litigation and allow countries concerned about excessive levels of litigation to abolish minimum share ownership requirements for plaintiffs (where they still exist). This does not mean that plaintiffs in countries with well-designed preliminary procedures will necessarily have high-powered incentives to bring large numbers of lawsuits. However, such procedures can remove considerable obstacles that undermine the effectiveness of the litigation system.

The full paper is available for download here.