The State Court Section 11 Problem: 3 Solutions

In a recent article, I described the phenomenon of Section 11 suits being filed against IPO companies in California state courts. This problem has continued, unabated … but there may be some relief on the horizon. Three possible solutions have emerged.

Option 1: A U.S. Supreme Court Decision

Boris Feldman and his team of litigators at Wilson Sonsini Goodrich & Rosati, on behalf of their client Cyan, Inc., have filed a petition with the Supreme Court of the United States asking for the Court to address wildly different practices followed by federal district courts in California and New York when it comes to motions to remand Section 11 cases that had initially been filed in state court.

It’s worth reading the Wilson Sonsini brief if you are interested in the nuances of how California courts ended up in the bizarre situation of reading the Securities Litigation Uniform Standards Act of 1998 in a way that turns congressional intent on its head.

Wilson Sonsini argues that the question is ripe for review, and that their petition “provides a rare opportunity to turn chaos into order.”

Fingers crossed that the Supreme Court grants the petition and restores order to ’33 Act litigation.

Option 2: Updating Lock-up Agreements

A second possible solution rests on the shoulders of the investment bankers who underwrite IPOs. Boris Feldman of Wilson Sonsini posted this proposal on the Harvard Law School Forum on Corporate Governance and Financial Regulation blog.

Bankers typically insist that all shares not being sold in an IPO pursuant to the S-1 registration statement be “locked-up.” Specifically, bankers insist that all holders of company securities agree not to sell their securities for at least 180 days after the IPO. Their argument is that the lock-up allows for more orderly trading of a company’s stock.

One consequence of the lock-up, however, is that the only shares trading in the market are shares that were sold pursuant to the S-1 registration. The absence of other shares in the market is a boon to plaintiffs.

In order to have standing to bring a Section 11 suit, plaintiffs must trace their specific shares back to shares that were issued pursuant to the S-1 registration statement. If the only shares trading in the market were sold pursuant to the S-1, plaintiffs can easily demonstrate that the shares they hold were purchased pursuant to the registration statement.

What if, instead, there were other shares in the market immediately after an IPO, such as shares previously held by employees and sold pursuant to Rule 144?

With a sizeable number of shares trading in the market in addition to the shares issued in the IPO, plaintiffs would struggle to meet the tracing requirement. This would at least reduce the size of the class. Enough shares in the market might make tracing all but impossible.

For clarity, investment bankers wouldn’t have to abandon lock-ups entirely for this solution to work. They could decide to apply the lock-up to some, but not all employees. For example, they could release lower-level employees from the lock-up. They could also allow non-IPO shares into the market on a rolling basis by releasing shares a little at a time as opposed to all at once.

Modifying lock-ups is a radical suggestion. Bankers will be hesitant to allow any modifications after so many years of taking the position that all shareholders must be subject to a 180-day lock-up. Moreover, once an investment bank allows any modification of a lock-up, it will be harder for that bank to obtain a pure lock-up in the future.

In addition, some might be uncomfortable with the appearance of deliberately making a Section 11 claim difficult to bring. However, there are real business reasons to loosen lock-ups beyond an effort to mitigate frivolous Section 11 claims.

For example, there is no doubt that holders of stock in a successful IPO may be eager for liquidity. There is certainly a good argument that a company’s employees would be happier if they could sell at least a portion of their equity holdings sooner than later. Particularly in a market that is very competitive for highly skilled workers, employee happiness is a legitimate reason for a company to negotiate a modified lock-up with its bankers.

It’s worth noting that the investment banks are typically named as defendants in state court Section 11 cases. Notwithstanding this fact, investment banks are not as motivated as companies to deal with the situation.

Speaking broadly, companies usually indemnify investment banks from securities litigation as a condition to underwriting a public offering. With few exceptions, the underwriting agreement requires that the IPO company pay the investment bank’s legal defense and settlement costs.

As such, investment banks don’t feel the economic impact of this type of litigation in the same way companies do.

Unfortunately for IPO companies, these costs are excluded from most D&O insurance policies. As a result, issuers (and their shareholders) usually feel the full brunt of Section 11 claims, while investment bankers feel almost nothing.

Option 3: The Grundfest Solution

Professor Joe Grundfest of Stanford University, also notably the founder of a successful public company and former Commissioner of the Securities and Exchange Commission, was intrigued by the Section 11 problem when I showed him the data.

His solution is an elegant one: solve the Section 11 state court problem by inserting in a company’s bylaws a choice of forum provision that makes federal courts the exclusive venue for litigation arising under the Securities Act of 1933.

This solution is a straightforward extension of the intra-corporate forum selection provision that Professor Grundfest introduced in 2010, and that has now been adopted by more than 1,000 publicly traded firms. The validity of the intra-corporate forum selection provision has been upheld by Delaware’s Chancery Court, and by a large number of other state courts, including, significantly for present purposes, California state courts.

Professor Grundfest is currently writing a law review article to lay out the argument for his solution to the Section 11 problem. One version of the forum selection provision reads as follows:

Unless the Corporation consents in writing to the selection of an alternative forum, the federal district courts of the United States of America shall be the exclusive forum for the resolution of any complaint asserting a cause of action arising under the Securities Act of 1933. Any person or entity purchasing or otherwise acquiring any interest in any security of the Corporation shall be deemed to have notice of and consented to the provisions of this bylaw.

As a reminder, early on there was significant litigation swirling around companies that had adopted choice of forum provisions in their bylaws. Ultimately, the Delaware courts settled the question favorably for companies attempting to reduce frivolous litigation.

In the Chevron case, Delaware affirmed that companies may include in their bylaws a choice of forum provision establishing Delaware state court as the exclusive forum for litigation pertaining to the internal affairs of a corporation. More recently, the Delaware legislature has codified this result.

The Grundfest Solution, however, is about federal securities law, not about corporate law. The first-blush reaction to this solution by most corporate and securities attorneys is that the type of limitation imposed by the Grundfest Solution might be prohibited by Section 14 of the ’33 Act.

The relevant language reads: “Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this title … shall be void.”

However, consider the difference between asking a party to waive compliance with any part of the ’33 Act versus asking a party to pre-designate which forum a dispute about ’33 Act compliance will be resolved.

The U.S. Supreme Court has previously agreed in Rodrigues de Quijas v. Shearson/American Exp., Inc. that provisions mandating arbitration to settle ’33 Act claims are permissible:

“By agreeing to arbitrate a statutory claim, a party does not forego the substantive rights afforded by the statute; it only submits to their resolution in an arbitral, rather than judicial forum.”

A customer agreement about settling account disputes, and not a company’s bylaws, were at issue in Rodrigues. Nevertheless, the argument goes, if designating arbitration is permissible under the ’33 Act, it’s hard to imagine that designating federal courts as the forum for federal securities claims would be impermissible.

Next Steps for Companies Contemplating an IPO

Inserting the Grundfest Solution in a corporation’s bylaws is a potentially low-cost solution that allows a company to mitigate its Section 11 litigation exposure. As with all innovations, however, early adopters face risks that fast followers do not. When discussing the issue with counsel, there are a number of factors to consider.

It May Not Work

The Grundfest solution is elegant and clever … but there is no guarantee that it will work until courts rule that the provision is valid. Such is the case when it comes to innovation and the law. Boards will want to have their eyes wide open on this point. On the other hand, just sitting back and allowing plaintiff firms to pummel the balance sheet of a corporation by extracting extortionate settlements isn’t great either.

As is true for all bylaw amendments, a board should document its careful and deliberate decision-making process as it determines what action is in the best interests of its shareholders. This way, if the bylaw is challenged, there is a record that allows a court to defer to the board’s business judgment.

Building the record should be straightforward. Included among a board’s observations might be the following:

• Federal courts have historically been the predominant venue for the resolution of Section 11 litigation.
• As a practical matter, federal courts have greater experience with Section 11 claims, including handling the complexity associated with things like the operation of the tracing doctrine and the standards by which the due diligence defense is asserted for expertised and non-expertised portions of the registration statement.
• Data comparing litigation outcomes in state versus federal court show that state court settlements are inflated due to procedural rather than substantive reasons.

Painting a Target on Your Company’s Back?

Professor Grundfest himself notes the potential “first mover disadvantage” with his solution: does adopting the Grundfest Solution effectively paint a target on the back of an IPO company? I think the answer is “not really.”

It’s true that early in the history of the intra-corporate forum selection provision, plaintiff counsel sued several companies that had adopted intra-corporate forum selection bylaws under a breach of fiduciary duty theory.

All but two of these companies settled their cases. Chevron and FedEx, however, proceeded to litigate the matter to a successful conclusion.

This litigation arose even though none of the companies were then seeking to enforce their intra-corporate forum selection provisions. Thus, there is a chance that plaintiff lawyers will bring a lawsuit challenging the adoption of a Section 11 forum selection provision, even if a company has not been named as a defendant in a Section 11 claim.

On the other hand, plaintiffs don’t like to bring losing cases, and the odds of a plaintiff prevailing on such a claim are not great. The combination of a company’s having a good record as to why the board adopted the Grundfest Solution and the reasoning behind why state courts have been supportive of intra-corporate choice of forum provisions is a good defense for IPO companies and their boards.

Another concern is this: will plaintiffs somehow target Grundfest Solution IPO companies when bringing Section 11 claims?

Again, I think the answer is “not really.” It’s still the case that there will be no Section 11 suit brought by shareholders unless the company’s stock price falls below the IPO price. However, if that happens, there is a high likelihood of being sued regardless of whether or not a company adopted the Grundfest Solution.

Arguably, the Grundfest Solution might act as a deterrent to plaintiffs who want to bring their case in state court. At least in the beginning, before everyone has adopted the Grundfest Solution, plaintiffs would logically avoid suing companies that have adopted it—but not because it’s effective.

Plaintiffs would avoid suing companies that have adopted the Grundfest Solution to avoid the possibility of proving in court that the Grundfest Solution works.

Once that happens, everyone will adopt it, effectively turning off the plaintiff’s Section 11 state court money fountain for all time.

But let’s say that a plaintiff isn’t good at game theory, or for some other reason decides to target a company that adopts the Grundfest Solution. There’s still no suit until the company’s stock price falls below its IPO price.

At that point, the company was likely to be sued anyway, and based on historical data, the cost of settlement would be significant. The incremental cost of motion practice on the question of the Grundfest Solution would be marginal in comparison.

Disclosure and SEC Review

Given the untested nature of the Grundfest Solution, it seems likely that a company would add some disclosure about this bylaw in their S-1 registration statement. This, of course, means that the SEC will review the provision.

The SEC has stood in the way of efforts by companies to implement litigation innovation in the past. Carlyle Group’s effort to prohibit shareholders from bringing class action suits against it by imposing mandatory confidential arbitration is a good example. After discussions with the SEC and others, the Carlyle Group ultimately dropped its effort.

In this case, however, the SEC would be considering whether federal court is the appropriate venue for the resolution of federal claim. There is no effort to eliminate the right of shareholders to have their claims heard in open court, only the clarification that the court be a federal court (as such cases have been heard for decades), not a state court.

Moreover, the class action mechanism would still be available to shareholders. Given these factors, it’s likely to be difficult for the SEC to object to the Grundfest Solution.

The Grundfest Solution and Public Companies

As I discussed in my earlier article on Section 11 suits against IPO companies, once the three-year statute of limitations has passed, the Section 11 problem effectively goes away.

But what about newly public companies that are still within their three-year statute of limitations? The same discussion about whether an IPO company paints a target on its back when it adopts the Grundfest Solution applies here. So long as a company does not yet have a Section 11 claim filed against it, considering the Grundfest Solution is a good idea.

Proxy Advisor Reaction

One additional potential downside is a negative reaction by proxy advisory firms like ISS and Glass Lewis. They certainly had initial negative reactions to nominating and governance committees of companies that adopted choice of forum provisions without first seeking shareholder approval.

These concerns, however, seem to have been mitigated as the proxy advisory firms better understood the issues that motivated companies to adopt the provisions in the first place.

The proxy advisory firms now seem to understand that such provisions protect shareholders by helping companies avoid frivolous litigation. It seems likely that the proxy advisory services would ultimately reach a similar conclusion vis-à-vis the Grundfest Solution.

Debt Issuances

Historically, some of the largest Section 11 settlements have arisen in conjunction with public debt issuances by firms that are already publicly traded. Firms can respond to this risk by inserting a Section 11 forum selection provision in the bond indenture.

Doing so should significantly increase the probability that in the event of Section 11 litigation, the claim will be resolved in federal and not state court. Introducing the Grundfest Solution into bond offerings raises none of the fiduciary duty or proxy advisor issues that arise when the Grundfest Solution is implemented to regulate claims brought by shareholders.

The D&O Insurance Carrier Response

The Grundfest Solution is not just important to IPO companies; it’s also a win for the D&O insurance carriers that insure IPO companies.

Given that the Grundfest Solution is not yet tested, it’s unclear how much credit insurance carriers will give to companies that adopt it. Having said that, it’s arguably in the D&O insurance industry’s best interest to have as many companies as possible adopt the Grundfest Solution to mitigate the expense of settling frivolous Section 11 claims.

The alternative is to continue to be hit by unnecessarily expensive claims—claims that would be easily dismissed if brought in federal court. This isn’t a good strategy for insurance carrier sustainability. Moreover, there is a lot of client frustration in the face of very high D&O insurance self-insured retentions and premiums.

Carriers might encourage behavior that helps both their clients and themselves by offering lower self-insured retentions and premiums to companies that adopt the Grundfest Solution.

If this is too radical, another idea would be to offer a zero-retention sublimit to advance legal fees associated with defending the Grundfest Solution, whether before or at the time of a Section 11 suit. To be sure, this type of sublimit is likely to be a competitive advantage to the carriers that offer it.

In Sum

While we wait and hope that the Wilson Sonsini petition to the U.S. Supreme Court will be successful, and perhaps negotiate with investment bankers to modify lock-up agreements, the Grundfest Solution offers a potential path for companies contemplating an IPO sooner than later.

Boards that are thoughtful, have worked through the issues with outside counsel, and are willing to take a bold step to avoid paying extortionate settlements to the plaintiffs’ bar may find the Grundfest Solution very appealing.

And what if plaintiffs sue a company’s directors and officers for breaching their fiduciary duty by adopting the Grundfest Solution, even if plaintiffs’ probability of success is quite low for all the reasons described above?

Surely the highest, best use case for D&O insurance is for it to provide a defense (and, where necessary, settlement) for thoughtful boards that have worked carefully through the issues and decided to take decisive action for the good of their shareholders.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.