Featured Faculty Opinion: John C. Coffee Jr.

New York Law Journal

July 17, 2003

Post-Enron Jurisprudence
John C. Coffee Jr. is the Adolf A. Berle Professor of Law, Columbia University School of Law, and director of its Center on Corporate Governance.

Plaintiffs have won a seemingly unbroken string of victories in Delaware over the last year. In five cases over this interval, the Delaware Supreme Court has reversed decisions in favor of the defendant directors,(1) and in two more recent Chancery Court cases, In re The Walt Disney Co. Derivative Litigation,(2) and In re Oracle Corp. Derivative Litigation,(3) derivative actions against directors have been permitted to go forward. To paraphrase Dorothy's remarks on entering the Land of Oz, "this sure doesn't look like Delaware anymore."

Indeed, in a recent memorandum to clients, one major New York law firm has speculated that Delaware courts, "mindful of how much of the state's revenues come from corporate franchise tax," are exercising a stricter scrutiny in order to ward off the threat of further federal intrusion into state corporate governance.(4) Perhaps this speculation is unavoidable, but it is also the product of a tunnel vision focused exclusively on Delaware. When one looks beyond Delaware, one discovers exactly the same phenomenon in decisions in other state courts and in federal court. Derivative actions are being allowed to proceed; dismissed securities class actions are being reinstated by appellate courts, and once settled rules limiting litigation are being discarded. More importantly, a common policy rationale underlies this new trend: Courts are stating explicitly that private litigation plays an important role in deterring fraud and must not be discouraged by overbroad barriers. The tone of these new decisions is best exemplified by the California Supreme Court's statement this year in Small v. Fritz Companies Inc.,(5) where it said:

When Congress enacted the Private Securities Litigation Reform Act of 1995 and the Uniform Standards Act of 1998, it was almost entirely concerned with preventing nonmeritorious suits . . . But events since 1998 have changed that perspective. The last few years have seen repeated reports of false financial statements and accounting fraud, demonstrating that many charges of corporate fraud were neither speculative nor attempts to extort settlement money, but were based on actual misconduct . . . . Eliminating barriers that deny redress to actual victims of fraud now assumes an importance equal to that of deterring nonmeritorious suits.(6)

One can sympathize with the implicit idea here that courts must balance two types of errors: permitting frivolous actions to go forward versus terminating meritorious actions. Yet, when one examines the actual holding in Small v. Fritz Companies Inc. and its implications, it is hard not to conclude that the pendulum has swung too far and too fast. As discussed below, the new "post-Enron jurisprudence" emerging over the last year is a mixed bag of old ideas that have moved from dicta to holdings and new ideas that seem not to have been fully analyzed.

Small v. Fritz Companies provides an instructive starting point, in part because it announces the most significant doctrinal change. In it, the California Supreme Court announced this year that a non-trading shareholder may sue a corporation for damages where the shareholder relies on a false financial statement issued by the corporation. In federal court, such a non-trading shareholder suing under Rule 10b-5 would be cut off by the U.S. Supreme Court's decision in Blue Chip Stamps.(7) But in Small v. Fritz Companies, the California Supreme Court rejected Blue Chip Stamp's logic and upheld "a cause of action by persons wrongfully induced to hold stock instead of selling it."(8) Although the Court denied that it was expanding the common law of fraud in permitting such a "holder's action," and did insist that a plaintiff holder show "actual reliance on the misrepresentations," the net effect is to open the courthouse door very wide for a new species of stockholder litigation. Moreover, because it expressly recognized that such an action could be brought for negligent misrepresentation as well as for fraud, it would not even seem necessary to plead facts showing scienter on the part of the defendants in order to sue as a holder in California.

What will be the impact of such a rule? Because plaintiffs in California must allege and prove actual reliance, it will be difficult to certify a class action based on this theory, as reliance is an individual issue that tends to preclude class certification.(9) Also, the Securities Litigation Uniform Standards Act (SLUSA) broadly proscribes class actions based on state law and alleging material misrepresentations or omissions.(10) Institutional investors can sue, however, either individually or on a coordinated basis, because their individual losses will often be sufficient to justify litigation. But therein lies the rub. Not only do institutional investors get a remedy that in most cases smaller shareholders will be unable to exercise, but the former's new remedy comes largely at the expense of the latter. Consider, for example, the standard stock drop case that usually triggers a federal securities class action: assume that the company announces an earnings restatement and its stock price falls 25 percent in one day. Now, such an announcement will trigger not only a federal securities class action but in all likelihood a number of state court suits in California by institutional holders who can claim credibly to have relied on the corporation's prior financial statements. As shareholders entitled to the fiduciary loyalty of management, these shareholders may be able to sue on a negligent misrepresentation cause of action in California state court. The combined impact of the federal class action and the individual suits in state court could conceivably turn a case of bad disclosure into an event that threatens insolvency. Even if insolvency does not result, a wealth transfer from small shareholders to large shareholders probably will. If California wants to redesign its litigation remedies from the ground up, it needs to consider ways to bring the moribund derivative action back to life and thus focus the penalties on the villains, not the victims.

Small v. Fritz Companies seems then to be an example of the pendulum swinging too far and too fast, but most other recent cases only show the pendulum retreating from a prior deregulatory high water mark. In No. 84 Employer-Teamster Joint Council Pension Trust Fund v. America West Holding Corp.,(11) the U.S. Court of Appeals for the Ninth Circuit has just reversed and remanded a Rule 10b-5 class action that the district court had dismissed for failure to satisfy the PSLRA's pleading requirements. Plaintiffs alleged that America West's two controlling shareholders had sought to "pepper the market' with false statements that covered up operational, maintenance, and safety problems at America West until these two shareholders were permitted to sell their shares pursuant to a stockholders' agreement. Nonetheless, the district court dismissed the action, finding that any alleged omissions by the defendants must have been immaterial as a matter of law "because the market failed to react immediately to the public announcement" of these problems.(12)

Overruling the district court, the Ninth Circuit rejected any "bright-line rule requiring an immediate market reaction."(13) Although the Third Circuit had adopted precisely such a bright-line rule in Oran v. Stafford,(14) in 2000, the Ninth Circuit backed away from it, emphasizing the need to enhance, not weaken, existing litigation remedies:

Securities fraud class actions are not all good or all bad. In a large public securities market, dishonest insiders may be able to cover their tracks fairly well, and falsely claim to be as surprised as the ribbon clerks, when they take the market for a ride. Unless reasonable inferences from circumstances suffice to get a case to a jury, the welfare of victimized investors and the integrity of the stock market may be insufficiently protected from deceptive manipulation . . . In this era of corporate scandal, when insiders manipulate the market with the complicity of lawyers and accountants, we are reluctant to raise the bar of the PSLRA any higher than that which is required under its mandates.(15)

Strong words indeed! But, more importantly, this was from the same circuit that only a few years earlier in Silicon Graphics had raised the bar higher than any other circuit by requiring plaintiffs to establish a unique level of scienter, "deliberate or conscious recklessness."(16)

Recent federal derivative cases have also shown the same skepticism of board passivity and the same willingness to find a lack of good faith as Delaware cases have shown this year. The most discussed derivative case this year is probably In re Abbott Laboratories Derivative Litigation,(17) in which plaintiffs claimed that the directors of Abbott Laboratories had been aware of significant safety violations and yet took no action for over six years, despite repeated FDA notices and eventually the highest civil fine ever imposed by the FDA. Excusing demand, the Seventh Circuit said that these allegations, if proven, demonstrated a "systematic failure of the board to exercise oversight."(18)

While the Disney and Abbot Laboratories decisions simply reinstate derivative actions and permit them to proceed to trial, one recent decision goes a step further and actually imposes liability on directors and officers for breaches of the duty of care and loyalty. In Pereira v. Cogan,(19) a controlling shareholder paid undisclosed dividends, salaries, and compensation to himself, at a time when the corporation was insolvent, without the prior approval of the board. Egregious as his acts were, the board knew relatively little at the time, but did ratify these transactions, based on conclusory reports from officers, by approving a series of unanimous written consents. U.S. District Judge Robert Sweet found the board's level of inattention not only to flunk the business judgment rule, but to amount to "abdication," which he further found to be a breach of the duty of loyalty. This last step should remind counsel how uncertain are the protections afforded by Delaware General Corporation Law §102(b)(7). Although that section permits a charter amendment eliminating monetary liability for breach of the duty of care, this provision is by its terms inapplicable either to the duty of loyalty or to a breach of the duty of care that is accompanied by a lack of "good faith." Judge Sweet's decision shows that when courts lack confidence in boards, they can easily sidestep exculpatory provisions.

Pereira v. Cogan should particularly chill the hearts of inside general counsel, because it illustrates how vulnerable they are becoming. In Pereira, it was uncertain whether the general counsel even actually knew that the controlling shareholder was making regular small loans to himself on a monthly basis that eventually totaled over $10 million. No matter, said the court, because the general counsel was on constructive knowledge once these loans were eventually disclosed in a footnote to the financial statements. Still, as a non-director, the corporation's general counsel took no action to authorize, approve, or conceal these loans. Nonetheless, the court held him legally responsible because Delaware law requires that any corporate loan to an officer must be specifically approved by the board as "expected to benefit the corporation."(20) Hence, the general counsel's failure to advise the board that such loans required their approval made him a proximate cause of the resulting loss.

More generally, the Pereira court found that the general counsel failed to advise the board as to its monitoring obligations and its structural inability to satisfy them.(21) So viewed, the general counsel becomes the corporation's chief corporate governance officer with a duty to advise the board to install necessary compliance and monitoring programs. Since the Caremark decision in 1996,(22) liability for failure to monitor has been a theoretical possibility, but it has now become a reality, with the general counsel today seeming a particularly exposed potential defendant.

A new post-Enron jurisprudence appears to be emerging across a variety of jurisdictions. Its hallmarks are a judicial distaste for "blind" reliance on conclusory statements and perfunctory ratifications and a suspicion that warnings to the corporation may have been conveniently ignored or repressed by the board. Even in privately held corporations (such as that in Pereira v. Cogan), the failure to utilize audit or compensation committees will give rise at least to an adverse inference. To rely safely on experts, the board needs more than a naked conclusion and an expert's pedigree being placed before it; instead, it needs a chain of reasoning that it engages.

How far will the pendulum swing? A historical parallel exists and suggests that judicial confidence in boards will take some time to re-establish. Between the late 1930 and early 1940s, courts became uniquely risk averse and regularly held liable bank directors for risky or inadequately collaterialized loans by their institutions.(23) Neither before nor since has the risk of liability been as high. Ultimately, the same forces and consciousness that sped the Sarbanes-Oxley Act through Congress by overwhelming majorities also influences courts. Finley Peter Dunne's Mr. Dooley knew this long ago.

MM Cos. v. Liquid Audio IncOmnicare, Inc. v. Healthcare IncLevco Alternative Fund Ltd. v. Reader's Digest Ass'nSaito v. McKesson HBO Inc.Telxon Corp. v. MeyersonBlue Chip Stamps v. Manor Drug StoresBirnbaum v. Newport Steel CorpIn re Silicon Graphics Inc. Sec. LitigRoncomi v. LarkinPereira v. CoganIn re Caremark Int'l Inc. Deriv. Litig.Litwin v. Allenxxxxxxxxxxxxxx
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Corporate Securities
Post-Enron Jurisprudence

(1) See, e.g., MM Cos. v. Liquid Audio Inc., 813 A.2d 1118 (Del. 2003); Omnicare, Inc. v. Healthcare Inc., 2003 Del. LEXIS 195 (Del. April 6, 2003); Levco Alternative Fund Ltd. v. Reader's Digest Ass'n, 803 A.2d 428 (Del. 2002); Saito v. McKesson HBO Inc., 806 A.2d 113 (Del. 2002); Telxon Corp. v. Meyerson, 802 A.2d 257 (Del. 2002).
(2) Civil Action No. 15452 (Del. Ch. May 28, 2003).
(3) Civil Action No. 18757 (Del. Ch. June 13, 2003).
(4) See Debevoise & Plimpton Client Update, "What's Happening to the Business Judgement Rule?" (June 19, 2003).
(5) 30 Cal. 4th 167, 65 P.3d 1255, 132 Cal. Rptr. 2d 490 (April 7, 2003).
(6) 65 P.3d at 1263.
(7) Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). This rule goes back even earlier. See Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952).
(8) 65 P.3d at 1256-57.
(9) Most states, including California, follow Federal Rule of Civil Procedure 23(d)(3), which requires that the common issues of law and fact predominate over individual issues. Reliance is inherently an individual issue, and if it must be shown as a prerequisite to liability, then class certification would seem possible only in limited circumstances.
(10) In 1998, SLUSA added §28(f) to the Securities Exchange Act of 1934. It precludes any class action in state or federal court based on state statutory or common law alleging a misrepresentation or omission of a material fact. Individual actions are not precluded, but any coordinated action by 50 or more persons is deemed a class action and is similarly precluded. Section 28(f) precludes only class actions involving listed securities or securities of investment companies.
(11) 320 F.3d 920 (9th Cir. 2003).
(12) Id. at 933.
(13) Id. at 934.
226 F.3d 275, 282 (3d Cir. 2000).
(15) 320 F.3d at 946
(16) See In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 979 (9th Cir. 1999); see also Roncomi v. Larkin, 253 F.3d 423, 429 (9th Cir. 2001).
(17) 325 F.3d 795 (7th Cir. 2003).
(18) Id. at 808-09.
(19) 2003 U.S. Dist. LEXIS 7818 (S.D.N.Y. May 12, 2003).
(20) See Delaware Gen. Corp. L. §143. See also Pereira v. Cogan, supra note 19, at *183.
(21) 2003 U.S. Dist. LEXIS 7818 at * 182 (noting that the general counsel "never discussed with the Board the need to establish compliance and monitoring programs or an audit committee and the obligation to supervise and evaluate Cogan as CEO.").
(22) In re Caremark Int'l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996) (Allen, Ch.).
(23) The leading New York case in this era was Litwin v. Allen, 25 N.Y.S.2d 667 (Sup. Ct. 1940) (finding purchase of bonds by bank subject to seller's right to repurchase for six months to breach the duty of due care). For a fuller review of the decisions in this era, see Patricia McCoy, A Political Economy of the Business Judgement Rule in Banking: Implications for Corporate Law, 47 Case West. Res. L. Rev. 1, 40-43 (1999).