Securities litigation is becoming more popular as investors seek to assuage their financial losses. M&A suits in particular are skyrocketing.
Investors can be a fickle lot. When stock prices are climbing and dividend checks arrive, most are content. But if performance suffers or dividends are cut, the annual meeting can be a tense affair. A company that decides to sell or merge can quickly become a target for litigation filed by shareholders who feel they're not getting their fair share.
Securities class action suits may be filed for a number of reasons, including fraud, unsuitable investments, bad investment advice and more. When the suit involves a merger or acquisition, it often means a breach of fiduciary duty. Such cases are on the rise as investors become more aggressive about recouping financial losses.
M&A-related filings usually involve shareholders bringing a suit against the board of the company whose stock they own, says attorney Brian Troyer, a partner in the business litigation practice group at Thompson Hine.
"Obviously there can be different configurations of parties, but that's the typical type of case that's brought. The claim will be one of several kinds. The shareholders of the company being acquired or merged into another company will claim that the price that they're receiving is inadequate, that board members have breached their fiduciary duties to the shareholders. ... In some cases, directors might have conflicts of interest if they have some other interest in the transaction," Troyer says.
Such cases involve a lot of Monday morning quarterbacking, says Jim Balthaser, a partner and leader of Thompson Hine's private company counseling group. "It's looking back in history at what was done and saying it could have been done better and that shareholders would have received more. You'll see directors hire outside counsel to guide them through the process so there isn't an easy allegation of conflict of interest. Whoever is filing has the benefit of hindsight," he says.
These suits are typically referred to as "bump up cases," says Dan Bailey, chairman of the directors and officers liability practice group for Bailey Cavalieri. "The claim is against directors of [the selling] company, alleging that the directors breached their fiduciary duties in investigating the transaction, negotiating the price of the transaction and otherwise approving the transaction for recommendation to the shareholders," he says. "What the litigation seeks to recover is an increase or a bump up in the price paid to the shareholders."
Large financial institutions are typically used as lead plaintiffs in class actions, Troyer says. "State pension funds and union pension funds, those are typically the types of lead plaintiffs since the 1995 Private Securities Litigation Reform Act that reformed federal law. That practice has, to a large degree, percolated to a lot of the state courts, as well," he says.
But serving as lead plaintiff doesn't necessarily bring a bigger settlement check. In federal court, lead plaintiffs cannot be awarded additional recovery dollars, but they are often reimbursed for expenses related to the case. Other courts still have some discretion, Troyer says. "The answer can be different in state court cases, where judges sometimes will award incentive awards or bonuses to lead plaintiffs depending on the type of case and the circumstances," he says.
The overall financial impact can vary. The majority of cases are settled quickly, Bailey says. "The settlements are usually not too large. There's a fee to the plaintiff's counsel for bringing the litigation. There might be some additional disclosures that defendants agree to make to shareholders in connection with a shareholder vote on the transaction," he says. Attorney fees can range anywhere from 5 percent to 25 percent of a settlement or recovery.
Sometimes, a case may be filed before a deal is closed, says Quintin Lindsmith, a partner and past chairman of the litigation group at Bricker & Eckler. "They become used as leverage by shareholders. The mere threat of holding up acquisition or doing something to impede acquisition creates a tremendous amount of leverage-more than the merits of the case itself. If it settles the lawsuit, someone has made a business decision that the cost is worth getting rid of it, even if meritless, in order to close the transaction," he says.
By the Numbers
Directors should be on their toes regarding investor litigation. The total number of filings for federal securities class actions rose from 155 in 2009 to 174 in 2010, a 12 percent increase, according to research from PricewaterhouseCoopers. The year saw a decline in the number of filings related to the financial crisis, but 2010 still saw the second-highest level of overall securities filings in the last five years.
The number of M&A class action filings increased significantly last year, according to Cornerstone Research. In 2010, there were 40 cases filed with M&A-related allegations--a 471 percent increase from seven filings in 2009.
"From 2007 to 2009, the majority of class action suits were related to financial services or credit. Now, an M&A spike has hit. A lot of people are making guesstimates as to exactly why. Some commentators say it's the plaintiff's bar sort of following the most vogue and interesting thing and scrambling for new business because traditional fraud cases are on the decline now," says attorney Don Hughes, a partner at Squire, Sanders & Dempsey.
"During that crisis time period--the real depths of the recession--mergers and acquisitions really fell off," Troyer says. "Lots of companies went into very conservative modes, like conserving cash, looking inward and streamlining operations, rather than go out in the M&A market." As the economy began to stabilize, the M&A market experienced an upswing, which in turn caused an increase in related class action filings.
"As the credit crisis began to ease up, you could see in our firm's practice and others' that companies that had cash available or access to credit would go out to the market and acquire what might have been perceived as a weaker company but a good strategic fit," Balthaser says. "Because there was a greater volume of transactions, there was opportunity to challenge those transactions."
The rate of M&A filings isn't likely to ease up soon. "Anytime parties announce a merger transaction, you will see plaintiff firms putting out press releases saying they're doing investigations into that transaction, looking for potential clients. We see that almost immediately," says Bob Tannous, a partner and chairman of the corporate finance and securities practice group at Porter Wright Morris & Arthur.
"The ink isn't even dry and you'll see it," agrees Jim King, a partner in Porter Wright's litigation practice. "We've seen more cases in the past 12 to 18 months than we've seen before then. They've all been class actions or shareholder derivative actions."
The Buckeye State is on par with the rest of the country when it comes to M&A securities cases. "Ohio's not a unique jurisdiction. The fact that we're getting them indicates a spike in activity overall. Ohio lags behind larger jurisdictions like California or New York," King says.
Matt Fornshell, a partner and coordinator of the securities regulation practice area for Schottenstein Zox & Dunn Company, agrees. "We haven't seen a lot of it here, but nationally clearly there has been a spike on the M&A side. I think it's a function of where large public company M&A transactions are taking place, and that tends to be on the coasts," he says.
There has also been a noticeable spike in China, including several cases involving "reverse takeovers"--mergers between a Chinese company and a dormant U.S. company performed in order to list Chinese companies in the United States. Twelve securities class actions were filed against Chinese companies in 2010, accounting for 42.9 percent of filings against foreign issuers, according to Cornerstone Research.
"We think that's because you have some of these foreign issuers that were not previously on the New York Stock Exchange and are now subject to greater scrutiny," Fornshell says. "They're seeing this additional litigation because they're getting a closer look by American investors and regulators."
The proposed merger of shoe retailer DSW and parent company Retail Ventures Inc. (RVI) via a tax-free stock swap has landed those Columbus companies in court. The February agreement stipulated that each Retail Ventures share would be traded for 0.435 DSW shares. RVI's only business for the last two years has been holding a 62 percent stake in DSW, since it sold off Value City Department Stores and Filene's Basement. DSW's announcement said the merger would simplify public company reporting requirements and expenses.
It didn't take long for law firms to smell blood in the water. Just one day after the announcement, San Diego-based law firm Robbins Umeda was investigating possible breaches of fiduciary duty. Briscoe Law Firm, Kendall Law Group, the Law Firm of Levi Korsinsky and the Law Office of Joseph Klein jumped on the bandwagon from out of state, too.
Two class action lawsuits have been filed in the Franklin County Court of Common Pleas against RVI and its directors and officers. Steamfitters Local No. 449 Retirement Security Fund filed Feb. 14, and Richard Farkas filed March 11.
Both cases allege breach of fiduciary duty, citing that the exchange ratio of the DSW shares ($15.76) is less than the $15.94 closing price for RVI's stock the day the merger was announced. The suits also claim conflict of interest, noting that Jay Schottenstein is chairman of both companies, he controls more than 50 percent of the voting shares of RVI, and that some board members are common to both companies.
Also notable locally are several securities class actions filed by former Ohio Attorney General Richard Cordray. One case undertaken on behalf of the Ohio Public Employees Retirement System and the State Teachers Retirement System of Ohio involved the 2009 merger of Bank of America and Merrill Lynch. Both companies were accused of failing to disclose financial losses and executive bonuses to BoA shareholders, who approved the merger. The case settled for $475 million.
A spokeswoman for new Attorney General Mike DeWine says via email that such lawsuits can have merit. "Litigation never should be pursued lightly, and a culture of litigation can degrade the business climate significantly. Sometimes, however, litigation may prove the only course available to recover financial losses wrongfully imposed on our pension funds that invested in good faith, or to guard against practices that harm investors by disregarding legal requirements designed to allow the markets to function as fairly and smoothly as appropriate," writes Lisa Hackley.
Outside of Central Ohio, a Delaware case involving the buyout of Del Monte Foods Company by Kohlberg Kravis Roberts & Company and other private equity firms warns against conflicts of interest, Troyer says.
Barclays Capital, acting as a financial advisor to the Del Monte board, was accused of providing funding to buyers. "One of the allegations was that Barclays was in violation of confidentiality agreements, that they steered one investor to another investor so they could make combined offers, which the court viewed as potentially decreasing competition," Troyer says.
In a similar case involving the merger of Art Technology Group and Oracle Corp., plaintiffs argued that Art Technology had failed to disclose information about financial advisor Morgan Stanley's prior work for Oracle. The court ruled that both companies had to disclose to Art Technology shareholders the annual compensation paid by Oracle to Morgan Stanley from 2007 to 2010 and a description of the services rendered. "Boards, particularly of companies being sold, need to be very careful and exercise a lot of due diligence about the independence of financial advisors," Troyer says.
There's not much directors and officers can do to prevent M&A-related class actions, particularly when their company is on the selling end.
"The question is not how can you keep yourself out of court, because if you're involved in one of these transactions and it's a public company, it's very likely that you'll be sued no matter what you do," Bailey says. "The question is making sure you behave properly to make that case largely worthless.
"You want to make sure that the directors who are involved in the whole process in terms of evaluating a proposed acquisition, negotiating, making disclosures--all that activity needs to be directed by truly independent directors who aren't officers or employees and, therefore, aren't potentially going to lose their job if the company gets acquired," Bailey says.
Litigation comes with the territory, and public companies can expect to be sued every few years, Fornshell says.
"You can try to make sure you're prepared with an eye toward expected litigation and do what should be done in terms of fairness of stock price and the documenting of what you did to determine the fair share price, including outside experts," Lindsmith says. "That better insulates the board against claims of breach of fiduciary duty if they can show that what they did was prudent and reasonable."
When advising directors, Hughes lists a series of practical considerations: stay involved, consider all alternatives, carefully select members of the team, monitor perceptions of bias, establish a communication plan and build a formal record. "Most of this is not rocket science. It's amazing how you come into a situation that's been going on and they haven't done that stuff," he says.
"They need to set up a team of directors, management personnel, legal advisors and financial advisors that will be involved in the process of evaluating their options," Hughes says. That team should consider all M&A scenarios, including not entering into a deal at all. The committee should also avoid bias or even the appearance that members favor one solution over another.
"When this sort of situation arises, the board should create a special committee of independent directors. Those independent directors should retain separate advisors, like lawyers and investment bankers experienced with helping companies of that size in that industry," Balthaser says.
The independence of both the special committee and its advisors is crucial. "What's at stake is whether the deal they negotiated goes through. If you look at a case like Del Monte, what's difficult for directors is the court found that the directors essentially breached their duties because they were misled by their own financial advisor," Troyer says. "What can directors take from that? They should do their best to ensure the independence of the various members of their advisory team."
Michelle Davey is an editorial assistant for Columbus C.E.O.
Reprinted from the June 2011 issue of Columbus C.E.O. Copyright © Columbus C.E.O.