In a seminal empirical study of derivative litigation, Professor Roberta Romano found that derivative litigation is relatively rare.[1] Of those cases that go to trial, shareholder-plaintiffs almost always lose. As is generally true of all litigation, however, most derivative suits settle. Only half of the settled derivative suits resulted in monetary recoveries, with an average recovery of about $6 million. In almost all cases, the legal fees collected by plaintiff counsel exceeded the monetary payments to shareholders. Romano further concluded that nonmonetary relief typically was inconsequential in nature.
Romano’s empirical analysis is consistent with our analysis of the relevant players’ incentives. A substantial percentage of derivative litigation likely consists of strike suits, which are settled for their nuisance value. Conversely, meritorious suits likely are settled too cheaply, albeit with inflated legal fees paid to plaintiff’s counsel. Because settlements typically are structured so that both any monetary payment and any legal fees are paid out of the corporate treasury,[2] derivative litigation necessarily tends to reduce the value of the residual claim.
Derivative litigation mainly serves as a means of transferring wealth from investors to lawyers. At best, derivative suits take money out of the firm’s residual value and return it to shareholders minus substantial legal fees. In many cases, moreover, little if any money is returned to the shareholders—but legal fees are almost always paid. Why would a diversified shareholder approve such a process?
If derivative litigation cannot be justified on compensatory grounds, can it still be justified as a useful deterrent against managerial shirking and self-dealing? In short, no. There is no compelling evidence that derivative litigation deters a substantial amount of managerial shirking and self-dealing. Certainly there is no evidence that litigation does a better job of deterring such misconduct than do markets. There is evidence that derivative suits do not have significant effects on the stock price of the subject corporations, however, which suggests that investors do not believe derivative suits deter misconduct.[3] There is also substantial evidence that adoption of a charter amendment limiting director liability has no significant effect on the price of the adopting corporation’s stock, which suggests that investors do not believe that duty of care liability has beneficial deterrent effects.[4]
A radical solution would be elimination of derivative litigation. For lawyers, the idea of a wrong without a legal remedy is so counter-intuitive that it scarcely can be contemplated. Yet, derivative litigation appears to have little if any beneficial accountability effects. On the other side of the equation, derivative litigation is a high cost constraint and infringement upon the board’s authority. If making corporate law consists mainly of balancing the competing claims of accountability and authority, the balance arguably tips against derivative litigation. Note, moreover, that eliminating derivative litigation does not eliminate director accountability. Directors would remain subject to various forms of market discipline, including the important markets for corporate control and employment, proxy contests, and shareholder litigation where the challenged misconduct gives rise to a direct cause of action.
If eliminating derivative litigation seems too extreme, why not allow firms to opt out of the derivative suit process by charter amendment? Virtually all states now allow corporations to adopt charter provisions limiting director and officer liability. If corporate law consists of a set of default rules the parties generally should be free to amend, as we claim, there seems little reason not to expand the liability limitation statutes to allow corporations to opt out of derivative litigation.
[1] Roberta Romano, The Shareholder Suit: Litigation without Foundation?, 7 J. L. Econ. & Org. 55 (1991).
[2] Some commentators assert that most out-of-pocket losses in derivative litigation are ultimately paid by liability insurers under D&O liability policies. See, e.g., Reinier Kraakman et al., When are Shareholder Suits in Shareholder Interests?, 82 Geo. L.J. 1733, 1745-46 (1994). If so, the cost of such suits still comes out of the residual claim in the form of insurance premiums.
[3] See Daniel R. Fischel & Michael Bradley, The Role of Liability Rules and the Derivative Suit in Corporate Law: A Theoretical and Empirical Analysis, 71 Cornell L. Rev. 261 (1986).
[4] See, e.g., Michael Bradley & Cindy A. Schipani, The Relevance of the Duty of Care Standard in Corporate Governance, 75 Iowa L. Rev. 1 (1989); Roberta Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 Emory L.J. 1155 (1990).
