FORUM: Tackling shareholder disputes
October 2016 | SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION
Financier Worldwide Magazine
FW moderates a discussion on tackling shareholder disputes between Ffion Flockhart at Norton Rose Fulbright LLP, Edward S. Horton at Seward & Kissel LLP, Noelle M. Reed at Skadden, Arps, Slate, Meagher & Flom LLP, and Sean Upson at Stewarts Law LLP.
FW: Are you seeing an increase in the number of shareholder disputes in today’s business world? Could you provide an overview of some of the common causes of such disputes?
Flockhart: When talking about shareholder disputes, there are two general categories that come to mind. The first category is claims by shareholders against the directors of a company – and possibly the company itself – for alleged failures of governance. This type of shareholder action naturally lends itself to claims by shareholders in large numbers. As a result, claims of this nature are more common in the US where class actions are more prevalent. In England, there is an equivalent procedure for bringing such claims under what is known as a group litigation order or GLO. While there have not been many claims under GLOs yet, the indications are that they are becoming more popular. Common causes of action relate to statements made in listing prospectuses, or in other published information relating to the issuance of securities. Alternatively, minority shareholders may petition the court for relief where they can demonstrate that the company is being run in a manner unfairly prejudicial to them or an actual or proposed act or omission would prejudice their interest. The second category is claims between investors. This type of claim can arise for a number of reasons. For example, there could be a dispute as to the ownership of a company’s shares, or as to the availability and operation of pre-emption or redemption rights. Alternatively, there could be a contractual issue as to the parties’ rights and obligations under a shareholders’ agreement, for example. Over the years, the English courts have seen a steady flow of these disputes, and that continues to be the case.
Reed: The nature of shareholder disputes is continually evolving. Historically, the big drivers for shareholder class action lawsuits have been a poor business climate, the company’s release of unexpected bad news, industry-wide scandals, and the announcement of a fundamental transaction such as a merger. The considerations that drive these traditional shareholder lawsuits have not changed fundamentally in recent years. What has changed is the level of shareholder activism. While disputes with activists often take place in the corporate arena, we have seen many of them spill over into litigation. If anything, that trend seems likely to accelerate in the coming years. In private companies, shareholder disputes tend to be related to the health of the business climate. Shareholders are less likely to look for or pursue potential issues in healthy companies. Many disputes in private companies arise from miscommunications or misunderstandings about the shareholders’ respective roles in the organisation. But in my experience, shareholder disputes arise most often when a shareholder believes that someone is receiving improper or disproportionate benefits from the company or when a minority shareholder is looking to sell his or her interest – and those two circumstances often arise together.
Upson: Over the last two or three years there has been a marked increase in shareholder disputes. This trend has emerged for a number of reasons. First, there has been a rise in institutional shareholder activism. This has most prominently been about institutional investors challenging boardroom pay but that same activism has driven pension funds and hedge funds to pursue claims for misleading financial statements. Second, the appetite for claims from corporate ‘scandals’ has crossed the Atlantic – and so shareholder claims often arise from an issue which has had a lot of press attention, such as the VW emissions scandal. Third, the legislative and regulatory framework has facilitated such claims. The amendments to the Financial Services and Markets Act, which allow claims for misleading published statements, are still relatively new but investors are increasing using the new provisions to bring claims. Finally, the maturing UK litigation funding market has enabled investors to pursue their claims whilst taking the cost and risk off of their balance sheet.
Horton: There is no question that the level of shareholder disputes and the number of activist holders has grown significantly since the global financial crisis. The post crisis environment was ripe for shareholder activism in large part due to the frustration of many shareholders with the relatively slow economic and corporate earnings growth during the early years of the recovery. Low stock prices following the crisis, low levels of M&A activity at a time when many opportunities were perceived to exist as a result of substantial cash reserves or undervalued business lines – at least in the eyes of some shareholders – as well as increasing spreads between performance and executive compensation, fuelled claims that management and boards were at best acting too slowly to enhance shareholder value, and at worst acting in their own self-interest at the expense of their shareholders. Whether increased shareholder activity resulted in greater shareholder value remains in dispute. Statistical evidence suggests enhanced shareholder value over the short to medium term, but the longer term effects are less clear. Despite this uncertainty, attractive returns of activist funds during this period relative to other investments resulted in significant capital inflows that also contributed to the growth of activist shareholder activities during the period.
FW: Have any recent, high-profile shareholder disputes caught your attention? What unique challenges and legal considerations do these cases highlight?
Reed: The most interesting cases that we have seen recently have involved private disputes between owners – or alleged co-owners – in companies. In one lawsuit, two investors redeemed their interests in a company that was later sold based on a much higher valuation. The redeeming investors then sued, alleging that they were fraudulently induced to redeem their interests. Although the stock redemption agreement included a disclaimer of reliance on statements by the company, the court of appeals ultimately concluded that the disclaimer was not enforceable. More recently, Energy Transfer Partners won a $470m judgment against Enterprise Products based on an alleged breach of a partnership agreement. In that case, the key issue was whether the parties’ written agreements had disclaimed a partnership. The jury concluded that the written agreements were irrelevant because the parties had subsequently created a partnership through their conduct. These cases highlight the challenges that attorneys face in drafting documents that can effectively limit liability. In each case, the parties had written agreements that purported to address the specific risk that came to pass – and yet they could not sufficiently manage that risk.
Upson: The RBS and Lloyds action group claims and the VW emissions scandal are the standout disputes of the last few years. These cases illustrate that shareholder litigation is complex and challenging on many levels. For example, the misleading public statement or prospectus which forms the basis for the claim is generally underpinned by substantial financial disclosure within the defendant. The reported RBS decisions have highlighted the need for effective management of disclosure in these cases. Also, these cases often involve different claimant groups and possible regulatory investigations. Strong, effective and sensible case management by the parties and the Court is therefore key. Also, there are the challenges thrown up by the cross-border nature of claims – and the VW claims are a good example of this, where investors potentially can claim in more than one jurisdiction. Each jurisdiction has a distinct prospectus and misleading statement liability regime, different limitation periods and rules of disclosure, so that getting it right on jurisdiction is vital. Indeed, shareholder claims often throw up the question of who, in the management of the company, knew what, and when. One therefore wants a jurisdiction with a good disclosure regime.
Flockhart: In England, claims by shareholder action groups in the aftermath of the financial crisis have probably been the most high profile cases to hit the courts, and there have certainly been many. While getting some of these cases off the ground may have been challenging at one stage, the advent of the GLO process and the increasingly prominent role played by third-party litigation funding – backed by after-the-event (ATE) insurance – has led to a growth in such claims. The ability of external capital providers to step in and fund the legal costs of bringing a claim in return for a share of any damages is a hugely important development as a lack of funds would previously have prevented a claim from progressing. The availability of ATE insurance also mitigates or removes the unsuccessful claimant’s obligation to pay the successful defendant’s costs. Essentially, this means that an impecunious claimant can litigate at a significantly reduced financial risk – a real game-changer, particularly for claims which are suited to the GLO procedure.
Horton: One of the more interesting recent trends in shareholder activism is what are not high profile disputes. While high visibility public disputes initiated by well known activists grab the headlines, there has been greater growth in terms of both number of transactions and committed capital toward disputes that remain below the public radar. These generally involve smaller sized target companies, but interestingly also are initiated by holders with relatively small percentage interests that may be able to remain below the public disclosure requirements of US securities laws for many holders. The successes of these behind the scenes negotiations challenge the traditional concept in the US that a shareholder’s ability to influence corporate policies requires a minimum ownership level, and also present challenges to companies with respect to monitoring shareholding and potential dispute before they arise, making it all the more important to pay close attention to all holders.
FW: In your opinion, how important is it for companies to develop a quick and decisive strategy for resolving shareholder disputes? Do you believe that companies pay enough attention to this issue before disputes of this nature occur?
Upson: A quick and decisive strategy is vital. Companies have paid too little attention to the changing landscape and increasing prevalence of shareholder claims. This manifests itself in a lack of a proactive and early strategy to resolve claims when they arise. By contrast, defendant companies tend to go into ‘lock-down’ for at least the first year after claims are presented and, in that time, they issue plain denials of the claim. This is often despite the fact that the underlying misleading statement or misrepresentation is admitted. This is a damaging and short-term strategy since disputes often only settle after there has been significant publicity which encourages further claimant groups to emerge – which in turn make a sensible resolution harder to achieve. The full extent of a company’s wrongdoing in connection with a material misstatement is, in any event, usually borne out in extensive and expensive disclosure, and as such, it is in everyone’s interests to try and seek early resolution. Early and sensible analysis of the claims and engagement with claimants therefore would manage both reputational damage and the final financial cost of the original misstatement.
Horton: The potential costs in terms of increased demands on management and boards have attracted the attention of most public companies in recent years. Short of avoiding becoming an activist target in the first place, ignoring a shareholder’s complaints will only ensure its escalation, while likely missing an opportunity to reach a settlement that may be acceptable to all parties. However, this is not to say all shareholder proposals are in the best interests of the company or should result in a corporate response. Additionally, there is no ‘one size fits all’ policy with respect to board composition, strategic M&A transactions or governance policies, which are all common targets for activists, and attempts to adopt certain practices solely to avoid shareholder challenges are misguided. From a company’s perspective, it is also important to remain objective in assessing a shareholder’s claims rather than automatically taking a defensive position; certain claims may have merits that should be addressed and in the best interest of the company and all holders. Companies may also benefit from recognising that regardless of the merits of the allegation, once a shareholder dispute becomes public, it can be difficult for a shareholder to leave empty handed, and a token settlement may avoid a prolonged battle with shareholders and the possibility of a less favourable outcome for the company.
Flockhart: It is clearly very important for companies to be attuned to their shareholders, particularly in the current era of increased shareholder activism. Typically activist strategies include raising concerns with the company’s board, seeking disclosure of certain information and – most conspicuously – seeking to influence decisions at general meetings, for example with respect to executive remuneration. The key message for boards is to take this type of intervention seriously and carefully consider the concerns that are being raised. In general, the boards of English companies do this pretty well, with the positive result that issues are addressed before formal adversarial proceedings are considered.
Reed: In today’s world, it is essential for companies to proactively deal with potential shareholder disputes. If a company knows that it is about to announce something that could anger or surprise the shareholders, it should consider bringing in litigators and potentially other crisis management experts at the beginning to help navigate any backlash. Companies should also be attuned to the issues that shareholder activists are focusing on. If, for instance, shareholder activists have been focusing on a particular corporate governance reform during other companies’ proxy seasons, the company’s board should take a careful look at the issue to determine what action is in the best interest of the shareholders. For privately-held companies, the stakes involved in shareholder disputes are even higher. These companies usually benefit from early, decisive steps to resolve the dispute. If a breakup is necessary, a company is typically best served by dealing with it as quickly and proactively as possible. We have also seen situations where relatively minor disputes quickly escalated into major lawsuits, and ultimately the breakup of the ownership team. Often this entire process could have been averted with a well-timed, diplomatic phone call.
FW: To what extent are alternative dispute resolution (ADR) methods now being regularly considered as a viable alternative to litigation in shareholder disputes?
Flockhart: On the same theme of shareholder activism, it is now possible and – to a degree – expected that there will be some dialogue between shareholders and the board before a step is taken which the shareholders perceive may not be in the company’s interests. However, if the issue is not resolved at that early stage and the shareholders initiate proceedings, the full range of ADR methods are available. ADR methods, such as mediation, offer parties to a dispute the opportunity to resolve their issues before potentially significant legal costs are incurred – a commercial incentive which applies just as much to shareholder actions as it does to other forms of commercial dispute, including claims between shareholders. ADR is also now firmly embedded in English court procedure, with a default position that parties to any form of commercial litigation are expected to attempt ADR at an early stage. As a result, all the indications are that ADR is not only a viable alternative to litigating shareholder disputes; it is also an established step in the litigation process.
Reed: In shareholder disputes involving public companies, there typically is no formal ADR mechanism that the parties must follow. Instead, the parties will have to decide what form of ADR, if any, makes sense in the context of a particular dispute. In a claim for damages, mediation is still the preferred form of ADR. In a dispute with shareholder activists, the most effective form of ADR may be a face-to-face meeting between the principals. Privately-held companies, in contrast, have more flexibility to address ADR issues up front. Many privately-held companies now include ADR provisions in their key agreements that range from mandatory arbitration to requiring an aggrieved party to meet and confer with the other side before filing suit. I have seen several cases recently where the parties used this pre-dispute process to settle their differences before a lawsuit was filed.
Horton: Shareholder disputes we see in the activist space generally result from disagreements as to commercial and business decisions of how the company is being run, rather than specific legal claims relating to management or director misconduct. While allegations of breaches of board fiduciary and other duties and management failures are common assertions by activist holders, rarely are such breaches so clear cut that a shareholder chooses to have them decided as a matter of law. Rather, the objective behind publically raising the disputes, if not successful ‘voluntary’ change by the company, is to convince fellow shareholders of the weight of its claims and, ultimately their proxy. As a result, whether or not ultimately resulting in an actual proxy solicitation, neither the court no other arbitration forums are relied upon on a regular basis.
Upson: ADR is regularly considered in shareholder disputes although this often occurs at a later, post-disclosure stage. ADR throws up interesting challenges in shareholder disputes. High-profile claims are often pursued by various action groups and the expectations of a one group of investors may differ greatly from those of another group. Some claimant groups may remain engaged or invested in a company and their interest may include steps to achieve proper future governance and disclosure. For other groups, who have sold their investments, settlement may be purely financial in terms of recovering the loss in share price. ADR is, of course, no stranger to multiparty disputes, but shareholder disputes regularly require a more complex and structured approach to any form of resolution.
FW: What advice would you give to parties embroiled in a shareholder dispute in terms of the options for mitigating the costs – in both a financial and reputational context?
Reed: It all depends on the nature of the dispute. For public companies, the biggest cost of shareholder activism is often reputational. In this setting, the company needs to have a principled decision and a process to get its message out to the marketplace. If the dispute is just a standard damages claim, the company’s primary focus should be on an early resolution – whether by a dismissal on the merits or by settlement. Unfortunately, there is no simple way to mitigate the costs for a true corporate crisis. Instead, the company must determine its essential goals and then coordinate a multi-front defence to meet those goals. It is essential to think the issue through to resolution to avoid wasting time and reputational capital fighting a battle that either cannot be won or is not worth the cost of winning. On the other hand, it sometimes is important for a company to mount a vigorous defence. But even in those situations, companies should always be focused on the endgame in making strategic decisions. In the private company context, the best way to address these issues is before the dispute ever arises.
Upson: Claimants and defendants alike should engage on the issues and any possible resolution at an early stage. If there is a need to deal with a limitation period, or to allow mature examination or investigation of a claim, a short stand-still agreement is sensible. The parties should also remain alive to referring the matter to an ad hoc arbitration to resolve the dispute out of the glare and pressure of publicity.
Horton: Advice applicable to both shareholders and companies is to be realistic about your and your shareholder’s positions. Notwithstanding recent high profile cases in the US, even strong and well-reasoned analysis for change by shareholders typically result in only modest, or at best incremental, change as public company holders typically are wary of wholesale change. A company with strong defensive measures in place such as staggered boards, strong corporate governance policies in line with market standards and significant insider or friendly shareholdings is also, in the end, likely able to negotiate for only modest changes, if any. Similarly, a company that has significantly underperformed its peer groups is going to have a much harder time arguing against change than a market performer. The fact that only a very a small percentage of disputes initiated by shareholders result in a fully contested proxy solicitation can be seen as an indication that the costs of such a challenge act as a deterrent to all but the most favourable opportunities for shareholders. Where actions are guided by reasonable expectations, there is also less reputational risk on the part of the shareholder and the company, although it is important for companies to recognise the value to holders of at least some claim to have accomplished something, when considering whether to agree to settlement terms.
Flockhart: Whether the shareholder’s claim is against the board – under the Companies Act 2006 – or against another shareholder, any claimant in a shareholder dispute should think carefully about the availability of third-party litigation funding and ATE insurance. Conditional fee agreements and ATE insurance can provide a means of shifting the burden of legal costs elsewhere. More generally, the received wisdom is that parties should attempt ADR before the litigation progresses too far. Otherwise, it is a question of running your claim or defence as efficiently as possible. On the reputational side, the risk of adverse publicity can be mitigated by identifying whether there is sensitive information that may become public, considering confidential alternatives to litigation, such as arbitration or mediation, and keeping your communications team briefed early and often.
FW: What advice can you offer to shareholders when it comes to drafting and understanding key corporate documents, such as articles of association, in terms of mitigating disputes or assisting in their resolution?
Horton: While there are limits to what can be accomplished, charter document provisions remain a powerful tool, both defensively and offensively. While a determined holder looking to effect board change, who has a long-term horizon and deep pockets, may ultimately defeat provisions such as a staggered board and accomplish its objective without triggering a poison pill, but by imposing significant costs and delay, such provisions may deter a larger number of claims, and at the very least will effectively allow the company to control the process, since it is coming from a position of strength. This stronger position may also result in a significantly better settlement outcome for the company than could be expected in the absence of such provisions. Conversely, company charter documents that allow shareholders to call and set the agenda for shareholder meetings provide considerably less negotiating room for the company. Likewise, proxy access provisions included in corporate by-laws do not guarantee shareholders open access to the nomination process. The courts and the SEC through no action letters have been fairly deferential to limitations imposed by companies in proxy access provision.
Flockhart: It is hard to be specific but, in most cases, corporate documents aimed at mitigating or resolving a shareholder dispute will be a variation of a standard form document which has been developed and refined over many years. While there may therefore not be much of an opportunity in practice to influence the drafting of such documents, where there is, it is usually beneficial to get a lawyer on board to ensure that the wording is clear and that it provides for an effective dispute resolution mechanism.
Reed: On the procedural front, many companies’ bylaws now require shareholder disputes to be heard in specific courts – for instance, the Delaware Court of Chancery. By selecting a court that is well-versed in shareholder disputes, a company can somewhat mitigate the risk of meritless strike suits. The current judicial trend is to enforce these forum selection provisions. On the substantive front, companies and their shareholders should try to anticipate the issues that are most likely to give rise to disputes and address those specifically in the corporate documents. This exercise will typically be very specific to a company. For instance, the parties might be able to disclaim or narrow the scope of the directors’ fiduciary duties. The parties can add even more contractual protections in a privately-held company. For instance, they can include specific provisions that address the specific role the various stakeholders will have in managing the company, the process that will be used in buyouts, and the dispute resolution procedures that will govern any shareholder disputes.
Upson: For many shareholder claims – whether in England or other jurisdictions – claims are based on misstatements in published statements relied upon by claimants. For any institutional investor having a clear record of why it took its decision to buy, hold or sell a security – and, for example, an indication of what published statements were relied upon and which metrics in those statements were key – will be a real advantage in resolving later claims.
FW: Looking ahead, what are your expectations for shareholder disputes in the years to come? What issues and challenges are likely to remain prevalent in this area?
Upson: Within the next three years we expect to see the first key English court decisions on shareholder claims – particularly those under the Financial Services and Markets Act. These decisions may include judgments on cases such as RBS, Lloyds or VW. I expect judgments over the next three years to give clarity on issues such as the extent of knowledge which needs to be shown by officers of the company to found a claim, what form of reliance on published statements claimants will need to show and what is the exact measure of loss for a claimant who has relied on false or misleading published statements. We have important guidance on these issues from courts in the US and Australia but clarification from English courts will be welcome. Subject to the outcome of this first series of decisions, we expect to see a real growth in large-scale shareholder claims often by institutional investors.
Horton: It is hard to imagine the rate of growth of shareholder activism in recent years continuing indefinitely. We have seen some evidence of this easing already, which can be attributable to several factors. The first is simply that there are limits to the number of attractive opportunities for activists. Typical factors that are relevant to a shareholders’ analysis of an attractive opportunity includes the company’s performance relative to its peers, the concentration and character of the shareholder base, which provides a good indication of support an activist can expect, and an analysis of the defensive measures the company has in place. Specific transactions or omissions of management or the board, particularly those involving a conflict of interest, make a particularly attractive target for activists, but wrongdoing, even alleged wrongdoing, is not a requirement. Despite recent high profile disputes with large companies, much of the low lying fruit has been explored in the small and mid-cap space, where the majority of activist disputes are played out.
Flockhart: Shareholder activism is now a common and, in many circumstances, valuable feature of the relationship between boards and shareholders, and we do not expect to see that changing any time soon. As litigation funding becomes increasingly popular and available, it also would not be a surprise if shareholder class actions under the GLO procedure became more frequent. Otherwise, we expect to see a steady flow of claims between investors, as historically this has provided fertile ground for disputes. As for potential challenges, companies with dual listings in the UK and US can face the particular headache of parallel shareholder actions relating to the same issues in different jurisdictions. There is not an easy answer to this, and as long as dual listings remain in vogue companies and their boards will need to deal with this complexity as best they can.
Reed: The level of shareholder activism is likely to increase over the next few years. Other than that, we are not expecting any tectonic shifts in the world of shareholder disputes. In the context of shareholder disputes between private persons, the biggest challenge is drafting enforceable language that establishes the parties’ legal rights. Unfortunately, we see some decisions that appear to clarify the duties that parties owe and the contractual language necessary to affect the parties’ intent, only to be followed by decisions that cast doubt on the enforceability of the parties’ written agreements. We hope to see some more clarity from the courts on this issue.
Ffion Flockhart is a dispute resolution lawyer and qualified solicitor-advocate. With an insurance law background, she advises clients across a number of industries on the management of key financial risks as well as on the resolution of disputes. She is known in particular for her policy wording work for large corporates and financial institutions, as well as her work on matters involving directors and officers (D&O) liability, transaction liability and cyber risk. She can be contacted on +44 (0)20 7444 2545 or by email: email@example.com.
Edward Horton is a partner in Seward & Kissel’s Capital Markets Group. Mr Horton focuses his practice on corporate securities law and has represented domestic and foreign issuers and underwriters in connection with a variety of securities transactions. He also advises domestic and foreign public companies with respect to securities law compliance matters, stock exchange listings and corporate governance matters, and advises institutional shareholders in connection with contested proxy solicitations, activist investing and related matters. He can be contacted on +1 (212) 574 1265 or by email: firstname.lastname@example.org.
Noelle M. Reed heads the Houston litigation practice. She has extensive experience representing clients in complex litigation in state and federal trial and appellate courts and arbitrations. Ms Reed was a trial attorney with the Department of Justice’s Terrorism and violent crime division and an assistant US attorney in the Southern District of Texas. As a prosecutor, she handled criminal cases involving terrorism, public corruption, fraud, organised crime, drug trafficking, money laundering, environmental violations and tax offences. She can be contacted on +1 (713) 655 5122 or by email: email@example.com.
Sean Upson is a partner in the Commercial Litigation and Investor Protection Litigation departments. He has a wide-ranging domestic and international litigation practice, specialising in complex, commercial shareholder, financial and contract disputes. He/She can be contacted on +44 (0)20 7822 8200 or by email: firstname.lastname@example.org.
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