The Fundamentals of Shareholder Litigation

Every enterprise, from a large public company to a small private business, needs to be concerned about lawsuits from company’s ultimate owners – the shareholders or other stakeholders. In this episode, Dorsey Partners Kent Schmidt and  Kirstin Schubert explore basic shareholder rights and how lawsuits are brought to assert and vindicate those rights. They unravel some of the complications that arise in this unique type of litigation and ways companies can prepare to weather a shareholder lawsuit.

This podcast is not legal advice and does not establish an attorney-client relationship or create any duty of Dorsey & Whitney LLP or those appearing in this podcast to anyone. Although we try to assure that the content of this podcast is accurate, comprehensive, and reflects current legal developments, we do not warrant or guarantee those things. The opinions expressed in this podcast are the opinions of those appearing in the podcast only and not those of Dorsey & Whitney. This podcast is considered attorney advertising under the applicable rules of certain states.

Transcript

Voiceover
Welcome to another episode of the SharkCast on Litigation Risks Management where we explore why businesses are so frequently sued and how to mitigate and navigate the dangers lurking in these risky waters. Join us now as we welcome our host, Kent Schmidt, litigation partner at the law firm of Dorsey & Whitney.

Schmidt
I’m glad you’ve joined the podcast today because we have a great conversation in store for you. I’m pleased to be joined by my colleague and friend, Kirsten Schubert, a partner at Dorsey & Whitney. Kirsten and I have worked together in the trenches in shareholder litigation in recent years. She’s incredibly knowledgeable and experienced in this area of law. She has worked on shareholder litigation from the hallowed halls of the Court of Chancery in Delaware to the rough and tumble federal shareholder public company litigation out here in California with me and in other jurisdictions. Welcome, Kirsten, I’m very pleased that you have agreed to be a guest on the podcast.

Schubert
Thanks, Kent, thanks for having me.

Schmidt
Well let’s get started. The phrase shareholder litigation likely calls to mind large public companies facing claims by shareholders as their stock tanks and The New York Times and other newspapers around the country cover their woes. The poster child of shareholder unrest and dissatisfaction in recent months is one Elon Musk. I’m sure listeners have heard of him. 

The shareholder litigation that we are going to talk about here includes not just those high profile cases, but other, private company cases. These lawsuits can embroil even a small mom and pop company, a family-owned business, private companies as well as publicly-traded corporations. So I think it’s timely an important topic for us to address, these issues, from the company’s perspective, and from the executive perspective. Not just the Elon Musk’s of the world must understand. First of all, before we dive into shareholder litigations and all the ins and outs, let me ask you, Kirsten, how did you end up getting involved in shareholder litigation in your career?

Schubert
When I first started at the firm 15 years ago, one of my first cases was a shareholder case relating to a large public company here in Minnesota and I started working on that, I really liked the partners and the people, and I loved that area of law, so I have been doing it ever since.

Schmidt
And I don’t think I really have to ask you this question, ‘cause I think I know the answer. You really do enjoy shareholder litigation, don’t you?  As compared to some of the other things you did?

Schubert
I do. I think that, in general, the fiduciary litigation, dealing with boards of directors, even trustees, corporate officers, I think that there’s a really great, personal story to be told with respect to those people and those entities. They’re just trying to do a good job and I think it’s important to put a judge in the court room with those folks as they’re exercising their duties of care and duties of loyalty and really defending them as they try to move forward exercising their discretion in the best way for the company.

Schmidt
So, sometimes we involve ourselves in, for example, contract disputes or regulatory-related disputes that come down to technical meaning of a contract term or the meaning of a regulation. And in shareholder disputes, you really do have a story with personalities involved. You have someone, perhaps, that allegedly just got a little too greedy, started looking after themselves instead of the interest of their shareholders. So, I think you’re right, you do have an overall fundamental fairness principle that is an issue in shareholder litigation, don’t you?

Schubert
Exactly, I think that’s exactly right.

Schmidt
And that’s true whether it’s a public company claim or one of the smaller, privately-held businesses. Now, you’ve done litigation involving family business, you have a whole additional dynamic when it’s the brothers and sisters, second generation fighting. Those types of shareholder lawsuits call for special care and handling, don’t they?

Schubert
Absolutely. You’re dealing with people who have been working at a company their entire lives; maybe they grew up working, you know, it was their dad’s company, it was his dad’s company and they have taken over the reins and, you know, there’s a lot of emotional investment in those kinds of companies and those kinds of cases. And I think that that’s important to think about as we’re dealing with our clients on an everyday basis. And that’s one of the reasons that I really like these cases and these clients is that I feel like I can really be their advisor and their counselor and help them through the problems that they face on a daily basis, really closely to them and their families.

Schmidt
 So, as we delve into some of the more technical aspects of shareholder litigation, let’s get some terminology and some definitions out on the table. First, when we’re talking about Shareholder litigation, we’re speaking of the individuals who own a certain percentage of a corporation. But there are also in addition to corporations, limited-liability companies and partnerships. And they involve some of the same dynamics, so for ease of reference we’ll just continue to refer to these as shareholders. In the LLC context its members of the LLC, in the partnership context it is of course partnerships but we’re just going to refer to these claims as shareholder claims. Now we often hear the phrase shareholder derivative litigation. It’s quite a descriptive phrase, can you tell our listeners what it means when we use the word derivative litigation to describe shareholder litigation.

Schubert
Derivative litigation is a claim brought by a shareholder or stockholder on behalf of the company. So the shareholder steps into the shoes of the company and brings the claim on the company’s behalf against the other defendants.

Schmidt
That’s an interesting concept for people to understand because it’s a very audacious step for a shareholder to take, isn’t it?  You may have five percent, two percent of the company, but the law allows you to bring a lawsuit in the name of the corporation. That’s something you don’t encounter in other context, right?

Schubert
Yes, completely.

Schmidt
And then we’re going to get into some of the repercussions of that concepts or limitations on that concept, but before we do, we’ve already talked about fundamental fairness being a common theme. It is often said shareholders are owed a fiduciary duty. For someone that’s not familiar with these concepts, how would you best describe the issues and the principles of the fiduciary duty that’s owed to shareholders?

Schubert
There are a couple of fiduciary duties that are owed to shareholders, in general, there are lots of different versions of fiduciary duties floating around in our world, for the shareholder litigation context we have the duty of care, the duty of loyalty, the duty of good faith. Essentially on the duty of care it really requires a board of directors to engage in a deliberative and thoughtful process as they’re making decisions for the company. I think process is a key phrase for any person who is involved in exercising fiduciary duties. It really allows the company to make sure that they’re looking at the right factors, considering in the right things as they’re making decisions. It documents that process, you know, we can write down exactly what they did, exactly what they considered, and then you can look back and use that as your justification for having made a decision.

With the duty of loyalty, you’re really required to be disinterested and independent when you’re making decisions for the company and as a fiduciary for its stakeholders. We see the duty of loyalty in a lot of different contexts but it is a foundational principle when it comes to shareholder litigation. We, as part of the shareholder litigation, have a duty of oversight, which is pretty interesting and oftentimes is the basis of a claim. In shareholder litigation, the duty of oversight really refers to risk management. Essentially, it is a failure of board level director to implement a system that would help monitor compliance and controls within the company. And then the failure to then monitor that system that you’ve implemented with respect to the duty of oversight. The Delaware court has found within the last year that that duty can be applied to senior officers in addition to just directors. So it’s important for executive officers, senior executives, to really understand that duty when they are exercising, you know, their own duties of management and oversight within the company.

Schmidt
That is an important development in Delaware law and I’m sure other states will probably follow that example. You do have that phenomenon that happens a lot that Delaware speaks and other states say well if it’s good enough for Delaware, we might as well adopt that rule in our jurisdiction as well.

Even though, it’s a completely different statutory scheme than the Delaware statutory scheme. That’s a good segue into one of my next questions, you’ve invoked Delaware already, and I mentioned Delaware in my introduction. There’s a lot of shareholder litigation in Delaware and that is first because most large public companies are incorporated in Delaware. Let’s talk a little bit about the unique issues that arise in litigating Delaware. You and I have both done a fair amount of Delaware, Court of Chancery, shareholder litigation so, what are some of the unique aspects of litigating a shareholder case in the state of Delaware.

Schubert
Well I’ll start by saying first you are not in front of judges, you are in front of chancellors and vice chancellors. Which is such a, I mean that’s just one symptom or indication of what a unique animal it is to practice out of that court. The law is very well developed in the Delaware Chancery Court. In much more so than any other state that I know and most other states look to Delaware to define corporate guiding principles, look at it for the corporate law development because it is so well developed out there. They see, I would say, the most complicated cases in the country, I’m sorry New York. I know that you’re oftentimes, you know, the venue for the really complicated cases but in this instance, Delaware is really the prime venue for litigating novel issues of corporate law and getting those high profile cases out there. So the chancellors and vice chancellors are really, really well educated, really have tools to make decisions that other courts don’t have.

Schmidt
You know, I would add and I wonder if you have this experience as well, I am always amazed at the efficiency of the Delaware court. So I practice a lot in California, you file a case, a business case in Los Angeles, you know, it may be a year or so before you are before a judge. And that judge really knows nothing about the case. I mean he or she picked up the docket, you know, an hour before your hearing. In Delaware Chancery Court, it’s amazing to me how engaged the court is in understanding the issues and getting the most efficient case management process in place right away and you’re off the races quite quickly.

Schubert
Absolutely.

Schmidt
Well I thought it would be helpful to our listeners if we walked through a shareholder dispute and do it in a somewhat chronological fashion. In my experience and I know yours as well, shareholder lawsuits often begin in perhaps what seems like innocuous sense rather than a process server at reception handing a lawsuit, a letter comes in the mail. And for someone who is not familiar with the significance of the letter, perhaps it’s thought of a not that big of a deal, it’s a letter requesting information. And of course speaking about a books and records demand. Can you unpack that a bit for our listeners and why it is that shareholder lawsuits begin with a books and records demand often, in Delaware as well as other jurisdictions?

Schubert
Yeah, so we see the books and records demand as kind of the initiating indication that a case is going to come our way. And the reason for that is that the potential plaintiffs or the stockholders who make the request are oftentimes looking to gather information that could help support a complaint. So information that’s not in the public realm even of public companies, could help them bolster their complaint. So they’ll use those demands as a way to conduct a phishing expedition into the deliberations of the company.

Schmidt
Then we go back through this entire process, back and forth, I’ve done it many times and I’ve been on both sides of these, where you’re representing the corporation, you’re representing the shareholder and there’s a bit of a bargaining back and forth as to what types of information you’re entitled to, what protections should be in place to avoid a situation of misuse. What are some things that companies can anticipate will emerge in this back and forth over a books and records demand?

Schubert
Well the first thing is to read the statute really carefully. The statute, which is section 220 of the DGCL, has very specific form and manner requirements that a requesting stockholder is required to meet, so that would be things like, you know, they have to show that they are either a record holder or a beneficial owner of the stock. They have to show that they are requesting the documents for a proper purpose and that the requests are tailored to discover information about that purpose. There’s a couple of specifically listed categories of documents that are required to be produced but most of the tension comes in this request for quote other records. And you know, the way to kind of handle that in our experience has been to negotiate with the requesting stockholder. The recent development under Delaware law really has really been to allow requestors, stockholders to get more information than they would have been allowed to get say, five years ago. So now we’re looking at Boards of Directors and companies that have to turn over not only board meeting minutes but sometimes stacks. We’re looking at emails which was never an issue before. And so you’re kind of starting at a broader scope than we were if you had gotten this request say, pre-pandemic. And so we really are dealing with a greater scope and so you have to keep that in mind while you’re negotiating back and forth with a stockholder who is making the demand.

Schmidt
And then if the company doesn’t respond to the demand or makes an inadequate response, what’s the shareholder’s remedy?

Schubert
They can ask the court to force the company to produce documents and information.

Schmidt
And again I’m always amazed at how efficiently those books and records demands are heard. It’s not a long process and then next thing you know the company is faced with a court order from a Delaware Court of Chancery saying turn over the documents right away. And a deadline and consequences for failing to follow the court order.

Schubert
Absolutely. And if you are a smaller privately owned company, it could be really difficult to pull together, you know, all of the requested information within three to four weeks. And so you really have to, it’s really you know, it’s unfortunate when we get this call from our clients because we have to break the news that sometimes they may have to drop what they’re doing in order to respond to this request. It’s not just something you can table and see if the shareholder comes back. So it is something you have to deal with right away and in a quick fashion.

Schmidt
So I think the takeaway here is take these books and records demands very seriously. Short timelines and they are reflective of the informational rights that the shareholders have. The next step in the process, Kirsten, is to make a demand typically on the Board of Directors. If there’s some concern about the direction of the board or self-interested transaction. Can you explain to our listeners why the rule exists that a shareholder make a demand on the board before resorting to judicial remedies?

Schubert
The request for information from the board is part of the demand obligation relating to a derivative action. So in order to bring a derivative action, a shareholder has to either show that they have requested information from the board, made a demand and not been responded to appropriately, or that it would have been futile to make a demand. So the demands step is super important in deciding whether a derivative action can be brought and maintained.

Schmidt
So let’s go forward in the next step in the process; there’s been a demand that’s been made on the board, the board has declined to accept the shareholder demand, now the shareholder files a lawsuit. Whether it’s in Delaware or some other jurisdiction, what are the standard next steps in the process by which this shareholder claim is going to be adjudicated?

Schubert
In shareholder actions there is generally a heightened motion to dismiss standard. You can’t get away with a lot of the upon information and belief allegations that you might see in more standard contract cases. You know, to make a shareholder claim, you generally have to plead, well, plead facts to overcome the business judgment rule presumption. And so, that oftentimes is difficult because you gotta get a view into what’s happening in the boardroom.

So there is a sort of heightened obligation upon Plaintiffs in shareholder cases that you might not see in some of the more traditional litigation.

Schmidt
So, for listeners that aren’t familiar with what the business judgment rule is and its limitations, can you unpack that a bit?

Schubert
Sure. The business judgement rule applies in states other than Delaware. We’ve been talking a lot about Delaware here, but it is something that you see across the country in general. In these kinds of corporate shareholder cases, the directors have considerable deference in exercising their fiduciary duties. The courts don’t want to interfere with everyday business decisions. So the business judgement rule has been developed--it protects directors from liability if they are not interested in the subject of the business decision. They are informed with respect to the subject of the business decision and they rationally believe that the business decision is in the best interest of the company. Directors who exercise that authority in good faith and with reasonable care, even if the benefit of hindsight resulted in an unfortunate result, they still get the deference under the business judgement rule. It is a rebuttable presumption; if the Plaintiffs were able to plead that the Directors did not meet the discretion requirements that go along with the business judgment rule, a standard called the entire fairness standard applies. And that really considers whether the transaction was entirely fair to stockholders, viewed objectively, is it fair and reasonable?  And you’ve gotta look at both the process that was followed and the price. So it is a, if they can get passed the business judgment rule and get to the entire fairness standard, it’s a much higher burden for the company and for the directors to deal with.

Schmidt
The next step in the process of shareholder litigation is often discovery. Often there is a discovery stay in place while a motion to dismiss is being filed and heard and briefed. And then when we get to discovery, it can be very onerous for the company, isn’t that right?

Schubert
Yes. Discovery and shareholder actions can be very onerous. It’s one of these kinds of cases where oftentimes, senior executives and directors have to collect documents, they get deposed, they have to go through emails, serve as witnesses. They can spend a lot of time and energy on the case itself. Discovery can be really burdensome on the company in general, it can really cost a lot of money. It’s actually, I think, nobody would dispute, it’s the highest driver of fees for a company in this kind of litigation. So it can be onerous, it’s something that we try to limit at the front but you can’t get away from the fact that if you’re in discovery, it’s going to take you some time and some money.

Schmidt
I think it’s the case also in discovery, that sometimes the issue that was central to the claim, why the claim was brought in the first place becomes secondary because in the process of obtaining all of this discovery, you find, actually, what we were complaining about is nothing compared to this smoking gun that we discovered in these emails or in these board minutes that we didn’t know existed.

Schubert
That is 100% true. And that’s especially true in these kinds of cases where it’s really this kind of human story about people exercising judgment, you know, people making decisions. It really is different than a contract case where you’re looking at how the contract is applied and, you know, what people do in compliance with the contract. This is really substantive humans just making decisions. So there is a lot of opportunity to move beyond what we would think would kind of be the headline issue.

Schmidt
Compared to Delaware Court of Chancery, what are some of the differences in litigating a shareholder claim, for example, in state court in Minnesota?  I’m sure you’ve done many of those as well. A lot of differences between the two, or somewhat similar?

Schubert
Well, there are different rules. So we’ve been talking about the, you know, Delaware books and records demand for example, it’s a different standard in Minnesota. They have different requirements. And so you have to be really careful about which law applies to which situations and which principals Minnesota, for example, has adopted from the Chancery Court and the DGCL. So that in of itself is a big difference. Minnesota state court, the discovery, it’s gonna be different. The types of information that the court deems relevant are gonna be different. Obviously different judges, so you know, like we said, the Chancery judges are extraordinarily well-versed in these kind of corporate issues. You know, state court judges across the country are dealing with all kinds of different stuff. So in that respect it is going to be different, but in the end, it’s all of the fiduciary duty principles all are the same.

Schmidt
Right. We talked about the litigation process and many cases don’t go to trial, they end up being settled. What are some of the special considerations unique to shareholder claims in the context of settling these types of lawsuits?

Schubert
Well you know, there’s always kind of the business decision about what you want to fight and what you don’t want to fight. And, you know, with Shareholder disputes you’re really, you know, dealing with people who are owners of the company, and so you’ve got disputes among people who have some form of control. Whether its minority or majority. So there’s kind of that business operation decision that’s unique to a shareholders case that doesn’t exist in a lot of other business disputes. But you’re also in some instances, you know, you’ve gotta get court approval for the settlements so that’s something to think about, its time, energy, but, you know, you’re also disclosing things publicly that you might not want to have disclosed. So there are some additional considerations that we think about when we’re thinking about shareholders disputes and settlements.

Schmidt
In some of the shareholder cases I’ve done involving say, two founders that started a business that had equal shares and then one kicks the other out. One of the issues to grapple with, is should these two people be doing business together?  So you know it may be some conflict of interest, self-dealing, that brought this to a head, but if you want to resolve a case the real thing that’s gonna be in the best interest of all parties is a buyout of some sort. And you go through the appraisal process and try to figure out what are those shares worth?  And who might step in as the alternative shareholder?  So a lot of complex restructuring issues can come from shareholder litigation. Is that your experience as well?

Schubert
Oh absolutely. And really a lot of these cases are thinking practically about what’s going to work for the parties going forward. So like you said, you know there is probably a strong consideration about whether two business partners who are equal owners can really continue to operate the business together. And then, you know, ordering the buyout can be a really long and onerous process. Getting a court to accept an appraisal you have to go through a couple different processes for that depending on where you are in the US. It can be super difficult so those are additional considerations I think we take into account.

Schmidt
Well I think our time to discuss shareholder litigation is drawing to a close. We can chat further on all sort of these intricacies and challenges, from courts from California to Delaware and everywhere in between. But at this point in our show we’d like to turn to a segment we call the deeper dive, and learn a little more about you Kirsten. And what type of person you are when you’re not working on shareholder and other litigation. And one question that I do like to ask my guests, because I’m always learning as well, on how to participate in a good work/life balance. What are some things you’ve learned to de-stress and set aside your work on the weekend or the evenings and develop a good work/life balance?

Schubert
So I am a big hobby person. I don’t have kids and so my weekends are not filled with, you know, soccer coaching and things like that. But…

Schmidt
Too bad.

Schubert
I know.

Schmidt
Soccer coaching is fun. No it’s not.

Schubert
I know but traveling to the tournaments. No…

Schmidt
I had one season where I was an assistant coach just because no one else, no one else would step forward. Like there wouldn’t be a team if I didn’t volunteer to be assistant coach.

Schubert
So sort of for my de-stress thing, my strategy in life really has been to develop interests and hobbies outside of work. About six years ago, seven years ago, I suppose, I started riding horses. I started lessons through a riding school out in Minnesota. We’re lucky enough here that a forty minute drive from downtown gets you into some beautiful pastures and countryside. So I started riding then I have been riding ever since. I ride twice a week. My horse’s name is Smitty. We do shows, like competitions.

Schmidt
Wow.

Schubert
During the summer, which is really fun. So that’s one of my things. And then I do yoga and I try to get outside when I can and see friends. So I actually have managed to maintain a pretty good work/life balance given the stressors of our jobs and some of my other outside activities.

Schmidt
What other hobbies have you had that are things that you find are very fulfilling? Or maybe you don’t do them anymore.

Schubert
Travel is a big one. So I still travel a lot. I as an example, seven years ago, I went to Antarctica by myself with a group of travelers. I booked on an icebreaker ship…

Schmidt
What?

Schubert
…and went down to Antarctica for two weeks.

Schmidt
So Minnesota winters just not good enough for you?

Schubert
 Not good enough.

Schmidt
You gotta go to Antarctica. So what was that like?

Schubert
Awesome.

Schmidt
What was Antarctica like by yourself?

Schubert
It was like being on the moon. It was such a wild experience because, and to clarify, I was on a boat with other people, I just didn’t go with anybody that I knew.

Schmidt
Sure.

Schubert
Yeah. So I wasn’t alone on the peninsula or something. But it was incredible. It was just like being alone and seeing nothing else touched by people ever was just the most incredible feeling you could ever imagine.

Schmidt
Well, have you seen the movie Where’d You Go Bernadette?

Schubert
No.

Schmidt
 That’s a movie about a woman that, if I recall correctly, went to Antarctica.

Schubert
Oh, you’re kidding.

Schmidt
 Like sort of on a whim, or she was kind of searching for herself, and it had some crisis going on in her life and, so, you really should check it out.

Schubert
I definitely will watch that.

Schmidt
Yeah. I think its Cate Blanchett is in it so yeah, definitely check it out.

Schubert
Yeah, I’ll check that out. Yeah, that was kind of a whim for me too. I just was sitting around one day and it was the summer in Minnesota but I was just like, I need to go somewhere interesting, and so I just decided to go there.

Schmidt
That’s an amazing story.

Schubert
It was awesome.

Schmidt
 I’m not sure I’ll ever be ambitious enough to go to Antarctica but maybe it’s something that when I’m retired, I would consider. But…

Schubert
It is just the most incredible, and the penguins. I went because I thought it would be cool to see penguins and they just walk over your feet. I mean it’s, you’re just living in this majestic world that you never even could imagine existed.

Schmidt
 Wow that’s amazing. Really, really ambitious vacation you’ve got. You know, I had Skip Durocher on the podcast recently and he was telling me about some of his interesting vacations but, Antarctica tops them all, so.

Schubert
Well, just to give you a sense of work life balance, I was gone for three weeks on that trip and when we were on the boat, we didn’t have cell access, it was only a satellite phone. And so I actually had to leave work without the ability to talk to anybody for, you know, two weeks and then only by email the other week. And I was able to do it and it was just a really great experience and I felt really supported by the firm and that the industry has come a long way that they would let a lawyer disconnect like that.

Schmidt
Wow, bravo, well great for you. Well, looks like our time is about up, returning once more to our topic of shareholder litigation, let me, Kirsten, give you the last word. What do you think is the number one takeaway that you’d like our listeners to consider on the topic of anticipating shareholder litigation claims?

Schubert
I think it’s really important to take shareholder rights seriously. If you get any kind if notice or indication that some shareholders are looking for information that they might not otherwise be looking for. Think about where you are, what you’ve done, if there’s anything you can do in the future to make sure that your protected should they decided to move forward with a claim.

Schmidt
Well that’s a very good word of advice and that’s all the time we have for today. Thank you all for listening. I’m indebted to the extraordinary team at Dorsey & Whitney for making this podcast and episode possible. For more resources on this and other litigation risk, go to litigationrisk.com where more information can be found including a book on managing litigation risk, written by yours truly. Until next time my friends, this is yet another reminder that there are a lot of sharks swimming out there in the murky waters so swim safely.

Voiceover
This podcast is not legal advice and does not establish an attorney-client relationship or create any duty of Dorsey & Whitney LLP or those appearing in this podcast to anyone. Although we try to assure that the content of this podcast is accurate, comprehensive, and reflects current legal developments, we do not warrant or guarantee those things. The opinions expressed in this podcast are the opinions of those appearing in the podcast only and not those of Dorsey & Whitney. This podcast is considered attorney advertising under the applicable rules of certain states.