Skip to main content

In disclosure-only settlements, corporations provide more information to shareholders in exchange for a release on all potential claims against the company.

"The existence of law is one thing; its merit or demerit another."

This is the nub of legal positivism, an influential theory of law that separates the existence of rules from the ethical or practical quality of the rules. One lesson of legal positivism is that good policy is not reflected by our laws and we may need to change our laws in order to enact good policies.

This lesson was taught to me, perhaps inadvertently, by Sean Griffith, my corporate law professor at Fordham Law School in New York. In the United States, law is traditionally taught by the sometimes punishing, constantly fear-inducing, Socratic method. Professors, at random, pick law students to quiz about the day's reading. It's a good system for developing rigorous analytical skills, increasing classroom participation, inspiring classic scenes in cult movies, and causing stress-induced acid reflux.

Problem is, without the threat of the Socratic method, no one talks and no one does their homework. If the professor asks a question, the room sits silent. Sadly, fear works.

Prof. Griffith's "fruit machine" was a perfect solution to this problem. The fruit machine was deviously simple – it was a computer program that would randomly choose a classmate to answer the question. If there weren't enough people, or the same few keeners were answering questions, Prof. Griffith would pull the lever on the machine. It retained the threat of the Socratic method but allowed us, as a class, to avoid some of the embarrassment of being unexpectedly called upon. The looming threat of the fruit machine motivated people to talk without the terror of the Socratic method. It was a good study in incentives and rule making.

Which brings us to Prof. Griffith's award-winning article, Confronting the Peppercorn Settlement in Merger Litigation: An Empirical Analysis and a Proposal for Reform, with Jill Fisch and Steven Davidoff Solomon (The New York Times' Deal Professor and an inspiration for this column), which explores what happens when seemingly good rules go bad.

This rule is appropriately titled the "American Rule," which has resulted in a preponderance of "disclosure only" settlements in Delaware merger litigation (Delaware is, for all sorts of reasons, the pre-eminent jurisdiction for U.S. corporate law).

A problem with public mergers is the merging companies have bad incentive when it comes to disclosure – if you want shareholders to approve of your merger, you're more inclined to disclose good facts than bad facts. So, a rule that encourages companies to disclose all facts – not just good facts – is, in theory, a good rule.

Hence the "American Rule," which allows plaintiffs' lawyers to recover costs for so-called "disclosure only" settlements. Disclosure-only settlements are generally born out of a dispute over the fairness of a board's actions during a merger. Instead of continuing to litigation, the shareholders and the acquiring parties agree, outside of court, that the corporation give supplemental information in an amended disclosure statement, which is given in exchange for a broad release of all potential claims against the board of the acquiring corporation. The idea is that the supplemental disclosure allows shareholders to vote on the merger with more information (merger lawsuits are filed after the merger is announced but before it closes). In Delaware, courts will approve the settlement and award a fee to the lawyers who brought this suit, so long as the plaintiff benefits from it. The greater the benefit, the more justifiable the fees.

More information is beneficial to shareholders. But the American Rule – designed to bring about more information – creates a powerful incentive: If all it takes for a lawyer to get paid is additional disclosure, there is a strong incentive for a lawyer to find plaintiffs to bring a lawsuit.

The result of this rule has been much litigation: In 2013, 97.5 per cent of public company mergers in Delaware were challenged in shareholder litigation.

So, Prof. Griffith and his colleagues set out to answer the obvious question: Is the benefit to shareholders greater than the cost of litigation? To answer this question, they looked at whether supplementary disclosures affected shareholder voting. The core assumption was that the additional disclosure should increase the number of "no" votes for a merger because, on balance, the additional disclosure would likely be negative disclosure about the merger. And yet, their finding was that the presence of a disclosure-only settlement has no effect on voting at all.

In one sense, this is unsurprising – a disclosure-only settlement creates a bounded option for shareholders: Sue and, at worst, you win additional disclosure and get your legal costs covered; at best, you get an increased merger premium and get more money. Whether you're voting yes or no is irrelevant – there is nothing to lose.

But this also means that this is a bad rule. Litigation is costly and the only people gaining a real benefit are lawyers. Moreover, by allowing disclosure-only settlements, state courts are duplicating a role well served by U.S. federal courts, which directly address questions related to disclosure.

Conversely, Delaware's disclosure jurisprudence is built out of hasty suits over procedure and compensation, not suits alleging inadequate disclosure. The better rule is to leave disclosure litigation to federal courts.

It's easy to view the rise of disclosure-only statements as a story about unscrupulous lawyers, but that's not it. If lawyers didn't pursue disclosure-only settlements, they wouldn't be doing their jobs – plaintiff shareholders were entitled, by law, to bring litigation where the downside was merely more disclosure. It's the job of courts and, yes, academics to examine these rules to see if they're achieving the desired outcome. To look at the facts and recommend better laws, or to find that the current laws are being misapplied.

Which brings us to a recent ruling in which Delaware Chancery Court Judge Andre Bouchard rejected a disclosure-only settlement and the commensurate $500,000 (U.S.) lawyer's fee. Taking a look at old laws in light of the new academic evidence, the court found the additional disclosure was of limited value, leaving the corporation with a broad release from all claims and conferring little benefit to the shareholders. Counsel for the amicus curiae (literally, "friend of the court") in the case – coming down from his ivory tower to argue that the disclosure-only settlement should be rejected – was Sean Griffith.

Adrian Myers is a lawyer at Torkin Manes LLP.

Report an error

Editorial code of conduct

Tickers mentioned in this story