Q&A: Director and shareholder disagreements

June 2022  |  SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION

Financier Worldwide Magazine

June 2022 Issue

FW discusses director and shareholder disagreements with Roger A. Cooper at Cleary Gottlieb, Ben Trust at CMS Cameron McKenna Nabarro Olswang LLP, Fred Brown at Grant Thornton and Jenness E. Parker at Skadden, Arps, Slate, Meagher & Flom.

FW: To what extent have you seen a rise in director and shareholder disputes in recent times? How would you describe the risk of litigation in this area?

Cooper: In the US, we have observed a definite rise in high-profile disputes between directors and shareholders that lead into litigation. Such litigation is usually brought derivatively against the board – shareholders assert claims on behalf of the company, typically against directors and officers for breaches of fiduciary duties to the company and its shareholders. New filings of shareholder derivative suits in the federal courts more than doubled from 2017 to 2020, according to data from LexisNexis. At the same time, some recent favourable decisions for shareholder plaintiffs may encourage further litigation in this area. The law of Delaware, where many US companies are incorporated, imposes a high pleading bar for bringing fiduciary-duties claims for directors’ failure to exercise oversight of the company – referred to as Caremark claims. But, beginning with the Delaware Supreme Court’s 2019 Marchand decision, there has been a pattern of the Delaware Chancery Court allowing more Caremark claims to proceed past the pleadings stage. Recently, the court permitted a Caremark claim to proceed against Boeing’s directors related to the 737 MAX airplanes. The court found that plaintiffs had pled that Boeing’s directors failed to establish an airplane safety reporting system and turned a blind eye to ‘red flags’ showing safety problems.

Brown: Director and shareholder disputes appear to grow steadily in the UK as the level and pace of investment grows. We see a range of shareholder disputes, the most common being section 994 unfair prejudice claims, in which we value a minority stake in the business for its buy out. Formal legal disputes are understandably avoided where possible given their associated risks of cost, emotional distraction and business disruption. A recently developing area in the UK is in securities litigation. These types of claims involve groups of shareholders in public companies who suffer losses, for example when share prices drop on the announcement of ‘bad news’ that should have been properly reported sooner, or not at all. A well-established and growing practice in the US, these types of derivative actions have grown in the UK, led by precedents such as the Tesco accounting misstatement and the Volkswagen emissions scandal. This is likely to grow and poses a potential threat to listed corporates, especially as increasing attention is paid to the ethical responsibility of business.

Parker: Over the past several years, there has been a rise in the number of section 220 books and records demands, particularly since the Delaware courts have limited the array of defences that corporations can make in responding to such demands. In part, this has led to a greater number of lawsuits being filed after books and records are obtained – both derivative actions, typically oversight claims, and direct actions challenging fairness of mergers. Although not as voluminous, we have also seen an increase in special purpose acquisition company (SPAC)-related litigation in the Delaware courts. Further, we have seen numerous circumstances where significant stockholders that own less than a majority of stock be challenged in litigation as having ‘de facto’ control.

Trust: Director and shareholder disputes, and how best to effectively deal with them, are always relatively high on the boardroom agenda due to the frequency with which they now arise. At present we are seeing a lot of activity in this area, especially claims with an international dimension. The coronavirus (COVID-19) pandemic has produced some particularly audacious disputes; this development and the general uptick in disputes may relate, in part at least, to the inability to discuss matters face to face during lockdown. Shareholders are increasingly focused on proactively managing the performance of their ever-increasing investments and are prepared to subject boards to a far greater degree of scrutiny, relating to governance, share performance or related matters. We have encountered disputes ranging from strategic branding to company benefit arrangements, as well as the more orthodox financial accounting disputes and disputes involving director remuneration and conflict of interests. Saying this, parties still appreciate the need to preserve commercial relationships and are naturally wary of the time, energy and costs associated with full-blown litigation.

FW: What are the main trends and developments causing conflict and disagreement between directors and shareholders? In what ways has the coronavirus (COVID-19) pandemic impacted relationships between directors and shareholders?

Brown: It seems likely to us that the COVID-19 pandemic will, ultimately, give rise to more disputes. We know that disputes tend to arise in times of difficulty, and uncertainty and operating difficulties in recent times has led many businesses to suffer or cease trading. While, anecdotally, we have not seen a noticeable rise in such disputes yet, it may be because the effects of the pandemic are far from behind us and we remain in a challenging business environment, in which supply chain issues, increased food and energy prices and the difficulty in passing on these costs to consumers put pressure on businesses. Management is focused on business as usual or even survival. Often claims come later, once the immediate crisis has passed and affected parties have the time to count their losses and try to make some recovery. We have certainly seen an increase in transaction-related claims due to the surge of high value business acquisition activity since the start of the pandemic, although these cases are usually time-bound, so claims must be made more promptly.

Parker: Any situation where minority stockholders may be disenfranchised or treated unfairly causes conflict. Moreover, with the ability to ‘see under the hood’ with access to books and records, stockholder plaintiffs are filing more oversight cases than ever before, and several in recent years have managed to survive a motion to dismiss, which historically was unheard of. The unique structure of SPAC deals with founders and sponsors investing small amounts with significant upside potential value if a deal is accomplished has resulted in tension and increased stockholder scrutiny. Also, we are seeing conflict related to director responses to any environmental, social and governance (ESG) issues that stockholders may consider too late or insufficient. Other than busted deal litigation, the COVID-19 pandemic sparked disputes between directors and stockholders in connection with performance and disclosures related to performance. This is starting to smooth out, though. The Ukraine conflict has been the most recent grounds for analysis of material adverse effect (MAE) clauses.

Trust: COVID-19 had an undeniable financial impact on many companies, and we have seen this play out in the disputes arena. In relation to the personality and relationship element of such disputes, much of recent M&A activity has been in relation to companies where management and individuals are not necessarily central to the value of the company. Equally, lockdown meant it became challenging to maintain relationships when being prevented from meeting in person. An issue that may once have been resolved due to the strength of the personal relationships has more recently quickly escalated to a dispute due to the difficulties in discussing such matters via Zoom, for example, or email. However, perhaps the main developing trend in the UK has been an increased shareholder focus on directors’ decisions, with a greater appetite to challenge strategic corporate decisions where shareholders feel that such decisions are not promoting the success of the company.

Cooper: Shareholders have recently shown particular interest in using litigation, or threats, to pressure companies in several key areas, especially related to ESG issues. Over the past two years, shareholder plaintiffs have filed a number of derivative suits alleging lack of diversity on boards. These cases have generally been dismissed at the pleadings stage – including against directors of The Gap, Facebook, Cisco Systems, Oracle, Qualcomm, NortonLifeLock, and several other companies – but may reflect a broader shareholder focus to use litigation to pursue ESG goals. Shareholder plaintiffs have pursued derivative litigation against directors following high profile cyber security incidents, claiming the board failed to exercise oversight over data security. The Delaware Court of Chancery recently dismissed such a claim against the directors of Marriott International, however, finding that the plaintiffs had not cleared Caremark’s high threshold. The court highlighted that “the growing risks posed by cyber security threats do not lower this high threshold that a plaintiff must meet to plead a Caremark claim”. As climate change remains a pressing social and political issue, derivative litigation by shareholders seeking change to corporate policies related to climate may increase. Much of this litigation has to date been brought under the federal securities laws, but that may expand to state law fiduciary duties claims by shareholders. COVID-19, by contrast, has not resulted in a significant wave of derivative litigation. While shareholder-plaintiffs have brought such cases – for example, cases related to boards entering into transactions or approving stock options for themselves during the pandemic – the uptick has not been as significant as expected.

FW: Could you outline the range of dispute resolution options available to directors and shareholders in dispute?

Cooper: Resolution of disputes between directors and shareholders in the US is always possible through engagement and an informal or formal agreement by the board and company to make changes, for example in governance or strategy or board composition, depending on the issue. And if that is not possible, some shareholders will sell their shares and walk away. Another avenue, short of full-on litigation, for shareholders of Delaware corporations is to access the company’s books and records under section 220 of the Delaware General Corporation Law. It authorises a stockholder to request such documents to investigate wrongdoing or other issues. The use of section 220 appears to be on the rise. New case filings in the Court of Chancery to enforce such rights have more than doubled from 2017 – approximately 75 filings – to more than 160 in 2021. Recent Delaware law has also arguably expanded the scope of what shareholders are entitled to and made it easier for them to show a basis for accessing such documents. A shareholder can then use those documents to put additional pressure on the board or to bring a lawsuit.

Trust: Dispute resolution options available will depend on the structure of governance within each specific company. In many cases, articles of association, or if there is one, a shareholders’ agreement, will specify the approach for resolving disputes. In addition to those avenues, the Companies Act confers both significant rights to shareholders, such as access to information, calling meetings and tabling resolutions, among others, and significant obligations on directors – using articles of association for a proper purpose, as well as the now codified director’s duties. These rights and obligations are often used tactically as part of a dispute resolution strategy. Mediation, being a voluntary meeting between the parties held on a ‘without prejudice’ and confidential basis with a neutral mediator appointed to help the parties work toward a settlement, or a standard ‘without prejudice meeting’ between parties, without an independent facilitator present, or indeed a full expert determination – often on accountancy-related issues – process, are often included as the initial methods of alternative dispute resolution (ADR).

Brown: Tension between shareholders can often be resolved through an informal process including commissioning an independent valuation to support a negotiated exit. If parties have early sight of what a reasonable buyout price might be, there may be less reason to get into an expensive and time consuming legal process; the right outcome might be for the minority shareholder to be bought out for a reasonable price that can be negotiated between the parties. Expert determination, which can be specified as a dispute resolution mechanism in a shareholders’ agreement, can be a quicker, more cost-efficient mechanism in the event of a dispute and resulting buyout. It is more flexible than litigation or even arbitration and the decision maker will themselves be an expert in the field, reducing the need for parties to engage their own experts. It is also a process of mutual consent, whereas litigation through the courts can be brought by claimants without the agreement of the other party. Arbitration, a middle ground, can be swifter than litigation and is confidential, but requires agreement by both sides to arbitrate, and litigation may be required to enforce the resolution.

FW: Should a dispute arise, what initial steps need to be taken to ensure the situation does not spiral out of control? What are the potential consequences if a disagreement is not settled speedily and amicably?

Parker: If you get a section 220 demand, respond reasonably. Maintain an amicable relationship with your adversary. If dealing with a litigation demand, it is important to remain in communication with the stockholder and work diligently to assess whether to bring claims. Failure to respond could result in a lawsuit and put the company in a bad light in court in the initial stages of a lawsuit. A company should endeavour to be in the best position possible if and when a lawsuit arises. Potential consequences if a dispute is not resolved early and amicably include lengthy, expensive and contentious discovery, including depositions, and potentially multiple discovery disputes. Moreover, it can easily take three years from the time a complaint is filed to a post-trial decision. There is nothing speedy about a full-blown trial and damages numbers could be significant if not negotiated and resolved early on.

Trust: Understanding what exactly has caused the dispute is important. If someone has misunderstood or misread a situation then there may be an opportunity to manage expectations and prevent a dispute from escalating. As a dispute escalates, lawyers become involved and decisions become increasingly strategic, driven by procedural requirements. Courts are reluctant to interfere in existing contractual arrangements and make decisions that effectively rewrite the terms of commercial agreements. Suggesting a mediation or a without prejudice meeting at a relatively early stage of a dispute offers parties an alternative way to explore more commercial solutions, including options that a court will not be prepared to order. Litigation and arbitration are both expensive and lengthy processes. Once a party has taken the decision to commence legal proceedings, they have made a significant financial investment in the outcome of that process. This raises the stakes and can make disputes much harder to settle.

Brown: Communication is fundamental to resolving conflicts. Develop and maintain open lines of communication, however this can be achieved – either with a representative or via neutral parties. The stories of corporate or family disputes are a microcosm of the whole human saga – anger, joy, resentment, hope, betrayal and utter relief. Terminology and legal precedents are important mechanisms which must be respected to support justice, but do not express the human experience. It is here where we see the most important consequences of dispute. These are emotional and financial pain – damage to businesses and livelihoods. Where possible, dispute is best avoided.

Cooper: Potential disputes between directors and shareholders can be resolved through informal engagement before rising to the point of a section 220 demand or a derivative lawsuit. While a board generally does not have a legal obligation to discuss or negotiate with a shareholder over a complaint or proposal, in many situations it may be in the company’s interest to nevertheless engage to determine whether a reasonable resolution is possible in order to avoid a broader dispute. The board may consider such engagement in particular if the shareholder has significant holdings or is a potential ‘activist’ investor, where discussion and negotiation may defuse the situation. But, of course, the board may disagree with the shareholder and determine that no reasonable resolution is possible, in which case litigation against the board may become unavoidable.

FW: What proactive measures can be deployed in anticipation of a potential director and shareholder disagreement, to smooth the resolution process?

Brown: It is key to ensure that there is a paper trail. Document decision making within the business and its rationale; this is most commonly through risk registers and board minutes. This will ensure there is evidence to support the rationale for any decisions that are later questioned. The exiting shareholder or director is at an inherent disadvantage in terms of access to information. Even if litigation or arbitration can be avoided, information is fundamental to the resolution process. Gather and agree essential pieces of information that reflect the performance and reveal the value of the business. The more that can be agreed, the swifter and less painful the resolution.

Cooper: Once a dispute arises, the process is likely to proceed to engagement with the complaining shareholder in an effort to find an early resolution, but progression to litigation if no such resolution exists remains possible. Of course, the best way to prevent such issues is to ensure the board is well-informed and well-functioning, and that it keeps shareholders reasonably informed of the company’s business goals and strategies, but there is no way to prevent entirely through proactive measures disputes from arising and progressing into litigation. The board should therefore also be consulting with litigation counsel to be prepared to defend itself and the company – including through litigation, if necessary – if a resolution is not attainable.

Trust: If a disagreement is anticipated, from the outset ensure that a formal dialogue is in place and that all parties remain committed and engaged with that process. While parties are often tempted to ‘clam up’ at this point, continued transparency, sharing of information and communication are essential. Meetings that take place to discuss sensitive matters, even if on a ‘without prejudice’ basis, should have an agreed agenda and be properly minuted. Even in the most difficult commercial disputes, approaching a dispute as you would a transaction, with a structured and process driven timetable in place, can help parties reach an agreement. When trust and goodwill are in short supply, focusing on negotiating the terms of procedural mechanisms, such as Tomlin orders and escrow agreements, can help. Appointing a neutral expert to help the company evaluate the issues in dispute may be a cost-effective measure to avoid the need for litigation.

Parker: Full and accurate disclosures are critical. This is the path to successfully invoking various defences under Delaware law. Further, well-drafted board materials can be the difference between a trial and an early dismissal at the pleadings stage. No matter what type of transaction, but especially if a transaction is even arguably interested or involves a controlling stockholder, procedural protections, such as a special committee of independent directors, or a majority of the minority vote, are important factors for obtaining the most favourable standard of review.

FW: What advice would you offer on carefully drafting and understanding key corporate documents, such as the articles of association, to help mitigate disputes or assist their resolution?

Trust: Absolute clarity in the drafting of the documents and the parties having a common understanding of those terms is critical. Make sure that everyone understands what they have committed to do and the specific processes which will apply in the event that there is a dispute. If the obligations imposed by a shareholders’ agreement are unfair or unrealistic at the outset, then this may cause resentment at a later point in the commercial relationship. Before signing, consider holding a ‘pre-mortem’, ideally with your other business partners, and explore what everyone thinks should happen to the business venture in a worse-case solution. Feedback from a ‘pre mortem’ session may help you achieve the right balance of risk and reward in the key corporate documents.

Cooper: In terms of governance, companies should carefully consider whether to adopt a forum selection provision to charters or bylaws. This provision can be used to require any shareholder suit related to the internal affairs of the company, such as a derivative claim against directors for breach of fiduciary duties, to be brought in a specified court, often the Delaware Court of Chancery. These provisions are becoming standard. Choosing Delaware in particular allows companies and boards to litigate these disputes in courts that have extensive expertise in predictably resolving corporate law claims based on well-developed case law. Further, to position the board to defend potential Caremark claims, and to potentially limit the scope of section 220 books and records demands, the board should ensure that its formal board-level records – including board minutes, board books and other centrally maintained files – are well drafted. These records should reflect, at a high level, all of the information the board receives and the material reasons for decisions the board makes, so that courts are not left to second guess the board’s exercise of its oversight duties based on an incomplete record. Also, there is Delaware law that where a board’s records are not sufficiently detailed to evidence important board decisions, shareholders may be entitled as part of a section 220 demand to electronic communications to fill in the record, including emails and text messages used for board-related communications. Companies should ensure that formal records are reasonably complete to mitigate the risk that a court will require that broader production of documents.

Parker: It is important to draft each provision of a corporate document so that the intent is clear. Where there is ambiguity, there is room for litigation. On specific provisions, forum selection provisions, both for breach of fiduciary duty claims and Securities Act claims, have helped curb multi-forum litigation and dissuade less energetic stockholders’ counsel to litigate in forums like Delaware. Exculpatory provisions limit money damages to breaches of the duty of loyalty for directors, and, if the Delaware general assembly passes the latest proposed legislation, the same will be true for senior officers. Advancement and indemnification provisions, or individual contracts, are also very important, not just to retain talent, but also are a factor in derivative litigation brought on behalf of the company. Corporate documents include company books and records. It is critical to maintain these records consistently, and in a manner that reflects the board’s decision making.

Brown: Experienced professional advisers not only produce carefully drafted legal documents that reflect the nuances of your situation, but also take the time to ensure you understand them. If a dispute later arises and an expert determiner must be appointed to value a shareholding for a buyout, they are bound by the contract wording. Taking time to ensure the key corporate documents are well drafted and reflect accurately the commercial intentions of parties and anticipate likely risks or address the known features of the business is key to mitigating or swiftly resolving disputes. Similarly, in the case of transactions, get good due diligence and take the time to discuss and understand any issues that are raised from it. Ensure that the approach to valuation for the deal is well documented. This will reduce the risk of disagreement, for example in relation to the methodology for quantifying the impact of alleged non-disclosure in the case of breach of warranty, or in settling earn out disputes.

FW: What are your predictions for director and shareholder disputes over the coming months? What issues and challenges are likely to remain prevalent?

Cooper: Disputes will continue to be an area of significant litigation activity. Boards of Delaware companies should expect that any significant negative event affecting the company may be followed by shareholder demands for books and records, and potentially followed by Caremark claims alleging that the board breached its duties. This trend will likely accelerate in light of the increased focus on ESG issues. We expect the plaintiffs’ bar to look to these issues to drive litigation, as some shareholders increasingly demand that corporations take responsibility for these broader social and political issues.

Parker: Last year, many predicted that there would be an explosion of SPAC-related litigation. However, recent caselaw and US Securities and Exchange Commission (SEC)-proposed amendments could stem that tide. Challenges to the fairness of transactions involving controllers is always attractive to stockholders and a current trend that will likely continue. At present, the uptick in section 220 books and records demands does not seem likely to abate soon. We may also see some Ukraine-related MAE litigation. There could be additional appraisal cases arguing for an increase in value between signing and closing, or in attempts to obtain books and records where they are unavailable otherwise. There will likely be increased deal litigation with the use of company documents at the pleadings stage. Finally, stockholders may increase their utilisation of discovery from either fiduciary duty or appraisal cases to tag advisers or add back defendants that were dismissed early on, which has recently seen some success.

Brown: The increased focus on the role of business in climate change and the transition to net zero is creating new types of claims. For example, ClientEarth is initiating a derivative claim – that is, where a shareholder ‘steps into the shoes’ of the company – against the directors of Shell for “failing adequately to prepare the company for a transition to net-zero and manage climate risk”. This follows ClientEarth and Friends of the Earth’s successful application in March 2022 for judicial review of the UK government’s net-zero strategy. These are some of the first examples of such legal processes in connection with climate change that will no doubt serve as important precedents. Businesses and investors should be aware of the potential for shareholder activism to influence the strategy of the business, both through shareholder voting rights – which have historically rarely countered management – and claims seeking to hold directors personally liable.

Trust: How a company reports its emissions and the plans it has developed to reduce its carbon footprint is still largely unchartered territory, as are many other areas of ESG, which are fast becoming front and centre in the minds of directors and shareholders. In relation to carbon emissions specifically, due to the extent of the reporting required it is likely to be a huge challenge for companies and fundamentally different to other forms of established financial reporting. Increased scrutiny from a wide variety of stakeholders, including employees, investors and regulators, should be anticipated. Director and shareholder disputes are likely to arise, as directors and possibly also company advisers are both now considered potential targets for activist claimant shareholders looking to challenge corporate emission reporting plans.

Roger Cooper leads Cleary’s securities and M&A litigation practice. He has a particularly strong record of success representing foreign issuers in US courts and handling matters with complex cross-border or international dimensions. His experience is enhanced by his close partnerships with Cleary’s tightly integrated global teams. He was a lead partner representing Petrobras in the largest US securities class action ever brought against a foreign issuer. He can be contacted on +1 (212) 225 2283 or by email: racooper@cgsh.com.

Ben Trust is the co-head of CMS’ litigation and arbitration team based in the London office. With a strong international perspective, he resolves complex disputes for primarily corporate clients and financial institutions. He acts in both an advisory and representative capacity for clients from a diverse range of sectors, including financial services, construction, sports, gaming, pharmaceuticals, manufacturing, real estate and energy. He can be contacted on +44 (0)20 7524 6234 or by email: ben.trust@cms-cmno.com.

Fred Brown is a director in Grant Thornton’s forensic and investigations practice. Mr Brown has specialised in forensic and investigation work since 1990 and is regularly instructed as an expert witness, in particular in commercial disputes and private clients claims. He undertakes business valuations including for commercial disputes, matrimonial matters and other proceedings, and is an experienced investigator, having conducted many sensitive investigations in both the public and private sectors. He can be contacted on +44 (0)117 305 7626 or by email: fred.brown@uk.gt.com.

Jenness Parker represents public and private companies, their directors and advisers in litigation including derivative and class actions, corporate governance disputes, M&A-related actions, books and records matters, appraisal proceedings, advancement and indemnification actions, other Delaware statutory matters, federal securities laws and complex contractual disputes. She has achieved success for her clients at all stages of litigation, including motion practice, preliminary and permanent injunctions, and trials. She can be contacted on +1 (302) 651 3183 or by email: jenness.parker@skadden.com.

© Financier Worldwide

THE PANELLISTS

Roger A. Cooper

Cleary Gottlieb

Ben Trust

CMS Cameron McKenna Nabarro Olswang LLP

Fred Brown

Grant Thornton UK LLP

Jenness E. Parker

Skadden, Arps, Slate, Meagher & Flom

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