How Shareholder Litigations Deter Directors and Officers - U.S. and Italy, a Comparative Analysis

Abstract

This paper focuses on the issue of whether shareholder litigations brought in the U.S. - namely, derivative suits and securities class actions - and their equivalent in the Italian law system, achieve their principal regulatory goal of deterring corporate directors and officers from engaging in unlawful conduct, in addition to compensating shareholders and investors for the harm they suffered.

In the U.S., effective derivative suits and securities class actions, contingency fees, and the rule concerning legal expenses, create an entrepreneurial system in which directors and officers are ultimately deterred by the private enforcement of the law. Nevertheless, the presence of other interests not aligned with the public interest in optimal deterrence causes the deterrence effect to suffer peculiar distortions. Indemnification agreements and D&O liability insurance deeply shape the remaining deterrence effect, in particular, D&O liability insurance shifts the risk of losses to a third party that fails to reintroduce it. This paper analyzes possible solutions to this problem that have been receiving scholarly attention.

With regard to the Italian legal system, this paper stresses the causes behind the ineffectiveness of the Italian private enforcement system of corporate laws and analyses what solution, if any, may be adopted. The lack of economic incentives for the plaintiff shareholder, the absence of discovery rules and the difficulty of accessing useful information to be used in litigation, impair the effectiveness of the enforcement system and with it the deterrence goal. Lastly, this paper addresses how differing social landscapes and judicial attitudes also play a role in the deterrence effect within the two legal systems.

1. Introduction: Why shareholder litigations matter

1.1. Justifications for shareholder litigations.

The term “shareholder litigations” encompasses all civil actions brought by shareholders against the corporation in order to recover economic losses suffered as a result of management misconduct. Corporate and securities laws are designed to eliminate the negative consequences of the “agency costs” caused by the separation between ownership and control, and the enforcement systems that support these laws help to accomplish this result. When corporate managers (control) fail to act in the best interest of the shareholders (owners), through the tool of shareholder litigations, shareholders can sue to seek relief for the losses they suffered, enforcing the laws that were designed to protect their interest. If shareholder litigations are effective in enforcing corporate and securities laws, agency costs will be eradicated, shareholders and investors will be protected, and capital markets will gain investors’ trust, thus enhancing their ability to attract and retain capital.¹ Furthermore, this will lower the costs of raising new capital for corporate entities thus making the whole economy more efficient.²

Shareholder litigations are remedies that are private in nature, and are designed to satisfy the private interest of shareholders in recovering losses deriving from management’s misbehaviors.

They also, however, have a remarkable public regulatory purpose. In taking action against corporate misbehavior, they discourage future socially inefficient actions thus providing a public good.³

Corporate directors and officers, understanding that they might be held liable for the harms they cause to investors, refrain from engaging in harmful conducts that will induce investors to sue them and recover the losses suffered. Therefore, efficient shareholder litigations can redress agency costs.

Shareholder litigations, like any civil remedy, have two policy justifications: compensation and deterrence. The compensation rationale, as the words suggest, is to compensate shareholders and investors for the losses they suffered as consequences of management’s misbehavior and therefore to make them as they would have been if the wrongdoing had not occurred. However, the compensation rationale’s standing as primary justification is jeopardized by some crucial limitations.

First, shareholder litigations often involve a process called “pocket shifting”. Most of the time the plaintiff is a shareholder of the defendant corporation that ultimately funds directly or indirectly (through the indemnification and through D&O liability insurance) the settlement and, eventually, the final judgment. In other words, the costs arising from shareholder litigations fall perversely on shareholders themselves instead of falling on corporate management that committed the misconduct.⁴

Second, the compensation that can be achieved through shareholder litigations is often inefficient since it does not make shareholders and investors whole. Interfering interests play a role in determining the amount aggrieved shareholders can recover and it is most of the times just a fraction of their total loss arising from management’s misbehavior. However, these may be instances in which the deterrence rationale, emphasizing public good, must take precedent over the compensation rationale. In other words, a weakness for compensation becomes strength for the deterrence and, understood the primacy of the deterrence rationale (public good) on the compensation rationale, the latter could be sacrificed in favor of the former. This weakness is, in reality, strength on the deterrence side of the medal of shareholder litigations.⁵ The third limitation of the compensation rationale is that a rational shareholder could eliminate the risk of losses stemming from management’s conducts through holding a diversified portfolio of shares.⁶ Losses derived from some shares would be offset by gains in others, since shareholders will inevitably find themselves on both sides of an unlawful transaction at some point. The analysis of these three limitation of the compensation rationale leads to the conclusion that if shareholders were all rational and diversified, and compensation was the only justification for shareholder actions, shareholder litigations could be considered useless and therefore had to be abolished.

The weaknesses described regarding the compensation rationale do not usually affect the deterrence side, unless in those cases where the wrongdoer extracts an economical benefit from the unlawful conduct. Indeed, in these cases the cost imposed on the defendant by shareholder litigations has to be greater than the benefit she can achieve through the misconduct.⁷

The deterrence rationale of shareholder litigations applies to a prospective wrongdoer who avoids harmful conduct, because she knows she may be forced to pay the cost of the harm she causes to shareholders, inducing potential defendant to be good in order to avoid liabilities. The difference between the words “cost” from the world “harm” is evidence of the conceptual separation between the compensation and deterrence rationales of shareholder litigation. In other words, even if the redress recovered does not make shareholders whole (i.e. the compensation rationale is weak), directors and officers will still seek to avoid the possibility of bearing the costs derived from the enforcement of corporate and securities laws (i.e. deterrence). In the United States, the deterrence rationale is highly regarded as the ragione d’être of civil remedies and is the basis of the system of private enforcement.⁸ Efficient shareholder litigations deter directors and officers from opportunistic behaviors by corporate managers and leads to the erosion of agency costs. The presence of punitive damages in the American law system is primary evidence of such consideration. With punitive damages, increasing the expected liability for the tortfeasor enhances deterrence.⁹

Even though these introductory thoughts seem straightforward and logical, the rationales sustaining shareholder litigations and, more generally, civil remedies may deeply vary from one legal system to another. In Italy, the concept that civil remedies can deter and compensate at the same time has just recently taken shape in new rules and regulations. Nonetheless, some problems still affect the effectiveness of these rules and prevent them from achieving the intended deterrence effect.

For the purpose of this work I will focus my attention on the most representative shareholder litigations brought in the U.S. - namely, derivative suits and securities class actions - and their equivalent in the Italian law system, focusing particularly on the issue of whether these forms of civil litigation achieve their goal of deterring corporate directors and officers from engaging in unlawful misbehaviors that will harm shareholders and investors. Then, if they attain their regulatory goal, how do they achieve it. In other words, after having assessed whether deterrence is provided by shareholder litigations, determine whether an optimal level of deterrence is achieved is as important. For this purpose, we must bear in mind that deterrence works best when focused on the culpable.¹⁰ This assumption means that whenever the costs that shareholder litigations impose on management is not strictly related to the underlying merit of the claim, but rather on other factors, the enforcement system fails to provide an optimal level of deterrence. However, some distortions are inevitable if deterrence is seen as the first goal of the shareholder litigations.

1.2. Private and public enforcement of corporate and securities laws.

As we noted, in the context of corporate and securities laws, actions brought by shareholders and investors fall within the category of private as opposed to public enforcement. With the term enforcement, I mean the ways in which the observance or obedience of a law or a set of laws can be compelled. It is well recognized among scholars¹¹ that the assessment of a legal system’s quality, notwithstanding the interaction of several other variable,¹² is a two-factor evaluation encompassing the quality of the laws themselves and the level of enforcement granted to them.

The private enforcement of corporate laws and securities laws allows, from one ex-post point of view, aggrieved shareholders or investors to sue officers and directors. From an ex-ante point of view, the prospect of shareholder litigations deter directors from engaging in harmful conducts producing the so called in terrorem effect.

As opposed to private enforcement, the public enforcement of a particular set of laws is the enforcement achieved through supervisory agencies and criminal sanctions. The Securities Exchange Commission (SEC) in the U.S. and the Commissione Nazionale per le Società e la Borsa (Consob) in Italy are the two public agencies in charge of enforcing corporate and securities laws. These public agencies, despite their differences, have, ex ante, a power to specify the laws through further regulations and a duty of surveillance on the prospective wrongdoers and, ex-post, a power to punish illegal conduct through independent actions and to support private shareholder litigations. It follows that litigation is only a manifestation of the whole enforcement process.¹³

In the American legal system, the enforcement of corporate and securities laws is overseen by a plurality of enforcement agents. Despite one efficient public enforcer (SEC), the system is strongly characterized by civil actions and, in particular, by the securities class actions. Private enforcement is highly considered as a fundamental device in order to achieve an optimal level of deterrence on prospective wrongdoers together with the action of the public enforcer. Indeed, the majority of the total monetary sanctions imposed in the United States are obtained through private litigations and not by public enforcement.¹⁴ U.S. directors and officers face a high risk of being sued by shareholders if they engage in unlawful conduct.

There is a consensus among scholars, both in the European and the American context, that an efficient level of enforcement for a legal system should be achieved through the interplay between public and private enforcement systems.¹⁵ There are at least four arguments against a legal system that relies only on the public enforcement of laws, suggesting the necessity of collaboration between the two.¹⁶

First, public agencies are not always the most effective enforcers because they do not have access to the widespread information that private parties possess. Second, they lack the financial resources to investigate and monitor all potential wrongdoers and to pursue all the pending investigations with the same vigor. Third, the public agency itself can face agency costs, in the sense that the interest pursued by the people acting on its behalf may differ from the public interest originally assigned to the agency. Fourth, the action of the agency could become predictable, and in planning unlawful conducts potential wrongdoers could look to previous agency action in an attempt to avoid persecution. Thus, public agencies might lack the right incentive to pursue the public interest and provide the public good of deterrence.¹⁷ On the other hand, a legal system solely based on the private enforcement of laws is criticized by scholars for having the same weaknesses. In this scenario, the incentives of the subject initiating private action may not necessarily be aligned with the public interest at stake (i.e. deterring potential wrongdoers).¹⁸ The private actor might not have access to information that can be disclosed only through sophisticated devises in the hands of the public enforcer. Third, the abundance of private actions may lead judges to different interpretations of the law and thus to the overall instability and uncertainty of the law system. Therefore is clear that, in order to reach an optimal level of deterrence on the prospective wrongdoers it would be unwise for any country to put all enforcement powers in either the public or private enforcer’s hands. The right balance between the two forms of enforcement is the result every legislator should attain.¹⁹

1.3. Italian shareholders litigations and the enforcement system.

The Italian conception of civil remedies and their functions is vastly different from that of the U.S., and the deterrence rationale is not particularly welcome. The compensation rationale has long been considered its only justification. Punitive damages are not accepted and private remedies which do not compensate but deter are still considered diffused exception rather than another facet of private litigation.²⁰ However, some progress toward deterrence has been made. Drawn from the Law and Economics, the conception that civil remedies lead to deterrence as to compensation has nevertheless slowly permeated the Italian legal culture. One of its main lessons has been that, from a functional perspective, civil remedies are not so different from public fines or taxes because they compensate and deter at the same time.²¹

The ownership structure of Italian corporations is substantially different from those in the U.S. In Italy, as in Europe in general, few listed companies are widely held. Firms are generally controlled by a large blockholder, and dispersed ownership is very rare.²² This kind of capital structure has two consequences. Dominant shareholders have both the incentive and the power to discipline management, and the problem of agency costs shifts from the relationship between management and dispersed shareholders to the relationship between the majority and the minority shareholder.²³ It is interesting to note that a recent study has found a correlation between the ownership structures of corporations and the level of protection granted by a law system to minority shareholders.²⁴

The enforcement of corporate and financial market laws in Italy is described by Luca Enriques as the “weak or dark side” of the 1998 Italian capital market reform. The Italian legislator has been generous in creating several rights among shareholders and third parties but has not been as thoughtful in providing ways of enforcing those rights. Indeed the Italian corporate and capital market laws system is typified by the profusion of rights created by the legislator but are not balanced by the due level of enforcement needed.²⁵

Unlike the U.S., the Italian enforcement system of corporate and securities laws rely mostly on the powers granted to the public agency, namely the Consob. When capital markets laws was reformed in 1998 through the decree Law no. 58, the Consolidated Financial Services Act(CFSA), the Consob was given a central role in the enforcement of the corporate and financial markets laws.²⁶ However, the agency, as recent financial scandals demonstrate, is traditionally far from aggressive in monitoring and tackling violations.²⁷

The private enforcement system is underdeveloped and, notwithstanding recent good faith efforts towards its implementation by the Italian lawmakers (e.g., the introduction of derivative suits in 1998(CFSA) and the recent introduction of the Italian class action) it nonetheless remains weak and mostly ineffective due to several factors. First, they have been legally transplanted without taking into account other structural (the primacy of the deterrence rationale over the compensation rationale) and procedural devices that make them effective regulatory tools in the U.S.²⁸ Second, even if all the legal and procedural obstacles that prevent a full employment of shareholder litigations as regulatory tools were overthrown, legal formalism and doctrinal legal thoughts - still predominant in courts, law faculties and the legal profession - might inhibit the expected results.²⁹ Third, a change in social norms should follow the change in the legal landscape. Indeed, studies have shown that social norms play an important role in shaping corporate directors behavior and their impact is usually undervalued.³⁰

1.4. Enhancing deterrence through representative litigations.

In discussing deterrence as the primary public policy justification for shareholder litigation and civil remedies, it is necessary to address representative litigations and the ways they can ultimately enhance deterrence and discourage corporate management from unlawful conduct that could result in harms for shareholder and investors.

Minority shareholders face a well-know collective action problem.³¹ In other words, a minority shareholder or an investor, harmed by some unlawful behavior of the corporation’s management, might not have sufficient economic incentives to sue. If a corporate unlawful conduct aggrieves a minority shareholder indirectly, through her participation in the corporation, she will not be willing to sue because she will bear all the costs associated with an action that will ultimately benefits her, only to the extent of her participation in the business, and all the other shareholders of the corporation on their pro rata basis.

Other times, when the harm she suffers is direct and it does not derive indirectly from her participation in the corporation, shareholder might not be willing to sue because what she can recover will not exceed the harm suffered plus the costs of the litigation. Moreover, the shareholder will have to bear all the costs of the action in the event it is unsuccessful. In other words, the private shareholder lacks a sufficient private economic incentive to pursue an action that will ultimately create “only” the public good of deterring corporate management.³² It is the task of business law to fix this problem by reintroducing the private economic incentive. If the law would not regulate such issue, this hurdle would fundamentally undermine the deterrence rationale of shareholder litigations. If shareholders and investors do not sue because they lack an economic incentive to do so, directors and officers will be undeterred in pursuing their interests and will extract private benefits of control from the corporation instead of enhancing the interest of the shareholders.³³

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¹ La Porta, Lopez- de- Silanes, Schleifer & Vishny, Investor protection and corporate governance, 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=183908); Coffee, The Rise of Dispersed Ownership: The Roles of Law and State in the Separation between Ownership and Control, Columbia law and Economics Working Paper, 2001, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=254097); Jensen, Meckling, Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure, Finance Economic Journal, 1976, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=94043)

² Levine, Ross, Financial Development and Economic Growth: Views and Agenda, World Bank Policy Research Working Paper No. 1678, 1999, (http://ssrn.com/abstract=604955); La Porta, Lopez-de-Silanes, Schleifer, What works in Securities Laws?, Tuck School of Business Working Paper No. 03-22, 2003, (http://ssrn.com/abstract=425880 or doi:10.2139/ssrn.425880)

³ Coffee , Law and Market: The impact of enforcement, Columbia Law and Economics Working Paper n. 304, 2007, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=967482)

⁴ Coffee, Reforming the securities class actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#)

⁵ In the U.S. the plaintiff’s lawyer, through a contingency fee agreement, can obtain a share of the total recovery, thus reducing the amount intended for the benefit of harmed investors. However this provide the right incentive for the plaintiff’s lawyer to sue, enhancing deterrence upon directors and officers

⁶ Coffee, Reforming the securities class actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#) ; Romano, Empowering Investors: A Market Approach to Securities Regulation, Yale Law Journal, Vol. 107, No. 5, 1998, (http://ssrn.com/abstract=10555)

⁷ If the wrongdoers accrues a gain from the unlawful conduct the recovery obtained have to superior to the benefit accrued by the defendant in order to preserve the deterrence rationale; Coffee, Reforming the securities class

⁸ Coffee, Reforming the securities class actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#) actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#)

⁹ However, punitive damages are subject to constant criticism from American scholars since their award is often related to social norms instead of law rules due to the presence of the jury trial; Robert D. Cooter, Punitive Damages, Social norms and Economic analysis, 1998, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=109970)

¹⁰ Coffee, Reforming the securities class actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#) , Choi, The Evidence on Securities Class Actions, UC Berkeley Public Law Research Paper No. 528145, 2004, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=528145)

¹¹ La Porta, Lopez- de- Silanes, Schleifer & Vishny, Investor protection and corporate governance, 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=183908)

¹² Coffee, Do norms matter? A cross country examination of private benefits for control, Columbia University Law and Economics Working Papers n. 183, 2001, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=257613)

¹³ J. Armour, Enforcement strategies in the UK corporate governance: A Roadmap and an Empirical Assessment, in ECGI Law Working Paper N. 106, 2008, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1133542)

¹⁴ Coffee, Reforming the securities class actions: An essay on deterrence and its implementation, Columbia Law and Economics Working Paper n. 293, 2006, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=893833#)

¹⁵ Cox, Thomas, Kiku , SEC enforcement action for financial fraud and private litigation: An empirical enquiry, in Duke Law Journal Vol. 53 p, 737, 2003, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=429140)

¹⁶ Jackson, Roe, Public enforcement of Securities laws, Preliminary evidences, 2008, Journal of Financial Economics, Vol. 93, 2009, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1000086)

¹⁷ Shavell, Economic Analysis of Law, NBER Working Paper Series, Vol. w6960. 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=226405) ; Giudici, Private Law Enforcement in a Formalist Legal Environment: The Italian Sai-Fondiaria Case, ECGI Working Paper No. 094, 2008

¹⁸ Shavell, Economic Analysis of Law, NBER Working Paper Series, Vol. w6960. 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=226405)

¹⁹ Cox, Thomas, Kiku , SEC enforcement action for financial fraud and private litigation: An empirical enquiry, in Duke Law Journal Vol. 53 p, 737, 2003, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=429140)

²⁰ P. Benazzo, Le pene civili nel diritto privato d’impresa, (Milano, 2005); Giudici, Private Law Enforcement in a Formalist Legal Environment: The Italian Sai-Fondiaria Case, ECGI Working Paper No. 094, 2008

²¹ Pietro Trimarchi, Causalita’ e danno, Giuffre’ Milano, 1967 10

²² Enriques, Volpin, Corporate Governance Reforms in Continental Europe, Journal of Economic Perspective Vol. 21 No. 1, 2007, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=970796)

²³ Enriques, Volpin, Corporate Governance Reforms in Continental Europe, Journal of Economic Perspective Vol. 21 No. 1, 2007, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=970796)

²⁴ La Porta, Lopez- de- Silanes, Schleifer & Vishny, Investor protection and corporate governance, 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=183908)

²⁵ Enriques, Modernizing Italian Corporate Governance Institutions, mission accomplished? ECGI, Working Paper, 2009, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1400999)

²⁶ Enriques, Modernizing Italian Corporate Governance Institutions, mission accomplished? ECGI, Working Paper, 2009, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1400999)

²⁷ Giudici, Private Law Enforcement in a Formalist Legal Environment: The Italian Sai-Fondiaria Case, ECGI Working Paper No. 094, 2008; Ferrarini, Giudici, Financial Scandals and the Role of Private Enforcement: The Parmalat Case, ECGI Working Paper No. 123, 2005, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=730403)

²⁸ Giudici, Representative Litigations in Italian Capital Markets: Italian Derivative Suits and ( if ever) Securities Class Action, ECGI Working Paper, 2009

²⁹ Enriques , Diritto socierario Statunitense e diritto societario Italiano: and never the twain shall meet, Giurisprudenza Commerciale, Part I, pp. 274-287, 2007, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1014824)

³⁰ Coffee, Do norms matter? A cross country examination of private benefits for control, Columbia University Law and Economics Working Papers n. 183, 2001, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=257613)

³¹ Olson, The Logic of Collective action: Public Good and the Theory of Group, Harvard University Press, 1965; Choi, The Evidence on Securities Class Actions, UC Berkeley Public Law Research Paper No. 528145, 2004, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=528145)

³² Miller, Of Frankenstein Monsters and Shining Knights, Myth, Reality and the Class Action Problem, Harvard Law Review, 1979; Giudici, Representative Litigations in Italian Capital Markets: Italian Derivative Suits and ( if ever) Securities Class Action, ECGI Working Paper, 2009

³³ La Porta, Lopez- de- Silanes, Schleifer & Vishny, Investor protection and corporate governance, 1999, (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=183908)