April 21, 2022
April 21, 2022
Public companies and their directors and officers are frequent targets of shareholder class action lawsuits arising from an initial public offering or secondary public offering. These lawsuits, asserting violations of the Securities Act of 1933 (the “Securities Act”), are driven by experienced plaintiffs’ firms and can be extremely burdensome and costly to defend, especially if allowed to proceed into fact discovery. Companies often feel pressured to settle these lawsuits—even if the case is ultimately winnable—to avoid these costs and distractions to the business.
Understanding the background and effectiveness of federal forum provisions as a defense tool against Securities Act lawsuits is essential for directors, which the rest of this article explores.
Most securities claims are brought under provisions of the Securities Exchange Act of 1934 and must be litigated in federal court (not state court). Defendants in securities cases generally prefer litigating in federal court because the procedural standards are more favorable and the judges are usually more familiar with the intricacies of the law. Whether or not a case proceeds in federal court versus state court can often determine the outcome.
Lawsuits relating to an offering, however, often include claims under the Securities Act. In recent years, plaintiffs’ firms have taken advantage of a quirk in the law that allows plaintiffs to file lawsuits brought under the Securities Act in state court and bars defendants from moving these cases to federal court. This practice was affirmed by the US Supreme Court’s 2018 decision Cyan Inc. v. Beaver County Employees Retirement Fund.
Immediately following Cyan, the number of Securities Act lawsuits filed in state court skyrocketed to all-time highs. Companies increasingly faced costly and duplicative parallel state and federal actions, as well as multiple lawsuits in different state courts.
After Cyan, many companies amended their corporate charters and adopted federal forum provisions (FFPs) requiring that Securities Act lawsuits be brought exclusively in federal court. The theory was that if a plaintiff shareholder filed a Securities Act lawsuit in state court against a company that had adopted an FFP, the lawsuit could be dismissed on the grounds that it should have been brought in federal court.
In March 2020, the Delaware Supreme Court ruled in Salzberg v. Sciabacucchi that FFPs are facially valid under Delaware law. However, the Delaware Supreme Court acknowledged, “Perhaps the most difficult aspect of this dispute is not with the facial validity of FFPs, but rather, with the ‘down the road’ question of whether they will be respected and enforced by our sister states.” In other words, would state courts outside Delaware enforce FFPs?
In the two years since Sciabacucchi, the consistent answer among state courts has been “yes.”
Most notably, several decisions from California and New York state courts have upheld and enforced FFPs following Sciabacucchi. In 2020 and 2021 combined, more than 80 percent of state court Securities Act lawsuits were filed in either California or New York. Plaintiffs’ firms routinely file Securities Act lawsuits in these states due to perceived strategic advantages, including less stringent pleading standards and some individual courts allowing plaintiffs to engage in fact discovery before a ruling on the motion to dismiss—a practice that is not allowed in federal court.
In California, at least four separate state court decisions have enforced FFPs in lawsuits brought against Restoration Robotics, now part of Venus Concepts, Uber Technologies, Dropbox, and Sonim Technologies. A New York state court likewise recently enforced an FFP in dismissing a lawsuit brought against Casa Systems, and a Utah state court enforced an FFP in a lawsuit brought against Domo.
Companies that anticipate making a public offering should strongly consider adopting FFPs in their charters if they have not done so already. FFPs provide an effective, practical defense against shareholder class actions brought under the Securities Act. While plaintiffs may still file Securities Act lawsuits in federal court, an FFP can effectively deter weaker lawsuits and gives the company the best shot at winning early and avoiding a costly settlement down the line.
Furthermore, even if an FFP is adopted after the offering at issue, this likely would not render the FFP ineffective. While the law is still evolving on this issue, numerous court decisions have held that analogous forum-selection clauses are enforceable even if adopted after the alleged wrongdoing occurred.
Finally, while the enforcement of FFPs adopted by Delaware corporations is now relatively settled, some uncertainty remains about whether FFPs adopted by companies incorporated outside of Delaware are valid and enforceable. While this issue has not yet been addressed by any state courts, the recent decisions in California, New York, and Utah suggest that FFPs could similarly be held effective.
Jonathan Rotenberg is a partner and Paul Yong is an associate at Katten Muchin Rosenman.
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