4.2.2 Empirical insights

Many legal writings attribute the origin of section 102(b)(7) DGCL to Smith v. Van Gorkom.1 The case involved a proposed leveraged buy-out merger of TransUnion by the Marmon Group. Van Gorkom, TransUnion’s chairman and CEO, proposed a share price that would facilitate a leveraged buy-out but did not represent the per share intrinsic value of the company. The proposed merger was subjected to board approval. The Delaware Supreme Court found that the directors were grossly negligent because the merger was, in the absence of an emergency situation, promptly approved without substantial inquiry or any expert advice. For this reason, the board of directors breached their duty of care to the company’s shareholders and could not be protected under the business judgment rule.

It has been suggested in the literature that the controversial landmark case fuelled the liability crisis.2 The case prompted an outcry from boards of directors and a sharp increase in insurance premiums for directors’ and officers’ liability insurance (D&O).3 Many legal writers cited Van Gorkom to explain why Delaware subsequently adopted section 102(b)(7).4 While there was a time when actions by shareholders or other parties were rare, Trieschmann and Leverett noted in 1990 that companies now should ‘better protect their directors and officers from the increasing amount of litigation.’5 Trieschmann and Leverett based their argument on a survey conducted by The Wyatt Company in 1988. According to this survey, there were 24 D&O claims among the companies surveyed in 1975 as opposed to 157 claims in 1988. ‘An increase of more than 500 percent in 13 years.’6 Furthermore, ‘stockholders represent the major source of all claims’, accounting for 35 to 50 percent as opposed to third-party claims, accounting for 35 to 45 percent of the claims.7 Based on an empirical study of shareholder derivative and class action lawsuits between 1970 and 1979, Jones identified that the largest part of shareholder actions in the late 1970s related to securities disclosures and insider trading, followed by merger related actions, charges of self-dealing and illegal acts.8 To bring these lawsuits into perspective, the study showed that shareholder litigation was highly concentrated in a few companies. Furthermore, the vast majority of corporate executives seemed to have had no direct experience with shareholder litigation. Relatively few companies carried the burden of the claims. Only 13 companies (less than 6.8% of the total) were involved in more than four lawsuits; 171 companies were involved in one or less (91.6%); and 69.5% experienced none at all.9 Large companies were more likely to be involved in multiple actions because they had more shareholders to account for and because these companies were unable to resolve the claims at a pace equal with the rate at which the claims were being filed.10 Jones’ trend analysis further showed that the group of companies studied tended to have hardly any more lawsuits each year than in the previous year. Indeed, legal risks due to shareholder litigation was argued to be ‘neither great nor growing at a significant rate.’11

Assuming that litigation risks have since been growing, a more recent study involving external director out-of-pocket liability from between 1968 to 2005 conducted by Black, Cheffins and Klausner found only four cases in which external directors were found liable. With respect to these cases, the researchers found only two instances where the director suffered out-of-pocket liability.12 As with Jones’ study, the researchers also found that shareholder lawsuits were the largest source of risk. Roughly 3000 shareholder suits have been filed in U.S. federal courts since 1990, yet only four of these suits have gone to trial, none of which involved external directors. The claimant won in only one instance, as the researchers reported.13 Clearly, directors’ fear of personal liability is not based on the actual liability exposure but on the perceived liability exposure.14 Moreover, Black, Cheffins and Klausner argued that some characteristics of the U.S. legal system may amplify directors’ fear of personal liability. The researchers raised three factors which may encourage litigation. First, litigants pay their own legal expenses regardless of the outcome of a case. In other words, a claimant bringing a marginal case does not have to worry about paying the defendant’s expenses in the event the claim is dismissed. Second, derivative litigation rules allow any shareholder to bring proceedings against a director on behalf of the company. Third, a claimant’s attorney is typically seen as an ‘entrepreneur’, aggressively seeking legal violations and prospective clients rather than waiting passively for a prospective claimant to knock on the door. These incentives may explain the volume of claims that have been instigated in contrast with the very low number of claims that actually reached a court for trial.

Against the backdrop of the changing liability environment for American directors and the typical characteristics of the US legal system, the exculpatory provision should be seen foremost as a barrier to frivolous litigation. As can be learned from case law, exculpatory clauses prove their best value when courts allow director defendants to use the clause to terminate litigation by motion early in the proceeding. Accordingly, if a director defendant can raise the clause in a motion to dismiss, the lawsuit can be terminated before beginning discovery and public purview.15