Author: Natalie Douglass, Esq.
Recently, a California appellate court upheld a trial court decision enforcing federal forum provisions for initial public offering (IPO) litigation under the Securities Act of 1933 ('33 Act). This decision is an important development because it represents the first appellate-level ruling on the issue outside of the state of Delaware.
To illustrate the significance of this ruling, some history is necessary.
Insurance market reaction to the Cyan ruling
In 2018, the United States Supreme Court held in Cyan1 that the Securities Litigation Uniform Standards Act of 1998 (SLUSA) does not eliminate state courts' jurisdiction over claims brought solely under the '33 Act and that the cases cannot be removed to federal court. Many viewed this ruling as an unintended consequence of poor legislative drafting.2
There were many implications from this ruling, including increased costs from (1) the increase in '33 Act claims in state courts and issues with duplicative cases, multi-jurisdiction litigation and forum shopping; and (2) the lack of Private Securities Litigation Reform Act of 1996 (PSLRA) safeguards, such as limiting discovery until the court determines the pleadings conform to federal law.
The insurance market responded swiftly to Cyan by increasing retentions, reducing capacity and increasing rates. Many carriers once interested in writing primary layers of insurance were no longer interested in doing so. In short, Cyan's impact was almost instantaneous and remained the biggest issue in Directors & Officers (D&O) underwriting for IPOs.
Many Delaware corporations began amending their corporate bylaws and charters to include federal forum provisions in response to the Cyan decision. Later, three entities that had enacted these provisions faced '33 Act cases in state court, which put the validity of these forum provisions before the Delaware court.
Initially the Delaware Court of Chancery had held these federal forum provisions to be invalid. Specifically, the courts found that under Delaware General Corporation Law, forum selection is expressly permitted for internal corporate claims and did not find that the underlying securities claims were internal in nature.
In Sciabacucchi,3 three entities appealed the Court of Chancery rulings. In fact, recognizing the impact that a successful appeal would have on the D&O insurance marketplace, a funding consortium of D&O insurers and two D&O brokers (Gallagher being one) helped to fund the appeal. On appeal in 2020, the Delaware Supreme Court reversed, finding that the federal forum provisions were facially valid. This decision was considered a significant win for Delaware-domiciled entities.
With precedent only applicable to Delaware, questions remained as to how persuasive the holding would be in other jurisdictions. Fortunately, trial courts in California and New York came to the same results, although with slightly different analysis.4
The implications of the California appellate court decision
That brings us to this most recent development. In the instant case,5 plaintiffs in one of the California cases appealed, and the court ruled that the federal forum provisions were valid and enforceable.
Among other grounds, the California appellate court found that the provisions were within shareholders' reasonable expectations because: (1) they were made public as part of the IPO process; and (2) that the provisions were not unconscionable because they were made obvious in the certificate of incorporation and merely sought to have shareholders bring their claim in a local federal court.
This ruling is significant as it is the first appellate ruling applying California law, creating a broader expanse to support the validity and enforceability of these provisions.
What does this mean for our clients?
First, it's important to emphasize the value that federal forum provisions have brought to the D&O industry. It isn't theoretical; the proof is in the numbers. State court and parallel filing frequency are down significantly since Sciabacucchi. Cornerstone Research highlighted in their Securities Class Actions Filings: 2021 Year in Review Report, "2021 had the most federal-only Section 11 [1933 Securities Act] filings since 2015, and the greatest share of federal-only filings since 2014, likely an effect of the Sciabacucchi decision."6 The chart below from the aforementioned Cornerstone Research report shows a dramatic look at the pre- and post-Sciabacucchi data.
The current appellate ruling only bolsters this effect. Note that according to Cornerstone Research, 80% of the state '33 Act claims were filed in California and New York in 2020 and 2021.7 While binding precedent only exists now in California and Delaware, this ruling does offer an additional source of persuasive authority for other states to evaluate. When you also consider that New York has already ruled in favor of enforceability of federal forum provisions, albeit at a trial court level providing limited precedential value, it seems that the relevant courts are willing to uphold federal forum provisions and brings us closer to closing this SLUSA "loophole."
Given the perception that a legislative "fix" was unlikely, forging this path judicially has served as a meaningful remedy for corporations. Insureds considering an IPO, those that recently went through an IPO, or even those that are considering additional stock offerings, should consult with outside counsel regarding implementation of federal forum provisions.