Let’s Make A “Deal Tax”

They call it the “deal tax”: When a public company announces a merger or acquisition, it is greeted with one, two or half a dozen lawsuits, sometimes drafted and filed within hours of the announcement.

Lawyers sued over 73 percent of all M&A deals for more than $100 million in 2017, according to a recent report by Cornerstone Research, down from a high of 94 percent in 2013. They filed an average of 2.8 lawsuits per challenged deal. That was down from more than five lawsuits per deal in 2013 but still a surprising number given these M&As are lawyered by some of the top attorneys on Wall Street. Can they really be getting it wrong so consistently?

Of course not. M&A litigation is a symptom of a legal system that encourages lawyers to file suit in hopes of negotiating a settlement—and a rich fee. That can be a good thing when shareholders challenge a truly smelly deal, as when Grupo México used its control over then-Southern Peru, a NYSE-traded mining company, to swap $3 billion in Southern Peru stock for its interest in a troubled Mexican copper mining business. The Delaware Supreme Court in 2012 upheld $2 billion in damages for Southern Peru’s minority shareholders and $304 million in attorney fees.

Over the years, Delaware judges have gotten adept at spotting such deals. They’ve also learned how to identify less meritorious cases, including “deal tax” lawsuits where the plaintiff lawyers are really only using the threat of holding up an otherwise legitimate deal to earn a quick fee.

The most egregious example of this was “disclosure-only” settlements, where lawyers sued over supposed omissions in the proxy statement discussing a transaction and agreed to settle in exchange for minor wording changes and a fee. Shareholders got nothing, while the defendant company got a release from all claims, dubbed an “inter-galactic release” by disgruntled Delaware judges. Many defense lawyers considered it a prudent trade.

“Ask yourself: Would I rather have a world where 90 percent of the transactions result in a lawsuit, and I can just write a check and call it a cost of doing business?” says Abby Rudzin, a partner with O’Melveny & Myers. “Or a world where only the ‘meritorious’ cases go forward, and I end up writing a very large check at the end?”

Delaware largely ended the disclosure-only game in 2016 with a landmark decision, In re Trulia. Rather than give up, entrepreneurial plaintiff lawyers took their business to federal courts. And while the rules in federal court can make it harder to sue and get a court-approved settlement, lawyers found a way around that, too. Instead of negotiating a legal settlement, they agree to dismiss their case in exchange for a “mootness fee.” Because once a case is dismissed, the matter is moot. Get it?

Plaintiff lawyers received a mootness fee in 63 percent of M&A cases in federal court in 2018, according to research by Professor Steven Davidoff Solomon at the UC Berkeley School of Law, with fees typically ranging from $50,000 to $300,000. Mootness dismissals “appear to have displaced formal settlements entirely in federal court litigation,” Davidoff writes.

How can lawyers trade a valuable claim on behalf of shareholders, their supposed clients, for nothing more than a fee? Ask the federal judges who approve these agreements, which have sprouted like mushrooms after their colleagues in Delaware shut down the disclosure-only settlement racket.

Defense lawyers are under no illusions about what they’re getting: an end to another meddlesome M&A lawsuit.

“It is effectively a settlement, it’s just not a formal settlement that gets anyone a release,” says Rudzin. “It’s a little bit wink-wink, nod-nod. Everybody knows what’s going on.”

Read more: How To Keep M&A Deals On Track