The Shareholder Suit: Litigation without Foundation?

Abstract

Shareholder litigation is accorded an important stopgap role in corporate law. Liability rules are thought to be called into play when the primary governance mechanisms-board of directors (Williamson), executive compensation (e.g., Smith and Watts), and outside block ownership (Shleifer and Vishny)- fail in their monitoring efforts but the misconduct is not of sufficient magnitude to make a control change worthwhile. By imposing personal liability on corporate officers and directors for breach of the duties of care (negligence) and loyalty (conflict of interest), litigation is thought to align managers' incentives with shareholders' interests. The efficacy of shareholder litigation as a governance mechanism is hampered by collective action problems because the cost of bringing a lawsuit, while less than the shareholders' aggregate gain, is typically greater than a shareholder-plaintiff's pro rata benefit. To mitigate this difficulty, successful plaintiffs are awarded counsel fees, providing a financial incentive to the plaintiff's attorney to police management. There is, however, a principalagent problem with such an arrangement: the attorney's incentives need not coincide with the shareholders' interest. For instance, settlement recoveries in