Will Fee-Shifting Put the Kibosh on Non-Meritorious Derivative Actions?

On May 8, 2014, the Delaware Supreme Court ruled that a corporate by-law providing for fee-shifting in claims brought against the company by shareholders was permissible under the Delaware General Corporation Law (DGCL).  The decision (which can be found here) occurred in connection with an internecine dispute in a private corporation (the ATP Tour that operates the professional men’s tennis tour), but it raises the prospect that public Delaware corporations could do the same to stem what some believe to be a blight of frivolous derivative shareholder litigation.  See Losing a Shareholder Lawsuit Could Soon Become More Expensive, linked in the column to the right.

The issue arose after the Delaware federal district court certified several questions to the Delaware Supreme Court about the validity or enforceability of the by-law after the ATP Tour won the case brought by its member shareholders.  The Supreme Court ruled that such a by-law was permissible under the DGCL and Delaware common law, but did not decide whether the by-law was enforceable in this case, saying that enforceability of such a provision depended on surrounding facts and circumstances not presented in the certified questions.

But the threat of possible fee-shifting by-laws impacting the cottage industry of private derivative litigation drew a lightening-rod response.  Those who believe the prevalence of knee-jerk derivative actions is abusive and harmful to shareholder interests were delighted at the prospect of possible “loser pays” by-laws.  Securities lawyers who bring derivative claims argue that such a provision might eliminate “nuisance suits,” but it would also deter meritorious actions because no shareholder would commence an action that provides essentially no individual relief but would expose the plaintiff to a large fee award if the action failed.  (Whether the same is true for the plaintiff’s law firms that actually generate many of these cases, and benefit from the settlements that often occur, is not clear.  Nor do I know whether a firm taking on the risk of such an award against its client would be ethically permissible.)

One thing is reasonably clear: For many years specialist plaintiff’s law firms have generated many derivative actions of questionable merit, at best, because of the possibility that out of a portfolio of such claims, a number will generate lucrative settlements (to the lawyers, in terms of attorneys’ fee reimbursements).  The Delaware Chancery Court has been trying for years to “encourage” plaintiff’s firms not to bring knee-jerk derivative actions, for example when companies merge or bad corporate news is announced, but instead to first engage in inquiry as to whether a valid claim might exist by issuing a demand to inspect books and records under Section 220 of the DGCL, which might, or might not, provide the necessary particularized facts to support a derivative claim.  (Vice Chancellor Laster recently reiterated the court’s concern about this problem at pages 38-59 of his opinion in Louisiana Municipal Police Employees’ Retirement System v. Pyott, which can be found here.)

In actuality, the widespread adoption of fee-shifting by-laws by corporations, assuming they would be approved by shareholders, might have unforeseen consequences.  Even while developing strict standards for shareholder actions that seek to supplant or second-guess the business judgment of Boards of Directors, the Delaware courts have strongly advocated the need for, and value of, such actions as an important means of preventing Board or management policies that stray beyond business judgment to self-perpetuation or aggrandizement (see pages 39-40 of VC Laster’s opinion).  In a court of equity, the adoption of by-laws that impose high burdens on unsuccessful actions could lead a court to be less demanding of derivative plaintiffs who appear to have acted in good faith.  Derivative plaintiffs currently face a high bar in pursuing derivative actions.  It might not be prudent to press for by-laws that could create incentives to loosen those standards.

Straight Arrow

May 21, 2014

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