“The first trickle through a leak in the dam” that eventually causes the dam to collapse is how Professor John Coffee characterized the adoption of fee-shifting bylaw or charter provisions by 24 companies since May of this year. The “dam” here is the practice of private enforcement, as a supplement to public enforcement, of laws governing fiduciary duties, regulation of securities and other matters. His testimony, along with that of Professor Lawrence Hammermesh, was presented to the SEC’s Investor Advisory Committee at its Thursday meeting, a portion of which was devoted to the movement toward adoption of fee-shifting provisions.
As discussed in this Cooley Alert and this post, generally, under the so-called “American rule,” parties to litigation must pay their own attorneys’ fees and costs. A fee-shifting bylaw or charter provision, however, obligates a stockholder-plaintiff in intra-corporate litigation to pay the company’s (and perhaps its directors’) legal fees and costs if the plaintiff is not “successful.” According to Hammermesh, provisions adopted so far tend to define “successful” as the substantial achievement, in substance and amount, of the full remedy sought. Typically, the provisions extend liability for fees beyond the plaintiff to include persons with a direct financial interest in the case as well as to persons offering assistance in the case to the plaintiff, which could be interpreted to apply to counsel and expert witnesses. Although initially presumed to apply primarily to derivative actions for breaches of fiduciary duty, fee-shifting provisions, depending on the scope of the particular provision, could be applied more broadly to securities law claims and even to some consumer or tort claims. The theory under which liability is imposed, which Hammermesh termed the “doctrine of corporate consent,” provides that, by buying shares, investors assent to be bound by the terms of the charter and bylaws. (Binding those providing assistance to stockholders requires another leap, however….) In his view, as a Delaware attorney, the doctrine made sense when applied to provisions determining the forum of litigation, so-called “exclusive forum” provisions. Applying the concept to fee-shifting provisions was, in his view, a bridge too far.
But not in the view of the Delaware Supreme Court. In May of this year, in ATP Tour, Inc. v. Deutscher Tennis Bund, the Delaware Supreme Court held that a “fee-shifting” bylaw adopted by a board was “facially valid” under Delaware law. Although the bylaw was held to be legally permissible under Delaware law, the ATP Court stated that whether a bylaw is valid and enforceable “as applied” in any individual case turns “on the circumstances surrounding its adoption and use,” in particular, whether the bylaw was “adopted or used for an inequitable purpose.” Notably, according to the ATP court, “[t]he intent to deter litigation… is not invariably an improper purpose.” While ATP was a non-stock membership corporation, the logic and language of the decision appeared to be applicable to typical stock corporations, although that result was not clear.
The Delaware corporate bar, concerned about the potential impact of ATP, advocated that the Delaware legislature adopt legislation to prohibit fee-shifting provisions that would impose monetary obligations in the absence of individual consent. The legislature, faced with strong opposition from the Chamber of Commerce and others expressing concern about the high proportion of merger transactions subject to stockholder challenges, determined to postpone consideration of this legislation until 2015.
In the meantime, at least one state, Oklahoma, has upset the “American Rule” by adopting legislation to require the non-prevailing party in derivative litigation initiated by stockholders to pay the legal fees and costs of the prevailing party.
Given the number of one-way loser pays provisions adopted in the past five months, including many in connection with IPOs, Coffee wondered why the SEC was “sitting on the sidelines.” In his view, these broadly worded fee-shifting provisions could have such a serious chilling effect on potential cases seeking to enforce compliance with federal securities laws and fiduciary duties that, eventually, there might be no private enforcement mechanism at all. For example, many plaintiffs, counsel and expert witnesses may feel too threatened to bring actions. (See, e.g., these posts regarding the Hemispherx case, where plaintiffs’ counsel asked the Delaware Chancery Court either to invalidate the company’s fee-shifting bylaw or to remove them as counsel from the suit.) There was also some speculation that liability under some fee-shifting provisions could be imposed on whistleblowers or those initiating proxy contests. Coffee also anticipates that appeals may effectively disappear as losing plaintiffs trade their rights of appeal in exchange for waivers of fee-shifting provisions. In Coffee’s view, private enforcement has significant value as a deterrent; while he acknowledges that private enforcement is certainly “imperfect,” that is no reason, in his view, to “throw the baby out with the bathwater.” Even if the Delaware legislature acted, Coffee contended, many corporations are incorporated outside of Delaware and would not be affected, especially if there were a “race to the bottom” among the states to attract corporations on the basis of permission of these provisions. Moreover, if Delaware acts only to a limited extent, these types of provisions could still have a significant chilling effect on private litigation. Coffee believed that many companies were waiting to see what action the Delaware legislature took before moving forward with these provisions. He speculated, however, that unless the legislature acted in January, hundreds of companies would adopt fee-shifting provisions.
What is Coffee’s prescription for the SEC? Coffee suggests, unless the provision at issue expressly precluded application in cases involving the federal securities laws, that the SEC file amicus briefs in litigation arguing that these provisions are contrary to public policy as expressed in the federal securities laws and therefore any state law permitting them is preempted. (E.g., think indemnification.) In addition, he recommends that the SEC not grant acceleration of registration statements for companies the charters or bylaws of which contain onerous or punitive versions of fee-shifting provisions. To support his case, Coffee analogized to the SEC’s refusal to grant acceleration for entities that would require mandatory arbitration that is onerous or punitive. Notably, a more modest provision –one that comes into play at the motion-to-dismiss stage and would allow only a modest recovery — might be, in Coffee’s view, acceptable. Finally, Coffee recommends that the SEC begin to collect data to show the amount of fee recovery that could be involved.
Some members of the committee appeared to find disconcerting the professors’ testimony regarding the potential breadth of application of fee-shifting provisions and the resulting chilling effect. One member concluded that the effect of fee-shifting provisions would be to render fiduciary duties “a dead letter.” He also suggested that the committee recommend that the SEC require amplified disclosure, including a statement to the effect that the SEC views these provisions as contrary to public policy, similar to the disclosure regarding indemnification of control persons for federal securities law violations. It was noted, however, that there was little evidence thus far that investors were frightened off by these types of provisions; a number of companies with recent highly successful IPOs, including a large Chinese internet company, have had broad fee-shifting provisions in their charters or bylaws. Another committee member, however, was concerned that the SEC not federalize state law: if there were a carve-out in the provisions for the federal securities laws, the matter should fall “back in the laps of the Delaware courts.”
It is possible that individual ADs in various Offices of Corp Fin could decide to require, on the basis of materiality, more expansive disclosure regarding the nature of these fee-shifting provisions as part of the review-and-comment process, without action by the SEC as a whole. However, judgments regarding policy-related matters would likely require decision-making at levels higher up the SEC food chain. It remains to be seen what recommendations the committee will make to the SEC regarding fee-shifting provisions and whether the SEC will decide to take any action. Stay tuned.