“No Pay” Provisions: The Forgotten Middle Ground In The Fee-Shifting Battle

If it becomes law, Delaware State Senate Bill 75 will prohibit Delaware stock corporations from adopting provisions in their bylaws or certificates of incorporation that would shift legal fees to the losing party in stockholder litigation. [1] The debate over these so-called “loser pays” provisions and the proposed legislation prohibiting them has generated controversy nationwide. Opponents of the legislation argue that abusive lawsuits impose a “merger tax” and that prohibiting “loser pays” provisions would “eliminate an important mechanism” that could “protect innocent shareholders against the costs of abusive litigation.” [2] Proponents of the legislation contend that “loser pays” provisions would “foreclose meritorious stockholder claims [and] render illusory the fiduciary obligations of corporate directors.” [3] Both sides of the public debate have overlooked the availability of “no pay” provisions, which could transform stockholder litigation without the effects that make “loser pays” provisions unpalatable to many. [4]

In its simplest form, a “no pay” provision requires each side to bear its own fees and costs in stockholder litigation, unless the court concludes that one side litigated in bad faith. [5] Policymakers, practitioners and academics should consider “no pay” provisions as both a tool to address the recent torrent of stockholder litigation and potentially the next battleground if Delaware’s legislature prohibits “loser pays” provisions. [6]

First, “no pay” provisions are important because they could restore the so-called “American Rule” to a critical type of stockholder litigation. The American Rule has been a fixture of the legal landscape in the United States since its inception. [7] But a stockholder suit challenging a transaction that settles in exchange for the issuance of supplemental disclosures falls within the “corporate benefit” exception to the American Rule. [8] Under this exception, the reviewing court awards the plaintiff’s attorney a fee (to be paid by the corporation) for obtaining a “benefit” for the corporation’s stockholders. Because the average fee award for a disclosure settlement is approximately $500,000, [9] the prospect of this type of fee award subsidizes shot-in-the-dark claims by lawyers representing stockholders who do not internalize the cost of authorizing an attorney to bring suit against the corporation. “No pay” provisions applicable to class action litigation that settles for disclosures would restore the American Rule to this key type of stockholder litigation by requiring each side to bear its own fees and costs. This would fundamentally change the economics of the decision to file suit, because weak suits that could only generate a disclosure settlement would no longer be profitable for lawyers to prosecute on a contingent fee basis. [10]

Second, “no pay” provisions lack the most problematic characteristic of “loser pays” provisions. “Loser pays” provisions threaten to impose significant costs on stockholder plaintiffs who are unsuccessful. Critics of “loser pays” provisions argue that the potential imposition of these costs on stockholder plaintiffs would reverse the limited liability structure of the corporate form by imposing the debts of the corporation (and potentially related parties) on one or more of the corporation’s stockholders. These critics also argue that that the potential imposition of millions of dollars in defense costs would chill even meritorious claims and effectively bar the courthouse door to small stockholders. By contrast, “no pay” provisions would simply eliminate the profitability of pursuing a suit that settles for specified benefits (perhaps disclosures or other non-monetary benefits), unless the stockholder plaintiffs have agreed to pay their attorneys.

Third, “no pay” provisions are endlessly scalable and could be crafted to apply only to specifically identified types of claims, forms of litigation or specific types of settlements. For example, a “no pay” provision could expressly permit fee-shifting if (a) the litigation achieves a monetary benefit for the corporation, (b) the litigation results in disclosures that exceed Delaware’s materiality threshold by a specified margin, [11] or (c) a court determines that the non-monetary benefits obtained in the litigation exceed a specified dollar-equivalent value. [12]

Fourth, if crafted to provide simply that each side shall bear its own fees and costs, “no pay” provisions would preserve the opportunity to seek fee awards from common fund recoveries in class actions, since the plaintiff class would be paying its own lawyers. This would be consistent with the American Rule’s fee-allocation regime. [13] Plaintiffs’ lawyers might also retain the opportunity to seek fee awards for obtaining common fund recoveries and non-monetary, therapeutic benefits in derivative actions, since the corporation would be paying lawyers pursuing claims on the corporation’s behalf. Tailored in this way, “no pay” provisions would bite only in situations where a class action resulted in non-monetary benefits to a plaintiff class, and where the court would (absent a “no pay” provision) typically require the corporation to pay the fees of the lawyers representing the class in accordance with the “corporate benefit” doctrine.

Fifth, “no pay” provisions appear to be consistent with Delaware’s traditional approach to corporate governance, which favors private ordering within a framework imposed by a broadly enabling corporate statute and common law principles developed on a case-by-case basis under the leadership of Delaware’s judiciary. [14] Even if Delaware’s legislature prohibits “loser pays” provisions, the Delaware Court of Chancery would retain the power to regulate “no pay” provisions in fact-specific circumstances.

Sixth, “no pay” provisions appear to be facially valid under Delaware law. On May 8, 2014, the Delaware Supreme Court rejected a facial challenge to the validity of a “loser pays” bylaw adopted by a Delaware non-stock corporation in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 560 (Del. 2014). To the extent this holding applies to Delaware stock corporations, it suggests that “no pay” provisions would survive scrutiny. Critics would undoubtedly challenge “no pay” provisions as incompatible with the authority of the courts to shift fees pursuant to the “corporate benefit” doctrine. But the corporate benefit doctrine is a common law feature founded on public policy concerns arising out of the application of the American Rule in specific contexts. [15] A reviewing court could easily find that the public policy benefits of permitting private ordering regarding attorneys’ fees among the parties to the corporate bargain, especially in a context where the volume of non-meritorious stockholder litigation raises basic questions about the legitimacy of Delaware’s system of corporate governance, outweighs the countervailing considerations. If one conceives of “no pay” provisions as embodying a decision by stockholders to waive the right to seek fees from the corporation for obtaining specific types of corporate benefits (and forgo the associated incentives), they seem difficult to challenge as fundamentally contrary to Delaware

For all of these reasons, “no pay” provisions deserve far more attention from policymakers, practitioners, and academics than they have received to date. They could easily become a critical tool for regulating stockholder litigation. If Delaware’s legislature prohibits “loser pays” provisions, “no pay” provisions could also become the next battleground between the antagonists in the current debate over fee-shifting.

Endnotes:

[1] As of May 20, 2015, SB 75 still requires approval by the Delaware House Judiciary Committee, the full House and Governor Markell before it becomes law. See Michael Greene, Fee-Shifting Bill Expected for Early June Vote Before Delaware House Committee, Corp. L. & Accountability Rep., May 15, 2015, http://www.bna.com/feeshifting-bill-expected-n17179926551/.
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[2] Letter from Harold Kim, Exec. Vice President, U.S. Chamber Inst. for Legal Reform, to Members of the Delaware Senate (May 6, 2015) (“May 6 Chamber Letter”).
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[3] Letter from Institutional Investors to Norman Monhait, Chair, Del. Corp. Law Council (Nov. 24, 2014).
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[4] See, e.g., Ed Batts & John Reed, Delaware (Again) Proposes Sledgehammering Fee-Shifting Bylaws, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Mar. 12, 2015), available at https://corpgov.law.harvard.edu/2015/03/12/delaware-again-proposes-sledgehammering-fee-shifting-bylaws/ (“there is no room for a middle ground of proportionate fee allocation”); May 6 Chamber Letter (arguing the proposal fails to provide “a replacement tool to deter the filing and prosecution of these illegitimate actions”).
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[5] For example, a “no pay” provision could provide:

To the fullest extent permitted by law, in the event that any [Claiming Party] initiates or asserts any [Representative Claim] or joins, offers substantial assistance to, or has a direct financial interest in any [Representative Claim] against any [Company Parties], then, regardless of whether the [Representative Claim] is successful in whole or in part, neither the [Claiming Party] nor the [Claiming Party’s] attorneys shall be entitled to recover any [Litigation Costs] from the corporation on account of the [Representative Claim], unless (a) [the Court] determines that the corporation litigated [in bad faith], (b) [the Court] determines that the [Representative Claim] was derivative or (c) the [Bylaws] or [Certificate of Incorporation] or other contract provides the [Claiming Party] a right to advancement or indemnification from the corporation on account of the [Representative Claim].

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[6] David Marcus, Fee Shifting Bylaws Not Ready for Prime Time, TheDeal.com, May 19, 2014, http://pipeline.thedeal.com/31/10005978063/15051894.t?d=6&cmpid=em:RG052014#10005978063 (noting the possibility that corporations could attempt to opt out of the corporate benefit doctrine by bylaw); Sean J. Griffith, Correcting Corporate Benefit: How To Fix Shareholder Litigation By Shifting The Doctrine On Fees, 56 B.C. L. Rev. 1, 57–58 (2015) (same).
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[7] See, e.g., Arcambel v. Wiseman, 3 U.S. 306 (1796).
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[8] See Tandycrafts, Inc. v. Initio Partners, 562 A.2d 1162, 1164-65 (Del. 1989); Chrysler Corp. v. Dann, 223 A.2d 384, 386 (1966).
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[9] Jill E. Fisch, Sean J. Griffith & Steven Davidoff Solomon, Confronting The Peppercorn Settlement In Merger Litigation: An Empirical Analysis And A Proposal For Reform, 93 Tex. L. Rev. 557, 568 (2015) (citing Matthew D. Cain & Steven Davidoff Solomon, Takeover Litigation in 2013, at 4, tbl.B (Ohio State Public Law Working Paper No. 236, 2014), available at http://www.ssrn.com/abstract=2377001, archived at http://perma.cc/XP2B-8C8B).
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[10] Critically, stockholders and their lawyers could still prosecute disclosure claims, but the pursuit of those claims would not be profitable for the lawyers unless the stockholder clients agreed to pay them, either for their time, or for the benefit achieved pursuant to a success fee arrangement.
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[11] Bright-lines would obviously be preferable. Setting a materiality-based standard could invite litigation over whether particular disclosures meet the test.
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[12] Drafters would need to confront and address the possibility that corporate actors might want the flexibility to waive “no pay” provisions to pave the way for settlements that might ultimately benefit the litigants. Embedding a “no pay” provision in a certificate of incorporation would make waiver impractical and potentially increase the litigation-dampening effect of a “no-pay” provision.
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[13] Griffith, supra note 7, at 40–41, 44, 46.
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[14] Theodore N. Mirvis & William Savitt, Shifting the Focus: Let the Courts Decide, 53 Bank & Corp. Governance L. Rep. 8, 11 (Jan. 2015).
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[15] See, e.g., In re Dunkin’ Donuts S’holders Litig., C.A. No. 10,825-VCC, 1990 WL 693165 (Del. Ch. Nov. 27, 1990); In re Nat’l. City Corp. S’holders Litig., C.A. No. 4123-CC, 2009 WL 2425389, at *5 (July 31, 2009).
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