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E-MailAlbert H. Choi is Albert C. BeVier Research Professor and Professor of Law at the University of Virginia Law School and Visiting Professor of Law at Columbia Law School. This post is based on a recent paper by Professor Choi. This post is part of the Delaware law series; links to other posts in the series are available here.
After the financial crisis of 2008, there was an explosion of lawsuits by shareholders against their corporations, particularly in mergers and acquisitions transactions. Partly in response to this “flood” of litigation, a number of corporations began devising strategies to deter shareholder lawsuits. One strategy was the fee-shifting bylaw, which would obligate the plaintiff-shareholder to reimburse the corporation’s expenses (including attorneys’ fees and other costs) when the plaintiff is unsuccessful in litigation. Initially, whether the bylaw—adopted unilaterally by the directors and without express shareholder consent—would be honored by the court was uncertain. But that uncertainty was resolved, at least in Delaware, through the case of ATP Tour, Inc. v. Deutscher Tennis Bund (“ATP Tour”). [1] In the case, the Delaware Supreme Court upheld the fee-shifting bylaw adopted by the directors of ATP Tour, Inc., largely by applying the contractarian principle. According to the Court, charters and bylaws constitute a contract between a corporation and its shareholders, and the directors can amend the bylaws by adopting a fee-shifting provision when the amendment right is granted to them in the corporation’s charter. The case generated a substantial amount of controversy, but a number of corporations promptly took advantage of this newly validated right. Only a year later, however, the Delaware legislature took away that right by amending the Delaware General Corporation Law to prohibit altogether fee-shifting provisions, either in the charter or the bylaws.
This rocky history has left an important question unanswered: as a matter of corporate law policy, should the directors of a corporation be allowed to incorporate a fee-shifting provision through a unilateral bylaw amendment? A small number of scholars have analyzed related issues on fee-shifting bylaws, such as: whether the Delaware Supreme Court’s contractarian approach is sound; how bylaws and charters are similar or different from contracts; whether corporate directors are breaching their fiduciary duty by shifting the defense costs onto plaintiff-shareholders; and whether the Delaware legislature is beholden to the plaintiffs’ bar. In comparison, my paper, Optimal Fee-Shifting Bylaws, takes a more normative approach to the question of whether fee-shifting bylaws are desirable at all and, if so, in what form. In analyzing this problem, the paper links the corporate law literature on charters and bylaws with the law and economics literature on fee-shifting rules in litigation and, foremost, argues that neither the adopters of fee-shifting bylaws nor the Delaware legislature is correct, and the optimal fee-shifting rule would likely lie somewhere in between. When we first examine the actual bylaw provisions employed by the corporations prior to the 2015 legislative amendment, they are broad and one-sided, hence posing the danger of discouraging even the meritorious suits (those with high probability of success) from being filed and proceeding. On the other side of the spectrum, the legislative amendment that bans all fee-shifting provisions errs on the opposite end by not sufficiently encouraging the meritorious suits and discouraging the frivolous ones.
Referencing the law and economics literature on fee-shifting and litigation leads to an argument that fee-shifting provisions can be optimal (unlike the view taken by the Delaware legislature) and the optimal fee-shifting provision employs a more symmetric shifting of the expenses (unlike the version used in ATP Tour and subsequent corporations). The optimal, symmetric fee-shifting provision encourages meritorious lawsuits while discouraging frivolous ones. The reasoning is straightforward. When a plaintiff has a meritorious claim (a claim with high probability of success), under the optimal fee-shifting regime, the plaintiff knows that she is unlikely to bear the cost of prosecution, since the defendant will have to reimburse her for the expenses in the likely prosecutorial success. This, in turn, makes her more like to proceed with the lawsuit, compared to the regime where she needs to worry about her litigation expenses. On the other hand, if she has a frivolous claim (a claim with very low probability of success), under the optimal fee-shifting rule, she knows that not only is she unlikely to get any recovery from the corporation-defendant, but she also will likely have to reimburse the defendant’s litigation expenses. This makes her less likely to proceed with the claim, compared to the standard regime under which she needs not worry about having to reimburse the defendant for the expenses in the case of loss. In short, the optimal fee-shifting rule will magnify the positive return for the plaintiff with a meritorious claim and further depress the return for the plaintiff with a frivolous one, thereby providing a more effective screening function.
The analysis also reveals that symmetric fee-shifting is more effective in achieving the screening function with respect to direct lawsuits compared to derivative lawsuits. This is because derivative lawsuits already incorporate partial fee-shifting by allowing the plaintiff’s attorney to recover fees from the corporation if she is successful. A more balanced fee-shifting provision, on the other hand, will impose a higher threshold on the merits of the lawsuit (probability of success) for the plaintiff’s attorney to bring litigation. As an empirical support, the paper also examines two other, important areas where fee-shifting provisions are frequently used. The first area is stock purchase agreements (among commercially sophisticated parties), which allow the winner (of a contract dispute) to collect litigation expenses from the loser, often without involving the court to determine the merits of the lawsuit. The second area is indentures for publicly issued bonds, contracts that govern the relationship between the bondholders and the borrowing corporations (along with the indenture trustees). With respect to the indentures, the federal Trust Indenture Act, as a default rule, expressly allows the court to shift expenses to the loser on a case-by-case basis. Unlike the stock purchase agreement scenario, fee-shifting under the Trust Indenture Act depends on the court’s determination of the merits of the claim. These two sets of examples offer us useful modules for devising the optimal fee-shifting regime for corporate litigation. Given that not all commercial contracts utilize a fee-shifting provision and that the adopted provisions vary (as exemplified by the two modules), the paper argues that there is no single fee-shifting provision that will work for all types of cases. To allow for flexibility while making sure that there is no undue restriction on the shareholders’ right to bring lawsuit, the analysis suggests that the courts should consider a more vigorous application of the “proper or equitable purpose” review.
The full paper is available for download here.
191 A.3d 554 (Del. 2014).(go back)
