Sneaky new trend in IPOs: Make shareholders pay if they sue and lose

October 9, 2014

If you bought Alibaba shares last month when the Chinese mobile commerce company went public, you participated in the biggest-ever initial public offering. Alibaba raised $25 billion from investors when its shares began to trade on the New York Stock Exchange. Its price has dropped a bit from its record high of more than $99 on the first day of trading, but as of Thursday afternoon Alibaba was swinging back up toward $90 a share.

You’d better hope that the stock price is as solidly based as it seems, because if Alibaba’s officers and directors are engaged in fraud, shareholders will have a very tough time suing for their losses. That’s certainly what the company intends. On the very last page of its 38-page articles of association, Alibaba includes a provision stating that any shareholder who initiates or assists in a claim against the company must pay the company’s defense fees and costs unless shareholders win a judgment on the merits. This sort of “loser pays” fee-shifting is an exception to the general rule in the United States that each side bears its own costs of litigating – and it effectively precludes shareholder class actions suits because investors and their law firms don’t want to risk paying defendants’ legal fees.

If you’re a shareholder who suspects wrongdoing at Alibaba, good luck finding a plaintiffs’ firm to represent you. Shareholders will have the same problems if they try to sue Smart & Final, a grocery chain in the western United States that also went public last month, or if they want to go after ATD Corp, a tire distributor that announced plans for an IPO in August. Both of those companies – along with six other limited liability corporations and limited partnerships, according to Institutional Shareholders Services – have also adopted charter provisions that shift the cost of defending shareholders’ claims to investors who sue and lose.

The clauses aren’t all the same. Alibaba is incorporated in the Cayman Islands, for instance, so it doesn’t have to worry about shareholders bringing breach-of-duty claims against directors (for themselves or on behalf of the corporation) under state laws. Its fee-shifting provision addresses only claims against the corporation itself. ATD and Smart & Final are Delaware corporations, so their fee-shifting provisions would presumably cover suits brought against directors and officers in Delaware Chancery Court as well as federal-court securities cases.

Both Delaware companies acknowledge in their filings that there’s some uncertainty about the future of these provisions in the state. The Delaware Supreme Court seemed to open the door to fee-shifting earlier this year, in a case called ATP Tour v. German Tennis Federation, which involved a privately held organization. In response, the state’s Corporate Law Council quickly introduced legislation to block public companies from shifting defense costs to investors, but (under pressure from business lobbyists) the state legislature tabled the proposed new law in June. (In Oklahoma, meanwhile, state lawmakers enacted legislation in September to extend loser-pays rules to all shareholder derivative suits against corporate board members.) About 10 small public companies, according to ISS, have changed their bylaws to include loser-pays provisions. Challenges to a couple of those are underway in Delaware Chancery Court.

Fee-shifting provisions adopted in IPOs, however, will be difficult to eradicate in court. Typically, when shareholders protest some new restriction on their rights, they claim that corporations changed the rules without their consent. But if shareholders bought stock in the IPO of a company whose corporate charter includes a loser-pays provision, that argument won’t carry much weight. Defendants will argue that their founding corporate documents told shareholders what to expect.

But here’s the thing: Alibaba, Smart & Final and ATD haven’t made it very easy for shareholders to understand (or even see, in Alibaba’s case) what they’re giving up in these fee-shifting provisions. As professor J. Robert Brown Jr. of the University of Denver’s Sturm College of Law was the first to point out, Smart & Final – apparently the first company to go public with a fee-shifting provision in its certificate of incorporation – provided only a bare-bones disclosure of the provision in its prospectus. ATD did disclose that its bylaws include a fee-shifting provision but just in its second amended registration statement. Alibaba didn’t even mention its loser-pays clause in its prospectus. “Alibaba had a lot of corporate governance issues,” Brown said. “At a minimum, there should have been fulsome disclosure” of the provision, he said, “alerting investors and describing the consequences.”

Even securities defense lawyer Maurice Lefkort of Willkie Farr & Gallagher, who has hailed fee-shifting provisions as a way to curtail meritless shareholder suits, told me he was surprised that Alibaba’s provision appeared only in the corporate articles. (Lefkort also said that the technical language of the provision may not actually preclude Alibaba investors from suing, but that’s another story.) “One would have expected it to be in the prospectus,” Lefkort said.

Alibaba and Smart & Final both had to get past the Securities and Exchange Commission to bring their shares to the market. The SEC is supposed to be a watchdog on shareholder rights: You may recall, for example, that in 2012, when the private equity fund Carlyle floated the idea of requiring shareholders to arbitrate claims against the company instead of suing in court, the SEC quietly objected and Carlyle dropped the provision. The commission has balked at other mandatory arbitration clauses as well. So where has the SEC been on fee-shifting?

So far, the commission has been quiet, but that’s probably going to change. On Thursday afternoon, the SEC’s Investor Advisory Committee is slated to hear presentations from Columbia Law School professor John Coffee and Widener Law professor Larry Hamermesh about fee-shifting provisions. Sturm professor Brown, who is the SEC committee’s secretary, said he will be advocating that companies at least do a better job of disclosing the clauses to shareholders in IPO filings.

That’s a bare minimum, said plaintiffs’ lawyer Christine Azar of Labaton Sucharow. The fee-shifting debate has so far focused on state-court causes of action, such as breach-of-duty suits in Delaware or Oklahoma. But Alibaba’s provision is intended cut off shareholders’ federal securities claims, Azar said, and shareholders who relied on the prospectus may not even have realized the company was trying to limit their rights. “It’s crazy,” Azar said. “From the SEC, this was like nothing, and it’s a huge IPO.”

Azar said she’ll be shocked if the SEC remains silent on corporations’ obligation to provide full disclosure on fee-shifting provisions. She told me she’s hoping the commission does more than that: “The SEC needs to determine whether these clauses fundamentally limit the rights of shareholders,” she said.

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