Why proposed legislation in Delaware won’t end loser-pays fight

March 20, 2015

If you think the furious debate over corporate loser-pays provisions in shareholder litigation will end if Delaware legislators enact the proposal suggested earlier this month by the state bar’s Corporation Law Council, think again.

Columbia Law School professor John Coffee looked closely at the actual language of the council’s proposal and realized that it distinguishes between “Delaware-style” shareholder litigation – derivative suits and M&A class actions – and securities fraud class actions under federal law. The proposal would prohibit corporations from adopting loser-pays charter or bylaw provisions in the sorts of shareholder cases typically litigated in Delaware Chancery Court. But as Coffee points out, the council is silent on fee-shifting in federal-court cases. Its proposed prohibition on fee-shifting does not extend to shareholder class actions under the Securities Act of 1933 or the Securities Exchange Act of 1934.

Coffee’s article suggests a motive for the split. Delaware lawyers on both the plaintiff and defense sides, he says, want to squelch the threat that fee-shifting poses to their own business in Chancery Court, but they don’t want prohibitions on such provisions to drive companies to incorporate in other states. “In short, Delaware may have found a compromise that protects the local bar without threatening Delaware’s competitive position,” Coffee wrote. “The premise here is that defense counsel sees derivative actions as a nuisance, but securities class actions as a serious threat.”

So let’s assume that Delaware passes the bar council’s proposed law. What would happen? You can be sure that additional Delaware corporations would join the ranks of the 50 or so companies that have already adopted fee-shifting bylaws or included provisions in corporate charters. The new clauses wouldn’t shift fees in Chancery Court breach-of-duty suits against board members but would require shareholders in federal court securities fraud class actions to pay defense costs if they lost.

And that prospect would inevitably lead to a clash between corporations and shareholders over Delaware’s authority to pre-empt federal securities laws. The resolution of that conflict could profoundly impact the securities class action industry.

There is no doubt, as both Coffee’s article and a new paper on fee-shifting by plaintiffs’ lawyers Mark Lebovitch and Jeroen van Kwawegen of Bernstein Litowitz Berger & Grossman point out, that loser-pays provisions dissuade public pension funds from serving as lead plaintiffs in securities class actions. If corporations are permitted to adopt fee-shifting, pension funds, which have a fiduciary duty to their own beneficiaries, are unlikely to be willing to bear the risk of paying defense costs in unsuccessful cases. Coffee hypothesizes that the only investors who will rationally take the risk of serving as lead plaintiffs are judgment-proof small shareholders with no real assets.

That is exactly the opposite of Congress’ intention in the Private Securities Litigation Reform Act (PSLRA) of 1995, which was based on the premise that institutional investors are more desirable lead plaintiffs than shareholders with small stakes. According to Coffee, if the Delaware Corporation Law Council proposal passes as written, in other words, Delaware could be considered to be frustrating congressional purpose.

Congress also enacted its own very moderate version of fee-shifting in PSLRA, according to both Coffee and Lebovitch, when it called on judges to review dismissed securities class actions for possible violations of Rule 11 of the Federal Rules of Civil Procedure. If judges find that a shareholder complaint was frivolous, they have discretion to order plaintiffs to pay defense fees as a sanction. To borrow Coffee’s metaphors, Congress used a scalpel; defendants with fee-shifting provisions want to use a club. “Again, the broader sweep and harsher impact of such ‘loser pays’ provisions arguably frustrates the more moderate balance that Congress intended to strike,” the professor wrote.

If Delaware enacts the council’s proposal, he said, federal courts may find it particularly offensive that the state prohibits loser-pays bylaws for Delaware cases but not for securities fraud class actions. “To many federal courts, this may look as if Delaware is discriminating against federal litigation,” Coffee wrote. “Does Delaware have a right to uniquely burden federal litigation with a fee-shifting rule that does not apply in Delaware?”

We know that one very interested bystander is closely monitoring what happens in Delaware. On Thursday, Securities and Exchange Commission chair Mary Jo White said in a speech at Tulane Law School’s annual M&A conference that although the SEC hasn’t yet filed an amicus brief asserting “possible preemption and/or public policy arguments” against loser-pays provisions, the agency has said many times in the past that it regards private suits under federal securities laws as an important complement to regulatory enforcement.

“I am concerned about any provision in the bylaws of a company that could inappropriately stifle shareholders’ ability to seek redress under the federal securities laws,” White said. “All shareholders can benefit from these types of actions. If the commission comes to believe that these provisions improperly hinder shareholders’ exercise of their rights, it may need to weigh in more directly in this discussion.”

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