Robbins Arroyo LLP Attorneys Discuss the Risks of Fee-Shifting Provisions to Shareholders and Public Companies
As featured in American Bar Association’s Securities Litigation Spring 2015 Newsletter on June 9, 2015
Fee-Shifting After ATP Tour
In ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Delaware Supreme Court upheld a fee-shifting provision in a Delaware non-stock corporation’s bylaws. The provision provided that plaintiffs pursuing intracorporate litigation could be held liable for the opposing party’s legal fees if the litigation did not substantially achieve the desired results. Following the ATP decision, a number of publicly traded companies sought to limit shareholder derivative litigation by adopting a fee-shifting provision in their bylaws or corporate charters.
The adoption of a fee-shifting provision by public companies would have a chilling effect on derivative litigation. Shareholders would risk facing liability for millions of dollars in attorney fees if they brought an action—a barrier to entry so steep that few shareholders would seriously consider bringing these actions on behalf of the public companies in which they are invested.
The chilling effect on derivative litigation would be a significant loss for shareholders and publicly traded companies. As noted by the U.S. Supreme Court, the “purpose of the derivative action [is] to place in the hands of the individual shareholder a means to protect the interest of the corporation from the misfeasance and malfeasance of ‘faithless directors and managers.'” Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (citation omitted). The derivative action is a vital tool for enforcing fiduciary duties because “directors and officers of a corporation may not hold themselves accountable to the corporation for their own wrongdoing.” Agostino v. Hicks, 845 A.2d 1110, 1116 (Del. Ch. 2004).
Recognizing the potential dangers of fee-shifting provisions, the Delaware Corporation Law Council (DCLC)—a committee comprised of both plaintiff and defense attorneys—responded quickly. Just a few weeks after the ATP decision, it circulated a draft amendment to be submitted to the Delaware legislature that would eliminate the ability of Delaware stock corporations to implement fee-shifting through their bylaws or corporate charter. Karlee Weinmann, Del. Attys Push To Shield Stock Cos. From Fee-Shifting Ruling, Law360 (May 22, 2014). However, the passage of the amendments proposed by the DCLC was tabled for the next legislative session after public criticism from groups supporting fee-shifting, including the U.S. Chamber of Commerce and some publicly traded companies. Claudia H. Allen, Delaware Proposal Banning Fee-Shifting and Permitting Exclusive Forum Provisions, Corporate & Financial Weekly Digest (Mar. 20, 2015). In early March 2015, the DCLC submitted a revised proposal that once again proposed eliminating the ability for Delaware stock corporations to impose fee-shifting on shareholders through bylaws or charter provisions. Id. A legislative response to the proposal is expected soon, as the Delaware legislature’s current legislative session ends on June 30, 2015. Id.
Fee-shifting is a misguided and overbroad tool for a number of reasons. First, as it has been implemented thus far, it targets all shareholder derivative litigation, not just unmeritorious claims. Second, it places far too much power in the hands of the defendants—including directors and executives that may not always have shareholders’ best interests in mind. Finally, it is inappropriate given the already significant hurdles that have been implemented to deter unmeritorious derivative actions. In sum, fee-shifting impinges on a vital tool for shareholders to redress the wrongdoing of faithless fiduciaries and improve the value and corporate governance of public corporations.
Nearly All Shareholder Litigation Targeted, Not Just Unmeritorious Actions
Several commentators have observed that the version of fee-shifting seen in ATP (referred to herein as the ATP model), already appears to have become the template for fee-shifting provisions since the decision. Claudia H. Allen, Fee-Shifting Bylaws: Where Are We Now? at p. 2, Bloomberg BNA Corporate Law & Accountability Report (Jan. 16, 2015); John C. Coffee, Jr., “Loser Pays”: Who Will Be The Biggest Loser?, The CLS Blue Sky Blog (Nov. 24, 2014). However, the ATP model is problematic in that it does not limit fee-shifting to instances where there was no substantial justification for the action or where the action failed to provide a substantial benefit to the company. Instead, it applies broadly to any covered action where the plaintiff did not “obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought,” ATP, 91 A.3d at 556, an incredibly high standard for measuring success, which may require a trial victory on all accounts with full damages awarded. This standard has been interpreted as requiring “complete success.” “Loser Pays”: Who Will Be The Biggest Loser?, supra.
Requiring complete success is an overbroad and unworkable metric for a number of reasons. First of all, the Delaware Supreme Court already cautioned that “there might be difficulty applying the ‘substantially achieves’ standard.” ATP, 91 A.3d at 560. Moreover, the mere fact that a plaintiff did not obtain exactly, or “substantially,” what he sought to achieve, in both “substance and amount,” does not mean that the action was unmeritorious. More realistically, it could have been due to difficulty obtaining proof of wrongdoing dating back many years, or a failure to convince the trier of fact in a close case. Shareholders also often have to contend with exculpatory provisions that limit the liability of directors and officers and significantly raise shareholders’ burden in establishing liability, making complete success more difficult in the shareholder derivative context. Shareholders also face the burden of overcoming the business judgment rule. Another difficulty is that shareholders often seek corporate governance reforms, and it can be difficult to know at the outset of a case the exact form these will take by the end of the action. These reforms depend on the corporate governance and personnel in place at the company, all of which may potentially change during litigation. Thus, obtaining substantially all the corporate governance reforms sought in “substance and amount” would be difficult to evaluate, let alone achieve. This factor may tend to incentivize shareholder plaintiffs to seek less risky and less meaningful reforms so that their potential exposure is minimized. Further, a shareholder may be able to cause a company to implement all, or the majority, of the corporate governance reforms sought prior to the completion of the action, which, depending on the action, could be substantially all the relief sought. This could penalize shareholders who are able to cause the corporation to enact meaningful corporate governance reforms early on in the litigation, by leaving them exposed to paying the defendants’ attorney fees if they do not continue litigating.
Another troubling aspect of the ATP model of fee-shifting is that shareholders could be held responsible for fees unless they pursue the case through to “a judgment.” Yet judgments in civil litigation are increasingly rare—and particularly so in shareholder litigation. This model also fails to appreciate that litigation is fluid and that parties are constantly reassessing their cases as they progress. This is especially true for shareholder derivative actions where plaintiffs do not get access to formal discovery until after surviving a motion to dismiss. What might appear at first glance, with the benefit of an informal investigation and even an inspection demand, to be a very meritorious case could turn out to be otherwise once discovery begins. Additionally, what if a shareholder obtained most of the relief sought, against most of the defendants through settlement, but could not settle with every defendant? Plaintiffs would then be in the anomalous position of having received most of the benefits sought yet still facing liability for what could be substantial fees from the non-settling defendants, unless they pursued the case through to a judgment against them as well. This could give the most egregious wrongdoers extra bargaining power in derivative actions, allowing them to hold up otherwise valuable settlements. This imbalance of bargaining power is one of the main problems with fee-shifting.
Fee-Shifting Places Too Much Power in the Hands of Defendants
Among the reasons why fee-shifting makes derivative litigation incredibly risky is that it creates perverse incentives for defendants and gives them too much power. The stronger a plaintiff’s claim the more resources defendants could throw at the case—not only to defend the action but also to rack up massive legal fees to hang over the heads of plaintiffs as a bargaining chip. Defendants could focus their resources on one narrow aspect of the case to ensure plaintiffs could not achieve complete success. Similarly, plaintiffs hoping for a quick trial could be delayed over and over again, preventing them from receiving a “judgment on the merits” while defendants incur ever-increasing legal fees, thus exposing plaintiffs to increasingly more risk. Fee-shifting also disproportionately discourages difficult claims, even though they may be very meritorious. For example, plaintiffs may be dissuaded from bringing Caremark claims based on directorial failure of oversight, given that they are considered “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).
Defendants could also exert pressure on plaintiffs even in the investigatory phase of derivative litigation. Plaintiffs are often encouraged to investigate by using the “tools at hand,” including primarily books and records inspection demands made pursuant to Section 220 of the Delaware General Corporation Law (Section 220). King v. VeriFone Holdings, Inc., 12 A.3d 1140, 1147 & n.36 (Del. 2011). Yet if fee-shifting is applied to these tools, shareholders will have yet another barrier. The imposition of fee-shifting if shareholders do not receive any or all the books and records they requested could chill requests, causing shareholders to utilize these tools less frequently and making their demands more timid to ensure they are more likely to achieve complete success. This would directly contradict the Delaware Supreme Court’s preference, as expressed in King, that shareholder inspection demands be used liberally as an investigative tool. See 12 A.3dat 1145. Ironically, this could actually lead to more unmeritorious litigation, as some shareholders may not consider it worth the risk to pursue the limited documents they could receive in an inspection demand, where they hardly ever can recover fees.
Given the negotiating power fee-shifting puts in defendants’ hands, shareholders would face substantial financial risks; but even worse, these financial risks would be hard to assess. Shareholder derivative actions are complicated, often document intensive, and vigorously litigated. Moreover, because of the nature of the claims, there are often multiple sets of defense counsel—e.g., counsel for the company itself, counsel for inside directors, counsel for executives, etc.—which could potentially lead to higher attorneys’ fees and make it more difficult for a plaintiff to predict defense costs. Related actions can also impact the litigation in unpredictable ways by, for example, requiring litigation over motions to intervene or motions to stay, providing yet another layer of uncertainty to predicting potential exposure. This uncertainty, combined with the leverage given to defendants by fee-shifting, results in a powerful deterrent, particularly since shareholder plaintiffs already face a number of challenges in pursuing a derivative action.
Shareholder Litigants Already Face Hurdles that Deter Unmeritorious Litigation
This is not the first time that critics of shareholder actions have sought restrictions to curb litigation, and significant hurdles have already been put in place to deter unmeritorious claims. For example, shareholders seeking to represent the interests of a company and its shareholders in derivative litigation must make a demand on the company’s board of directors for the remedies they seek or establish that making such a demand would be a futile act. If shareholders attempt to establish that a demand was futile, they need to do so by utilizing informal investigation methods, without the benefit of formal discovery. Making matters more difficult for shareholder plaintiffs, courts require shareholders to produce pleadings that contain particularized facts establishing why a demand would be futile. These pleadings must detail why each director or a majority of the board of directors cannot impartially consider a demand. For actions involving Delaware corporations, one way shareholders can enhance their investigative efforts to achieve this level of particularized pleading is through a demand to inspect the corporation’s books and records pursuant to Section 220. While shareholders can obtain certain books and records through an inspection demand, the scope of such demands is limited in comparison to what would be available through formal discovery. E.g., Paul v. China MediaExpress Holdings, Inc., No. CIV.A. 6570-VCP, 2012 WL 28818, at *6 (Del. Ch. Jan. 5, 2012). Further, the process for obtaining these books and records presents its own set of hurdles, including identifying a proper purpose for the documents and establishing that the documents are “necessary and essential” to that proper purpose. Wal-Mart Stores, Inc. v. Ind. Elec. Workers Pension Trust Fund IBEW, 95 A.3d 1264, 1279–80 (Del. 2014). Often plaintiffs will have to go all the way to trial and potentially even appeal to enforce their right to inspect any documents at all or to ensure they are permitted to inspect all the documents they determine to be necessary to their proper purposes. This process can also take months, or even years, as in Wal-Mart. Additionally, shareholders are not typically entitled to fees for this process. Thus, the addition of fee-shifting to the shareholder derivative litigation landscape is unnecessary because it is already quite difficult to maintain a derivative action. And these are only the hurdles that a shareholder faces in trying to get past a motion to dismiss; litigating the action through to a successful verdict presents additional challenges.
Fee-Shifting Is an Overbroad Mechanism that Harms Shareholders
For all these reasons and more, fee-shifting is an overbroad idea that does not work. The approach tips the scales of justice too far in corporate fiduciaries’ favor, making it even more difficult for shareholders to address breaches of fiduciary duty. As stated by Norman Monhait, the head of the Corporation Law Section of the Delaware Bar, even if some consider there to be an excess of shareholder litigation, “a measure that potentially eliminates all such litigation could create serious concerns for the stockholders of Delaware corporations.” Del. Attys Push To Shield Stock Cos. From Fee-Shifting Ruling, supra. Fee-shifting makes derivative litigation, already a significant challenge for shareholders, into a herculean task akin to climbing Everest: a feat that few would even attempt because of the risks. Fee-shifting should be rejected in Delaware, and elsewhere, because it threatens to remove almost all the utility of the derivative action, a critical tool that shareholders can utilize to protect their investments when faithless fiduciaries who are supposed to be protecting shareholders’ interests fail to do so.