Let Corporations Shift Fees in Shareholder Suits

In Sunday’s New York Times, Gretchen Morgenson bemoans the Delaware Supreme Court’s recent decision permitting corporations to adopt bylaws that shift the costs of unsuccessful shareholder litigation to those who bring the suit. Such rules allow a corporation that prevails in a shareholder suit against corporate malfeasance to collect attorneys’ fees.  She quotes only experts who share her views that Delaware law should be amended to prevent such fee shifting provisions.

But my initial review of the issue suggests that it would be a mistake to immediately prohibit such bylaws.  Substantial agency problems arise between the class action lawyers who typically bring such shareholder suits and the shareholders who are supposed to benefit. Lawyers are thus more likely to bring suits that have no merit for shareholders, particularly because they can shape settlements to provide profits for themselves in the form of high attorneys’ fees. (Corporations face high litigation costs and risks of adverse publicity that may encourage  settlements even of suits without merit).  The shareholders then often bear this expense. The corporation’s money is ultimately theirs.

The fee shifting bylaw will strengthen the position of the corporation in negotiations with class action lawyers, who will now effectively face higher litigation costs if they lose. Consequently, fewer frivolous lawsuits may be filed. It is true that the rule may also deter some meritorious suits, but the rule can still be a good one if the net effect helps shareholders. The question is whether it is more likely that the corporation will choose a rule on litigation costs that will more likely benefit their own shareholders than  the general American rule in litigation under which each side bears their own costs.

In my view, corporations are likely to make the better choice about whether a fee shifting rule should be adopted or not for their particular sets of lawsuits.  Shareholders and corporations share common interests in deterring frivolous lawsuits.  To be sure, corporate officials, unlike shareholders also want to avoid meritorious ones.  But their ability to adopt a litigation rule that unduly favors their interests is limited by the power of shareholders. First, a majority of  shareholders can amend the bylaw and eliminate fee shifting.  (As Professor Stephen Bainbridge notes, there is uncertainty about whether a board of directors could then overturn shareholders’ amendment under Delaware law. I think here Delaware law should indeed be amended to permit shareholders to prevent such a back and forth). Second, shareholders can take account of the rule in their decision to buy or sell the stock, and institutional shareholders with large holdings can make this more than a theoretical possibility, bringing pressure to choose the better rule.

Over time, we can also learn about the results of different fee shifting rules—learning that will not occur if such fee shifting rules are immediately  prohibited. This new development lets markets and researchers assess whether the structure for shareholder litigation can be improved.