Leave it to a distinguished law professor to actually read the text of proposed legislation and locate the gaping hole in it. In this post, “Delaware Throws a Curveball,” Professor John Coffee analyzes the proposed Delaware legislation on fee-shifting bylaws and finds it wanting.

The proposed legislation would prohibit “any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an intracorporate claim….” “Intracorporate claims” are defined as “claims, including claims in the right of the corporation, that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity,” or as to which the corporation law confers jurisdiction on the Court of Chancery. For example, these would include  “claims arising under the DGCL, including claims of breach of fiduciary duty by current or former directors or officers or controlling stockholders of the corporation, or persons who aid and abet such a breach.”  For a discussion of the background of fee-shifting bylaws and related caselaw, as well as the proposed Delaware legislation, see this post .)

But, Coffee points out, the proposal “still leaves open the ability of board-approved bylaws to impose liability on shareholders in other contexts.” What types of actions are not covered? According to Coffee, “it does not cover federal securities class actions, which do not need to allege a ‘violation of a duty,’ but rather must allege a material misstatement or omission. Typically, the principal defendant in a securities class action will be the corporation issuer, itself, and officers and directors may not be named. Moreover, because a misrepresentation by a corporate officer may have been intended to benefit the corporate issuer, it did not necessarily violate a duty owed to the entity. Thus, read literally, the new legislation would not preclude a board-adopted bylaw that shifted the corporation’s and other defendants’ expenses against a plaintiff who lost (or was less than substantially successful) in a federal securities class action (at least so long as the action did not allege a ‘violation of a duty’ by any corporate officer or director).”

The omission of federal securities litigation from the legislation, he observes, could spur attentive counsel to craft fee-shifting bylaw provisions that apply except where prohibited under the proposed Delaware provisions.  Similarly, plaintiff’s counsel in securities litigation could add claims to complaints that assert “violations of a duty,” even where the claim does not legally strengthen the case, just to come within the ambit of the proposed Delaware amendments.

Coffee then speculates about whether this omission is unintentional or deliberate, concluding ultimately that there may have been good reason for Delaware counsel to craft the provision as is:

“Why? This is speculative and may sound cynical, but the Corporation Law Council may have wanted to cover only traditional ‘Delaware-style’ litigation (where the interests of the Delaware Bar on both sides were jeopardized if ‘loser-pays’ fee-shifting were to reduce the volume of such litigation). In contrast, securities litigation tends not to be brought in Delaware nor to involve Delaware counsel in most cases. If the goal was to protect the local Bar, nothing more needed to be done than to exempt ‘Delaware-style’ litigation from the impact of ‘loser pays’ fee shifting.”

While that may provide a reason for the focus on ‘Delaware-style’ litigation, it doesn’t explain why federal securities litigation was not covered: “Is there a reason why Delaware might deliberately not cover securities litigation? Here, one needs to consider Delaware’s persistent desire to preserve its market share in the competition for corporate charters.”  After all, fee-shifting provisions that offer protection in the event of securities litigation might have great appeal to companies deciding where to incorporate:

“Viewed realistically, corporate defense counsel are likely to feel far more threatened by securities class actions than by a traditional ‘Delaware-style’ litigation (which normally settles for non-pecuniary relief and often only for revised disclosures). In this light, the Delaware’s Corporation Law Council may have struck a very artful balance. That is, the proposed legislation may protect ‘Delaware-style’ litigation from the threat of fee-shifting, but not securities class actions. If corporate counsel can still use bylaws and charter provisions in Delaware to deter securities class actions, they will feel less inclined to move to rival jurisdictions. In short, Delaware may have found a compromise that protects the local Bar without threatening Delaware’s competitive position. The premise here is that defense counsel sees derivative actions as a nuisance, but securities class actions as a serious threat.”

Nevertheless, Coffee recognizes, companies may still be deterred from adopting fee-shifting bylaws designed to discourage securities litigation because of the harsh light in which proxy advisory firms, such as ISS and Glass Lewis, as well as some institutional holders view these types of unilaterally adopted provisions. Although, he suggests, companies may be able to deflect some of that scrutiny by adopting fee-shifting provisions pre-IPO when shareholders will have bought into the idea, ISS at least has made clear that, in assessing bylaw and charter changes at pre-IPO companies, ISS will consider the timing of the adoption of provisions that diminish post-IPO shareholders rights. In the end, Coffee predicts fee-shifting bylaws will still be adopted by companies that have less reason to be concerned with ISS, such as companies with controlling shareholders.

In addition, Coffee analyzes whether the federal courts would uphold bylaw provisions mandating fee-shifting or view them as preempted by the federal securities law.  Here, the key question is whether the purpose of Congress would be frustrated by the state law provisions that implicitly authorize adoption of fee-shifting provisions where not otherwise prohibited.  Here, he concludes that there are two important federal policies in the PSLRA that could be viewed to be frustrated by fee-shifting bylaws. First, one purpose of the PSLRA was to “shift control of the securities class action from nominal ‘in-house’ plaintiffs, who held possibly only 100 shares but who had sued in hundreds of cases, to institutional investors who had a real stake in the action and could monitor class counsel.” However, a typical “lead plaintiff,” such as a large pension fund, is unlikely to want to risk potential losses in a “loser pays” context, particularly where the probable recovery is not large, but the defendant’s expenses could be. “Ironically,” he notes, “the one party who could rationally serve as a lead plaintiff under a ‘loser pays’ rule will be the judgment-proof, nominal plaintiff with no assets.” The second policy lies in the sanctions provision of the PSLRA.  In contrast to typical fee-shifting provisions, the PSLRA sanctions provision can impose liability for fees on either side and only for culpable behavior, a more moderate balanced result that may be frustrated by the harsher impact of “loser pays” provisions. Nevertheless, the preemption caselaw is not entirely clear, and, Coffee suggests, federal courts may view the prohibition of fee-shifting in Delaware-based litigation, while tolerating it in federal litigation, as “burden[ing] federal litigation with a fee-shifting rule that does not apply in Delaware. To many federal courts, this may look as if Delaware is discriminating against federal litigation.”

One possibility that Coffee does not address in his post is that the SEC may step in to preclude the use of fee-shifting bylaws in connection with federal securities litigation.  Perhaps prompted by prior testimony of Coffee at a meeting of the SEC’s Investor Advisory Committee, where he asked why the SEC was “sitting on the sidelines” on this issue (see this post), SEC Chair Mary Jo White has previously expressed concern “about any provision in the bylaws of a company that could inappropriately stifle shareholders’ ability to seek redress under the federal securities laws. 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, as it did with indemnification under the Securities Act….” Now, she explained, the staff is focused on making sure that there is adequate disclosure: “Shareholders should be fully informed of a company’s efforts to affect their ability to seek redress so that the issue can be considered in voting and investment decisions.” But that could easily change in the future.