Delaware and the federal courts have been on a collision course since 2014 when the Delaware Supreme Court upheld the facial validity of a corporate bylaw that shifted the corporation’s (and all defendants’) legal expenses to a losing plaintiff. That 2014 decision, ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A. 3d 554 (Del. 2014), quickly led a number of public corporations to adopt similar “loser pays” bylaws and charter provisions, all of which are one-sided provisions (that is, only the plaintiff may be held liable) and most shift the fees against the plaintiff even if it wins (unless it is “substantially successful,” which is defined to mean recovering significantly on all its claims and theories).
But the ATP Tour decision also sparked a counter-reaction, as the Delaware State Bar Association has twice recommended a bill to the state legislature to repeal the decision. The current bill, which passed the Delaware Senate in May, would forbid any charter provision or bylaw that imposes liability on a stockholder for the attorney fees or expenses of the corporation or any other party in connection with “internal corporate claims.” Curiously, however, the proposed Delaware legislation is incomplete and will only partially repeal the ATP Tour decision. The Delaware State Bar’s bill narrowly defines its critical term “internal corporate claims” to mean “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.” This language clearly reaches derivative actions, but is ambiguous with respect to the securities class action (which need not be based on a breach of duty by any officer or director, but only on a misrepresentation or omission of a material fact by the corporation). This under-inclusive definition appears purposeful and not simply a negligent omission.
Why then does the proposed legislation only partially overrule the ATP Tour decision? This is speculative, but it could be that the Delaware bar cared only about the cases that they typically litigate in state court (and did not want to dry up). Corporate litigation is, after all, the leading industry in Delaware. Also, it could be that by allowing fee-shifting in securities class actions, Delaware can better compete for market share in the market for corporate charters with those other jurisdictions that will place no limit on fee-shifting provisions (Nevada, for example, is likely to tolerate fee-shifting bylaws in all cases). Whatever the intent, the effect is clear: federal securities class actions are not clearly covered. In some cases, plaintiffs may assert that there was a breach of duty by an officer, but it is hard to attribute an omission to anyone. More importantly, if the case is lost, it may be clear from the decision that there was no breach of duty.
Thus, the future holds the following possibilities: (1) the Delaware State Bar’s legislation seems likely to pass, in which case the ATP Tour decision could serve as the basis for the adoption of fee-shifting provisions applicable to federal securities actions (class or individual); (2) the Delaware courts could still find that fee shifting by means of a bylaw or charter provision cannot apply to the “personal” claims of a shareholder, in which case “loser pays” fee shifting would be entirely precluded in Delaware; and (3) corporations outside of Delaware can adopt (and have adopted) similar fee-shifting provisions and will seek to enforce them against plaintiffs who sue in federal court. So long as this ambiguity persists, plaintiffs will probably go out of their way to allege some breach of duty by an officer in connection with the corporation’s misrepresentation or omission. Still, if the case is lost, this claim may be unsustainable. One issue unavoidably arises: Can one-way fee-shifting apply in federal court based on state law authorization of such bylaw and charter provisions?
This situation is unique. States have rarely attempted to specify the procedural rules that apply in federal court, and when they have tried, they have often been rebuffed. In Wayman v. Southard, 22 U.S. (10 Wheat.) 1 (1825), the Supreme Court ruled that Congress cannot delegate its responsibility for framing the basic rules that apply in federal court to others. This result has come to be known as the “Anti-Delegation Doctrine.” It would nowhere seem more applicable than in the case that would arise if the pending Delaware legislation passes. Then, Delaware would essentially be authorizing for federal cases a fee-shifting rule that it rejects within its own borders. That offends not only the Anti-Delegation Doctrine but also the “rule against chutzpah”: Don’t do unto other jurisdictions what you will not do in your own.
Still, there have been occasional cases that have found state procedural rules to apply in federal court. In Cohen v. Beneficial Indus. Loan Corp., 337 U.S. 541 (1949), the Supreme Court held that a New Jersey statute requiring the plaintiff in a derivative action to post a “security for expense” bond applied in federal court as well, even though there was no similar federal rule. The Court reached this result by finding the statute intended to regulate corporate governance, rather than procedure. Conceivably, the same argument could be made with respect to a fee-shifting provision: namely, that the statute was intended to protect the corporation (and its officers and directors) from frivolous litigation, not to regulate procedure.
Yet even if this distinction can be drawn, the next question becomes whether the state statute conflicts with the policies underlying the federal securities law (and is therefore preempted). Because express preemption is not here applicable, a preemption claim must be framed to allege either “field preemption” or “obstacle preemption.” “Field preemption” recognizes that there are some contexts where Congress has so dominated the field as to leave little or no room for state action. "Obstacle" preemption instead looks to whether the state rule creates a substantial obstacle that frustrates a Congressional policy. No bright-line division separates these two doctrines, and the "cornerstone" of both doctrines is that the "purpose of Congress is the ultimate touchstone in every preemption case." See Hillsborough City Fla. v. Automated Med. Labs., 470 U.S. 707, 711 (1985).
Although a plausible argument can be made for field preemption because the Private Securities Litigation Reform Act (PSLRA) comprehensively prescribes standards for securities class actions, let’s consider only the easier case for “obstacle prevention.” Here, the PSLRA expresses at least two important federal policies that may be frustrated by a "loser pays" rule.
First, a major goal 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. It did this by creating a presumption that the "lead plaintiff" (PSLRA’s term) would be the person or group with the largest stake in the action. As a direct result, public pension funds are now the most common "lead plaintiffs" in securities class actions (but not in other class action contexts). Now, look what happens under a "loser pays" rule. The public pension fund owes its first duty to its pensioners. It knows that around half of securities class actions are dismissed before trial, and thus it would face liability in at least that percentage of the cases—and maybe more if the "loser pays" provision required (as most do) that the plaintiff be "substantially" or "completely" successful on all its theories to avoid fee-shifting. Moreover, there is a substantial asymmetry between the pension fund's likely gains and losses. If there is a settlement, plaintiffs have historically received 1–3 percent of their market losses (in terms of the decline in the stock's equity market capitalization). But if the case is lost, the pension fund, as the lead plaintiff, would be jointly and severally liable for all the corporate defendants’ expenses, which in a securities class action could often and easily exceed $10 million. Thus, as a fiduciary to its pensioners, the public pension fund would have difficulty accepting a 50 percent chance of such a liability (and an even higher risk under a "substantial success” standard) in return for a 50 percent (or so) chance of recovering 1–3 percent of its market losses in a settlement.
Conceivably, class counsel could agree to indemnify the public pension fund serving as lead plaintiff, but this is uncharted territory. It is not clear today, as a matter of professional ethics, whether counsel can cover the fee-shifting losses of its client. Even if it could, the law firm could become insolvent and thus unable to pay. If insurance can be obtained, it may only be available with large coinsurance or deductible provisions. As a result, many pension funds may prove unwilling to accept this risk and will no longer serve as lead plaintiff, thereby frustrating the original intent in the PSLRA.
Ironically, 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. A plaintiff's law firm could arrange to give a few shares to a number of otherwise asset-poor plaintiffs, and they could serve as lead plaintiffs (if no one else was willing). In short, we would have come full circle from an original environment of nominal plaintiffs to one of substantial plaintiffs capable of monitoring counsel and then finally back to the starting point. If this happened, Congress's intent would again be frustrated.
A second congressional policy that would be frustrated is that set forth in §21D(c) of the Securities Exchange Act of 1934, which was added by the PSLRA. Captioned "Sanctions for Abusive Litigation," it specifically addresses the problem of frivolous litigation, but in a different and more balanced fashion. Essentially, it provides that at the conclusion of a securities case, the court must make findings as to whether both sides have complied with Rule 11(b) of the Federal Rules of Civil Procedure. If the court finds a violation by either side, then §21D(c)(2) provides that sanctions in some form are mandatory, and §21D(c)(3) creates a presumption that the appropriate sanction is to shift the opposing side's "reasonable attorney fees" to the side that violated Rule 11(b). But §21D(c)(3)(A)(ii) requires that the court first find a "substantial failure" to comply with Rule 11(b) in the case of a claim that the complaint was so deficient as to flunk Rule 11(b)'s standards. Even then, the presumption favoring fee-shifting is rebuttable under §21D(c)(3)(B) if the court finds that the amount so shifted would “impose an unreasonable burden” and be “unjust.”
From a bottom-line perspective, what are the real differences between §21D(c) and a "loser pays" rule? First, the PSLRA provision is two-sided, while "loser pays" provisions are invariably to date one-sided, applying only to the plaintiff. Second, while a "loser pays" bylaw is automatic, §21D(c) relies on judicial discretion and interposes the court before any penalty is imposed. Third, §21D(c) requires not simply a technical failure, but a "substantial failure" in the case of a claim that the complaint was frivolous. Fourth and finally, excessive fee-shifting that imposes an “unreasonable burden” is to be avoided. In sum, Congress in the PSLRA decided to impose sanctions only for culpable behavior (and only for a "substantial failure"), whereas sanctions are automatic under a "loser pays" rule (even when the plaintiff is largely successful under the popular "substantial success" language in the typical "loser pays" formula).
Put differently, Congress opted to use a scalpel (possibly to preserve the viability of meritorious securities class actions), while corporations that adopt "loser pays" provisions are choosing the bludgeon. The broader sweep and harsher impact of such "loser pays" provisions arguably frustrates the more moderate balance that Congress intended to strike.
All that said, there have been a few decisions that have upheld fee shifting against the plaintiff in federal court based on a state statute. In Smith v. Psychiatric Solutions, 705 F. 3d 1253 (11th Cir. 2013), a fired employee brought a retaliatory discharge action in federal court, alleging violations of both the Sarbanes-Oxley Act (SOX) and the Florida Whistle-blower’s Act. She lost, and the district court awarded attorney fees to her employer on the basis of the Florida statute. On appeal, the Eleventh Circuit rejected her claim that SOX preempted Florida law and precluded fee shifting. It found that SOX said nothing about fee shifting. However, before one reads too much into this decision, one needs to realize that the Florida statute gave discretion to the court to determine if attorney fees should be shifted (and thus did not mandate fee-shifting as a “loser pays” rule would do). Also, the PSLRA speaks much more clearly than SOX to the issue of when fees should be shifted, and thus its goals can be frustrated even when SOX’s goals are not.
Assuming that the pending Delaware legislation passes, will it lead public companies to give up on fee-shifting? Probably not. Many will amend their bylaws to carve out “internal corporate claims” but still attempt to assert fee-shifting provisions in securities, antitrust, or RICO cases. Also, non-Delaware corporations will have increased incentive to adopt such “loser pays” provisions because they may hope to gain market share from Delaware in the market for corporate charters. Still, there is a downside to such attempts. The major proxy advisers—Institutional Shareholder Services (ISS) and Glass Lewis and Co.—have updated their proxy guidelines this year to indicate that they will oppose the reelection of directors who “unilaterally” adopt such a bylaw without a shareholder vote. In an era of heightened hedge fund activism, this is a powerful deterrent. Of course, some firms—especially those with controlling shareholders—may not fear ISS and could adopt such a provision. Also, if a non-Delaware corporation that is planning an initial public offering places such a provision in its certificate of incorporation, shareholders who buy in this offering have arguably accepted the provision.
At last count, about 73 public companies in at least nine different jurisdictions have adopted “loser pays” provisions (as of May 2015). This number may increase as non-Delaware and foreign jurisdictions authorize or uphold such bylaws. The critical variable will be the SEC’s attitude. It has long refused to approve or “accelerate” the registration statement of a company with a mandatory arbitration provision, but, until recently, it has expressed no position on “loser pays” fee shifting. In March, however, SEC Chairman Mary Jo White gave a speech at the Annual Tulane University “M and A” Conference, in which she expressed strong skepticism about fee shifting provisions adopted by board action. If it wanted, the SEC could effectively halt the use of such provisions.
Events still have to play out. Stay tuned!