Draft Minutes of October 9, 2014 Meeting

Appendix One:  Testimony Submitted by Professor Larry Hamermesh of Widener University School of Law

Appendix Two

Testimony of Professor John C. Coffee Jr.,

Adolf A. Berle Professor of Law,

Columbia University Law School

And

Director of its Center on Corporate Governance

Before

SEC Investor Advisory Committee,

Securities and Exchange Commission,

Washington, D.C.

October 9, 2014

“Fee-Shifting Bylaws: Can

They Apply in Federal Court?—

The Case For Preemption”

            Beginning this year, a number of public corporations (including the recent Alibaba IPO) have adopted bylaws or charter provisions that shift the corporation’s costs and expenses in shareholder litigation to the plaintiff shareholder if the latter is unsuccessful (or, in some cases, is less than completely successful[i]).  In effect, this is a one-way “loser pays” rule imposed by a board-adopted bylaw.  These new bylaws derive from a 2014 decision of the Delaware Supreme Court, ATP Tour, Inc. v. Deutscher Tennis Bund,[ii] which found a particularly sweeping bylaw adopted by a Delaware non-stock corporation to be “facially valid.”  That decision makes clear that a fee-shifting bylaw can be enforceable under Delaware law and applicable to shareholders who acquired their shares both before and after the bylaw was adopted, but it further noted that a legally permissible bylaw that is adopted for an “improper purpose” will be unenforceable in equity.  This limitation is an application of the familiar Delaware rule, first stated in Schnell v. Chris-Craft Industries,[iii] that powers legitimately possessed may not be used for an inequitable purpose.  Although the number of companies adopting such a bylaw is still small (I have a list of 24 examples, all adopted since May, 2014), the trend is accelerating, and many more companies would be likely to follow their lead if doubts about the enforceability of such a bylaw can be resolved in its favor.

            So where does that leave us?  The Delaware legislature may yet act to bar or limit fee-shifting bylaws.[iv]  Delaware may be motivated to act by the very plausible fear that such bylaws will reduce the volume of litigation in Delaware courts and thereby adversely affect Delaware’s leading local industry (i.e., corporate litigation).  But even if Delaware were to act, the issue would still not disappear, both because Delaware might only modestly limit the use of such bylaws and because corporations incorporated in other jurisdictions may adopt similar bylaws (and the prestige of the Delaware Supreme Court may lead other courts to accept its ruling, even if the Delaware legislature were to reverse or amend it).  This brief memorandum will not attempt any brief-like statement of the complicated case law on preemption,[v] but will focus instead on the policy issues and the need for SEC action.

            As our starting point, the initial question is: when will the Delaware Chancery Court (in the absence of new legislation) find that a fee-shifting bylaw was adopted for an improper purpose?  Here, a particularly relevant statement in ATP Tour, Inc. is that:

“The intent to deter litigation, however is not invariably an improper purpose. Fee-shifting provisions, by their nature, deter litigation. Because the fee-shifting provisions are not per se invalid, an intent to deter litigation would not necessarily render the bylaw unenforceable in equity.” 91 A. 2d at 560.

Although it is certainly conceivable that a bylaw adopted after a specific corporate transaction was initiated by the board (or even after a lawsuit challenging the transaction had been filed) could be seen as a self-interested and “improper” attempt by the board to immunize itself, it is far less likely that a fee-shifting bylaw adopted well in advance of the transaction would be similarly invalidated—at least by Delaware courts.  To be sure, the Delaware Supreme Court did not need to address these questions because the ATP Tour case came to it as a certified question from another court, and it properly limited itself to questions of law.  Nonetheless, within Delaware and absent legislation, the message of ATP Tour seems clear: fee-shifting will be upheld unless evidence of bad faith or improper purpose can be shown.

1. Fee-Shifting Bylaws in Federal Court

But what is the status of such a board-adopted bylaw in federal court? Here, it is important to note that the ATP Tour case was in fact brought in federal court in Delaware.  The plaintiff lost at trial,[vi] and the defendant moved for its costs pursuant to the bylaw.  The District Court denied this motion, effectively ruling that federal law preempts the enforcement of fee-shifting agreements when antitrust claims are involved.[vii]  But the Third Circuit reversed the District Court’s order, ruling that before addressing federal preemption issues, the District Court should have first determined whether the bylaw was enforceable under state law.[viii]  In fact, the Third Circuit expressed skepticism that the bylaw was enforceable under Delaware law.[ix]  On remand, the District Court certified this question of the bylaw’s enforceability under Delaware law to the Delaware Supreme Court.

With that initial question now resolved, the focus now shifts back to the preemption issue.  In general, federal courts have refused to enforce state law penalties intended to deter frivolous litigation.  In a leading case, Burlington Northern Railroad Company v. Woods,[x] a tort action was removed by the defendant from Alabama state court to federal court, where the defendant lost at trial and then appealed, posting a mandatory bond to stay the judgment.  On affirmance of the decision below, the Eleventh Circuit granted plaintiff’s motion for a mandatory penalty of 10% of the judgment amount, based on an Alabama statute that sought to deter frivolous appeals by imposing an automatic 10% penalty.  The Supreme Court reversed, finding that the Alabama statute had no application to a case in federal court (even when removed to federal court based on diversity jurisdiction).  Following its leading precedent of Hanna v. Plumer,[xi] the Supreme Court held that federal procedural rules applied in federal court.  Further, it noted a conflict between the Federal Rules of Civil Procedure (which permit a court in its discretion to impose a penalty for a frivolous appeal) and the Alabama statute (which made the penalty mandatory, whether the appeal was frivolous or not).

If we assume Burlington Northern to govern, the same conflict arguably exists between mandatory fee-shifting under a bylaw and the discretionary sanctions authorized for frivolous litigation by Federal Rule of Civil Procedure 11.  Yet, other decisions have applied state law requirements that amount in substance to fee-shifting in federal court.[xii]  In any event, before one concludes that federal law should preempt state law on this issue, one must focus on a critical difference between Burlington Northern and the case of a fee-shifting bylaw.  Fee-shifting under ATP Tours is not based on a state statute, but on a contract.  Indeed, the Delaware statute authorizing broad bylaws is no different from that of any other state jurisdiction.  Rather, under standard “black letter” corporate law, bylaws set forth a contract among the shareholders.  From this perspective, the fee-shifting bylaw is the same as an indemnification provision in which one party by contract agreed to pay the other’s legal expenses (at least under certain circumstances.)  In fact, the ATP Tour decision emphasizes that contractual agreements are an exception to the usual American rule on fee-shifting (under which each side bears its own legal expenses) that Delaware normally follows.

Hence, the Supreme Court’s standard position that federal procedural rules apply in federal court (and state procedural rules do not) might be sidestepped here if we view the bylaw as simply a contract among the parties.  But again one cannot stop at this point either—for at least two reasons.  First, federal courts have held that some contracts for indemnification are unenforceable because they conflict with the policies underlying specific federal statutes.  The leading such decision is Globus v. Law Research Service, Inc.,[xiii] in which the Second Circuit denied indemnification to an underwriter who had knowledge of the misstatement because, it said, such indemnification would be contrary to the policies underlying the federal securities laws.  Second, in Atlantic Marine Construction Co., Inc. v. United States District Court for the Western District of Texas,[xiv] the Supreme Court held in 2013 that contractual provisions among the parties do not supercede the Federal Rules of Civil Procedure but must be interpreted in a manner consistent with them.  In Atlantic Marine, the parties had agreed to a forum-selection clause providing that all disputes would be litigated in Virginia.  Yet, when a dispute arose, the plaintiff sued in Texas, and the defendant sought to have the case either dismissed or, in the alternative, transferred to federal court in Virginia.  Both the district court and the Fifth Circuit refused to do either, ruling that 28 U.S.C. §1404(a) was the exclusive mechanism for enforcing a forum-selection clause.  Both further concluded that the district court had to undertake a balancing-of-interests analysis.  On appeal, the Supreme Court partially disagreed.  Although it found that Section 1404 (and not the contract, itself) governed, it held that the District Court’s analysis improperly placed the burden on the defendant to prove that the requested transfer was appropriate.  Instead, it said the burden was on the plaintiff, as the party “flouting” its contractual obligations, to show that public-interest factors overwhelmingly disfavored the requested transfer to Virginia:

“Only under extraordinary circumstances unrelated to the convenience of the parties should a §1404(a) motion be denied.”[xv]

Because there was no preemption issue in Atlantic Marine, its relevance is limited, but it does have two implications: (1) contracts governing litigation are not necessarily enforced as written but must be interpreted through the prism of the Federal Rules of Civil Procedure; and (2) public policy questions may retain some modest relevance, even when there is no federal statute involved.  On this basis, a forum selection bylaw requiring  federal securities class actions to be brought in a preferred federal forum (for example, federal district court in Delaware) is likely enforceable, but will have to be implemented by means of Section 1404.

Atlantic Marine implies that fee shifting bylaws must at least be consistent with the Federal Rules of Civil Procedure, and these rules address the award of attorneys fees in Rules 54(d)(2) and 23(h).  Under Rule 54(d)(2)(C), the court must give a party “an opportunity for adversary submissions on the motion in accordance with Rule 43(a) or 78” and the court “must find the facts and state its conclusions of law as provided in Rule 52(a).”  Under Rule 23(h), the court must hold a hearing and any class member may object to the motion.  These restrictions are minimal, but they do provide a hearing at which the SEC could appear.

2. Is One-Sided Fee-Shifting Inconsistent With the Policies Underlying the Federal Securities Laws?

To ask this question is not to answer it.  The specific bylaw needs to be considered to determine the extent of the burden.  Most bylaws will presumably require a losing shareholder who sued the company unsuccessfully to pay indemnification, but some go even further and require the plaintiff to be completely successful (or face fee-shifting).[xvi]  Most (if not all) such bylaws will not pay the successful plaintiff’s fees or expenses.[xvii]  Such bylaws thus have two key faults: (1) they are one-sided in that they reimburse successful defendants, but not successful plaintiffs (thus, they are unlike the English Rule which shifts fees both ways evenly); and (2) they require fee-shifting even in cases that were reasonable or even meritorious (but lost on a technical legal defense or possibly were largely, but not entirely, successful).  These deficiencies may not seem as egregious as indemnifying a knowingly culpable defendant (which was the fact pattern in Globus), but they may do more to deter and chill private enforcement of law.  Inherently, defendants’ fees and expenses will often exceed plaintiffs’ expected fee award (in part because there tend to be multiple counsel representing the various defendants), and thus plaintiffs’ attorneys must accept a potential liability greater than their potential gain.  Since at least J. I. Case Co. v. Borak,[xviii] federal decisions and the SEC have asserted that private enforcement of law is a “necessary supplement” to public enforcement by the SEC and the Department of Justice.[xix]  Although the Supreme Court’s attitude may be less certain on this point today and clearly it will no longer imply a federal private cause of action, absent clear legislative direction, the Court has still shown itself unwilling to dismantle Rule 10b-5 class actions.[xx]  The SEC has not formally retreated from its support for private enforcement, but this issue will put its resolve to the test.

The case for preemption of fee-shifting bylaws is further strengthened in the context of the federal securities laws because Congress has struck a special balance in this area.  This balance recognizes that fee-shifting against the losing side may be appropriate, but requires judicial oversight.  Under Section 21D(c)(3) of the Securities Exchange Act of 1934 (which provision was added by the Private Securities Litigation Reform Act of 1995), a presumption in favor of fee-shifting is created if any motion or pleading fails to comply with Rule 11(b) of the Federal Rules of Civil Procedure.  This approach is two-sided and equally punitive to both sides in making full fee-shifting (rather than a lesser financial sanction) the presumptive penalty.  Because this approach is tougher and more punitive than the normal approach under Rule 11 of the Federal Rules (which would typically involve lesser financial sanctions), it represents a carefully focused federal policy that is in sharp conflict with automatic and one-sided fee-shifting without any role for judicial discretion.  Effectively, bylaws can turn a Congressionally-mandated system of two-sided fee shifting that is dependent on judicial discretion into an automatic system of one-way fee-shifting.

Bottom Line: Although there may be a case for preemption of fee-shifting bylaws in many contexts, this case is stronger in the case of securities litigation.

3. What Should the SEC Do?

The SEC could take a number of steps, all consistent with past practice.  First, the SEC could assert the case for preemption selectively as an amicus curiae in cases where no violation of Rule 11 seemed present.  This will require some careful case analysis by the SEC and should not be an automatic response.  Alternatively, the SEC could assert that automatic fee-shifting is always in violation of the Securities Exchange Act, unless it is predicated on a judicial finding that Rule 11 was violated.  This would be more controversial and it might involve the SEC seeking to defend a less-than-attractive plaintiff’s attorney.

Second, the SEC has in a closely related area refused to accelerate registration statements where the company’s certificate of incorporation or bylaws contained a mandatory arbitration clause.  This threat seems to have been effective.[xxi]  Yet, the SEC has not held up registration statements with fee-shifting provisions.  This is inconsistent.  Functionally, the two cases are equivalent, because both provisions effectively bar private enforcement.

Third, the SEC could require registrants to state in their registration statements that they understand that the SEC believes that the federal securities laws are inconsistent with fee-shifting bylaws.  Such a statement is already specified in Forms S-1 and S-3 with respect to indemnification provisions.[xxii]  This at least imposes an embarrassment cost on the issuer and alerts courts to the SEC’s views without the need for an SEC amicus position.

Finally, the SEC is uniquely positioned to gather relevant data.  In assessing the impact of fee-shifting bylaws, it would be useful to know what the average costs are that defendant firms incur on such litigation and that they would seek to shift.  The impact on the typical plaintiff’s firm could also be evaluated empirically.  Similarly, the SEC could assess whether insurance could alleviate this problem (if it were available) and at what cost.  Lastly, if Delaware were to impose partial curbs (permitting only some limited fee shifting), the SEC could assess the likely empirical impact of such a modified fee-shifting bylaw.

Conclusion

The impact of fee-shifting bylaws could be decisive.  The defendant’s expenses in a securities class action can easily exceed $10 million, and this amount would bankrupt many smaller plaintiff’s law firms.  It is questionable (and certainly unresolved) whether plaintiff’s law firms could obtain liability insurance to cover these amounts.  Even if a bold plaintiff’s law firm did sue, it would likely have to agree to indemnify the class representative from fee-shifting, and some class representatives might decline the position, fearing that the plaintiff’s firm could not fully protect them. 

As the case proceeded, the defendant’s expenses will progressively mount, increasing the potential penalty.  This will predictably force cheaper settlements, thereby injuring the class.  If fee-shifting bylaws are upheld, defendant issuers should logically regard them as a riskless move that has little downside.  Probably, proxy advisors would object to such board-adopted bylaws,[xxiii] but this is not the kind of board action that could easily fuel a proxy contest or be easily overturned by a shareholder vote.[xxiv]  As a result, such bylaws, if upheld, will predictably become widely prevalent.

Bottom Line: For the short-term, the ball is still in Delaware’s court while its legislature considers possible curbs.  Although the SEC need not oppose all fee-shifting provisions adopted through board or shareholder action, it must be prepared to take on open-ended and more sweeping bylaws—or concede the decline of private enforcement.

Final Thought:  If Delaware does act to restrain fee-shifting through bylaws, the potential for a “race to the bottom” arises.  Other states of a more conservative bent (consider, for example, Texas) might accept or even endorse fee-shifting bylaws.  At this point, some corporate lawyers will predictably advise their clients to reincorporate in Texas, and many IPO issuers might prefer to incorporate in Texas initially.  Even if small changes in corporate law will not produce a migration into or away from Delaware, this difference is a major one because it protects corporate managers and directors from potential personal liability.  In this light, an SEC announcement that it will challenge fee-shifting bylaws would chill interstate charter competition over protective bylaws (and might even be welcomed in Delaware).

---

---