A Delaware Court Decision Threatens Effective Enforcement of Our Nation's Securities Laws, While the SEC Stands Idly By

A recent Delaware court decision is threatening shareholders' ability to hold corporations and their executives accountable for corporate malfeasance, and the Securities and Exchange Commission (SEC) is standing on the sidelines doing nothing to address the problem.

Because the majority of publicly traded companies are incorporated in Delaware, Delaware courts often set standards for what corporations are permitted to do. In May, the Delaware Supreme Court ruled that a corporation's board of directors can unilaterally amend the company's bylaws to include a "loser pays" provision that shifts all litigation expenses to a plaintiff who sues the company for intra-corporate wrongdoing, and does not obtain a judgment "that substantially achieves, in substance and amount, the full remedy sought." In other words, you could go into court, prove your case, be awarded damages and, if that award is "substantially" less than the amount you sought, end up paying the corporation's legal fees -- fees that could be many times greater than the amount of your award.

As a general rule in the United States, parties pay their own attorneys' fees, but they can agree by contract to obligate the losing party to pay the winning party's fees. Because corporate bylaws are considered "contracts among a corporation's shareholders," shareholders can be bound by the company's bylaws, regardless of whether the shareholders actually approve them. While the watershed case in Delaware considered the application of a fee-shifting provision in a non-stock corporation's bylaws, there is nothing in the opinion that suggests the ruling was limited to those facts.

Stock corporations and their legal counsel apparently agree. More than two dozen stock corporations have changed their bylaws since the decision, and renowned securities law professor John Coffee predicts that those are the "first trickle of water through a leak in a dam."

For a company looking to insulate itself and its board of directors and executives from being held accountable for their actions, changing company bylaws to include a fee-shifting provision is a no-brainer. These provisions are entirely one-sided in favor of the companies that draft them. Specifically, they apply in only one direction, with the plaintiff shareholder paying the defendant corporation. And, as noted above, they may require a plaintiff shareholder to obtain a judgment "that substantially achieves, in substance and amount, the full remedy sought." While it is not entirely clear what constitutes being "substantially" successful, it is likely that winning one out of three claims, or obtaining a judgment for $1 million out of $3 million sought--each considered a victory in any reasonable sphere--might not be substantial enough. That would mean the winning plaintiff shareholder would still be considered the "loser" under the provision and have to pay the defendant corporation's legal fees.

The clear intent of these provisions is to erect virtually insurmountable barriers that immunize companies and their management from having to answer to their shareholders for their conduct, egregious as it may be. Knowing that in all likelihood a plaintiff shareholder will be footing the ultimate bill, a defendant company is likely to engage in a war of attrition, dragging on cases interminably and racking up exorbitant legal fees. With the threat of having to pay those astronomical fees, no reasonable shareholder is likely to bring suit, no matter how meritorious his or her claim.

Fee-shifting provisions may insulate companies and their management from being held accountable for wrongful conduct to shareholders arising under state claims. For example, fee-shifting provisions could effectively bar suits under Delaware common law when companies' boards of directors breach their fiduciary duties by failing to exercise reasonable care or by engaging in self-dealing transactions. Without the risk of being held accountable for their wrongful conduct, directors will be more likely to engage in wrongful conduct, especially if that conduct is financially beneficial to them.

Fee-shifting provisions also may insulate companies from being held accountable for violating federal securities laws. Under federal securities laws, registered companies are required to provide accurate and timely disclosure of material information about their businesses and the securities that they are offering. A company that fails to make adequate disclosures can be held liable by an investor who has suffered harm as a result of the inadequate disclosures. However, fee-shifting provisions could effectively bar shareholder securities suits. For example, a company could make a material misstatement or omission in its registration statement, or defraud investors into buying its securities, and not face liability. Thus, the presence of a fee-shifting provision could nullify private enforcement of the federal securities laws, weakening investor protections and undermining the integrity of our nation's capital markets.

Given the SEC's stated goal to foster and enforce compliance with the federal securities laws, it has a clear interest in curtailing the use of fee-shifting clauses. However, thus far, the agency has been unwilling to engage on the issue. If it wanted to, it could refuse to accelerate companies' registration statements if their bylaws include fee-shifting clauses. There is recent precedent for the Commission to exert its authority in such a manner; it just needs the will to act.

A Delaware court imprudently disrupted the landscape of corporate liability. It is the SEC's responsibility to ensure that that Delaware court's decision is not used to subvert the SEC's stated mission and goals.