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Who Should Pay When a Shareholder Sues the Corporation?

Why do so many attorneys and professional advisors recommend forming "Delaware corporations"? Why is it that Delaware is to corporate law what McDonalds is to franchising? For many, the reason to form a Delaware corporation is that Delaware provides a favorable tax structure for the entity and its shareholders. For just as many, the reason is that Delaware corporate law provides a great deal of flexibility to a corporation's board of directors, and that the Delaware laws facilitate a board's ability to decide upon and carry out many "fundamental" or "structural" transactions. The detractors of Delaware law and its progeny believe that such board-friendly corporate regulations are provided at the expense of shareholders, who too often bear the brunt of a poor result stemming from a board decision. The response of the Delaware aficionados is that shareholders always have access to the courts, through derivative actions, shareholder meetings and similar avenues, to protect their rights. End of discussion? Not so fast.

Jeff Mordock, in an article published in the July 11, 2014, edition of The Legal Intelligencer, wrote that several Delaware entities--including some publicly traded corporations--have adopted by-law provisions which require investors who sue their corporations to pay the costs of the litigation if the suits are unsuccessful. Of course, everything from the definition of "unsuccessful" to the definition of "costs of suit" will be debated and litigated (--to the delight of corporate litigators, who will get paid regardless of whether they are "successful" and without much argument as to what constitutes their "costs") for the next several years.

Those in favor of these fee-shifting provisions will point to the many lawsuits started by investors solely as a means of eliciting some sort of quick cash settlement, because the cost of defending even a poorly conceived action will be more expensive than a relatively substantial settlement. They will also speak of the chilling effect which these suits can have: Will a director make a decision solely based upon whether he or she will be sued, or whether the corporation he or she is trying to serve will be subjected to resource-consuming litigation?

Those against the fee-shifting provisions believe that a shareholder's right to bring suit is the last bastion of shareholder rights, i.e., the shareholder has little choice but to bring suit in order to examine the books and records of the corporation, to hold directors accountable, and to stop the epidemic of huge payouts made to various officers and large shareholders at the expense of the company's overall fiscal health and the smaller shareholders' interests. If a fee-shifting provision of the by-laws is adopted, the chilling effect upon the shareholder will encourage (or at least allow) more reckless activity from the board, and less transparency in the activities of the decision-makers.

In the end, it may turn out that the movement toward adopting fee-shifting by-law provisions will be self-defeating: If more and more corporations adopt by-laws containing fee-shifting provisions, there will be some state legislatures which will simply pass legislation to prohibit such measures. In Delaware, there have been some bills proposed which would limit or prohibit fee-shifting provisions, but such bills have not yet gained traction. If the Delaware legislature does not adopt a law which prohibits fee shifting by-laws, chances are that it will be seen as a natural extension of Delaware's laissez-faire attitude regarding broad-based discretion for corporate directors. If the legislature adopts a bill to limit or prohibit fee-shifting by-law provisions, it will be a warning to the leaders of Delaware corporations that there is a limit to the protection of directors under Delaware law.

In the meantime, permit me to posit that investors should do what many of their advisors have been telling them to do for years: Investigate before investing. Yes, of course, study the financial data, read the reports and find out about the corporation's leadership and majority investors. But now, if possible, it might not be a bad idea to get a look at the company by-laws as well.

Ken Milner

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