All eyes are on Delaware, where soon the Delaware Bar Association will recommend to the state legislature whether or not to curb the Delaware Supreme Court’s decision last year to uphold the facial validity of a board-approved bylaw that shifted the attorneys’ fees of defendants to the unsuccessful (or less than completely successful) plaintiff. Much commentary has already focused on the merits of that decision, ATP Tours, Inc. v. Deutscher Tennis Bund,[1] and this column will not go there. That furrow has already been well plowed.[2]

Although this columnist agrees with the majority who believe the ATP Tour decision paints Delaware into a dangerous corner where the limited liability of shareholders is no longer secure, he also doubts that board-approved bylaws will be much used. Why? The short answer is that the major proxy advisors—ISS and Glass-Lewis—have announced that they will oppose the re-election of any board that adopts such a bylaw. In an era when even DuPont can be credibly attacked by a lone hedge fund, this is a fight that few seasoned firms want. Thus, the more likely scenario for the future will be the insertion of fee-shifting provisions into the corporate charters of IPO firms. Then, shareholders will buy into the offering knowing of the limitation (at least when the SEC is sufficiently awake to require disclosure of the provision).[3]

Use of a charter provision sidesteps some problems, but not all. Of the issues that remain, the most important is the issue of federal preemption, at least with regard to the application of such a provision in federal court. In addition, there are arguments under Delaware law that will have to be faced once the issue shifts from the facial validity of the provision to whether it has been inequitably employed. Finally, there remains the question of whether the SEC can refuse to accelerate an IPO registration statement with such a provision.

At the outset, it is best to acknowledge one’s biases and predispositions. This columnist believes that there may be a colorable case of a “loser pays” provision in the context of “M&A” class actions, brought typically in state court and challenging the fairness of an arm’s length merger. These actions are brought in something like 95% of all mergers,[4] and they typically settle for only cosmetic relief. Their ubiquity may reflect an excessive incentive to litigate. But federal securities contexts are a very different context that Congress comprehensively addressed in the Private Securities Litigation Reform Act (“PSLRA”). Thus, if preemption is appropriate, it should apply in some contexts and not in others. This issue of federal preemption will inevitably be litigated because, even if Delaware legislature acts to curb the ATP Tour decision, issuers incorporated in other jurisdictions have already adopted such a provision.[5]

A. Federal Preemption

A simple primer on preemption should begin with the recognition that there are three categories of preemption: express preemption, field preemption, and implied conflict (or “obstacle”) preemption.[6] Express preemption is not applicable here, but the latter two theories may be. “Field preemption” recognizes that there are some contexts where Congress has so dominated the field that it has left little or no room for state action. “Obstacle” preemption looks to whether the state rule creates a substantial obstacle that frustrates the purpose of the Congressional rule. There is no bright-line division between these two doctrines, and the “cornerstone” of both is that the “purpose of Congress is the ultimate touchstone in every preemption case.”[7] Moreover, there is a “presumption against preemption,” which is heightened in areas traditionally regulated by the state (such as corporate law).[8]

Nonetheless, the PSLRA is a comprehensive statute that regulates the smallest details of securities class actions, including how attorneys’ fees are to be calculated and specifying when they should be at least presumptively shifted.[9] Thus, a persuasive case can be made that the PSLRA should give rise to “field preemption,” as Congress could hardly have contemplated when it passed the PSLRA in 2005 that states would attempt to regulate fee-shifting in federal court actions. Nor would Congress have wanted the states to adopt rules that could trump the hard-and-fast rules standards it was adopting.

From the standpoint of “obstacle preemption,” the PSLRA sets forth at least two important federal policies that are 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 only 100 shares but had sued in hundreds of cases,[10] 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” (its term) would be the person or group with the largest stake in the action.[11] As a direct result, public pension funds are now the most common “lead plaintiffs” in securities class actions (but not in other litigation 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 40% 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. Moreover, there is a substantial asymmetry between the pension fund’s likely gains and losses. If there is a settlement, plaintiffs will likely receive 1% to 3% of their losses (in terms of the decline in the stock’s market capitalization),[12] but if the case is lost, the pension fund would be alone liable for the corporate defendant’s expenses, which in a securities class action could easily exceed $10 million (and other defendants will also have claims). Thus, as a fiduciary to its pensioners, the public pension fund will have difficulty accepting a 40% chance of such a liability (and an even higher risk under a “substantial” success standard) in return for a 50% (or so) chance of recovering 1-3% of its market losses in a settlement.[13]

Conceivably, class counsel could agree to indemnify the public pension fund serving as lead plaintiff, but this is uncharted territory and the law firm could become insolvent and thus unable to pay. As a result, many pension funds may be unwilling to accept this risk and will no longer serve as lead plaintiff, thereby frustrating Congress’s 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). Because they were effectively judgment-proof, they would not be deterred by a “loser pays” rule. In short, we would have come full circle from an original environment of nominal plaintiffs to one of substantial plaintiffs capable of monitoring 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 Section 21D(c) of the Securities Exchange Act of 1934, which was added by the PSLRA.[14] Captioned “Sanctions for Abusive Litigation,” it also 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 Section 21D(c)(2) provides that sanctions are mandatory, and Section 21D(c)(3) creates a presumption that the appropriate sanction is to shift the opposing side’s “reasonable attorneys’ fees” to the side that violated Rule 11(b). Finally, Section 21D(c)(3)(ii) requires the court to 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.

So what are the differences between Section 21D(c) and a “loser pays” rule? First, the PSLRA provision is two-sided, while “loser pays” provisions are inevitably one-sided, applying only to the plaintiff. Second, while a “loser pays” provision is automatic, Section 21D(c) relies on judicial discretion and interposes the court before any penalty is imposed. Third, Section 21D(c) requires not simply a technical failure, but a “substantial failure” in the case of a claim that the complaint was frivolous. 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 marginally successful under the popular “substantial success” variation on the “loser pays” formula).

Thus, when Congress chose to address the problem of “frivolous” securities litigation (as was surely the goal of PSLRA), it did so by (1) relying on the trial court to make the critical determination, (2) insisting on a culpability-based violation (i.e., Rule 11(b)) before sanctions were triggered, and (3) making the provision two-sided (i.e., defendants could also receive sanctions). Each of these determinations is effectively reversed by a “loser pays” rule. Indeed, a “loser pay” makes it possible that millions in costs could be shifted to the plaintiff in a case where the court, itself, imposed sanctions only on the defendant for violating Rule 11(b). Put differently, Congress opted to use a scalpel (possibly to preserve the viability of meritorious securities class actions), while defendants that adopt “loser pays” provisions are choosing the blunderbuss. Again, the broader sweep and harsher impact of the “loser pays” provision arguably frustrates the more moderate balance that Congress intended to strike.

Strong as these arguments may be, relatively few cases have dealt with the preemption of procedural rules. Three such cases merit attention. In Burlington Northern Railroad Co. v. Woods,[15] the issue was whether a state law requiring an appellant to post an appeal bond applied in federal court. Even though the action had been tried in federal court based on diversity jurisdiction, the Supreme Court found the state rule on appeal bonds not to apply, finding instead that only federal procedural rules applied under its landmark decision in Hanna v. Plumer.[16] Nonetheless, other decisions have upheld the application of state procedural statues in federal court, some even permitting fee-shifting against the losing side in federal court.[17] A particularly relevant such case is Smith v. Psychiatric Solutions, Inc.,[18] decided last year in the Eleventh Circuit. There, 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 Act. She lost, and the district court awarded attorneys’ fees to her employer. On appeal, she argued that SOX preempted Florida law and precluded such an award of attorneys’ fees to the defendant. But the Eleventh Circuit found no conflict between SOX and the Florida statute, because SOX said nothing about defendants’ attorneys’ fees. Still, before one reads too much into this decision, one must recognize that the Florida statute made fee-shifting discretionary with the court (and did not mandate them in the way that a “loser pays” rule does). Also, the PSLRA is distinct form SOX in that it is not silent on fee-shifting, but has a very clear position on when fee-shifting is appropriate.

Another recent decision in the Ninth Circuit, McDaniel v. Wells Fargo Investments, LLC, has found the Securities Exchange Act to preempt a California statute, noting that when the “federal law grants an actor ‘a choice,’” and state law “would restrict that choice,” the state law must be preempted, at least when preserving “that choice [had] a significant regulatory objective.”[19] Arguably, federal law gives the district court judge a choice as to fee-shifting whereas a “loser pays” rule restricts that court’s choice. If we view judicial discretion over fee-shifting to be central to the PSLRA’s approach to regulating securities class actions in federal court, then a state law that takes that choice away from the court becomes very vulnerable.

Of course, a “loser pays” rule is not mandated by state law, but only permitted by bylaws or charter provisions authorized by Delaware law. Ultimately, this is a distinction without a difference. If a state law-mandated “loser pays” rule would be preempted, then so should a state law-authorized rule.[20] If the state cannot do something because it conflicts with federal law, it cannot authorize others to do what it cannot do. At present, only Delaware has held bylaws to authorize the imposition of monetary liability on non-consenting shareholders, and its unique position makes it more vulnerable to preemption than if a dozen states had done so.

The bottom line here is that plaintiffs can muster strong arguments that a federal court in a securities class action should find that a “loser pays” rule is preempted by the Securities Exchange Act. This prospect would be enhanced if they pick as their target a bylaw that requires “substantial success” so that even a winning plaintiff could be held liable. Finally, if the SEC would join such a suit as an amicus curiae, then the prospects for success seem even higher. But that would require the SEC to rediscover its backbone, which lately it seems to have misplaced.

B. Delaware Restrictions

Although the Delaware Supreme Court has upheld the “facial validity” of a “loser pays” rule and noted in passing that discouraging frivolous litigation is a legitimate objective, it still has substantial discretion. It is well established in Delaware jurisprudence that powers legitimately possessed by the corporation may not be used for an “improper purpose.” This line of cases dates back at least to Schnell v. Chris-Craft Industries in 1971.[21] When could this line of cases invalidate a board-approved bylaw? Examples might include a bylaw adopted to address pending litigation or a company with a controlling shareholder. Admittedly, charter provisions will be harder to invalidate in Delaware,[22] and this is another reason why IPOs are likely to be the more popular route for implementing a “loser pays” regime.

C. SEC Acceleration

The SEC has for a decade or more refused to accelerate an issuer’s registration statement that contained a mandatory arbitration clause. Had they not done so, federal securities litigation would have long since disappeared. But a strong “loser pays” rule is the functional equivalent of a mandatory arbitration clause. The one difference is that refusing to accelerate a registration statement of an issuer with a “loser pays” rule is less vulnerable to attack than refusing to accelerate a registration statement with a mandatory arbitration clause. The Federal Arbitration Act has been repeatedly read by the Supreme Court to express a policy favoring arbitration, one that overcomes any policy in the federal securities laws.[23] Thus, the SEC takes a legal risk in refusing to permit mandatory arbitration clauses in corporate charters, but that is not true in the case of “loser pays” rules because there is no federal policy favoring them.

For the SEC, the advantage of this route is that it does not require them to spend scarce resources on litigation. It would be up to the issuer to sue the SEC, and experience has shown that issuers and underwriters do not wish to delay the offering to engage in such collateral matters.

Conclusion

Ultimately, the SEC must recognize at some point that if they do not resist bylaw and charter provisions that impose liability on dissident shareholders for exercising their legal rights, their failure will come to haunt them. Today, the issue is whether the corporation’s (and other defendants’) legal costs can be shifted against a shareholder/litigant who is not “substantially” successful. Tomorrow, the issue could be whether, under a functionally similar bylaw, a losing proxy contestant or a shareholder who makes a shareholder proposal under Rule 14a-8 can be held liable for the corporation’s expenses if the proposal does not receive majority approval. If corporations can chill shareholder litigants, they probably can also deter shareholder proxy contestants as well. At that point, it may be too late for the SEC to object.

ENDNOTES

[1] 91 A. 3d 554 (Del. 2014).

[2] Much commentary has recently appeared predicting a variety of horrors if Delaware does (or does not) adopt legislation to overrule the ATP Tour decision. See, e.g., Lisa Rickard, “Delaware Flirts With Encouraging Shareholder Lawsuits,” The Wall Street Journal, November 15, 2014 at A-11. Conversely, for a cogent article detailing the problems with the decision, see J. Robert Brown, Jr., “Shifting Back the Focus: Fee Shifting Bylaws and a Need to Return to Legislative Intent,” in Cohen, Round Table on Fee-Shifting Bylaws (Part Two), Bank and Corporate Governance Law Reporter, January, 2015, at 13. Professor Brown is responding to an article in the same Round Table by Theodore Mirvis and William Savitt, “Shifting the Focus: Let the Courts Decide,” p. 8.

[3] In the Alibaba IPO in the fall of 2014, the largest recent IPO, no disclosure was made of Alibaba fee-shifting charter provision. Whether this was the result of SEC negligence or whether the SEC staff actually believed the provision was not material is not clear.

[4] See Robert Daines & Olga Koumerian, Shareholder Litigation Involving Mergers and Acquisitions (2013) at Figure 1 (Cornerstone Research).

[5] For example, Alibaba is incorporated in the Cayman Islands. Indeed, for an IPO issuer, the prospect of eliminating all intra-corporate litigation is probably far more important than the comparative advantages of Delaware law over that of New York, California or elsewhere. A Delaware incorporation may ensure a sophisticated judiciary, but that is important only if one faces the prospect of litigation.

[6] See Hillsborough Cnty. Fla. v. Automated Med. Labs, Inc., 470 U.S. 707, 713 (1985).

[7] Wyeth v. Levine, 555 U.S. 555, 565 (2009)(quoting Medtronic, Inc. v. Lahr, 518 U.S. 470, 485 (1996)).

[8] See CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89 (1987); Freedman v. Redstone, 753 F. 3d 416 (3d Cir. 2014); Green v. Fund Asset Management, L.P., 245 F. 3d 214 (2001); Armstrong World Indus., Inc. v. Adams, 961 F. 2d 405, 418 (3d Cir. 1992).

[9] See Section 21D of the Securities Exchange Act of 1934 (“Private Securities Litigation”), 15 U.S.C. § 78u-4. This provision both contains rules on who is to be given control of the case, rules limiting the permissible fee award, and rules on fee-shifting in § 21D(c).

[10] Legendary names, such as Harry Lewis and William Weinberger, appeared as plaintiffs in hundreds of state and federal cases because they held small amounts of stock in many, many public corporations. Their willingness to sue repetitively may have been based on under-the-table payments. Similar payments eventually led to the indictment and conviction of several former partners at Milberg, Weiss.

[11] See Section 21D(a)(3) of the Securities Exchange Act of 1934.

[12] For this statistic, see Bulan, Ryan & Simmons, Securities Class Action Settlements—2013 Review and Analysis (Cornerstone Research 2013) at 8.

[13] In fairness, a very large pension fund with a substantial stake might take the risk if it anticipated recovering $15 million or more in the settlement. For example, if the potential recovery were $1 billion or more (thus placing the settlement in the all-time top ten of securities settlements), a fund with a 1% to 2% ownership level might expect a recovery to it of $10 to $20 million. At this point, it might anticipate a net expected recovery if the defendant’s total costs were under $20 million and the prospect of losing was under 50%. But that is not the typical case.

[14] See Section 21D(c) of the Securities Exchange Act of 1934.

[15] 480 U.S. 1 (1987).

[16] 380 U.S. 460 (1965).

[17] See, e.g., Smith v. Psychiatric Solutions, Inc., 750 F. 3d 1253 (11^th Cir. 2014); National Union Fire Ins. Co. of Pittsburgh, Pa. v. 757 BD, LLC, 560 Fed. Appx. 657 (9^th Cir. 2014)(fees shifted under an Arizona fee-shifting statute, despite claim of federal preemption).

[18] 750 F. 3d 1253 (11^th Cir. 2014).

[19] McDaniel v. Wells Fargo Investments, LLC, 717 F. 3d 668 (9^th Cir. 2013).

[20] A number of federal courts have found federal preemption to preclude indemnification of “knowing” securities law liabilities, even though such action is pursuant to private contract or a corporate bylaw. Such authorization of indemnification is analogous to bylaws mandating fee-shifting. See Globus v. Law Research Service Inc., 448 F. 2d 1276 (2d Cir. 1969); Heizer Corp. v. Ross, 604 F. 2d 330, 334 (7^th Cir. 1979).

[21] 285 A. 2d 437 (Del. 1971).

[22] See Stroud v. Grace, 606 A 2d 75 (Del. 1992)

[23] See, e.g., Shearson American Exp. Inc. v. McMahon, 482 U.S. 220 (1987).