Until very recently, it was not controversial to claim that shareholder litigation had entered a period of crisis.  A significant majority of deals involving publicly-traded corporations (most of which are organized in Delaware) were challenged in litigation, and to make matters worse, much of that litigation was multi-jurisdictional.  In large part, this resulted from the ability of plaintiffs’ firms to secure fee awards in connection with settlements that included no monetary relief.  In a typical “disclosure only settlement,” defendants agreed to provide additional, deal-related disclosures in exchange for a very broad release.  With the cooperation of released defendants, plaintiffs’ counsel could secure a fee award by characterizing the disclosures as a corporate benefit.

For a short period, however, fee-shifting and forum selection provisions offered hope to Delaware corporations.  With a one-way fee-shifting provision in either its charter or bylaws, a Delaware corporation could make filing litigation prohibitively risky.  With a forum selection provision, it could corral litigation into a single forum – either in Delaware or in another jurisdiction where the corporate decision-makers perceived some sort of advantage. The promise of these measures was not hypothetical:  In a series of three decisions, Delaware courts upheld the addition of one-way fee-shifting provisions, exclusive Delaware forum selection provisions, and exclusive non-Delaware forum selection provisions to the bylaws of Delaware corporations, even when added unilaterally by the board of directors.[1]

With the 2015 amendments to the Delaware General Corporation Law, however, the Delaware legislature significantly limited the ability of its corporations to adopt these measures.  Both fee-shifting and exclusive non-Delaware forum selection provisions are now completely forbidden.  Of the three measures previously approved by Delaware courts, only forum selection provisions that allow litigation in Delaware remain fair game.

On the surface, Delaware’s adoption of two new mandatory corporate law rules appears inconsistent with the state’s flexible, pro-private ordering approach to corporate law.  For this reason, the decision to repudiate a series of pro-private ordering decisions authored by some of the state’s most well-respected jurists was a curious development, to say the least.

In Corporate Governance, Collective Action and Contractual Freedom:  Justifying Delaware’s New Restrictions on Private Ordering, I argue that there are strong justifications for Delaware’s new limitations on private ordering and that they are consistent with the state’s policies favoring flexibility and private ordering in corporate law.  This is not to say that problematic litigation practices should have gone unaddressed.  Instead, the legislative restrictions should be understood alongside the Chancery Court’s new, more skeptical approach to disclosure only settlements and the fee applications that accompany them. With an exclusive Delaware forum selection provision, Delaware corporations are able to corral litigation into a jurisdiction that now disfavors disclosure only settlements.  They cannot, however, destroy many of the important benefits that result from shareholder litigation by over-deterring it (with fee-shifting provisions) or dispersing it into non-Delaware fora (with exclusive non-Delaware forum selection provisions).

Delaware corporations derive significant benefits from the ability of their shareholders to challenge management conduct in Delaware’s courts.  Delaware corporate law generally eschews bright-line rules in favor of generally-stated principles that are applied by the state’s specialized judiciary.  The resulting opinions are factually saturated (and for this reason some have argued that they are excessively narrow in scope), but it is through these decisions that Delaware corporations, their counsel, and others who provide them with corporate services are able to understand the applicable legal principles, design transactions, and assess risk.  Importantly, the benefits that result from the availability of this legal information are both backward- and forward-looking.  When a decision to incorporate or reincorporate in Delaware is made, the firm will have immediate access to the already existing body of Delaware case law.  It will also be able to count on a future flow of case law that addresses new issues when they arise.

Widespread adoption of fee-shifting and exclusive non-Delaware forum selection provisions (the two measures now prohibited by the DGCL) would significantly diminish many of these benefits.  The fee shifting provisions previously approved by the Chancery Court would over-deter shareholder litigation by putting plaintiffs in a fundamentally unbalanced situation with regard to litigation risk and reward.  Because any monetary recovery will be shared among affected shareholders, a plaintiff holding less than all of the affected shares will enjoy only a fraction of any benefit recovered.  But, if there is a one-way fee shifting provision in place, that  plaintiff bears all of the risk of having to reimburse defendants for their fees.  Defendants, of course, are not exposed to any additional risk on account of the provision.   There is little doubt that frivolous filings would be deterred by this realignment in the risk profile of shareholder litigation.  But it would also deter much litigation that is not frivolous, and that is where the problem lies.

Exclusive non-Delaware forum selection provisions would similarly destroy these benefits by dispersing litigation into non-Delaware fora.  Over time, the number of conflicting decisions would likely increase, and the lack of a common appellate court to harmonize conflicting precedent would create uncertainty as to the applicable rule or principle.

With regard to the informational benefits that result from case law, fee-shifting and exclusive non-Delaware forum selection provisions present a collective action problem.  The generation of these benefits requires a steady stream of disputes to enter and be decided by the Delaware courts.  While individual corporations have an incentive to opt-out of the costs of Delaware shareholder litigation by adopting one or both of the prohibited measures, widespread adoption would cut-off the flow of cases into Delaware’s courts and, with it, the benefits that result when those cases are decided.  Firms who opt-out while continuing to benefit from the generation of case law would be free-riding on the contributions of those that continue to have their shareholder disputes adjudicated by the Delaware courts.

Widespread adoption of fee-shifting provisions would also lead to a decrease in the flexibility available to Delaware corporations and their managers.  When investors can challenge management’s conduct after the fact (e.g., through fiduciary duty litigation), they have less need for ex ante rules intended to discipline and constrain management.  This, of course, benefits management who are able to operate with increased freedom and discretion.   But, if investors do not have a mechanism for challenging management’s conduct, they will be more likely to require rules and limitations up front.  Delaware’s success as a corporate home is likely due to the balance it has struck in this regard:  The freedom and discretion that management enjoys under Delaware law depends, to some extent, on the ability of shareholders to challenge management’s decisions after the fact.   Over-deterrence of shareholder litigation will put Delaware’s enabling approach to corporate law at risk by giving shareholders a reason to seek more extensive ex ante rules.

Shareholder litigation also indirectly facilitates flexibility and freedom by generating much of the factual information that fuels non-legal accountability mechanisms (e.g., the labor market for management and the risk of reputational sanctions).  These disciplinary forces are commonly cited reasons for the discretion and deference corporate management enjoys under applicable legal regimes.  When managers face reputational and professional consequences for behaving badly, there is less work for corporate law to do.  If over-deterrence of shareholder litigation restricts the flow of information about the conduct of management, however, non-legal accountability mechanisms will be less effective.  Investors will have reason to look to corporate law to fill the gaps.

Of course, the presence of strong justifications for Delaware’s new restrictions on private ordering does not do anything about the abusive litigation practices that made fee-shifting and forum selection provisions desirable to begin with.  This is where the Chancery Court comes in.  As a result of new case law announcing the Court’s unwillingness to allow the disclosure only settlement status quo to persist,[2] shareholder litigation has declined significantly in a short period of time.  The key is the ability of Delaware corporations to prevent migration of litigation into jurisdictions that are more permissive when it comes to fee awards by adopting exclusive Delaware forum selection provisions. Together with this case law, the Delaware legislature’s approach to fee-shifting and forum selection provisions makes sense.  Yes, the state has adopted new mandatory rules that limit the scope of possible private ordering.  But, in the long-run, these restrictions will help to preserve Delaware’s flexible, pro-private ordering approach to corporate law and the benefits that result from it.

ENDNOTES

[1] ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (2014) (upholding addition of fee-shifting bylaw); City of Providence v. First Citizens Bancshares, Inc., 99 A.3d 229 (Del. Ch. 2014) (upholding addition of non-Delaware forum selection bylaw); Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) (upholding addition of Delaware forum selection bylaw).

[2] See, e.g., In re Riverbed Tech., Inc. Stockholders Litig, 2015 WL 5458041 (Del  Ch. Sept. 17, 2015) and In re Trulia, Inc. Stockholders Litig., 2016 WL 325008 (Del. Ch. Jan. 22, 2016).

This post comes to us from Jonathan Rohr, a visiting assistant professor at Cardozo Law School. It is based on his paper, “Corporate Governance, Collective Action, and Contractual Freedom: Justifying Delaware’s New Restrictions on Private Ordering,” available here.