Striking Back at Stockholder Strike Suits: Corporate Charter Fee-Shifting Provisions

Nationwide concern about frivolous securities litigation has been so great that, in 1995, Congress adopted an act intended to curb it, over President Clinton's veto. Congress is considering additional legislation, responding to practices adopted by the plaintiffs' bar to circumvent the 1995 law.

Yet public companies have the power to ward off frivolous stockholder suits without Congressional intervention: A corporation can include fee-shifting provisions, which require the loser in a litigation to pay the winner's legal fees, in its certificate of incorporation or bylaws.

Fee-shifting provisions appear increasingly in business contracts. Lawyers who include these provisions believe that they deter speculative lawsuits and dilatory defenses. Additionally, it seems unfair to require the winner to bear his own legal fees, because the winner still would lose to the extent of his litigation costs.

The General Corporation Law of Delaware, the state of incorporation of choice for public companies, permits a corporation to include in its certificate of incorporation or bylaws any provision relating to the rights or powers of stockholders not contrary to Delaware law. The statutory language is broad enough to permit a corporation to require that, as a condition to a stockholder's bringing an action against the corporation or its directors or officers (in their respective capacities), the stockholder must enter an agreement with the corporation that the loser of the lawsuit will pay the winner's legal fees and expenses. Delaware courts acknowledge the validity, in general, of contractual fee-shifting provisions, but have not addressed such contracts in the particular context of stockholder litigation.

Federal courts, however, have considered, in a few cases, whether fee-shifting agreements violate the policy of the federal securities laws. Federal securities law void contract provisions purporting to waive an investor's rights under the securities laws, and it has been argued that fee-shifting agreements would so discourage the initiation of securities lawsuits as to constitute such a waiver.

Generally, these cases turn on the particular contract language in question, but conclude that fee-shifting agreements, in principle, do not violate public policy. For example, in In Re Integrated Resources Real Estate Securities Litigation, the New York federal district court held,

The public policy argument–that enforcing such agreements would discourage legitimate securities fraud actions–is too absolute. Where possible, the securities laws should not be construed against freedom of contract.

The court interpreted a Second Circuit Court of Appeals decision as also acknowledging, in principle, that fee-shifting contracts do not contravene federal securities law.

Because charter documents are interpreted essentially as contracts between the corporation and its stockholders, the reasoning in these federal court cases should apply equally to fee-shifting provisions in a corporation's certificate of incorporation or bylaws. Moreover, fee shifting is consistent with Congress's stated view that, in securities litigation, stockholders with large interests can better protect the interests of stockholders.

Any charter document amendment requiring fee-shifting ought to apply only to claims arising after its adoption. Given the sensitivity of the subject matter, a corporation contemplating adoption of such a charter amendment should consider seeking stockholder approval. I know of at least one instance, unfortunately, in which the staff of the Securities and Exchange Commission simply delayed commenting on a proxy statement containing a certificate of incorporation amendment to which the staff objected, thereby effectively preventing the company from submitting the matter to stockholders. To avoid such problems, the Board of Directors could adopt the fee-shifting provision as a bylaw amendment and submit its adoption to stockholders for ratification. If the company were prevented from including the ratification proposal in its proxy materials, the bylaw amendment would simply remain in effect without any stockholder action.