A ruling by one state court threatens the ability of all Americans to hold corporate wrongdoers accountable. Here’s what happened – and what can be done about it.
Read AFJAC President Nan Aron’s statement in response to the signing of the Delaware Corporation Law Amendment
Read AFJAC President Nan Aron’s statement on the passage of the Delaware Corporation Law Amendment in the Delaware House of Representatives
See what AFJAC has to say about Securities and Exchange Commission Chair Mary Jo White’s comments on fee shifting bylaws.
When a giant corporation gives its directors and executives lavish bonuses that drain the company’s earnings, when it misleads shareholders in the documents it publishes to persuade them to put their money into the company, or when it commits outright fraud, shareholders can lose millions of dollars.
And “shareholders” means almost all of us. If your 401(k) retirement plan includes stocks, you’re a shareholder. If you’re a public employee with a state pension, you’re a shareholder. (Even if you don’t have such a pension, if the pension fund loses money, taxpayers may have to make up the difference.) So you have a huge stake in holding big businesses accountable.
But one decision by one state court is making that a lot harder. The impact is huge because the state in question is Delaware. More than half the nation’s Fortune 500 companies are incorporated in Delaware. So when it comes to corporate law, as Delaware goes, so goes America.
Fortunately, the Delaware Legislature can undo the damage – and a bill has been introduced to do just that.
A Delaware court ruled that corporate Boards of Directors, acting entirely on their own, can amend corporate bylaws to make it prohibitively expensive for shareholders to sue them. They can force shareholders to pay millions, even tens of millions of dollars in attorney fees and other costs incurred to defend against the suits. Even the largest institutional investor would be extremely reluctant to take that kind of risk – no matter what kind of corporate wrongdoing the suit could expose.
You can win – and still have to pay
Provisions like those approved by a Delaware court commonly are called “loser pays.” But that’s misleading. The bylaw change approved by the Delaware court actually says shareholders can be forced to pay even if they win, but don’t achieve “complete success” – defined as “a judgment on the merits that substantially achieves in substance and amount the full remedy sought.”
So, for example, shareholders might sue seeking damages of $5 million. The court might rule in their favor and award $1 million. But the “winning” shareholder still would have to pay all of the costs of defending the suit – which might be, say, $2 million. It would be the ultimate Pyrrhic victory.
Preventing the next WorldCom
Remember WorldCom? Once it was among America’s largest telecommunications companies. But it all came crashing down in what was then the biggest bankruptcy in American history – caused by what was, at the time, the biggest case of corporate fraud in American history.
The company was brought down by a multi-billion dollar accounting scandal that ultimately sent the CEO to jail. But, as New York Times columnist Gretchen Morgenson points out, it also led to a shareholder lawsuit. She writes:
To settle the case, the WorldCom directors had to pay 20 percent of their net worth, a total of $25 million, out of their own pockets. That sent a strong message to corporate boards everywhere.
Had WorldCom been able to amend its bylaws in the way a Delaware court is now permitting, those shareholders might never have gotten compensation.
So it’s no wonder Prof. Jay Brown of the University of Denver Law School calls such bylaws “a nuclear weapon against shareholders.”
And it’s not just shareholders who actually sue who can be nuked. Prof. John C. Coffee, Director of the Center on Corporate Governance at Columbia Law School notes that a shareholder who blows the whistle on corporate wrongdoing to, say the Securities and Exchange Commission, or an employee-shareholder who sues for wrongful termination also may be liable to pay defense costs – if that whistleblower or employee is not completely successful.
In the months since a Delaware court ruled, more than two dozen corporations have rushed to add these clauses to their bylaws. Some of them made the changes right after they were informed they were being sued – or might be sued.
- Hemispherx BioPharma, Inc. adopted such a provision one week after discovery requests were served on the company.
- Lannett Company, Inc. adopted such a provision one day after disclosing it received subpoenas from the Connecticut Attorney General related a price fixing investigation.
- Insys Therapeutics, Inc. adopted such a provision after the announcement of a Department of Health and Human Services investigation and the filing of two related lawsuits.
New York Times columnist Gretchen Morgenson notes that nearly half a century ago, when he was Chief Justice of the United States, Earl Warren wrote about the fundamental unfairness of these kinds of provisions:
“Since litigation is, at best, uncertain, one should not be penalized for merely defending or prosecuting a lawsuit,” he wrote, adding “that the poor might be unjustly discouraged from instituting actions to vindicate their rights if the penalty for losing included the fees of their opponents’ counsel.”
Shareholders are already at a severe disadvantage when trying to hold corporate executives and directors accountable. Limiting their options even further is a giant step in the wrong direction.
Undoing the damage
But the damage has been undone. Delaware just passed a law that would prohibit corporations from adopting these kinds of changes to their bylaws. Investors and shareholders – all of us – now have a fighting chance to hold corporate wrongdoers accountable for their financial misdeeds.
Supporters of the legislation include:
- Alliance for Justice Action Campaign
- Consumer Federation of America
- Delaware Public Employees Council 81 AFSCME
Supporting legislative reform and access to the courts