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Fair Game

Shareholders, Disarmed by a Delaware Court

Who will hold corporate executives and directors accountable for wrongdoing?

Normally, regulators and prosecutors would be leading the charge. And while they have extracted big-dollar settlements from banks in the aftermath of the financial crisis, these supposed enforcers have been remarkably reluctant when it comes to pursuing high-level miscreants.

Hoping to achieve greater accountability wronged investors have filed many cases against top corporate officials, accusing them of breaching fiduciary duties and of other misdeeds. But even this enforcement mechanism is under attack, thanks to a recent decision by the Delaware Supreme Court.

In a proceeding last May, the court ruled that a company can adopt, without shareholder approval, bylaws requiring investors who file lawsuits against it to pay the company’s legal fees if the suit is unsuccessful. The court went so far as to say that a company’s “intent to deter litigation” might be a proper purpose for shifting legal fees to a plaintiff.

Because most companies are incorporated in Delaware, the state Supreme Court’s blessing of fee-shifting will result in fewer shareholder actions and less accountability, legal experts say.

“This is a nuclear weapon against shareholders,” said Jay Brown, a law professor at the University of Denver. “Delaware has already made it extraordinarily difficult to file successful lawsuits for breach of fiduciary duty. Now, in addition to a high likelihood you will lose, they are allowing companies to impose a financial penalty.”

Levying legal fees on unsuccessful plaintiffs could have one benefit: reducing the number of frivolous lawsuits filed, and there are many of those. But the rules are sure to have a chilling effect on meritorious cases. Fee-shifting won’t apply to cases in which the parties settle.

Since the ruling, more than two dozen companies have added fee-shifting language to their governing documents. Some have adopted new bylaws requiring that shareholders pay legal costs; others have simply disclosed the fee-shifting requirement in initial public offering statements.

One example is Smart & Final, a warehouse grocery store chain based in Commerce, Calif. Its initial public offering statement from August notes, “Our bylaws include a requirement that, to the fullest extent permitted by law, a stockholder reimburse us for all fees, costs and expenses incurred by us in connection with a proceeding initiated by such stockholder in which such stockholder does not obtain a judgment on the merits that substantially achieves the full remedy sought.”

A spokeswoman for Smart & Final said it believes the provision protects its shareholders by reducing the risk that they will bear the costs of meritless claims.

The Alibaba Group, the Chinese Internet giant that raised $25 billion from investors in September, also requires shareholders to reimburse it for legal fees. Alibaba’s articles of incorporation include a fee-shifting provision that wasn’t mentioned in its offering statement. (Alibaba’s rule does not seem to apply to derivative suits, which are filed on behalf of shareholders rather than by a shareholder; whistle-blower cases would be one example.)

Because Alibaba is headquartered in the Cayman Islands, it would be hard for a shareholder to sue the company in any case. But adding the burden of paying Alibaba’s legal fees in an unsuccessful lawsuit would most likely discourage a shareholder from suing the company for, say, failing to disclose a risk in its offering statement. Alibaba declined to comment.

Mr. Brown identified the types of cases that might be curbed because of fee-shifting rules. They include those accusing a company of fraud, false disclosures or violations of federal proxy rules, which govern the documents that shareholders rely on when they vote on corporate matters like mergers and election of directors.

Lawrence A. Hamermesh, professor of corporate and business law at the Widener Institute of Delaware Corporate and Business Law, said he was concerned that shareholders, as a result of fee-shifting, would be reluctant to bring important lawsuits related to breaches of fiduciary duties.

How fee-shifting bylaws “ought to be used or regulated is an important question with some pressing need to focus on,” Mr. Hamermesh said in an interview last week.

He also addressed these concerns in a recent meeting of the investor advisory committee at the Securities and Exchange Commission in Washington — a session that focused on fee-shifting.

Making losers pay both sides’ legal fees is the practice in Britain. But in the United States, it has always been rare.

When he was chief justice of the United States, Earl Warren articulated the position in the 1967 case Fleischmann Distilling Corporation v. Maier Brewing Company.

“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.”

It isn’t surprising that the business-friendly Delaware courts would rule against shareholders in this way. But critics say the ruling enters new and perilous territory.

“If public companies can effectively eliminate the right of any shareholder to seek redress from financial wrongdoing, the integrity of our capital markets will be severely threatened,” said Max Berger, a partner at Bernstein Litowitz Berger & Grossmann.

Given that Mr. Berger’s firm specializes in shareholder litigation, his view is to be expected. But it’s also worth recalling that his firm has handled many cases that have held corporate directors and other top officials accountable in recent years.

Among the most important was the case against WorldCom brought on behalf of company bondholders and stockholders who lost out in its giant bankruptcy. In 2005, that matter had an unusual outcome: 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.

It’s unclear what might be done to mitigate the effects of the Delaware ruling. At the recent S.E.C. meeting on fee-shifting, John C. Coffee Jr., a professor at Columbia Law School, suggested that the S.E.C. try to block fee-shifting either by filing a friend of the court brief contending that the bylaws violate federal securities laws or by not allowing company registration statements to move forward if they contain these kinds of provisions.

S.E.C. officials at the meeting gave no indication of what the commission might do.

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.

A version of this article appears in print on  , Section BU, Page 1 of the New York edition with the headline: Shareholders, Disarmed by a Court. Order Reprints | Today’s Paper | Subscribe

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