A Few Thoughts on Looser Pays Bylaws
A recent article in the May 19th edition of the Wall Street Journal titled “Loosing a Shareholder Lawsuit Could Soon Become More Expensive” caught our attention. The article discussed a May 8th decision by the Delaware Supreme Court on ATP Tour, Inc. v. Deuscher Tennis Bund over bylaws that shift the attorneys’ fees and costs to the loosing party. This has recently been referred to as Looser Pays Bylaws. The May 8th ruling resulted from a dispute between a private company and one of its shareholders, however lawyers believe the ruling would apply to any company incorporated in Delaware.
A number of the articles we reviewed in preparation for the writing of this blog article discussed the potential impact this ruling would have with respects to public companies and class action lawsuits. The consensus is almost unanoumous that Looser Pays Bylaws will reduce the number of shareholder class action lawsuits. Many of these lawsuits are frivolous and without merit, and end up being settled for less than the cost of successfully defending the lawsuit in court. Now, with the current ruling by the by the Delaware court, the lead plaintiffs in a class action lawsuit could find themselves on the wrong end of a judgment for legal fees if they fail to win their lawsuits. This risk alone, will immediately start to reduce the number of class action lawsuits filed against public companies. The critics of this decision, which are mostly plaintiff’s lawyers who like to file shareholder class action lawsuits that are typically settled with sizable payments for legal fees, claim that this ruling will make it easier for corporate managers to engage in bad conduct, because the threat of a lawsuit by shareholders is greatly reduced. I disagree. I think that this ruling makes it so that corporate management knows that if they behave badly, and a shareholder successfully wins a lawsuit, they will end up paying the shareholders legal bills as well as their own. Therefore if the company management has behaved badly, the shareholder/plaintiff will have a better chance of a recovery that also covers his legal fees. Here is why we tend to believe that this will be the case.
The majority of our work is with companies that are not among the Fortune 500. Some of these companies have D&O insurance, and some do not. For those companies that do not have D&O insurance the prospects of paying their own legal fees, damages, and the winning party’s legal fees is a strong deterrent against behaving badly. For those companies that have D&O insurance, the shareholders and the attorneys representing them understand that they will get paid following a successful lawsuit. Let me give you a good example of this based upon our own experience.
A very common issue involving smaller public companies is that some will issue stock as payment for services to consultants or employees. These shares are issued with a restrictive legend stating that they have not been registered under the Securities Act of 1933. However, as long as the company maintains its reporting status with the Securities Exchange Commission (SEC) they can typically have the restrictive legend removed after a six (6) month holding period in accordance with Rule 144 of the Securities Act. Disputes involving requests to have a restrictive legend removed and a company’s refusal to do so are governed by section 8-403 of the Uniform Commercial Code (UCC).
We have had numerous conversations with shareholders of public companies where the company is refusing their request to have the restrictive legend removed, and allow the shareholder to have free trading shares. The Uniform Commercial Code (UCC) is very clear on this, and it would be highly unusual for a shareholder to loose a lawsuit involving UCC 8-403. However, the management of companies that engage is such behavior are essentially telling these shareholders that the stock they own is not worth the legal fees to file and win the lawsuit, or they can run up their legal fees and make it cost prohibitive for them to pursue their claims against the company. In many of the instances we have consulted on, the shareholders have simply walked away, and written off their shares. However, that is not always the case.
In late 2007, Coral Capital Partners was engaged to provide a variety of services to Sun River Energy. By April of 2008, we had completed the primary tasks for which we had been engaged, however Sun River Energy was unable to pay us our agreed upon cash fee. In the summer of 2008, we agreed to accept stock in lue of the cash. Over the course of 2009 and 2010 we sold a portion of the shares we received, and then asked that the restrictive legend be removed from our remaining certificates so we could sell our remaining shares. Well, new management had taken over the company is the summer of 2010, and they refused. We were prepared to litigate, as this is a very simple dispute involving Section 8-403 of the Uniform Commercial Code (UCC). The value of our stock at the time far exceeded the estimated litigation expenses. A rather simple decision. Well, Sun River Energy struck first with a frivolous lawsuit that basically included every wild claim they could think of to accuse of having done. Their goal was simple; run up our legal fees as much as possible prior to the trial in order to make the lawsuit unprofitable for us. Sun River Energy backed away from a majority of their claims during the discovery process, admitting there was no basis for them during depositions. Sun River then dropped all of its claims against us immediately before trial; and as a result they were Dismissed With Prejudice at trial by the judge. We prevailed at trial, the Judge entered a judgment in our favor against Sun River Energy on October 23, 2014. Following the ruling, Sun River stipulated to paying a portion of our legal fees, but not all of them. Fortunately we have very good attorneys, and everyone is being taken care of fairly.
Sun River Energy is a company with a history of litigation against its own shareholders. The management of Sun River Energy has chosen to litigate against many of its shareholders who simply wanted to sell the shares of Sun River Energy (in the public market) that they legally owned and were entitled to sell. By our count, there has been at least seven (7) shareholder lawsuits involving Sun River Energy; the majority of which have involved shareholders were simply looking to have the restrictive legends removed from their certificates, as they were legally entitled to do. Our discovery indicated that their could have potentially been a significant number of additional lawsuits over this same issue by many other shareholders, had they chosen to engage in the fight against Sun River. The simple truth of the matter is that many of these shareholders would have litigated if there had been a better chance of having their legal fees covered.
We litigated against Sun River Energy in the Colorado District of the Federal Court system, and we won a clear victory and judgment in our favor. We have spoken with many of the other shareholders who found themselves in lawsuits with Sun River. Almost all of these other shareholders cited growing legal fees as a reason for settling lawsuits they strongly believed they could win at trial. This is a real shame, and a real issue for shareholders with legitimate claims against a company. We reviewed the other shareholder lawsuits, and we believe that everyone of them would have resulted in a victory similar to ours. While not every management team behaves rationally or with good intentions, the management of Sun River Energy might have behaved differently facing the prospects of several millions of dollars in legal fees for pursing lawsuits it could not win.
The Delaware Supreme Court clearly ruled that the fee shifting provision of the ByLaws was facially valid, as neither the DGCl or any other Delaware statute forbids its enactment. Additionally, and what we consider to be very important, the court stated that “no principle of common law prohibits directors from enacting fee-shifting bylaws.” As we read the courts ruling, we believe that fee shifting ByLaws can be enacted by a company that is incorporated in any state as long as that state does not prohibit them. We feel that this is very important and has the potential to change shareholder litigation nationwide, not just in Delaware.
We feel that fee shifting provisions of ByLaws are an important part of good corporate governance, and shareholder protection. We feel that they are a victory for good behavior, and a blow against bad behavior and frivolous litigation. Ultimately it is better for all of us if more companies adopt these provisions.
If you have any questions about the above blog post, please feel free to visit our web site, www.coralcapital.com and check out we have to offer. Feel free to contact us if you have any questions. We can be reached at 404-816-9220 and are always willing to speak with you.
About Coral Capital Partners
Coral Capital Partners is an independent consulting and advisory firm focused on companies and participants in the lower and middle markets. We partner with our clients to provide cost effective solutions to real world issues and situations. Our experienced team brings a diverse set of skills that allows us to service a wide variety of needs. Our area of services and expertise focuses on bringing services and solutions to our clients that are normally only available to much larger firms. Coral Capital Partners, Inc. provides services to Investment Banks, Private Equity Funds, investors, and both privately held and publicly traded companies, as well as various stakeholders in those organizations. This has included international public companies with operations on three (3) continents to smaller privately held domestic companies. Our experience in the areas of corporate advisory, due diligence reviews, and regulatory compliance allows for a cost effective and efficient solution to the issues at hand. Please feel free to contact our offices to see how we may be of assistance.