Exit polling from the election shows that voters are frustrated with Washington’s infighting, political gridlock, and inability to solve the nation’s problems. However, Americans are not waiting for the impasse in Washington to solve itself: They are increasingly taking matters into their own hands through state ballot initiatives and private litigation.
An example of this direct action is the effort to tackle the problem of stagnant wages through state ballot initiatives. Although Senate Republicans blocked efforts to raise the minimum wage nationally in April, Americans took action at the state level. Nine states have passed a minimum-wage increase this year, and voters in five states—including four deep-red states—approved ballot initiatives to raise the minimum wage.
While raising workers’ wages addresses part of the income inequality problem, it does not address the skyrocketing pay of those already at the top. This is perhaps best personified by runaway executive compensation. In 2013, the average pay for the CEOs of the nation’s top 350 companies was 300 times that of average workers. This ratio is more than 10 times higher than it was in 1965, when CEOs made 20 times that of the average worker.
Congress started to address this issue by passing the say-on-pay rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The rule requires corporations to give shareholders the chance to vote on executive compensation policies. As of December 2013, according to one review of say-on-pay litigation, approximately 150 public companies were unable to secure majority shareholder support for their executive compensation proposals. However, many of these corporations adopted these proposals anyway. Although the results of these votes are nonbinding, many shareholders objected to management’s actions and brought lawsuits against the companies’ directors for breach of fiduciary duty.
Indeed, people are also taking direct action through private litigation. Specifically, they are undertaking shareholder lawsuits that seek increased accountability from the bad actors that contributed to the financial crisis. Although the Obama administration has successfully obtained billions of dollars in settlements from banks for their role in the crisis, none of the directors or executives in charge of these financial institutions has been held accountable for his or her actions. As a result, shareholders have brought lawsuits against corporate officials for breach of fiduciary duty.
When political institutions are unable to respond to citizens’ needs, it becomes important for citizens to have an avenue of recourse. However, a recent court decision threatens to bring an end to private litigation. In ATP Tour, Inc. vs. Deutscher Tennis Bund, the Delaware Supreme Court held that companies can adopt broad fee-shifting bylaws without prior shareholder approval, requiring unsuccessful plaintiffs in a shareholder lawsuit to pay the company’s fees and expenses. These fee-shifting provisions threaten to stifle shareholder lawsuits. At a time when the concentration of power and wealth in corporate America’s upper echelons is increasing, it is critical to maintain this important check on the powers of corporate directors and executives.
The important role of private shareholder lawsuits
The power within corporations is often concentrated in the company’s management. While this concentration of skills may yield tremendous efficiencies, it can also give rise to differing interests between managers and shareholders. Shareholders can exercise their voices in management decisions by selling their shares, voting their shares, or bringing private lawsuits against corporations’ boards or officers for breach of fiduciary duty.
Private lawsuits are an integral part of the American regulatory system. As Georgetown University Law Center professor J. Maria Glover explained, they “are often necessary for meaningful enforcement of regulatory directives to occur.” Glover pointed to the example of WorldCom, a case in which the company’s accounting fraud was brought to the attention of authorities through private lawsuits brought by pension funds. According to Glover, this case is a good example of how private lawsuits by shareholders “may often be needed to prevent a noninsignificant amount of misconduct from escaping regulation.”
The important roles of private lawsuits in the context of enforcing securities laws have long been recognized. As Columbia University corporate law professor John C. Coffee Jr. noted, since at least 1965, federal courts have held that “private enforcement of law is a ‘necessary supplement’ to public enforcement by the SEC [Securities and Exchange Commission] and the Department of Justice.” Even former SEC Commissioner Harvey Goldschmid acknowledged that “private enforcement is a necessary supplement to the work that the S.E.C. does. It is also a safety valve against the potential capture of the agency by industry.”
In addition to being an integral part of the American regulatory system, private lawsuits can have broad positive effects on political and economic systems. A study of securities laws across 49 counties found that private enforcement measures help “foster greater investor confidence and ultimately [lead to] more robust securities markets.”
Despite the important role of private lawsuits, the recent Delaware Supreme Court decision could dramatically curtail this enforcement mechanism.
Chilling effect of fee-shifting rules
The Delaware Supreme Court decision allowing companies to adopt broad fee-shifting bylaws without prior shareholder approval would have a chilling effect on shareholder lawsuits. As Coffee explained, the companies defending these lawsuits often have higher fees and expenses than plaintiffs. The fee-shifting rule would require plaintiffs to take on the risk of paying defense fees and expenses, regardless of whether the plaintiffs’ claims were reasonable or meritorious. Forcing plaintiffs’ attorneys to “accept a potential liability greater than their potential gain” would discourage private shareholder lawsuits.
University of Denver corporate law professor J. Robert Brown Jr. elaborated on this, saying:
This risk provides a significant disincentive to file a suit against the board for breach of fiduciary duties. And this is not simply speculation. In Kastis v. Carter, counsel for plaintiffs sought to strike down a fee shifting bylaw and, in the alternative, to obtain dismissal of the case. In other words, as long as shareholders confronted the risk of having to pay the company’s fees, the case would not continue. These bylaws, therefore, have the potential to insulate board behavior from challenge.
Widener University School of Law professor Lawrence A. Hamermesh went so far as to warn that “fee-shifting bylaws makes shareholder-represented litigation impossible if corporations adopted them.”
Given the important role that shareholder lawsuits play, it is imperative that action be taken to prevent the harm inflicted by the Delaware Supreme Court decision from spreading.
Curbing fee-shifting provisions
Since ATP, Coffee has identified 24 corporations that have adopted fee-shifting bylaws or charter provisions, including Alibaba Group, Smart & Final Stores Inc., and Hemispherx BioPharma Inc. While fee shifting has not yet been widely adopted, the trend is troubling and should be halted before it has the opportunity to spread.
The SEC has an important role to play in curbing the adoption of fee-shifting rules. On October 9, it held a hearing on the matter, but it has not yet taken further action. It does, however, have some far-reaching options at its disposal consistent with past practice. For instance, as Coffee pointed out, the SEC could argue in court that federal law preempts fee shifting. It could also refuse to accelerate registration statements that contain fee-shifting bylaws, and it could require registration statements to include language stating that the SEC believes federal securities laws are inconsistent with fee-shifting bylaws.
At a time when political gridlock prevents the government from solving pressing problems for its citizens, it is imperative for Americans to have options for recourse. Now is not the time to shut off these avenues—especially not one as important as filing private lawsuits that help hold corporate actors accountable.
History shows that private lawsuits not only protect shareholders’ rights against bad behavior in corporate management’s highest levels, but also play an important role in enforcing securities laws. Given the country’s recent financial crisis, courts should not continue to weaken enforcement mechanisms of securities laws in such a dramatic fashion. The SEC should act to protect shareholder rights.
Anna Chu is the Director of the Middle-Out Economics project at the Center for American Progress.