(Reuters) - A handful of mostly tiny U.S. companies have become the first to adopt controversial bylaws that would shift legal fees to investors who sue and lose, which legal experts said could upend the economics of shareholder litigation.
The Delaware Supreme Court ruled in May that “loser pays,” or fee-shifting, bylaws were valid and could be used to deter lawsuits.
Six companies in recent weeks have adopted the bylaws, which govern relations between a company and its shareholders.
At least two of the companies, small medical device makers Echo Therapeutics Inc and Biolase Inc, have been sued by shareholders this year over the make-up of their board.
“The Echo board determined that the adoption of a fee-shifting bylaw provision and its potential effect in deterring future frivolous litigation was in the best interests of all shareholders,” the company said in a statement.
Biolase declined to comment.
The bylaws would apply to cases brought under Delaware corporate law, which governs the internal workings of companies. It would not affect securities fraud cases, which are brought under federal law.
The majority of U.S. companies incorporate in Delaware, in part because the state’s court protects directors from second-guessing by shareholders as long as they act in good faith.
Critics sketched out scenarios in which small shareholders would be too intimidated by the fee-shifting provisions to sue big companies over executive pay or deals to sell the company too cheaply.
But the bylaws have been used in situations where the company is small, and the potentially larger party is the investor.
“I think it’s notable that we’re not seeing the well-established, large-cap companies do it,” said Claudia Allen, an attorney with Katten Muchin Rosenman who tracks companies adopting the bylaws.
Earlier this year Echo settled a lawsuit brought by Platinum Partners by putting one of the hedge fund’s nominees on its board. Egan-Jones Proxy Services said in its report on Echo’s proxy vote that the settlement was driven in part by the potential expense of litigation.
The other companies adopting the bylaws were Westlake Chemical Partners LP, Townsquare Media LLC, Viper Energy Partners LP and LGL Group Inc. All but LGL are planning or recently completely initial public offerings and at least three of the six have a market capitalization under $100 million.
Allen said most companies are probably reluctant to adopt the bylaw because of the potential to harm investor relations.
“It’s not the U.S. system so you’ll become a lightning rod of controversy,” she said.
Under the “American Rule” in U.S. litigation, each party bears its own legal costs regardless of the outcome.
The Delaware Supreme Court ruled in May that the fee-shifting bylaw of ATP Tour Inc, an organization that oversees men’s professional tennis, was valid.
The ATP ruling prompted the state’s Senate to try to ban the use of fee-shifting bylaws, but the effort failed after heavy lobbying by the U.S. Chamber of Commerce.
Allen said it was far from clear if the bylaws adopted by Echo and Biolase would withstand scrutiny of a court, which would examine if it was an appropriate response to a perceived threat. That will have to wait until a shareholder sues, loses and gets stuck with the company’s legal bill.
Reporting by Tom Hals in Wilmington, Delaware; Editing by Leslie Adler