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CALIFORNIA CORPORATE & SECURITIES LAW

It’s Time To Put A Stop To Fee-Shifting (But Not In the Way You Might Think)

The problem with “fee-shifting bylaws” starts with the name.  A better name might be “anti fee-shifting bylaws” because they end the fee shifting that otherwise applies.  Without fee-shifting bylaws, plaintiffs’ attorneys are encouraged to bet with the stockholders’ money.  This is, of course, unfair to the stockholders.  Society also suffers because the current fee-shifting regime encourages skewed decision making on the part of plaintiffs’ attorneys.

To illustrate, suppose that a plaintiffs’ attorney identifies a potential derivative claim.  In order to determine whether the case is economically worth pursuing, the attorney should calculate the risk, i.e., the variability of results around an expected return.  These returns can be either positive or negative.  Below is a simple example of what this calculation might look like without a fee-shifting bylaw (the outcome includes any attorneys’ fees award.):

Probability Outcome Fees & Costs Return
    Plaintiff Defendants  
.1 $10,000,000 (win) ($500,000) $0 $500,000
.8 $500,000 (settlement) ($250,000) $0 $150,000
.1 $0 (loss) ($500,000) $0 ($500,000)

Because the expected return is a positive $150,000, it makes sense for the plaintiff’s attorney to pursue the case.  The picture becomes very different if the plaintiff’s attorney is forced to bear the full cost of the litigation:

Probability Outcome Fees & Costs Return
    Plaintiff Defendants  
.1 $10,000,000 (win) ($500,000) $0 $500,000
.8 $500,000 (settlement) ($250,000) $0 $150,000
.1 $0 (loss) ($500,000) ($500,000) ($1,000,000)

Now, the expected return is a loss of $350,000 and no rational plaintiff’s attorney should take this case.

As the foregoing rather simple example illustrates, the current regime supports lopsided decision making that encourages plaintiffs’ attorneys to pursue cases that they would never undertake if the legal regime required them to bear the full costs of their activities rather than shifting them to the stockholders.

[corrected table 6/1/2015 to reflect win value of $10,000,000, not $1,000,000 and to clarify that the outcome includes any attorneys’ fees award.]

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