Fee-Shifting Bylaw

A fee-shifting bylaw is a corporate rule that would require shareholders who lose a lawsuit against the company to pay the company’s legal fees—a brief and controversial experiment in corporate governance that federal courts and state legislatures shut down within a few years.

The Corporate Governance Problem It Addressed

In the mid-2000s, companies and their legal counsel grew frustrated with what they saw as a glut of frivolous shareholder suits—particularly derivative actions, where a shareholder sues on behalf of the corporation itself. The cost of defending these suits, even when the company ultimately prevailed, was substantial. A company might spend millions on legal fees only to win or have the case dismissed—while the plaintiff’s lawyers, working on contingency, faced no downside.

A small number of corporations, particularly in Delaware (where most large firms incorporate), attempted to address this through bylaws or charter amendments that imposed a “loser pays” rule: if you sued the company and lost, you would be liable for its legal fees. The theory was straightforward: such a rule would screen out weak or opportunistic claims and preserve board resources for actual governance issues.

Why the Rule Was Adopted—And Why It Failed

The fee-shifting approach gained traction between 2006 and 2009, adopted by a handful of major corporations. The intellectual appeal was clear: it mirrored existing rules in other contexts (some countries’ civil litigation regimes shift fees as a matter of course) and appeared to offer a targeted response to a real problem.

But federal courts and lawmakers moved swiftly against it. The mechanism ran into two fundamental obstacles.

First, federal securities law preempted it. Section 27 of the Securities Act of 1933 establishes that any waiver of compliance with the Act is void. Courts interpreted fee-shifting bylaws as an effective waiver: they discouraged shareholders from bringing valid federal securities claims by imposing a risk of cost liability that the law itself did not contemplate. In 2007–2008, federal judges in several cases struck down fee-shifting bylaws as unenforceable.

Second, state legislatures intervened. Delaware, responding directly to the practice, enacted the Stockholders Protection Act in 2009, which explicitly barred corporations from adopting bylaws that would require shareholders to indemnify the company for defense costs in intra-corporate litigation. Similar prohibitions were adopted by other states.

The speed of the legal pushback reflected a deeper concern: fee-shifting, even if well-intentioned, functioned as a litigation barrier that chilled legitimate claims. A shareholder with a genuine grievance might forgo suit if the downside risk of losing—and being forced to reimburse the company’s $5 million legal bill—felt too large. That in-terrorem effect contradicted the public policy embedded in securities law and state corporate law, which generally aimed to facilitate, not deter, shareholder accountability mechanisms.

What Replaced Fee-Shifting Bylaws

Rather than swing to pure cost-shifting, the post-2009 regime adopted targeted procedural safeguards that addressed the same underlying concern—weeding out frivolous claims—without blocking valid ones.

Plaintiff security bonds became the primary tool. Under Delaware law and similar statutes, a corporation could require a plaintiff in a derivative suit to post a bond (typically equal to a portion of the company’s anticipated legal costs) before proceeding. If the plaintiff lost, that bond could be applied to the company’s fees. The key difference from fee-shifting: the bond was capped at a reasonable multiple of anticipated costs and was secured upfront, rather than being an open-ended liability for any amount the company spent. A plaintiff with a colorable claim could still proceed; a plaintiff pursuing pure harassment might find the bond requirement dispositive.

Demand requirements were tightened. A shareholder bringing a derivative suit must typically demand that the board address the alleged wrongdoing first. If the demand is refused, the shareholder must prove that the refusal was unreasonable (under the “business judgment rule” standard). This procedural gate, already present in most state laws, became a more robust screen against weak claims.

Abuse-related fee-shifting also emerged: courts could order a losing plaintiff to pay the defendant’s costs if the litigation was found to be frivolous, abusive, or brought in bad faith. This applied the “loser pays” principle selectively, only to genuinely meritless suits, rather than to all losing claims.

Additionally, some firms adopted limitation provisions in their bylaws: carve-outs that prevented certain claims (such as those arising from federal securities violations) from being subject to fee-shifting—a compromise that acknowledged the federal preemption issue but attempted to preserve the mechanism for some categories of intra-corporate dispute.

The Unresolved Underlying Tension

Fee-shifting bylaws highlight a perennial tension in corporate governance. On one hand, shareholders need the threat of litigation to police management and prevent waste. On the other hand, that threat can be weaponized: entrepreneurial plaintiffs’ lawyers and activists can bring opportunistic suits that generate little economic value and consume company resources.

The cost and frequency of securities litigation grew substantially in the 1990s and 2000s, a trend that continues. Companies have legitimate reasons to seek ways to separate signal (material wrongdoing) from noise (technical violations or settled business disagreements). Yet mechanisms that are too effective at filtering claims risk making it too expensive for ordinary shareholders to vindicate real rights.

The post-2009 settlement—security bonds, tightened demand rules, selective abuse-related cost-shifting—represents an attempt to balance these concerns without erecting an absolute bar. Whether it has succeeded remains contested: plaintiff’s bar advocates argue it is still too onerous; corporate counsel argue it remains insufficient to deter marginal litigation.

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