Delaware’s Supreme Court has ruled that corporations can adopt bylaws requiring an investor who sues and loses to pay the company’s legal costs, potentially upending the economics of a booming type of shareholder litigation.

Last Thursday’s ruling in the little-noticed case concerned the bylaws of ATP Tour Inc. The organization oversees men’s professional tennis and has been trying to collect $17.7 million in legal fees from members who unsuccessfully sued its directors over a change in the tour schedule.

Delaware’s top court found the state’s corporate law did not prevent a board from amending bylaws to do away with the “American Rule,” which requires each party to bear its own legal costs regardless of the result.

“It is settled that contracting parties may agree to modify the American Rule and obligate the losing party to pay the prevailing party’s fees,” wrote Justice Carolyn Berger in the 14-page opinion. The court also held that deterring litigation was an acceptable reason for adopting such bylaws.

While ATP is not a stock corporation, legal experts said the ruling could apply broadly. They said that if corporations enact such bylaws, that could slash the number of investor lawsuits by ramping up the risks of suing a board for breaching duties to shareholders.

“I think it’s a disaster,” said prominent shareholder attorney Stuart Grant of Grant & Eisenhofer in Wilmington. “The Delaware Supreme Court seems to have caused Delaware to secede from the union,” he added, alluding to the American Rule.

Grant said a shareholder with 1 percent of a company’s stock—a large holding for a typical plaintiff—would never sue if they stood to get 1 percent of the benefit but risked bearing 100 percent of the cost if they lost. Investor lawsuits can cost millions of dollars to litigate.

The ruling could blunt critics of Delaware courts, who say judges there are not doing enough to stem a tide in recent years of certain class action lawsuits that are filed against every merger deal, sometimes by shareholders with only a few shares.

The lawsuits accuse board members of breaching their duties to shareholders under Delaware law by agreeing to sell the company too cheaply.

The weakest cases typically settle quickly, with directors being released from liability in return for giving shareholders a bit more information about the deal, but no more money. The companies also agree to pay the shareholder’s attorneys, who get around $400,000 for a typical “disclosure only” settlement.

The U.S. Chamber of Commerce has called the practice “extortion through litigation.”

The ATP ruling seemed to catch Delaware law experts by surprise. The question about ATP’s bylaw was sent to the Delaware high court by a federal judge in Delaware who was overseeing the tournament dispute.

Claudia Allen, a specialist in corporate governance at Katten Muchin Rosenman in Chicago, said directors adopting such bylaws could risk a backlash from investors unhappy about a board restricting their rights.

“You’re seeking to adjust the American Rule for a very good reason,” she said, “but the stockholder may not like it at all.”

(Reporting by Tom Hals in Wilmington, Delaware; Editing by Dan Grebler)

Topics Lawsuits Delaware