To the extent America has made progress in recent years in rolling back the extreme litigiousness of earlier years, one main reason has been the courts’ increased willingness to respect the libertarian and classical liberal principle of freedom of contract. Most legal disputes arise between parties with prior dealings, and if they have been left free in those dealings to specify who bears the risks when things go wrong, the result will often be to cut off the need for expensive and open-ended litigation afterward. Thus the courts’ willingness to enforce agreements to arbitrate disputes, rather than run to court, has played a major role in curbing what once looked like an ever-rising tide of workplace and consumer class action litigation. “Shrinkwrap” or “clickwrap” disclaimers of liability, despite their occasional absurdities, serve the very practical function of ensuring that when information technology or online services go wrong the result is not to sink providers in limitless liability over the consequences of data loss to buyers. And recognizing libertarian principles of free contract would be among the most promising ways to reduce the glaring costs and injustices of medical liability litigation, as Richard Epstein argued in his very early (1976!) paper, Medical Malpractice: The Case for Contract. 

In May, in a case named ATP Tour v. Deutscher Tennis Bund, the Delaware Supreme Court decided to enforce as written a corporate bylaw adopted by an enterprise incorporated in Delaware providing for a loser-pays rule in cases of claims against it by shareholders. Almost at once, the community of practicing Delaware corporate litigators, as well as plaintiff’s class action lawyers across the country, protested loudly: such a rule, by putting claimants at risk of their own money, would discourage all but the strongest claims (and, not incidentally, cut into counsels’ own livelihood of prosecuting and defending such claims). They demanded that the Delaware legislature step in to ban such bylaws and restore the legal status quo ante, along with its accompanying flow of litigation. Within weeks, the legislature was on the verge of passing such a ban, only to pull back when the national business community raised an uproar of its own to defend letting the bylaw experiment go forward. 

Prof. Steve Bainbridge, a leading corporate law expert at UCLA, has now published a two-part post on why lawmakers and regulators should leave freedom of contract alone when it comes to such bylaws. In Part One, he recounts the evidence for believing that the business of private class-action shareholder litigation generally serves the interests of the lawyers who run it and not that of investors, transferring money from corporate treasuries (ultimately, from investors themselves) to an essentially identical class of investors following a large haircut of legal fees and costs. Deterrence of fraud, self-dealing, and managerial shirking, while an important objective, is poorly served by the class-action mechanism both because guilty individuals seldom pay and because transactions such as mergers and businesses in volatile markets are routinely sued, and made to pay legal toll, whether their managers have misbehaved or not. The result is a less competitive capital market from which internationally mobile companies and investors are increasingly retreating to more predictable legal regimes in other countries.

In Part Two, Bainbridge brings public choice analysis to bear, noting that Delaware’s sought-after corporate law regime is heavily shaped by the interests of repeat-player lawyers, who want to keep Delaware law efficient enough to keep attracting national businesses to incorporate there, yet not so efficient that it does away with the litigation and advisory opportunities that make for their own livelihood. What constrains them from yielding entirely to self-interest is that there is competition between states. Legislators in Oklahoma have moved to authorize loser-pays bylaws for companies incorporated there, and although it would take a lot to get companies to consider departing Delaware as a preferred state of incorporation, a few episodes like this might do it. Inevitably, hints are now in the air of federal action to put Oklahoma in its place: Sen. Richard Blumenthal (D‑CT), a frequent ally of plaintiff’s lawyers, has asked the federal Securities and Exchange Commission to step in to squash the option.

I agree with Bainbridge’s bottom line: approving fee shifting bylaws “is the right answer from a policy perspective.” It’s also the answer that is most respectful of contractual liberty.