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Summaries and analysis of recent Delaware court decisions concerning business-related litigation.
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Court of Chancery Addresses Application of Fee-Shifting Bylaw
The Rites of Spring are upon us: budding flowers, warmer temperatures, and a Delaware court issuing an important decision just before the annual Tulane Corporate Law Institute begins. This year the honor of issuing that decision fell to Chancellor Bouchard who issued his opinion in Strougo v. Hollander, C.A. No. 9770-CB (Del. Ch.) on March 16, 2015. The opinion addressed plaintiff’s motion for partial judgment on the pleadings that a fee-shifting bylaw adopted after the challenged transaction did not apply to him. The Court found that the fee-shifting bylaw did not apply to the plaintiff in this case, and in reaching this conclusion, made some interesting comments that will undoubtedly further the debate over the proposed legislation to eliminate fee-shifting bylaws and regulate forum selection bylaws.
The facts of Strougo are not complex. The company, First Aviation Services, Inc., engaged in a 10,000-1 reverse stock split, allegedly at the behest of its chief executive officer and controlling stockholder, that had the effect of cashing out the plaintiff. Four days after effecting the reverse stock split, the company adopted a fee-shifting bylaw that would make a plaintiff liable for the defendants’ legal fees unless the plaintiff obtains “a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.” Eleven days after the company adopted the bylaw, the plaintiff filed the action on behalf of himself and a class of former stockholders of the company who had been cashed out, alleging that the reverse stock split was unfair. After learning of the fee-shifting bylaw, the plaintiff amended his complaint to challenge the bylaw. The plaintiff then filed a motion for partial judgment on the pleadings, not to challenge the facial validity of the bylaw, but on the grounds that it does not apply to him because it was adopted after he had been cashed out of the company. Before beginning his analysis of the parties’ arguments, the Court discussed the implications of the fee-shifting bylaw and what was not before the Court. These comments arguably provide the most interesting fodder for the current debate over fee-shifting bylaws. The Court first acknowledged that the entire fairness standard presumably would apply to the reverse stock split. The Court then noted that by definition, every member of the putative class received less than $84,000 as a result of being cashed out of company. The Court then stated:
As a practical matter, therefore, applying the Bylaw in this case would have the effect of immunizing the Reverse Stock Split from judicial review because, in my view, no rational stockholder – and no rational plaintiff’s lawyer – would risk having to pay the Defendants’ uncapped attorneys’ fees to vindicate the rights of the Company’s minority stockholders, even though the Reverse Stock Split appears to be precisely the type of transaction that should be subject to Delaware’s most exacting standard of review to protect against fiduciary misconduct. This reality demonstrates the serious policy questions implicated by fee-shifting bylaws in general, including whether it would be statutorily permissible and/or equitable to adopt bylaws that functionally deprive stockholders of an important right: the right to sue to vindicate their interests as stockholders.
Notwithstanding this stinging language, the Court found that it did not need to reach those issues, because the motion before it focused solely on the timing of the adoption of the bylaw. The Court held that the bylaw did not apply for two related reasons: (1) the board adopted the bylaw after the plaintiff’s interest in the company was eliminated as a result of the reverse stock split and (2) the General Corporation Law does not permit adoption of a bylaw that regulates the rights of former stockholders who were not stockholders when the bylaw was adopted. The Court acknowledged then-Chancellor Strine’s opinion in Boilermakers Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) which held that under Section 109 of the General Corporation Law, if a corporation’s charter authorizes the board to amend the bylaws unilaterally, the bylaws are an “inherently flexible” contract between the corporation and the stockholders. The Court held that it made sense that a stockholder whose equity interest is eliminated is no longer party to that contract and cannot be bound by amendments occurring after she was no longer a party. This holding, however, did not mean that former stockholders were no longer bound by the corporation’s bylaws; rather, they were bound only by the bylaws in place at the time their claim arose, even if the claim challenged a transaction that resulted in the elimination of her equity interest in the corporation. In short, once a stockholder is cashed out of a company, she is not subject to bylaws adopted after she was cashed out. The Court then supported its conclusion by noting it was consistent with principles of statutory interpretation, because the General Assembly knew how to distinguish between former and current corporate actors in other sections, but did not do so in Section 109. The Court also rejected defendants’ arguments that it was implicitly reviving the “vested rights” doctrine. The Court held that the plaintiff was not arguing that the bylaw does not apply because he acted in detrimental reliance on the bylaws in effect before it was adopted. Instead, the plaintiff argued that he was no longer party to the “flexible” contract when the bylaw was adopted. This opinion raises two interesting issues. First, the Court’s comment that no rational plaintiff’s lawyer would bring a case in the face of a fee-shifting bylaw likely will be used by both sides of the debate on the proposed legislation on fee-shifting bylaws. The proponents will say, “See, the Chancellor agrees that these bylaws will effectively eliminate stockholder litigation when it is needed most, so we are right to step in.” The opponents of the legislation will say, “See, the courts can handle the situation when they need to, so there isn’t any need for an outright ban on all fee-shifting bylaws.” Either way, these comments will certainly liven up the debate on the proposed legislation. Second, the Court’s analysis here developed further the case law on the ability of the board to regulate stockholder litigation pursuant to bylaws. The Court definitively stated that bylaws adopted after elimination of a stockholder’s interest cannot apply to that stockholder. The Court did not disturb the notion, however, that bylaws adopted after a challenged transaction could apply to stockholders whose equity interests were not eliminated. Even if the General Assembly adopts some or all of the proposed legislation addressing bylaws, there may still be room for development of the common law in this area.