DealLawyers.com Blog

May 22, 2014

Fee-Shifting Bylaws Not Ready for Prime Time?

Over on TheCorporateCounsel.net, I recently blogged about how the Delaware Supreme Court found that fee-shifting bylaws are permissible (there are numerous memos posted on that site about this case). As with exclusive venue bylaws, whether many companies decide to adopt these litigation-related bylaws will likely hinge on the reaction of the proxy advisors and major institutional investors. Here’s a nice article by David Marcus of The Deal about this case:

A recent decision from the Delaware Supreme Court has corporate lawyers and litigators pondering a potentially new way to curb shareholder litigation. On May 8, the court unanimously held legal under Delaware law a
corporate bylaw providing that a shareholder who sues the company unsuccessfully must pay it for the costs of defending the suit. Justice Carolyn Berger’s 14-page opinion in ATP Tour Inc. v. Deutscher Tennis Bund answered only the question of whether such bylaws are legal under Delaware statutory law and did not offer guidance on when a corporate board might be able to implement one consistent with its fiduciary duties. Combined with a 2013 decision in which then-Chancellor Leo E. Strine Jr., upheld a corporate bylaw that requires all fiduciary duty litigation against a company to be brought in the Delaware Court of Chancery, the ATP decision could give companies a powerful tool against insurgent shareholders. (Strine is now the chief justice of the state’s Supreme Court.)

Said one New York M&A lawyer, “This decision opens the door to adding these fee-shifting provisions on top of forum-selection bylaws, with the possibility that these fee-shifting provisions will be more effective in deterring
frivolous shareholder litigation altogether with the forum selection bylaws only effective in eliminating duplicative litigation outside Delaware.”

The ATP case originated not in Delaware state court but in federal court. The Deutscher Tennis Bund and the Qatar Tennis Foundation sued the ATP in U.S. District Court in Delaware after the organization downgraded the tournament played in Hamburg, which the DTB and the QTF own and operation. The plaintiffs claimed that the ATP — a Delaware membership corporation to which both entities belong — violated its fiduciary duties and U.S. antitrust laws with the downgrade. The federal district court found for ATP, which moved to recover its legal fees from DTB and QTF based on a provision in its bylaws. The district court certified the question of the bylaw’s legality to the Delaware Supreme Court.

Berger held that fee-shifting bylaws are “facially valid” under Delaware law but cautioned, “Whether the specific ATP fee-shifting bylaw is enforceable, however, depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that may otherwise be facially valid will not be enforced if adopted or used for an inequitable purpose.”

Companies may adopt a fee-shifting bylaw to deter litigation, Berger held, because the intent to do so “is not invariably an improper purpose. Fee-shifting provisions, by their nature, deter litigation. Because fee-shifting provisions are not per se invalid, an intent to deter litigation would not necessarily render the bylaw unenforceable in equity.”

The ruling was greeted with hearty approval by corporate lawyers, several of whom said that the ATP ruling should be applicable to stock corporations even though the decision involved a non-stock or membership organization. But that doesn’t mean corporations will start adopting such bylaws immediately, since proxy advisory firms and some institutional shareholders would likely oppose them vociferously and the bylaw would need to be appropriately tailored to a company’s specific situation. “In appropriate circumstances, such as the commencement of a sale process, the value of the bylaw could outweigh the negative consequences,” the lawyer said.

In a memorandum to clients, Wilson, Sonsini, Goodrich & Rosati PC said that boards of Delaware companies should “seriously consider” adopting such bylaws. The best time to do so would be “on a ‘clear day,’ when a board is not facing threatened or pending derivative litigation.” The optimal clear day might even be before a company goes public. The Wilson memo noted several caveats to the adoption of a fee-shifting bylaw. First, shareholders always retain the right to amend corporate bylaws and might well try to amend one that provides for fee shifting of litigation costs. Second, as Berger noted in the opinion, a Delaware court might hold that the board use of such a bylaw in a given situation might constitute a breach of fiduciary duties. Finally, the memo noted, other states might not honor fee-shifting bylaws. “The issue will likely be the subject of a lot of debate in the boardroom in the coming months as the recent Delaware decisions signal that companies may consider a variety of ways to control or limit the costs of frivolous litigation,” said Katherine Henderson, a partner in Wilson’s San Francisco office.

A. Thompson Bayliss, a partner at Abrams & Bayliss LLP in Wilmington, said that the ATP decision could encourage other kinds of bylaws designed to curb stockholder litigation. He suggested a bylaw that would opt out of the so-called corporate benefit doctrine, which allows stockholders to recover attorneys’ fees from the corporation if they confer a benefit on the corporation. At least in some instances, that type of bylaw would require suing stockholders to bear the costs of the litigation they bring, rather than imposing the costs on the corporation (and indirectly on the entire stockholder base). That could have a chilling effect on stockholder strike suits, but the widespread adoption of such bylaws remains a long way off, Bayliss said.