In Corporate Litigation | On March 17, 2015
On March 16, 2015, Chancellor André Bouchard of the Delaware Court of Chancery issued an important decision, on the high-profile topic of fee-shifting bylaws, in Strougo v. Hollander, 2015 WL 1189610 (Del. Ch. March 16, 2015). The bylaw in question had been adopted by the board of directors of First Aviation Services, Inc., a Delaware corporation. The bylaw provided that, if any stockholder of the corporation were to assert a claim against the corporation or any of its directors, officers or employees, the claimant would be obligated to pay all fees and expenses incurred in the defense of the claim, unless the claimant “obtain[s] a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought….”
The corporation’s board had adopted the fee-shifting bylaw four days after consummation of a 10,000-to-1 reverse stock split, the effect of which was to “cash out” the plaintiff and the class he purported to represent, and eliminate them as stockholders. In their suit, the plaintiff challenged both the reverse stock split and also the fee-shifting bylaw.
The plaintiff in Strougo moved for a ruling that the fee-shifting bylaw could not be enforced against them. The Court decided the motion based on “the narrow question … whether, as a matter of law, the Bylaw applies to Plaintiff’s lawsuit given that it was adopted after the Reverse Stock Split had been consummated.” Id., slip op. at 10. Addressing what he called an issue of first impression, the Chancellor held that:
the Bylaw does not apply here for two related reasons: (i) the Board adopted the Bylaw after Plaintiff’s interest in the Company was eliminated in the Reverse Stock Split; and (ii) Delaware law does not authorize a bylaw that regulates the rights or powers of former stockholders who were no longer stockholders when the bylaw as adopted.
Id. at 11. The Chancellor noted that, under Delaware law, including Boilermaker Local 154 Retirement Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), bylaws have been held to be, “in effect, an ‘inherently flexible’ contract between the corporation and its stockholders.” Strougo, slip op. at 12-13. He also held that a “logical and implicit corollary of Chevron is that a stockholder whose equity interest in the corporation is eliminated in a cash-out transaction is, after the effective time of that transaction, no longer a party to that flexible contract.” Id. Thus, “a former stockholder is not subject to, or bound by, any bylaw amendments adopted after one’s interest in the corporation has been eliminated.” Id. (emphasis added).
The Court of Chancery in Strougo rejected the corporation’s argument that the bylaw was necessarily enforceable under the Delaware Supreme Court’s decision in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), which involved a similar bylaw adopted by the board of a non-stock corporation. Chancellor Bouchard noted that the Supreme Court in ATP had held that “a bylaw amendment is enforceable against members who join the corporation before its enactment,” (Strougo, slip op. at 19, citing ATP, 91 A.3d at 560), but he also held that “the Supreme Court’s decision [in ATP] cannot responsibly be read to hold” that a bylaw “regulates the rights and powers of members who were no longer stockholders when that bylaw was adopted.” Strougo, slip op. at 19.
In dicta, the Chancellor in Strougo also questioned some of the “implications of the Bylaw and what is not presently before the Court.” Id., slip op. at 7. As the Chancellor 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.
Id., slip op. at 8-9.
The Delaware General Assembly is expected soon to consider proposed legislation that addresses some of the policy considerations identified by the Court of Chancery in Strougo. The proposed legislation has been subject to much discussion and debate among practitioners and academics, and such discussion is likely to continue until the legislation is acted upon, and possibly beyond that time.