In a case just decided, Strougo v. Hollander, C.A. No. 9770-CB (Del. Ch. Mar. 16, 2015), the Delaware Chancery Court addressed the issue of whether the timing of adoption affects the enforceability of a unilaterally adopted fee-shifting bylaw against former stockholders. While it appears that, in light of potential action by the Delaware legislature, the continued viability of fee-shifting bylaws in Delaware is somewhat tenuous, the case may also have application to the enforceability of other bylaw provisions to former stockholders.
The case was brought on behalf of a number of former stockholders who were involuntarily cashed out of a company as a result of a reverse stock split. After the split was effected, the company’s board adopted a fee-shifting bylaw, modeled after ATP Tour, Inc. v. Deutscher Tennis Bund (see this Cooley Alert and this post), which purported “to create fee exposure not only for former stockholders of the Company, but for anyone acting on their behalf,” including plaintiff’s counsel. The plaintiff filed suit, claiming that the split was unfair and, after learning of the bylaw, challenging the bylaw. The Court observed that facial validity of the bylaw was not at issue; rather, the plaintiff sought a partial judgment on the pleadings on the basis that the bylaw was inapplicable because it was adopted after the reverse split was effected and the plaintiff had been cashed out.
The Court agreed with the plaintiff. Applying basic principles of contract law, the Court concluded that the bylaw was not applicable “because it was adopted after the plaintiff was cashed out of the Company by operation of the Reverse Stock Split. More specifically, I hold that changes made to the Company’s bylaws after the plaintiff was cashed out are not binding on him for the same reason that a non-party to a contract is not bound by the terms of that contract. I also conclude that Section 109(b) of the Delaware General Corporation Law (the “DGCL”) does not authorize the adoption of bylaws to regulate the rights or powers of former stockholders whose interests in the corporation already have been eliminated.”
Before addressing the issue then before the Court, the Court “paus[ed] to consider” some of the policy implications of fee-shifting bylaws. Let’s just say that the Court did not hold back. The Court commented that ”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. [The Court had presumed that, because of the nature of the case, the entire fairness standard would apply.] 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.”
After reviewing the arguments of both sides, the Court held that the bylaw was inapplicable to the plaintiff 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 was adopted.” Section 109(b) of the DGCL authorizes bylaws that regulate the rights and powers of “stockholders.” Although bylaws are a flexible contract, “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.”
In addition, the Court looked to the opinion by then-Chancellor Strine in Boilermakers Local 154 Retirement Fund v. Chevron Corp, which upheld the facial validity of a forum selection bylaw: in that case, Strine “postulated in dicta that ‘it is not the case that a bylaw in effect at the time that a stockholder’s internal affairs claim arose cannot bind that stockholder simply because the transaction she is challenging resulted in her no longer being a stockholder.’ Instead, the bylaws in effect at the effective time of a cash-out transaction would continue to bind a stockholder who challenges that transaction post-closing ‘because her right to sue continues to be based on her status as a stockholder.’”
Accordingly, the Court held that “the governing bylaws are those in effect when the former stockholder’s interest as a stockholder was eliminated,” and that a “former stockholder is not subject to, or bound by, any bylaw amendments adopted after one’s interest in the corporation has been eliminated.” The Court distinguished other cases that held bylaws applicable to former stockholders on the basis that, in all of those cases, the bylaw was in effect while the former stockholder was a stockholder. In addition, it was not deemed relevant that the bylaw was adopted before the plaintiff filed suit or that the board had the right under the DGCL to continue to amend the bylaws after the reverse split. Nor did this case implicate the now-repudiated “vested rights doctrine,” because the plaintiff was not contending that he detrimentally relied on bylaws previously in effect while the plaintiff was a stockholder.