Two recent decisions, one from the Delaware Court of Chancery and one from the California Court of Appeal, Fourth Appellate District, refused to apply bylaws that impaired a shareholder/member plaintiff’s ability to pursue his or her claims against the corporation where the the relevant bylaw was adopted after the plaintiff’s claims accrued.
In Strougo v. Hollander, C.A. No. 9770-CB, 2015 WL 1189610 (Del. Ch. Mar. 16, 2015), the Delaware Court of Chancery held that First Aviation Services, Inc.’s non-reciprocal fee-shifting bylaw did not apply to a former stockholder’s challenge to the fairness of a reverse stock split that the corporation undertook and that had the effect of involuntarily cashing out the plaintiff and other stockholders/putative class members. The reverse stock split was completed on May 30, 2014. The directors adopted the fee-shifting bylaw four days later, on June 3, 2014. Ten days later, Strougo filed suit on behalf of himself and a class of former stockholders whose interests in the company had similarly been eliminated as a result of the reverse stock split.
Because First Aviation is a non-SEC reporting company, it did not publicly announce to stockholders that the Board had adopted the bylaw. Accordingly, plaintiff and his counsel did not become aware of the fee-shifting provision until after they had filed the lawsuit. Strougo moved for partial judgment on the pleadings that the bylaw did not apply in that case because it was adopted after the split had already been consummated. In a case of first impression, the Chancery Court agreed with Strougo and held that the bylaw could not apply to him since he was not a stockholder at the time the bylaw was adopted. Once the reverse stock split occurred, Strougo’s status as a stockholder was terminated and he was no longer a party to the bylaws, deemed by Delaware courts to be a contract between the corporation and its stockholders. Therefore, the court reasoned, Strougo could not be bound by future amendments to the bylaws any more than a non-party to a contract could be bound by the terms of that contract.
Interestingly, before addressing the narrow question of whether the bylaw would apply in that particular case, the court noted the serious policy questions implicated by the fee-shifting bylaw:
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 [his] 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 stockholder, 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.
In Cobb v. Ironwood Country Club, 233 Cal. App. 4th 960 (2015), the California Court of Appeal addressed the potential retroactive application of a bylaw amendment mandating arbitration. In Cobb, past and current members of Ironwood Country Club (“Ironwood”) filed a declaratory relief action in August 2012 that arose out of Ironwood’s alleged breach of a 1999 agreement with its members under which each member had loaned the club $25,500 to fund the club’s purchase of additional land. In December 2012, four months after plaintiffs filed their complaint, Ironwood’s board of directors adopted a bylaw mandating arbitration of “any claim, grievance, demand, cause of action, or dispute of any kind whatsoever . . . of or by a Member past or present.” Ironwood contended that because the plaintiffs had each agreed to abide by the club’s bylaws when they became members, including a provision which allowed those bylaws to be amended, they were automatically deemed to have accepted and agreed to the subsequently adopted arbitration amendment.
The court held that Ironwood could not retroactively apply a bylaw amendment mandating arbitration to force plaintiffs to arbitrate their claims months after they had already filed their lawsuit. In affirming the trial court’s decision denying Ironwood’s motion to compel arbitration, the Court of Appeal rejected each of Ironwood’s arguments and explained that giving it the unfettered right to terminate or modify the agreement would render the contract illusory and thus, unenforceable.
The Cobb court also made clear that California’s implied covenant of good faith and fair dealing, applicable in every contract, prohibits a party from making unilateral changes that would operate retroactively to impair accrued claims and rights. Despite Ironwood’s attempt to characterize the dispute as one that was “ongoing” between the parties and therefore subject to the new arbitration provision, the Court held that plaintiffs’ claim had already accrued by the time the bylaw was adopted, and application of the arbitration provision to the dispute would therefore qualify as “retroactive,” regardless of whether the dispute was technically still ongoing. The court held that Ironwood would thus violate the implied covenant of good faith and fair dealing by retroactively applying the arbitration bylaw to plaintiff’s previously accrued claims.
The court took further issue with the fact that the bylaw also purported to alter the parties’ substantive rights by limiting Ironwood’s liability, in that it mandated a waiver of any award for punitive or consequential damages. He noted that the one-sided nature of the provision, coupled with the purported waiver of any punitive or consequential damages, could render the bylaw unconscionable.
Strougo and Cobb indicate that in both Delaware and California, courts will not favor retroactive application of bylaw amendments, especially those that impair only the rights of past or present shareholders without similarly impacting the company’s exercise of its rights. It is important to note, however, that both decisions addressed only the narrow issue of retroactive applicability of bylaws adopted or amended after the plaintiffs’ claims had accrued and that the timing and chronology of events were outcome determinative in both cases. Neither case addressed the facial validity of the respective bylaws at issue, and both left open the possibility of applying similar types of bylaws against “proper” plaintiffs in the future.