In a recent en banc decision that could help stem the tide of intra-corporate stockholder litigation involving Delaware corporations and blunt criticism of the Delaware courts’ failure to discourage the obligatory class action filed against every merger, the Delaware Supreme Court has unanimously upheld the validity of a bylaw adopted by a Delaware non-stock corporation providing that an unsuccessful plaintiff in intra-corporate litigation (e.g., suits alleging breaches of fiduciary duties, derivative suits, claims arising under the General Corporation Law of the State of Delaware (DGCL), and other internal affairs claims brought by stockholders) would be required to pay the defendants’ attorneys fees and expenses.1 The Court further held that the enforceability of a specific fee-shifting bylaw would depend on the circumstances surrounding its adoption and use, and that if such a bylaw were adopted for an improper purpose it would be unenforceable. The Court specifically stated that a board’s intent to deter litigation would not necessarily be deemed an improper purpose.

Although the case involved a Delaware non-stock corporation, as discussed below, public and private Delaware stock corporations will find the decision relevant.

Opinion

Background. The underlying case involved an intra-corporate dispute involving a Delaware non-stock membership corporation, not a typical Delaware stock corporation. Two members of the ATP Tour, a global tennis organization (ATP), sued ATP and certain of its board members alleging both federal antitrust and Delaware fiduciary duty claims. The members’ claims were unsuccessful and, as a result, ATP subsequently sought to recover its legal fees, costs and expenses based on its fee-shifting bylaw.2

Certified questions of law for the Delaware Supreme Court. The Delaware Supreme Court’s opinion was issued in response to four certified questions of law submitted by a Delaware federal district court that had determined the validity of the ATP fee-shifting bylaw was an open question under Delaware law.

  • Fee-shifting bylaws are permissible under Delaware law, but their enforceability depends upon the circumstances surrounding their adoption and use. The Court held that the adoption of a fee-shifting bylaw by a Delaware non-stock corporation is facially valid since it was not prohibited by the DGCL or any other Delaware statute or common law. The Court noted that bylaws are “contracts among a corporation’s shareholders,”3 and that a validly-enacted fee-shifting bylaw falls within the settled contractual exception to the “American Rule” requiring parties to bear their own attorneys’ fees and expenses absent a statute or contract to the contrary. Although the case involved a non-stock corporation, the Court reached its decision after considering provisions of the DGCL and case law involving Delaware stock corporations. Thus, the Court’s decision would appear to apply to both Delaware non-stock and Delaware stock corporations alike.

Despite upholding the facial validity of a fee-shifting bylaw, the Court cautioned that the enforceability of the bylaw depended upon the circumstances surrounding its adoption and use. The Court noted that otherwise facially valid bylaws “may be enforceable if adopted by the appropriate corporate procedures and for a proper corporate purpose,”4 but “will not be enforced if adopted or used for an inequitable purpose.”5 The Court cited the landmark case Schnell v. Chris-Craft Industries which found a bylaw amendment adopted for the purpose of director entrenchment inequitable.

  • If valid and enforceable, a fee-shifting bylaw could shift fees where plaintiff obtains “no relief at all against the corporation.” Recognizing the difficulty in applying the “substantially achieves” standard found in ATP’s fee-shifting bylaw, the Court noted that as long as the bylaw is adopted and used for a proper purpose the bylaw would be enforceable to shift fees where the plaintiff obtains “no relief at all against the corporation.”6 The Court left open the issue of the situation where a plaintiff obtained some, but not all, relief sought. This issue is akin to the problem, in some cases, of determining who is the “prevailing party” where a clause visits attorney’s fees and costs on the party that does not prevail in litigation.
  • Fee-shifting bylaws adopted for an improper purpose are unenforceable. After writing that “[l]egally permissible bylaws adopted for an improper purpose are unenforceable,” the Court noted that one or more board member’s subjective intent to adopt a fee-shifting bylaw to deter litigation is “not invariably an improper purpose” that would render a bylaw unenforceable.7 The Court did not provide any other guidance as to what would be an improper purpose or use.
  • Bylaw amendments are enforceable against existing members. The Court cited last year’s Delaware Chancery decision involving the validity of a forum selection bylaw for the proposition that “stockholders will be bound by bylaws adopted unilaterally by their boards” if directors are authorized in the corporation’s charter to unilaterally amend bylaws.8

Enforceability of ATP fee-shifting bylaw not decided. Because the Court was only responding to certified questions, it did not have the factual record presented to it for consideration. As a result, the Court could only decide that the ATP fee-shifting bylaw was facially valid, but could not determine whether the bylaw was adopted for a proper purpose or was otherwise enforceable.

Practical Considerations

The decision provides an opportunity to consider the adoption of a fee-shifting bylaw to attempt to minimize the risk and costs associated with stockholder litigation. That said, boards should carefully consider whether such a bylaw is in their corporation’s best interest and consult with outside counsel and possibly institutional investors before proceeding. When weighing whether to adopt a fee-shifting bylaw, boards of Delaware stock corporations should consider, among things, the following:

  • The opinion does not directly address the validity or enforceability of a fee-shifting bylaw adopted by Delaware stock corporations. Since the DGCL provisions that the Court cited apply to stock and non-stock corporations, the Court’s decision would appear to apply to both Delaware non-stock and stock corporations alike. However, there is some risk that a Delaware court could find otherwise.
  • The opinion leaves open the possibility that a board’s decision to unilaterally adopt the bylaw could be subject to challenge as a breach of fiduciary duty and be deemed unenforceable. Boards should carefully consider their corporation’s circumstances and the board’s intention and purpose in adopting a fee-shifting bylaw. As noted by the Court, the intention to deter litigation is not necessarily an improper purpose. To reduce the chances of a successful challenge to the board’s action, boards should consider adopting a fee-shifting bylaw only when the corporation is not involved in, or facing potential, intra-corporate stockholder litigation.

Moreover, boards should be aware that the bylaw may be found unenforceable for other reasons. Prior to submitting the certified questions of law to the Delaware Supreme Court, the federal district court initially rejected ATP’s motion to recover fees because “federal law preempts the enforcement of fee-shifting agreements when antitrust claims are involved.”9

  • Courts outside of Delaware may not enforce a fee-shifting bylaw or may interpret it differently. As many plaintiff lawyers seek to bring suit in jurisdictions other than Delaware, a non-Delaware court may choose to apply its state’s law when determining whether to enforce and how to interpret a fee-shifting bylaw. In such cases, the bylaw may not be enforced or may be interpreted differently than the board expected. This raises difficult constitutional and choice of law questions about the reach of internal affairs and related doctrines.
  • To unilaterally adopt a fee-shifting bylaw, the board must be authorized in the certificate of incorporation to unilaterally adopt or amend the corporation’s bylaws. If a board is not authorized to unilaterally amend its bylaws, any fee-shifting bylaw adopted by the board would need to be approved by stockholders before taking effect. When considering whether to unilaterally adopt a fee-shifting bylaw, boards should be aware that adoption may result in stockholder proposals to repeal or otherwise amend the fee-shifting bylaw. For this reason, boards may deem it to be in the corporation’s best interests to submit any proposed fee-shifting bylaw to a stockholder vote.
  • Proxy advisory firms and institutional investors may not support fee-shifting bylaws. Boards should stay abreast of the latest positions of the proxy advisory firms, such as ISS and Glass Lewis, and the voting guidelines of the corporation’s institutional investors on fee-shifting bylaws to understand how the adoption of such a bylaw could impact the voting recommendations of the advisory firms and the voting of the institutional investors. Since this was a case of first impression, it is unclear how proxy advisory firms and institutional investors will react to the adoption of a fee-shifting bylaw. Based on the proxy advisory firms’ current positions towards exclusive forum bylaws and poison pills, it would not be surprising to see these firms recommend against fee-shifting bylaws outright or take a case-by-case approach where their recommendation is contingent on specified conditions being satisfied.
  • Stock corporations should take care in drafting their fee-shifting bylaw.Since ATP is a non-stock corporation, its fee-shifting bylaw may not serve as an effective template for Delaware stock corporations. We suggest you discuss any proposed language with your outside counsel to ensure not only that the bylaw is appropriate for a stock corporation, but also that the bylaw does not otherwise conflict with the corporation’s charter or other governing documents.
  • The opinion did not address the facial validity of a fee-shifting clause in a Delaware certificate of incorporation. Although it would appear that such a clause would be less susceptible to attack because stockholders would need to approve an amendment of the certificate of incorporation to insert such a clause, Delaware corporations attempting to include such a clause in their charter face some risk that a Delaware court could deem it invalid and unenforceable.