The Elusive Promise of Reducing Shareholder Litigation Through Corporate Bylaws

Holly J. Gregory is a partner and co-global coordinator of the Corporate Governance and Executive Compensation group at Sidley Austin LLP. This post is based on a Sidley update, and is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

Corporations today are routinely subject to expensive shareholder litigation for which shareholders ultimately foot the bill. Even weak shareholder claims pose significant costs and uncertainty, and exert significant settlement pressures, on corporations. Several recent state court decisions, however, underscore the potential for corporate bylaws, including those adopted by boards, to reduce incentives for the plaintiffs’ bar to file such lawsuits:

  • The Delaware Court of Chancery has upheld, at least as a general matter, the statutory and contractual validity of board-adopted bylaws that seek to limit the forum for intra-corporate litigation.
    • State courts in Louisiana, New York and Illinois have, in turn, enforced Delaware exclusive forum clauses.
  • The Delaware Supreme Court has upheld the statutory and contractual validity of bylaws that allocate the cost of intra-corporate litigation to a losing plaintiff.
  • A state court in Maryland has upheld a corporate bylaw that requires the arbitration of intra-corporate disputes.

Although these court decisions have spurred significant interest in board-adopted bylaws aimed at reducing incentives for the plaintiffs’ bar to file claims, caution is advised. Notwithstanding strong arguments in favor of deterring nuisance suits, which are costly to companies and their shareholders, some shareholders, shareholder rights advocates and proxy advisory firms have expressed disfavor with board-adopted exclusive forum and arbitration bylaws. Moreover, the Corporation Law Section of the Delaware State Bar Association has proposed a legislative amendment to the Delaware General Corporation Law (the “DGCL”) that would effectively prohibit Delaware stock corporations’ use of fee-shifting bylaws.

Exclusive Forum Bylaws

Prior to the late 1990s, plaintiffs commonly filed intra-corporate complaints in the jurisdiction of the state of incorporation. “The choice of law embedded in the decision to incorporate in any given state thus also operated as a de facto choice of forum provision.” Joseph A. Grundfest, The History and Evolution of Intra-Corporate Forum Selection Clauses: An Empirical Analysis, 37 DEL. J. CORP LAW 333, 373 (2012). However, as plaintiffs’ counsel have increasingly searched for the most generous forum for plaintiff counsel fee awards, it is now routine for a corporate action to be challenged in multiple jurisdictions. For example, according to an oft-cited paper authored by Matthew Cain and Steven Davidoff, 97.5% of takeover transactions valued at over $100 million in 2013 resulted in shareholder litigation, up from 39% in 2005 (link here).

Delaware Vice Chancellor J. Travis Laster proposed a potential solution to the problem of forum shopping in March 2010, in In re Revlon, Inc. Shareholders Litigation, 990 A.2d 940, 960 (Del. Ch. 2010) (link here), when in dicta he suggested the use of exclusive forum clauses in corporate charters: “[I]f boards of directors and shareholders believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, then corporations are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.”

Three years later, the Delaware Court of Chancery upheld exclusive forum bylaws adopted by two boards. Boilermakers Local 154 Retirement Fund and Key West Police & Fire Pension Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013) (link here). The fact that some shareholders had made their investments prior to the boards’ adoption of such bylaws was not an impediment. According to then-Chancellor Leo E. Strine, Jr., “the bylaws of a Delaware corporation constitute part of a binding broader contract among the directors, officers, and shareholders … This contract is, by design, flexible and subject to change in the manner that the DGCL spells out and that investors know when they purchase stock in a Delaware corporation.” The certificates of incorporation of each corporation authorized the boards to adopt bylaws unilaterally. Chancellor Strine noted, however, that based on the facts and circumstances of a particular case, a board-adopted exclusive forum bylaw may be subject to challenge if it operates unreasonably as applied or has been adopted or used for an inequitable purpose. He also emphasized that shareholders who object to such provisions have recourse in the form of board elections and shareholder proposals to amend or repeal such bylaws. The Delaware Supreme Court has not yet weighed in on this issue.

Decisions in three cases outside of Delaware suggest that foreign courts will respect exclusive forum bylaws, particularly if such provisions are adopted on a “clear day,” before a dispute has arisen:

  • Miller v. Beam Inc., 2014-CH-00932 (Ill. Ch. Ct. Mar. 5, 2014), granting the defendants’ motion to dismiss and enforcing an exclusive forum bylaw that provided that Delaware was the exclusive forum for M&A litigation.
  • Genoud v. Edgen Group Inc., No. 625,244 (19th Jud. Distr. Ct., East Baton Rouge, La. Jan. 17, 2014), granting the defendant’s motion to dismiss and enforcing an exclusive Delaware forum clause in a corporate charter.
  • Hemg Inc. v. Aspen Univ., No. 650457/13, 2013 WL 5958388 (N.Y. Sup. Ct. Nov. 14, 2013), granting the defendants’ motion to dismiss shareholder derivative claims based upon an exclusive Delaware forum clause in Aspen’s bylaws.

Fee-Shifting Bylaws

Generally, in the United States, including in the state of Delaware, unless parties to a lawsuit have otherwise agreed by contract (or a specific statute provides that the court can allocate costs against a losing party), each litigant is responsible for paying its own attorneys fees and court costs. Some jurisdictions outside the United States rely on a “loser pays” system to help discourage lawsuits of questionable merit and avoid pressures on corporations to settle non-meritorious suits early in the interests of saving the corporation time and money and avoiding uncertainty.

On May 8, 2014, the Delaware Supreme Court sitting en banc ruled, in ATP Tour, Inc. v. Deutscher Tennis Bund, — A.3d –, 2014 WL 1847446 (Del. May 8, 2014) (link here), that a board-adopted bylaw that provided for a losing plaintiff to pay defendants’ attorneys fees and costs associated with its intra-corporate suit was consistent with the provisions of the DGCL and Delaware common law. In 2006, the board of ATP Tour, Inc. (“ATP”), a non-stock, Delaware membership corporation, had amended its bylaws to provide that if a current or former member brought suit or counterclaimed against ATP, fellow members, or certain affiliates, and the member asserting the claim failed to “obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought,” the member must reimburse the fees, costs, and expenses incurred by ATP or other such parties defending against the claim or counterclaim. Thereafter, two members sued the company and six directors in the U.S. District Court for the District of Delaware and lost the claims on the merits. ATP moved to recover its fees, costs, and expenses under the fee-shifting bylaw, and ultimately the District Court certified the issue of bylaw validity and enforceability to the Delaware Supreme Court.

Although the Court warned that an otherwise valid bylaw would not be enforced if adopted or used for inequitable purposes, it stated that “intent to deter litigation … is not invariably an improper purpose.” In finding the bylaw at issue facially valid and enforceable, the Court also noted that a valid fee-shifting bylaw could require the plaintiff to bear the defendants’ expenses and could validly provide that such fee-shifting will occur only if the plaintiff is wholly unsuccessful, or as in the case before it, even if the plaintiff was partly successful. Further, the Court noted that fee-shifting bylaws can be enforced against pre-existing members of the corporation. Although the suit arose in the context of a non-stock membership corporation, the provisions of the DGCL concerning bylaws that were at issue apply to both stock and non-stock corporations, and therefore the ruling is not on its face limited to non-stock membership corporations.

This ruling has given rise to interest in the use of fee-shifting bylaws in traditional stock corporations. Yet, the potential use of fee-shifting bylaws as a mechanism to discourage nuisance suits may be short lived. The Corporate Law Section of the Delaware State Bar Association has reacted swiftly by proposing that the DGCL be amended to limit the effect of the ATP ruling. The stated concern is that requiring a shareholder plaintiff to bear the costs in a losing litigation would:

  • Unduly chill meritorious claims from being brought, and
  • Undermine the limited liability protections afforded to shareholders by Delaware corporate law.

The proposed amendments would clarify that fee-shifting bylaws, or other charter or bylaw provisions, may not impose monetary liability on shareholders of Delaware stock corporations (link here). Some have noted the irony of the Delaware corporate bar, usually stout defenders of Delaware corporations, petitioning the legislature to ensure the continuation of fiduciary duty lawsuits against Delaware corporations.

Arbitration Bylaws

In a pair of recent decisions relating to a real estate investment trust (“REIT”), a Maryland state court upheld bylaw provisions requiring shareholders to arbitrate rather than litigate claims. See Katz v. CommonWealth REIT, Case No. 24-C-13-001299 (Md. Cir. Ct. Feb. 19, 2014) (link here); Corvex Management LP v. CommonWealth REIT, Case No. 24-C-13-001111, 2013 WL 1915769 (Md. Cir. Ct. May 8, 2013) (link here).

The Circuit Court for Baltimore City, Maryland considered the Boilermakers decision of the Delaware Court of Chancery regarding the board’s ability to unilaterally adopt provisions addressing intra-corporate litigation, and held that Maryland law granted the trustees of REITs the unilateral authority to amend such bylaws. The Maryland Court concluded that all “shareholders assent to a contractual framework that explicitly recognizes that they will be bound by bylaws adopted unilaterally” and, further, that they have “purchased their shares with constructive knowledge that the arbitration bylaws were in effect and that their shares were subject to them.” The Maryland court explained that such constructive notice prior to purchase “is enough to constitute mutual assent of the parties.” Note that in a related case, Delaware County Employees Retirement Fund v. CommonWealth REIT, No. 13-10405-DJC (D. Mass. Mar. 26, 2014) (link here), the U.S. District Court for the District of Massachusetts observed that in light of the earlier Maryland decisions, the District Court would deny the plaintiffs’ request for a declaratory judgment that the arbitration bylaw adopted by the trustees was invalid and would not prevent the defendants from seeking to arbitrate the plaintiffs’ shareholder claims.

Practical Implications

In addition to the efforts to amend the DGCL noted above to prohibit fee-shifting in Delaware corporate bylaws or certificates of incorporation, shareholder pressures and pressure from influential proxy advisory firms may well inhibit the broad use of such provisions. For example, some shareholder groups and pension and union funds have expressed their disfavor of certain of these provisions, as follows:

  • Council of Institutional Investors. According to CII’s Corporate Governance Guidelines (Section 1.9), “Companies should not attempt to restrict the venue for shareowner claims by adopting charter or bylaw provisions that seek to establish an exclusive forum. Nor should companies attempt to bar shareowners from the courts through the introduction of forced arbitration clauses.”
  • AFL-CIO. Under the Proxy Voting Guidelines (Section D.16) of the AFL-CIO, “The voting fiduciary should vote against management proposals to restrict the venue for shareowner claims by adopting charter or bylaws provisions that seek to establish an exclusive judicial forum. Rules about where shareholders may sue are generally set by statute through the legislative process which balances competing concerns. Corporations should not deprive shareholders of the ability to bring lawsuits in the judicial forum of the shareholders’ choosing.”
  • New York State Common Retirement Fund. It has been reported that the Fund generally disfavors exclusive-forum provisions because the Fund believes that such provisions limit shareholders’ ability to hold corporations accountable.

Moreover, proxy advisory firms are likely to support shareholder proposals seeking to repeal exclusive forum, fee-shifting and arbitration bylaws. Both Institutional Shareholder Services (“ISS”) and Glass Lewis purport to review exclusive forum proposals on a case-by-case basis, taking into consideration, among other things, whether the company has adequately disclosed compelling arguments or evidence of abuse of legal process in other, non-favored jurisdictions. Note that ISS supported shareholder proposals to repeal exclusive forum bylaws at Chevron and United Rentals, Inc. in 2012, notwithstanding good corporate governance practices and public disclosures concerning the harms of multi-jurisdictional lawsuits by both companies. ISS stated that it was unable to determine that such harms were material.

Accordingly, we recommend that corporate counsel consider carefully the opportunities—and risks—associated with board-adopted bylaws that are intended to require a particular forum, arbitration or fee-shifting in connection with intra-corporate disputes. In particular:

  • Counsel should follow developments in this area closely. Counsel should be wary of adopting fee-shifting bylaws given ongoing legislative activity in Delaware and note that the Delaware courts have not yet weighed in on the enforceability of arbitration bylaws.
  • A company that is going public and has the opportunity to deter nuisance litigation by adopting provisions protecting against forum shopping or requiring arbitration of intra-company disputes in its certificate of incorporation or original bylaws should carefully consider doing so. There are advantages to this approach, given that later-board adopted bylaws could subject the board to criticism from shareholders and other groups. In addition, such later-adopted provisions may not be enforced if they are not adopted on a “clear day.”
  • A company interested in these bylaw provisions should first review the certificate of incorporation to confirm that it specifically grants the board the power to amend the bylaws.
  • Consideration of these bylaw provisions should be undertaken on a “clear day,” at a time when the company is not under a specific threat of litigation. Additionally, a board adopting these bylaw provisions should ensure that the board minutes accurately and fully reflect the board’s deliberations and the reasons why the board believes such provisions are in the best interests of the corporation and its stockholders. This may help to avoid equitable concerns that might lead a court to decline to enforce the bylaw as written.
  • A company considering board-adopted bylaw provisions should also consider the potential reaction of shareholders and shareholder rights groups, as well as proxy advisors. The reaction of some groups to exclusive forum and arbitration bylaws has historically been negative, and the response to the ATP decision regarding fee-shifting bylaws remains to be seen.
  • Delaware public companies will also need to review ongoing legislative developments when considering whether to adopt a fee-shifting bylaw. If approved by the Executive Committee of the Delaware State Bar Association and adopted by the legislature, the amendments proposed by the Corporate Law Section would become effective on August 1, 2014.
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