Deterring Frivolous Stockholder Suits Without Closing Doors to Legitimate Claims

The following post comes to us from Mark Lebovitch and Jeroen van Kwawegen of Bernstein Litowitz Berger & Grossmann LLP. This post 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.

The Delaware Supreme Court’s May 8, 2014 Opinion in ATP Tour, Inc. v. Deutscher Tennis Bund (“ATP”) marked a sudden and potentially transformative moment in the relationship among corporate boards, their stockholders, and the Delaware legal system. The article, Deterring Frivolous Stockholder Suits Without Closing Doors to Legitimate Claims, asserts that the “nuclear option” of allowing boards of public companies to employ fee-shifting bylaws against stockholders whose interests they are supposed to represent is poor policy and departs from well-established legal principles. Accordingly, the authors support the March 6, 2015 proposal from the Delaware Corporation Law Council to legislatively prohibit the use of fee-shifting provisions in the public company context. Rather than simply criticize ATP and support the legislative proposal, we propose a carefully tailored answer to frivolous litigation, which mitigates abuses, conforms to longstanding legal principles, and preserves the benefits of board accountability and meritorious stockholder litigation.

First, the article argues that directors must not be permitted to use their corporate and fiduciary powers as a weapon to avoid accountability to the stockholders whose assets they manage. The authors detail the policy and legal problems with the concept of allowing directors to impose fee shifting bylaws, putting in question the relationship between stockholders and boards that forms the foundation of the modern public corporation. If ATP applies to public corporations, the Delaware Supreme Court, sub silentio, reversed several bedrock principles of Delaware corporate law and upset the balance of powers between stockholders and boards that has been in existence for decades.

The authors observe that Delaware Supreme Court precedent previously distinguished “process-focused,” bylaws, from substantive bylaws. The process versus substance distinction flows naturally from the statutory treatment of charter provisions, under Section 102 of the Delaware General Corporation Law (“DGCL”), versus that of bylaws, under Section 109. By allowing director-adopted bylaws to regulate substantive and personal stockholder rights, however, the ATP Court applied a deferential standard applied to assess the validity of director-adopted bylaws that undermine core stockholder rights, while under the CA v. AFSCME precedent, Delaware law would apply a highly restrictive standard to a stockholder-endorsed bylaw that could, hypothetically, impinge on director powers.

Statutory distinctions between the substantive rights and powers set forth in a corporate charter and the procedural rules set forth in bylaws are rendered irrelevant if directors have free reign to rewrite substantive stockholder rights as they see fit. In this regard, director imposed bylaws that impair substantive stockholder rights, including the right to sue, do not fit the standard definition of an enforceable contract. Centuries of contract law makes clear that contracts cannot be materially changed without consideration or the ability to rescind.

Moreover, if fee-shifting provisions in corporate documents are treated as biding contracts, then these contracts are plainly related-party transactions that are void or voidable pursuant to DGCL § 144, absent one of three statutory safe harbors: (1) approval by disinterested and independent directors of the company; (2) approval by a disinterested and fully informed stockholder majority; or (3) judicial determination that the transaction was entirely fair to the company and its stockholders. Director-adopted fee-shifting provisions also conflict with Rule 11 of the Federal and Delaware Rules of Civil Procedure, governing frivolous litigation filings. Moreover, since the federal securities laws generally preempt any state law or agreement that would absolve individuals governed by federal disclosure law of liability for violations, Delaware potentially risks ceding its leadership position to federal law if it allows corporate directors to effectively block stockholder suits regardless of their merit. In sum, for a variety of policy and legal reasons, ATP should be legislatively overruled. The judiciary’s hands are tied by respect for stare decisis and the damage from a failure to prevent unilateral fee shifting will be swift and severe.

Besides challenging ATP, the authors propose an alternative to fee shifting to reduce the number of cases that provide no material benefit to stockholders and put a strain on corporations and the judiciary. Expanding upon the logic of existing Delaware case precedent, the authors propose a two part test that would eliminate the weakest two-thirds of all stockholder litigation. Under the proposed test, before “disclosure-only settlements” are approved, the Court would affirmatively determine that: (1) the disclosures providing the purported consideration to stockholders are, in fact, material, and (2) subject to judicial discretion to approve a broader release for good cause shown, the release is limited to the benefit of the disclosures obtained, so as to ensure that meritorious claims that were not properly vetted by counsel are not inadvertently or thoughtlessly released. A disclosure that is not material as a matter of law is not consideration as a matter of fact. Without consideration, there should be no settlement.

While corporate actors would lose their access to overbroad litigation releases, they could still obtain protection from future suit for conduct that was genuinely vetted through the litigation process. Most important, by applying the above-proposed rule, the number of frivolous suits will decrease, the increasingly hostile criticism of stockholder litigation in the merger context will lose its basis, the societal burden posed by meritless suits will be curtailed, and core stockholder rights and the societal benefit of meaningful stockholder litigation will be preserved.

The full article is available for download here.

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