Del. Chancery Court Eyes Fee-Shifting Bylaw, Casts Doubt on Enforceability in Test Case

By Michael Greene

March 11 — During a March 11 oral argument in what could be the first test case for fee-shifting bylaws in Delaware, the Delaware Chancery Court's Andre G. Bouchard questioned whether a corporation can bind stockholders to a fee-shifting bylaw that was adopted after their ownership interests were extinguished.

The plaintiff’s counsel, Gustavo F. Bruckner, Pomerantz LLP, New York, argued that the court should grant a motion for partial judgment on the pleadings—filed after the hearing—because allowing such a bylaw to be enforced flies against both contract and Delaware corporate law.

The defendant's attorney, Francis G.X. Pileggi, Eckert Seamans Cherin & Mellott, LLC, Wilmington, Del., countered that under certain circumstances a non-party can be bound to a contract, such as under a theory of promissory estoppel.

However, Chancellor Bouchard appeared to cast doubts about whether any of those limited circumstances applied to this case.

He also observed that under Delaware law, a stockholder cannot freeze the bylaw provisions that were in place at the time its shares were purchased because the deal a corporation has with its shareholders can change. However, he posited that this principle may not apply here because the bylaw imposed new obligations on stockholders after their ownership interests were extinguished.

Closely Watched Case

The plaintiff minority stockholder filed a Sept. 24 amended complaint against First Aviation Services Inc. and its board of directors alleging a breach of fiduciary duty in connection with a reverse stock split.

The amended complaint also included a challenge to a fee-shifting bylaw that the company enacted four days after the plaintiff and every other member of the putative class had their stock ownership in First Aviation extinguished, as a result of the reverse stock split.

The case involves two key legal questions. One is whether a company may bind stockholders to a bylaw adopted after their interests are extinguished, which is a question of first impression in Delaware. The second bears upon the scope of fee–shifting bylaws in Delaware in the wake of ATP Tour Inc. v. Deutscher Tennis Bund. In the May 2014 decision, the Delaware Supreme Court concluded that bylaws by Delaware non-stock corporations that shift litigation expenses to the losing party can be valid and enforceable.

Late last year, Chancellor Bouchard agreed to a proposed trifurcation that would resolve the more-nuanced issue regarding the timing of the defendant's “loser-pays” bylaw before any other issues in the case.

Proposed Legislative Amendments

Since the Supreme Court's ATP Tour decision, fee-shifting bylaws have proven to be a lightning rod for controversy in the corporate community as almost 40 companies have enacted them, according to research by Claudia H. Allen, a partner and co-chair of the Corporate Governance practice at Katten Muchin Rosenman LLP. Last week, the Delaware State Bar's Corporation Law Council proposed long-expected legislation to restrict the ability of stock corporations to adopt fee-shifting bylaws.

During the March 11 oral argument, Bruckner stated that even though the proposed amendments may preclude fee-shifting bylaws, the applicable bylaw is nonetheless still unenforceable against the plaintiff.

“While I have not carefully studied the proposed amendments to the DGCL, it appears that the legislature is moving in the right direction,” Bruckner said in an e-mailed statement to Bloomberg BNA. “Without such protections, wrongful conduct towards stockholders will go unchecked, as fee-shifting imposes potentially limitless liability on stockholders. Legislatures nationwide should follow suit!”

Timing Arguments

During the March 11 hearing, the court also heard argument about whether the timing of the bylaw's adoption was inequitable.

Bruckner argued that it would be inequitable to enforce the bylaw at issue because it would allow corporations to continuously bind shareholders to new terms for an indefinite period of time.

However, Pileggi countered that the defendant company would have adopted the bylaw regardless of whether the plaintiff was a stockholder because the defendant had a controlling stockholder. He additionally asserted that it was too early for the court to determine whether it would inequitable to apply the bylaw.

Chancellor Bouchard questioned whether there were additional facts that need to be developed.

After the hearing, in a statement e-mailed to BBNA, Bruckner said: “Our case is a prime example of why fee-shifting bylaws are pernicious. Here a controlling stockholder forcibly cashed out minority stockholders. The board wrongfully allowed this taking to occur and then adopted a fee-shifting provision which essentially serves as a unilateral grant of immunity from prosecution.”

To contact the reporter on this story: Michael Greene in Washington at mgreene@bna.com

To contact the editor responsible for this story: Ryan Tuck at rtuck@bna.com