United States: Delaware Supreme Court Holds That Boards May Adopt Fee-Shifting Bylaws

In ATP Tour, Inc. v. Deutscher Tennis Bund, the Delaware Supreme Court recently found that a provision in a Delaware corporation's bylaws, if drafted for a proper corporate purpose, may provide that the losing party in intra-corporate litigation must pay the winning party's legal fees.1 While the proper corporate purpose determination hinges on the individual circumstances of each case, the court noted that "[t]he intent to deter litigation . . . is not invariably an improper purpose." We bring this opinion to your attention because of the potential planning opportunity it bestows upon corporate boards that have the power to adopt bylaws unilaterally. We also note, however, the conditions and potential drawbacks to such a bylaw provision.

What is a fee-shifting bylaw, and why did the Court find it facially permissible?

A fee-shifting bylaw is simply a provision in a corporation's bylaws that requires the losing party in intra-corporate litigation (such as a suit brought by shareholders against the company) to pay the winning party's legal fees. There can be more nuance to what is considered to be "winning," however. For instance, in ATP, the bylaw provided that the plaintiff would be liable for the defendant's legal fees if the plaintiff did not "obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."

The ATP Court applied common law principles relating to contracts in finding that the fee-shifting bylaw at issue was not per se invalid. Generally speaking, under the "American Rule," the losing party in a lawsuit is not responsible for the winning party's legal fees. However, states such as Delaware, New York, and New Jersey permit parties to modify this rule by contract, and provide that the loser is responsible for the winner's legal fees.2 Corporate bylaws are considered to be contracts between the shareholders and the corporation. Thus, the ATP Court found the bylaw provision at issue to be no different than any contract clause permitting fee-shifting.

What are the limitations on the Court's ruling?

Just as important is what the Court did not hold, the Court did not make a finding on the issue whether that particular bylaw was permissible under the circumstances of the case at hand. Such an analysis would involve a determination as to whether the bylaw was "adopted by the appropriate corporate procedures and for a proper corporate purpose," a determination that will now have to be made by the court that certified the issue to the Delaware Supreme Court. Thus, the ATP holding does not give directors carte blanche to pass a fee-shifting bylaw in all instances. In particular, directors must remember that in adopting a fee-shifting bylaw, they remain bound by their fiduciary duties to the corporation and shareholders. This means that they cannot adopt a fee-shifting bylaw if doing so would constitute a breach of their duty of loyalty to the corporation and the shareholders.

The Court did, however, provide some guidance on the "proper purpose" question when it noted that "[t]he intent to deter litigation . . . is not invariably an improper purpose." In that statement, the Court appears to be indicating that the general intent of a corporate board to prevent excessive shareholder litigation is not improper. However, the board might cross a line if it passes a fee-shifting bylaw in order to deter a specific lawsuit challenging improper conduct of the directors, or the directors attempt to entrench themselves in office. Such actions could arguably be a breach of the duty of loyalty.

What is the broader significance of the ATP holding?

Though ATP was decided in the context of a tennis-tournament scheduling dispute, it is likely to have its largest impact on mergers-and-acquisition litigation – which often pits dissident shareholders (and their attorneys) against corporate boards. Critics of these lawsuits decry them as often-frivolous actions that force companies to settle with the plaintiffs solely to avoid substantial litigation costs. It is possible that fee-shifting bylaws will serve as a deterrent against inappropriate shareholder litigation.

Does ATP apply to corporations formed in New York or New Jersey?

The ATP holding only applies to Delaware corporations. However, because of the high regard in which the Delaware Supreme Court is held on matters of corporate law, it is possible that a court may apply the reasoning of the ATP opinion even if it is considering an issue under New York or New Jersey law. The law of both of those states contains the same underlying elements as the ATP opinion -- i.e., bylaws must be passed for a proper corporate purpose and fee-shifting by contract is permissible. Accordingly, while no New York or New Jersey court has yet opined on this issue, it is likely that the ATP holding could be persuasive authority in a dispute under New York or New Jersey law.

Can corporations use the ATP holding to their benefit?

In Delaware corporations where boards have the power to adopt bylaws unilaterally, it may very well be that a bylaw provision providing for fee-shifting in the event of unsuccessful shareholder litigation would be upheld (and while there is less certainty, there is still good reason for New York and New Jersey corporations to implement such a bylaw provision). However, before adopting such a bylaw provision, the board must be comfortable that its purposes for passing the bylaw are proper. Additionally, Delaware, New York, and New Jersey law all provide that a majority of shareholders may overturn a bylaw adopted by the board. Thus, if a majority of shareholders are against the bylaw, they could presumably overturn it once it is passed (thus limiting the efficacy of the fee-shifting bylaw). Also, in the case of public companies, it remains to be seen whether proxy advisory firms will react adversely to directors voting in favor of such bylaw provisions.

Footnotes

1 --- A.3d ----, 2014 WL 1847466 (Del., May 8, 2014). While the ATP case involved a non-profit corporation, the holding appears to be equally applicable to for-profit corporations. It should also be noted that the ATP opinion did not address one of the underlying issues in the case, which was whether the fee-shifting bylaw provision could be preempted by federal antitrust law.

2 Mahani v. Edix Media Grp., Inc., 935 A.2d 242, 245 (Del. 2007) (Delaware law); North Bergen Rex Transport, Inc. v. Trailer Leasing Co., 730 A.2d 843, 848 (N.J. 1999) (New Jersey law); Hooper Associates, Ltd. v. AGS Computers, Inc., 548 N.E.2d 903, 904 (N.Y. 1989) (New York law).

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