Delaware Supreme Court Validates Fee-Shifting Bylaws

The Delaware Supreme Court has declared valid on its face a bylaw requiring the members of a non-stock corporation to pay its legal fees incurred in defending the members' unsuccessful suit against the corporation, endorsing an idea first proposed by Loeb & Loeb LLP more than 15 years ago.

After ATP Tour, Inc. downgraded a tournament owned by two members, the members sued the Tour, in federal court, alleging violation of federal antitrust law, as well as breach of fiduciary duty. The plaintiffs lost on every count, and the Tour then moved to recover its legal defense costs under a bylaw providing that if a member or owner brings a claim against the Tour or another member or owner and

"does not obtain a judgment on the merits that substantially achieves ... the full remedy sought, then [the losing member or owner and any other person having an interest in the claim] shall be obligated jointly and severally to reimburse the [Tour] and any such member or Owners for all fees, costs and expenses ... (including, but not limited to, all reasonable attorneys' fees and other litigation expenses) ... that the parties may incur ... ."

The district court certified to the Delaware Supreme Court four questions regarding the validity of the bylaw. Although the questions were framed with regard to a non-stock corporation, the Supreme Court made clear that its ruling applies to any corporation formed under the Delaware General Corporation Law.

At the outset, because neither the GCL nor any other Delaware statute or Delaware common law prohibits fee-shifting, the court presumed the bylaw to be valid. A corporation's certificate of incorporation similarly could include a fee-shifting provision.

A bylaw provision that is valid on its face nonetheless would be invalid, if adopted for an inequitable purpose, or if it had an inequitable effect. The court cited two cases in which bylaws were amended to increase a board's quorum and to require unanimous board action. In one case, the bylaws were held invalid, and, in the other, they were held valid, because of their respective purposes and effects.

The Supreme Court noted that an "intent to deter litigation ... is not invariably an improper purpose. ... [therefore], an intent to deter litigation would not necessarily render the bylaw unenforceable in equity." The court declined to rule on the validity of the Tour's bylaw provision, however, because the record was insufficient for it to determine whether the bylaw was adopted for a proper purpose.

Implications
The Delaware Chancery Court and courts in other states recently have demonstrated skepticism regarding some class-action challenges to corporate transactions, by reducing or rejecting plaintiffs' lawyers' fee requests when reviewing "disclosure-only" settlements that confer no tangible benefits on stockholders. Inasmuch as the Delaware Supreme Court's language in ATP may be considered broader than was necessary to resolve the questions precisely as posed, the case suggests that the court shares that skepticism and perhaps intends to encourage fee-shifting bylaws and charter provisions as a remedy.

Potential Avenues
Loeb & Loeb first proposed fee-shifting charter provisions and bylaws about the time that Congress passed the Private Securities Litigation Reform Act, to curb frivolous securities litigation. In addition to determining that these provisions were valid under Delaware law, we learned that the U.S. Second and Ninth Circuit Courts of Appeals had held fee-shifting provisions in securities transactions enforceable, in principle

Accordingly, we recommended implementing these provisions to discourage frivolous federal securities fraud claims.

The Loeb & Loeb proposal required a claimant to enter a fee-shifting agreement with the corporation as a condition to bringing claims against it, enabling the corporation to move to dismiss the action, if the plaintiff failed to agree to the fee-shifting arrangement in advance. In consideration of the kinds of equitable concerns referred to by the court in ATP, our original proposal made the fee-shifting arrangement reciprocal, requiring the losing party, whether the plaintiff or the corporation, to pay the winning party's legal fees, if the case proceeded to trial.

The corporation's potential obligation to pay the plaintiff's legal fees in a reciprocal arrangement is not as disadvantageous as it might appear, since the usual plaintiffs' attorneys' contingency arrangement effectively shifts the onus of plaintiffs' legal fees onto the corporation, if the action settles. Moreover, the fee-shifting bylaw or charter provision might require the parties to agree on how the winner's fees are to be determined (e.g., by hourly billing at agreed-upon maximum hourly rates), to temper the plaintiffs' counsels' speculative interests in the case and enable the corporation to better project its potential exposure.

Because the Delaware Supreme Court did not raise the issue in ATP, we can conclude that reciprocity need not be a condition to the validity of a fee-shifting bylaw or charter provision. In derivative cases, in which the corporation is only a nominal defendant, and the real defendants are the board and management, a reciprocity requirement might lead to difficult issues regarding who bears the fee-shifting burden, if plaintiffs prevail. Similarly, although a corporation could include claims against its underwriters or accountants in a fee-shifting requirement, for example, they might wish to be excluded from coverage of a reciprocal provision.

Alternatives abound, and a corporation should be able to adopt several provisions to address varying potential circumstances. The Delaware corporate bar is proposing legislation to prevent stock corporations from adopting the kind of provision that the Delaware Supreme Court approved in ATP, but, if enacted, the new law would not necessarily prohibit all fee-shifting arrangements.

This client alert is a publication of Loeb & Loeb LLP and is intended to provide information on recent legal developments. This client alert does not create or continue an attorney client relationship nor should it be construed as legal advice or an opinion on specific situations.

Circular 230 Disclosure: To assure compliance with Treasury Department rules governing tax practice, we inform you that any advice (including in any attachment) (1) was not written and is not intended to be used, and cannot be used, for the purpose of avoiding any federal tax penalty that may be imposed on the taxpayer, and (2) may not be used in connection with promoting, marketing or recommending to another person any transaction or matter addressed herein.