In a recent post, I noted the Delaware Supreme Court’s ruling upholding the validity of bylaw provisions shifting the costs of litigation to an unsuccessful intra-corporate litigation claimant, which is the latest in a series of judicial decisions in which courts have recognized the authority of corporate boards to address shareholder litigation concerns in their bylaws. As noted here, in 2013 the Delaware Chancery Court in a case involving Chevron and Federal Express upheld the validity of forum selection clauses in corporate bylaws.
Along with these Delaware decisions involving corporate bylaw provisions addressing shareholder claims, in 2013, a Maryland trial court ruled that a provision in Commonwealth REIT’s bylaws requiring shareholder disputes and claims to be resolved through binding arbitration is enforceable, as discussed here. Among other things, the Maryland court found that the sophisticated investors involved had assented to the provision because of a legend in the company’s stock certificates referring to the REIT’s bylaws. As interesting as this decision was, it was only a single trial court decision, and therefore arguably of limited value.
However, the enforceability of the Commonwealth REIT bylaw provision requiring shareholder claims has now been upheld by two other courts. As discussed in a May 15, 2014 Law 360 article by Andrew Stern, Alex Kaplan and Jon Muenz of the Sidley Austin law firm entitled “2 More Bullets to Fight Corporate Activism” (here, subscription required), these two courts have “elaborated upon and further supported the initial 2013 trial court decision enforcing the arbitration provision in Commonwealth REIT’s bylaws.”
According to article, the first of these two recent decisions was issued in February 2014 by the Maryland Circuit Court in Baltimore County, the same court that had issued the earlier decision. The more recent decision involved a separate shareholder derivative lawsuit against Commonwealth REIT, but unlike the earlier lawsuit which had involved “sophisticated shareholder,” the more recent derivative claim involved self-described “ordinary shareholders.” These “ordinary shareholder” argued that they could not be held to have assented to the arbitration provisions or to the unilateral ability of the board to amend the bylaws at the time they purchased their shares.
In rejecting the “ordinary shareholders” arguments, the Maryland court relied in part on the Delaware Chancery Court opinion in the Chevron case in which the Chancery court upheld the validity of the forum selection clause. In particular, the Maryland court referenced the Chancery court’s ruling that corporate bylaws are part of a “flexible” contract that may be amended unilaterally by corporate boards. As the law firm article puts it, “guided by the Delaware opinion, the Maryland court found that Maryland law provided the trustees of REIT’s with similar unilateral powers of which investors have adequate notice.”
Accordingly, the Maryland court held that the REIT’s shareholders assent to a contractual framework that “explicitly recognizes that they will be bound by bylaws adopted unilaterally,” and that they purchased their shares with constructive knowledge that the arbitration bylaws were in effect, which was enough to constitute mutual assent.
The Maryland court also rejected the argument, of the type the U.S. Supreme Court provision had rejected in its 2013 decision American Express v. Italian Colors Restaurant (for more information about which refer here) that the arbitration provision would make the pursuit of derivative actions prohibitively expensive. (The derivative claimants argued that in arbitration, unlike in a derivative lawsuit, they may not be able to seek or obtain reimbursement of their attorneys’ fees, as they might in a lawsuit.) In reliance on the American Express decision, the Maryland court said that the fact that it is not worth the expense involved in pursuing a remedy does not constitute the elimination of the right to pursue the remedy.
The second of the two recent cases that the law firm memo discusses also involves the interpretation of Commonwealth REIT’s arbitration provisions, but related to a shareholders derivative action that had been filed against the REIT’s trustees in the District of Massachusetts. As discussed in her March 26, 2014 opinion (here), Judge Denise Casper found that in light of the prior Maryland decisions she was precluded from ruling on the enforceability of the REIT’s arbitration provisions under the principles of res judicata. However, she went on to say that if she were not precluded, she too would have found REIT’s bylaw arbitration provision to be enforceable.
Applying Maryland law, Judge Casper held that “constructive knowledge, constructive notice, and knowledge/notice through incorporate-by-reference are adequate to inform and bind a party to a contract.” As the law firm memo discusses, Judge Casper found the legend on the stock certificates sufficient to bind the shareholders to the arbitration provision. She also rejected the argument that requiring derivative plaintiffs to arbitrate would render the prosecution of derivative actions cost-prohibitive.
Although the decisions discussed above recognizing the enforceability of arbitration provisions in corporate bylaws involve only a single company, the fact is that mulitple courts have now recognized the enforceability of arbitration provisions in Commonwealth REIT’s corporate bylaws. Certainly none of the courts have been persuaded to reject the possibility of a bylaw arbitration provision out of hand, and indeed none has been persuaded that such a provision should not be unenforceable. This does not mean, of course, that other courts might not be persuaded to reject or to decline to enforce an arbitration provision but it does suggest that these kinds of provisions may withstand challenge and scrutiny.
These cases involving Commonwealth REIT’s bylaw arbitration provision, along with the recent Delaware courts upholding the authority of corporate boards to amend their bylaws to address the way in which and the conditions under which shareholders may pursue intra-corporate claims represent a nascent but nonetheless potentially significant trend in the shareholder litigation environment. At least so far, courts have seemed receptive to the authority of corporate boards to adopt these kinds of provisions, which undoubtedly will encourage other boards to adopt similar provisions.
Moreover, it seems that though this trend still at this point is merely nascent, the courts have already started building off the earlier decisions on these issues. Significantly, the Maryland court looked to and relied upon the Delaware Chancery court’s decision in the Chevron case in considering the powers of boards to unilaterally adopt provisions addressing intra-corporate litigation, showing that the limited but building case law in this area could support other decisions on related issues and in other courts.
The Delaware Supreme Court’s recent decision upholding the validity of a fee-shifting by law has the potential to change the economics of shareholder litigation. However, the possibility that corporate boards might be able to adopt shareholder provisions requiring shareholder claims and disputes to be arbitrated could even more dramatically change the shareholder litigation landscape.
The possibilities in this regard would be further magnified if the bylaw arbitration provision were to expressly incorporate a class action waiver of the type the U.S. Supreme Court upheld in the American Express case. Of course, as I noted here, there is nothing that says that merely because the Supreme Court has recognized the enforceability of class action waivers in commercial and consumer agreements means that courts will enforce class action waivers in corporate bylaws. But I suspect it will only be a matter of time before we see a case involving class action waiver provision in corporate by laws
Given the U.S. Supreme Court’s willingness to enforce arbitration provisions in commercial and corporate contracts, more companies could decide to adopt bylaw arbitration provisions. At a minimum, I think we will see further activity in the courts addressing these kinds of provisions. On a more general level, I think we can expect to see further experimentation from corporate boards as they seek to address shareholder litigation in their corporate bylaws.
It does seem as if all of a sudden we are in a period where corporate boards are increasingly willing to try to use their corporate bylaws to try to shape the rules surrounding intra-corporate litigation, and at least so far courts have been receptive to the boards’ experimentation. It remains to be seen how far courts are willing to go with these experiments but at this point it does seem as if there is at least the potential that corporate bylaw revisions could significantly alter the shareholder litigation landscape.
Special thanks to Alex Kaplan of the Sidley Austin law firm for sending me a link to his and his colleagues’ article about the development involving the Commonwealth REIT arbitration provision.