As I noted in a recent post (here), on June 11, 2015, the Delaware legislature passed legislation prohibiting fee-shifting bylaws for Delaware stock corporations. On June 24, 2015, Delaware’s governor signed the statute into law, as discussed here. As I noted in my blog post about the legislation, though the statute has been passed, a number of questions remain about fee-shifting bylaws, including in particular what the legislation’s impact might be for bylaws purporting to shift fees in connection with federal securities litigation. As discussed here, according to Columbia Law School Professor John Coffee, as a result of the statute’s wording, there may be unanswered questions whether the statute prohibits bylaws shifting fees in connection with securities litigation.
In the following guest post, Neil J. Cohen, Publisher, Bank and Corporate Governance Law Reporter, takes the position that there may be arguments that the new legislation is broad enough to preclude bylaws that purport to shift fees in connection with federal securities litigation. (Please note that Neil wrote and submitted his article before the Governor has sighed the statute into law.) The “Note” at the beginning of the guest post is part of Neil’s article.
I would like to thank Neil for his willingness to publish his article on this site. I welcome guest post submissions from responsible authors on topics of interest to readers of this site. Please contact me directly if you would like to submit an article. Here is Neil’s guest post.
Note: The following article discusses a Delaware bill, passed by both the Senate and House, which prohibits a Board of Directors of a stock company from implementing fee-shifting provisions for “internal corporate claims.” The author asserts that securities fraud suits can fit within that category. The article is part of a Round Table on the Delaware legislation that includes Professors J. Robert Brown and John C. Coffee. The June, 2015 issue of the Bank and Corporate Governance Law Reporter containing the entire Round Table can be downloaded here.
The Governor of Delaware is expected to sign a bill, passed by the House and Senate, which prohibit fee-shifting provisions for “internal corporate claims”. The bill also contains a prohibition of bylaws or charter provisions that designate a forum other than Delaware as the exclusive forum. That provision would prevent corporations from choosing forums that allow fee-shifting provisions.
The legislators resisted a lobbing effort by the Chamber of Commerce’s Institute for Legal Reform to insert a provision expanding the Court of Chancery’s discretionary authority to shift to include cases that “plainly should not have been brought but that do not satisfy the extremely narrow ‘bad faith’ or ‘frivolousness’ exceptions”.
Assuming the Governor signs the bill, what is the outlook for fee-shifting provisions affecting securities fraud litigation? Will plaintiffs file for a declaratory judgment in Chancery Court or in District Court to strike the fee-shifting provisions as facially invalid under the new Delaware law? If so, the specific questions are likely to be whether the general bylaw authority under Section 109 of the law allows such provisions and, if so, whether Section 115, dealing with “internal corporate claims,” exempts them. If they are not exempt plaintiffs will be forced to overcome a high standard of proof to demonstrate they are invalid as applied. In the author’s opinion the best argument that the fee-shifting provisions are invalid is because they are exempt as “internal corporate claims” under Section 115 of the new law.
The analysis must start with § 109(b), Title 8 of the Delaware Code that provides:
The bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.
Section 109 is so broadly written it could conceivably allow the board to regulate shareholder conduct in any activity that creates costs for the corporation. For that reason it has traditionally been interpreted narrowly as allowing only bylaws for “internal matters,” i.e., that are peculiar to corporate governance. Such bylaws are considered “flexible contracts” with shareholders that allow the board to change or add bylaws without interfering with any “vested rights” of shareholders. The Round Table article by Professor Jay Brown, infra, provides a detailed description of judicial interpretation of Sec. 109.
Examples of lawsuits that are not peculiar to corporate governance include suits by shareholders alleging violations of contracts or torts. They are not internal matters because they are peculiar to individual losses rather than corporate governance.
This narrow interpretation of Section 109 was stretched to the breaking point by the Delaware Supreme Court’s en banc decision in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554, 555 (Del. 2014). In that case plaintiffs alleged and lost on both fiduciary duty and antitrust claims. The Delaware Supreme Court, sitting en banc, held that the non-stock corporation’s fee-shifting provisions were facially valid for both the internal fiduciary duty claim and the external antitrust allegations. The Court did not even mention that distinction, citing only the corporation’s legitimate corporate interest to “discourage litigation”. It approved a strict bylaw that imposes fees unless the plaintiff “substantially achieves, in substance and amount, the full remedy sought”. Reading between the lines, one feels the Court’s anger at plaintiff lawyers who, in 90% of the derivative suits filed after mergers, were perceived to use the judicial process to extort fees.
The ATP decision prompted the new bill, drafted by plaintiff and defense attorney members of the Delaware Corporation Law Council. The legislation does not overrule the ATP Tour regarding antitrust or other external claims. Instead it implicitly adopts the traditional view that since the Board can adopt fee-shifting provisions only for internal matters, only those matters need be the subjects of legislation. Therefore, the bill forbids only fee-shifting bylaws in matters of “internal corporate claims.” These are defined in Sec. 115 as:
Internal corporate claims” means claims, including claims in the right of the corporation . . . that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity . . . (emphasis added)
This language clearly includes derivative suits and proxy contests, matters that are peculiar to corporate governance and the Delaware Bar. Is it broad enough to also include securities fraud cases? Each of the italicized words is significant to statutory interpretation. If Sec. 115 were designed to excludes securities fraud lawsuits it would define internal corporate claims as exclusively “claims in the right of the corporation”—instead, the definition says “including claims in the right of the corporation,” leaving room for individual securities fraud claims.
Similarly, the language of the section is not restricted to claims alleging “a violation of a duty”; rather, it includes claims “based on a violation of a duty.” Securities fraud claims fit because they are based on a violation of a corporate officer’s duty to loyally obey the law on behalf of his employer. Finally, the section does not limit coverage to claims under Delaware law. Section 115 could have been deliberately worded to leave enough room for the Delaware courts to find that securities fraud cases are covered.
How Will the Case Be Argued?
Defendants will argue that even though ATP Tour involved a non-stock corporation, the decision is a controlling precedent for securities cases; thus, a corporation can adopt a presumptively valid fee-shifting provision that may only be challenged as applied to particular circumstances. (For example, plaintiffs could argue that the bylaws were enacted without careful deliberation, that they are overly preclusive or were designed to foil existing litigation.) Defendants will also maintain that securities fraud fee shifting is not covered by the “internal corporate claims” exemption in Sec. 115 of the new law because securities fraud claims are not “internal”: they are peculiar to personal losses, not corporate governance.
Plaintiffs will probably respond that if securities fraud cases are external the court should rule that they are illegal under the traditional interpretation of Sec. 109. This approach appeals to those who believe ATP was wrongly decided (See Professor Brown’s article, infra.) The problems with that argument is that Section 109 is very broadly written and it apparently contradicts ATP Tour, which held fee-shifting provisions for antitrust claims are facially valid. (See Professor Coffee’s Round Table comment, infra.)
We expect plaintiffs’ lawyers to challenge the fee-shifting provisions in declaratory judgment actions in the Delaware Chancery Court rather than in securities cases in District Court where they could be liable for millions in fee-shifting expenses.
In the Chancery Court the plaintiff’s lawyer would prefer to reconcile ATP Tour than oppose it: There is no conflict with ATP because under Sec.115 the issue is not whether the Board has the power to discourage litigation under Sec. 109. It is simply whether the Sec. 115’s definition of corporate claims can include fee shifting in securities fraud cases. It is a new statute, totally open to judicial interpretation without the headwind of ATP Tour.
But are securities cases “internal”? Like the antitrust claims in ATP, they are partly external and partly internal: Even though they involve personal claims for loss they are not like shareholder tort and contract claims against the corporation that are primarily personal. Securities fraud claims are primarily internal because they are based on a corporate officer’s breach of a common law duty of loyalty to the corporation, i.e., to loyally serve its lawful interests. Thus, the Chancery Court could hold fee shifting valid under Sec. 109 but prohibited under Sec. 115.
In short, possibly for political reasons, the new law does not specifically state whether fee-shifting bylaws in securities cases are facially valid under Section 109 or whether they are banned under Section 115. Those issues will ultimately be left to the Delaware Supreme Court. If it believes that a corporation’s right to drastically reduce securities fraud class actions is more important than the shareholder’s unobstructed right to bring them it will rule that Section 109 of the law allows strict fee-shifting provisions and Section 115 does not exclude them.
If so, the only remaining avenue to challenge the provisions will be as applied, an extremely difficult task. In AB Value Partners v. Kreisler Manufacturing, C.A. No. 10434 (Del. Ch. Dec. 16, 2014) Chancellor Parsons laid down an almost impossible standard. He ruled that the court would not invalidate an advance notice bylaw merely because it is unfair but only if “compelling circumstances suggest . . . an evident or grave incursion into the fabric of the corporate law.”
To date, over seventy-five corporations have adopted fee-shifting provisions. When the bill becomes law we expect those companies to amend their bylaws to provide that they do not include “internal corporate disputes, as defined by Sec. 115.” If they do not amend, the bylaws can be challenged as overly broad.
If the Chancery Court rules that stock companies may enact fee-shifting provisions for securities fraud suits and the SEC does not declare they are preempted by the securities laws we expect a flood of companies to enact them.
With respect to the possibility of a proxy contest, Professor Coffee believes “the passage of a shifting bylaw will hardly reduce the corporation’s value and thus will not make it a candidate for hedge fund activism (which usually is aimed at increasing share value over the short-term). No one else is likely to undertake the high costs of a proxy contest.” He discusses the preemption issue and the SEC’s options at www.lawreporters.com/feeshiftingbylaws.pdf.
 Conversely, in an article in the CLS Blue Sky Blog, Professor Coffee states that although “as first glance” the definition “may seem to” include securities fraud cases, on close examination the definition was more likely drafted to exclude them:
What is wrong with this definition? Like the well-known dog that did not bark in the night, there is something missing here. This under inclusive language clearly covers (1) derivative actions, (2) merger class actions based on Weinberger or similar breach of fiduciary duty claims; and (3) appraisal actions. But it does not cover federal securities class actions, which do not need to allege a “violation of a duty,” but rather must allege a material misstatement or omission. Typically, the principal defendant in a securities class action will be the corporation issuer, itself, and officers and directors may not be named. Moreover, because a misrepresentation by a corporate officer may have been intended to benefit the corporate issuer, it did not necessarily violate a duty owed to the entity. Thus, read literally, the new legislation would not preclude a board-adopted bylaw that shifted the corporation’s and other defendants’ expenses against a plaintiff who lost (or was less than substantially successful) in a federal securities class action (at least so long as the action did not allege a “violation of a duty” by any corporate officer or director).