Recent Delaware decisions have reinforced the expansive power and authority of a board to adopt and enforce corporate bylaws. Advance notice bylaws have become commonplace; exclusive forum bylaws are becoming more prevalent; and adoption of fee shifting bylaws generally awaits action by the Delaware legislature, which is expected in the upcoming 2015 session.
Exclusive Forum Bylaws
An exclusive forum bylaw typically requires that intra-corporate litigation (such as stockholder suits) be brought only in the courts of a specified state (generally where the corporation is incorporated, and sometimes where it is headquartered). The purpose is to increase the predictability and efficiency of stockholder litigation. The Delaware Chancery Court upheld the use of exclusive forum bylaws in 2013, finding that they are enforceable under Delaware law to the same extent as contractual forum selection provisions. Since then, the trend has been strongly toward the adoption of exclusive forum bylaws and their validation by the courts. During 2014:
- The Delaware Supreme Court unanimously reaffirmed a board’s power and authority to adopt an exclusive forum bylaw and to enforce it against stockholders who purchased their shares before its adoption, based on a corporation’s legitimate interest in rationalizing stockholder litigation (United Technologies v. Treppel, Dec. 23, 2014).
- The Chancery Court established that, absent particular factual allegations that an exclusive forum bylaw was enacted for an “improper purpose”, a board can adopt an exclusive forum bylaw during a transaction process, including even the day that a merger agreement is announced (City of Providence v. First Citizens Bancshares, Sept. 8, 2014).
- Courts in each of California, Illinois, Ohio, and Louisiana have indicated that they will honor a Delaware corporation’s bylaw that selects Delaware as the exclusive forum for intra-corporate litigation. (Only Oregon has refused to do so; and that decision was issued before the Delaware courts’ opinions upholding the validity of exclusive forum bylaws.)
- Over 100 companies, including many in the S&P500, have now adopted exclusive forum bylaws.
United Technologies v. Treppel (Dec. 23, 2014). In the most recent relevant decision, the stockholder-plaintiff, in a typical fact situation, demanded access to books and records of United Technologies (UT) under Section 220 of the Delaware General Corporation Law, as part of his determining whether to bring derivative litigation. UT requested that the stockholder agree to restrict his use of the materials obtained to cases filed only in Delaware, as any derivative litigation would be governed by Delaware law and there already had been related litigation filed in Delaware. While the Section 220 litigation was pending, the UT board adopted a Delaware exclusive forum bylaw. Treppel refused to agree to the restriction on his use of the materials and argued that he had the right to use the books and records in connection with bringing litigation in any court. The Court of Chancery ruled for Treppel, holding that he had sought the books and records for a proper purpose and that the court had no authority to impose the requested restriction on their use.
The Delaware Supreme Court reversed in a unanimous decision, affirming the validity of a corporation’s interest in selecting Delaware as an exclusive forum for litigation, so that the corporation can obtain consistent rulings on issues of Delaware law, made by the Delaware courts, and can avoid duplicative derivative lawsuits. Chief Justice Strine reasoned that a stockholder’s right to inspection is a “qualified” one; and that the court has “wide latitude” to restrict the use of materials obtained for inspection in order to further the legitimate interests of Delaware corporations, based on the particular facts and circumstances. The case was remanded to the Chancery Court, with the Supreme Court noting that the Chancery Court would be entitled to consider the following types of factors in determining how to use its discretion: (i) the fact that Treppel sought to file claims arising out of the same corporate conduct that was already the subject of derivative litigation in the Delaware courts; (ii) UT’s “legitimate interest in having consistent rulings on related issues of Delaware law, and having those rulings made by the [Delaware courts]”; (iii) UT’s having adopted “a forum selection bylaw that represents a non-case-specific determination by its board of directors that internal affairs litigation involving the company should proceed in a single forum”; and (iv) the investment UT had already “made (which comes at a cost to its stockholders) in defending not only the prior derivative litigation in the Court of Chancery, but also this § 220 action.” These factors would clearly seem to tilt in favor of the validity of the bylaw.
We expect that more companies will adopt exclusive forum bylaws in light of this year’s judicial developments. A number of law firms are routinely advising their corporate clients to adopt these bylaws as part of their efforts to lower the costs, risks, and inefficiencies of multi-jurisdictional intra-corporate litigation. The issues that remain with respect to exclusive forum bylaws are:
- whether (and when) additional states will uphold these bylaws;
- the extent to which courts will rely on connections between a corporation and the state selected as the exclusive litigation forum (if other than the state of incorporation);
- the impact on and reaction by stockholders;
- the views of proxy advisory firms; and
- what would constitute an “improper purpose” for adoption of the bylaw.
We recommend that companies consider adoption of forum selection bylaws, keeping in mind the following:
- the need to have conversations with the company’s major stockholders on the subject and to take into account the views of the major proxy firms (we summarize the relevant ISS policies below);
- the state selected as the exclusive forum should be the state where the corporation is incorporated or headquartered; and
- notwithstanding the Chancery Court’s First Citizens decision, it is preferable that forum selection bylaws be adopted on a “clear day” (prior to a transaction process or other anticipated litigation).
Fee-shifting bylaws impose an obligation on the non-prevailing party in intra-corporate litigation to bear the other party’s expenses in connection with the litigation. Thus, a shareholder bringing a lawsuit against a corporation must reimburse the corporation for all of its litigation expenses if the shareholder is not the prevailing party in the lawsuit. The Delaware Supreme Court upheld the concept as applied to non-stock corporations in the ATP Tour case in May 2014 (ATP Tour v. Deutscher Tennis Bund). The court did not address in ATP Tour whether the concept would apply equally to public stock corporations.
Current status. Since ATP Tour, a number of public stock Delaware corporations—primarily smaller companies and those in the process of going public—have adopted fee shifting bylaws. The bylaws generally have been very broadly drafted, typically providing for fee shifting for all types of claims—i.e., not only claims relating to “internal” matters such as fiduciary duties of directors, but to any claim against the corporation by stockholders. The covered claims presumably include—and, in certain cases, expressly include—actions brought under the federal securities laws. The bylaws typically shift the fees in any situation where the shareholders do not obtain a judgment on the merits that substantially achieves the full type and amount of the remedy they had sought—i.e., the fee-shifting occurs unless the shareholders “win” the case, including if the case is dismissed. The bylaws generally cover any and all kinds of fees, costs and expenses, and, in some cases, impose joint and several liability with the shareholders on anyone who offers “substantial assistance” to the shareholders or has a direct financial interest in the shareholders’ claim (which conceivably could include, for example, legal counsel to the shareholders).
The Delaware General Assembly had been expected earlier this year to pass legislation that would have limited the validity of fee-shifting bylaws to non-stock corporations. In response to concerns expressed by the business community about limiting public stock corporations’ ability to adopt the bylaws as part of their efforts to address meritless and duplicative legislation, the Legislature, with the support of the Governor, has directed the Delaware Bar Association to consider the proposed bylaw fee-shifting legislation and other issues relating to corporate litigation and to propose to the 2015 session of the Legislature “any legislative proposals deemed meritorious in continuing and promoting the adoption and use of [Delaware]’s business entity laws by corporations and their investors.” The resolution directing the bar association to further consider these matters indicated that the Legislature and the Governor supported limiting fee-shifting for public companies in order to avoid ATP Tour’s “upset[ting] the careful balance that the State has strived to maintain between the interests of directors, officers, and controlling stockholders, and the interest of other stockholders….” The resolution also, however, acknowledged concerns arising from the Delaware judiciary’s comments “on the abusive nature of meritless and duplicative litigation….”
Recently, a wide cross-section of institutional investors wrote letters to the Governor of Delaware, the Delaware Bar Association, and the Delaware Legislature, and to the major proxy firms, urging that they not support the authorization of fee-shifting bylaws for public stock corporations.
Kastis v. Carter (July 21, 2014). In the first case in which a fee-shifting bylaw was addressed after ATP Tour, a corporation had adopted a fee-shifting bylaw that purported to apply not only to future shareholder litigation, but also to the pending derivative action against the corporation in Delaware Chancery Court, in which discovery was then occurring. The plaintiff-shareholders filed a motion to invalidate the bylaw. At a scheduling teleconference in August, Chancellor Bouchard instructed the plaintiffs that they should amend their complaint if they wanted to challenge the fee-shifting bylaw (and, at the court’s urging, the corporation represented that it would not apply the bylaw to a challenge to the bylaw by the plaintiffs). The plaintiffs then filed a motion to amend the complaint to challenge the validity of the bylaw, and the corporation filed a motion for clarification, reconsideration or re-argument of the scheduling conference resolution. After briefs were submitted by both parties, in mid-September the corporation agreed not to apply the bylaw to this litigation, and the plaintiffs agreed not to pursue the issue of the validity of the bylaw in this litigation.
Our advice. In the face of uncertainty about the fate of the legislation, and the views of the major proxy firms, major institutions and other investors, it should be emphasized that there is also uncertainty as to whether the Delaware courts would, in fact, apply ATP Tour’s holding to public stock corporations. It is not clear that the reasoning that the court applied in the context of a nonstick sports league with a sophisticated and institutional shareholder base would apply equally to corporations with public shareholders with varying levels of sophistication. Notably, the Court of Chancery has reiterated in recent years (including in the Chevron decision) Delaware’s strong public interest in adjudicating corporate law disputes and its hesitancy to see those disputes resolved in other courts. Thus, there is a possibility that the Delaware courts may be reluctant to expand the holding of ATP Tour to the public company context. A decision is expected during the 2015 legislative session.
We have advised in previous memoranda to clients that, in many cases, companies will want to wait until the Legislature acts before adopting fee-shifting bylaws, and that there may be circumstances under which it will advantage a company to make any such bylaw subject to certain limitations.
Advance Notice Bylaws
An advance notice bylaw typically requires that nominations for directors made by a shareholder be submitted to a corporation within a specified time period (say, 60-90 days before the first anniversary of the previous year’s annual meeting). These provisions provide several benefits to a company, including giving a board time to evaluate the proposed candidates and preventing last minute “surprise attacks” by third parties for control or board representation. Advance notice bylaws have been consistently upheld by the courts. There have been a few instances of successful challenges to these provisions, based on ambiguous formulations or, even more infrequently, a finding that a board’s fiduciary duties require that the provisions be waived under the particular circumstances.
AB Value v. Kreisler (Dec. 17, 2014). In its recent decision in AB Value, the Chancery Court held that it will be only in extraordinary circumstances that a board of directors would be required to waive an advance notice deadline due to a change that occurs after the notice deadline has passed and before the stockholder vote. The court refused to issue a temporary restraining order enjoining the advance notice bylaw of Kreisler so that AB Value Partners, an activist hedge fund that owned 11% of the company’s stock, could run a competing slate of directors at Kreisler’s annual meeting.
The decision clarifies the very limited circumstances under which the court will enjoin enforcement of an advance notice bylaw amendment by reason of changes that occur during the period after the advance notice bylaw deadline has passed and before the annual meeting is held.
The court indicated that it would enjoin an advance notice bylaw (that was adopted on a “clear day” and that is facially valid) only when, at a minimum, (i) the board undertook material unanticipated changes after the bylaw notice deadline and (ii) the changes resulted in a “radical shift in the direction” of the company. (Further, a board action that creates a material change in the likelihood of success of a proxy contest is not a change that will support enjoining an advance notice bylaw.)
Our advice. There is no question that an advance notice bylaw plays a critical role in rationalizing a company’s board nomination process and they have become commonplace. When possible, it is preferable (although not critical) that an advance notice bylaw be adopted on a “clear day”. It is important that these bylaws be drafted clearly, as any ambiguity tends to be resolved by the courts in favor of the shareholders’ electoral rights.
Shareholder Reaction and Proxy Firm Policies
Shareholders have accepted advance notice bylaws and, as noted, they have become commonplace. ISS generally does not oppose advance notice bylaws that provide reasonable deadlines—which ISS has specified is not less than 60 days nor more than 90 days before the meeting.
Shareholders generally have not appeared to react strongly against the adoption of exclusive forum bylaws—but have objected to the concept of fee-shifting bylaws. ISS now reviews all bylaws that affect shareholders’ litigation rights (including exclusive forum and fee-shifting bylaws) on a case-by-case basis. In addition, ISS’s policy is generally to oppose a fee-shifting bylaw that applies even when a plaintiff partially prevails in a litigation. ISS’s policies adopted for the 2015 proxy season increase the subjectivity with which these bylaws will be reviewed, thus creating more uncertainty as to the result.
Factors ISS will consider when evaluating exclusive forum and fee-shifting bylaws. ISS recently adopted a policy that, when evaluating any bylaw affecting stockholders’ litigation rights, it will take into account such factors as: the company’s stated rationale for the bylaw; any disclosure by the company of past harm to the company from shareholder lawsuits that were unsuccessful or were brought outside the jurisdiction of incorporation; the breadth of application of the bylaw (i.e., to which types of lawsuits it would apply and the definition of key terms); and related governance features (such as the stockholders’ ability to repeal the bylaw and their ability to hold directors accountable through annual election of directors and majority voting).
Significantly, however, ISS has also indicated that it will apply to bylaws that are adopted without shareholder approval its new policy against a board’s unilateral adoption of any bylaw that “materially diminishes” stockholder rights. Factors ISS will consider when applying this new policy are: the board’s rationale for adopting the bylaw without shareholder ratification; disclosure by the company of any significant engagement with shareholders regarding the bylaw; the level of impairment of shareholders’ rights cause by the bylaw; the board’s track record with regard to unilateral board action on charter or bylaw amendments or other entrenchment provisions; the company’s ownership structure and existing governance provisions; whether the bylaw was adopted prior to or in connection with the company’s initial pubic offering; the timing of the bylaw adoption in relation to a significant business development; and other factors ISS deems appropriate to determine the impact of the bylaw on shareholders.
The full and original memorandum was published by Fried, Frank, Harris, Shriver & Jacobson LLP on January 14, 2015, and is available here.