A recent decision of the Supreme Court of Delaware may give Delaware corporations an important tool to discourage meritless shareholder litigation.  In ATP Tour, Inc. v. Deutscher Tennis Bund, No. 534, 2013 (Del. May 8, 2014) (“Op.”), the Court held that the directors of a non-stock corporation may permissibly adopt bylaws that shift attorneys’ fees and costs to unsuccessful plaintiffs in intra-corporate litigation, even where the intent of the fee-shifting provision is to deter litigation.

Background

The Supreme Court of Delaware’s opinion addressed certified questions from the U.S. District Court for the District of Delaware.  The underlying federal litigation involved ATP Tour, Inc. (“ATP”), which is a non-stock membership corporation that operates a global, professional men’s tennis tour.  ATP’s members are tennis players and entities that own and operate tennis tournaments.  Op. 3.  By joining ATP, members agree to be bound by its bylaws, which may be amended by its board of directors.  Id. at 4.

In 2006, ATP’s board amended its bylaws to add a fee-shifting provision.  The bylaws provide, among other things, that when any member asserts any claim against ATP or another member and “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought,” then the claiming member “shall be obligated . . . to reimburse [ATP] for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses)” incurred in connection with the claim.  Op. 4.

In 2007, ATP modified its tournament schedule and downgraded certain tournaments to a lower “tier.”  The affected tournament organizations (ATP members) sued ATP and most of its directors in the U.S. District Court for the District of Delaware, asserting antitrust claims and breach of fiduciary duty claims.  After a jury trial, ATP prevailed on all claims.  Op. 4-5.

ATP then sought to recover its legal fees, costs, and expenses under the fee-shifting provision of its bylaws.  The district court denied the fee request in light of the plaintiffs’ antitrust claims, holding that federal antitrust laws preempted fee-shifting agreements.  ATP appealed, and the U.S. Court of Appeals for the Third Circuit held that the district court, before addressing preemption, should have first determined whether the fee-shifting provision in the bylaws was enforceable as a matter of Delaware law.  On remand, the district court certified four questions of Delaware law to the Supreme Court of Delaware.  Op. 5-7.

Paraphrased, the four questions were:

1.       Whether the board of a non-stock corporation may lawfully adopt a fee-shifting bylaw like the one adopted by ATP.

2.       Assuming that such a bylaw could not be enforced against a claimant who obtains at least some relief, whether such a bylaw might be enforceable against a claimant who obtains no relief at all.

3.       Whether such a bylaw is unenforceable if it was adopted by directors who intended to deter legal challenges to other corporate action then under consideration.

4.       Whether such a bylaw is enforceable against members who joined the corporation before the bylaw was adopted.

The Supreme Court of Delaware’s Holding

The Supreme Court of Delaware held that a fee-shifting bylaw provision is not invalid per se, even if it is intended to deter litigation.  Moreover, such a bylaw provision may be enforceable against members of a corporation who joined the corporation before the bylaw provision was adopted.

As the Court explained, bylaws are presumed to be valid as long as they are consistent with the Delaware General Corporation Law, the certificate of incorporation, and other applicable laws.  A bylaw does not become “facially” invalid merely because there might be some circumstances in which it would be unenforceable.  Op. 8.  Moreover, a “bylaw that allocates risk among the parties in intra-corporate litigation” is within the permissible scope of bylaws in general because it relates 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.”  Id. at 9 (quoting 8 Del. C. § 109(b)).  Finally, bylaws operate as a contract among a corporation’s shareholders, and common law does not prohibit fee-shifting arrangements among contracting parties.  Id.  Thus, the Court concluded, fee-shifting bylaws are facially valid under Delaware law.  Id.

The Court clarified that “[w]hether a specific . . . fee shifting bylaw is enforceable, however, depends on the manner in which it was adopted and the circumstances under which it was invoked.”  Op. 10.  Even facially permissible bylaw provisions could be unenforceable if they were “adopted for an improper purpose.”  Id. at 13.  The Court noted, for example, that it had declined to enforce bylaws that were adopted for the purpose of entrenching directors or obstructing the rights of shareholders to undertake a proxy contest against management.  Significantly, the Court held that “[t]he intent to deter litigation . . . is not invariably an improper purpose.”  Op. 13.  Fee-shifting provisions, the Court reasoned, “by their nature” deter litigation but are not per se invalid.

Finally, the Court confirmed that amendments to bylaws are generally enforceable against members who joined the corporation before the bylaws were adopted.  The Delaware General Corporation Law permits a corporation’s certificate of incorporation to empower the directors to “adopt, amend or repeal bylaws” unilaterally, and if the directors are so empowered, “stockholders will be bound by bylaws adopted unilaterally by their boards.”  Op. 14 (citation omitted).

Because the certified questions addressed only principles of law, the Supreme Court of Delaware did not analyze whether ATP’s bylaw, in particular, was adopted for a proper purpose and thus enforceable in the circumstances of its case.  Furthermore, the Court did not consider the plaintiffs’ contention that the federal antitrust laws prohibit fee-shifting based on the particular claims asserted; that issue will be resolved by the federal courts.

Considerations

A threshold question is whether ATP’s holding is limited to non-stock corporations, or whether it applies to stock corporations as well.  Although ATP is a non-stock corporation and the certified questions were limited to non-stock corporations, the Supreme Court of Delaware’s reasoning does not appear to be so limited.  None of the statutory provisions or case law the Court cited are limited to non-stock corporations.  Indeed, the Court noted that the Delaware General Corporation Law applies to non-stock corporations (with some exceptions not relevant here).  Op. 8 n.10 (citing 8 Del. C. § 114).  Because the Delaware General Corporation Law governs bylaws for stock and non-stock corporations in the same way, ATP’s construction and application of that law also should apply to both.

Notably, ATP holds that it is permissible for bylaws to provide for fee-shifting in litigation that concerns intra-company disputes.  The Delaware Court of Chancery has previously distinguished such suits from those involving “external matters,” such as personal injury claims that do not concern shareholder rights.  See Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934, 952 (Del. Ch. 2013).  ATP does not suggest that corporations could effectively require fee-shifting outside the context of intra-company litigation.

Companies considering adopting a fee-shifting bylaw provision should be mindful that doing so for an improper purpose might render such a provision unenforceable.  Although the purpose of deterring litigation is permissible in general, purposes directed at a particular shareholder or suit could be deemed inequitable in certain circumstances.  Because the “enforceability of a facially valid bylaw may turn on the circumstances surrounding its adoption and use” (Op. 12), a board considering a fee-shifting bylaw should carefully consider and document the proper purposes of its decision.

Companies should also consider the full range of circumstances in which a fee-shifting bylaw could apply in light of its specific terms.  In addition to applying to shareholder suits, a broadly worded fee-shifting bylaw could also apply, for example, to litigation between a corporation and its directors or officers (e.g., suits for indemnification or advancement).  Corporations should consider whether such broad application is desirable and thoughtfully tailor the terms of the provision to meet the board’s intended purpose.

Finally, although fee-shifting bylaw provisions may benefit stockholders, some stockholders may be wary of such provisions.  And although the Supreme Court of Delaware has confirmed that boards may adopt such bylaw provisions without stockholder approval, such unilateral action may be disfavored by some stockholders or their advisors.  For example, companies that unilaterally adopt these provisions may receive stockholder proposals requesting the company to repeal the provision or put it to a stockholder vote.  Accordingly, in evaluating whether to adopt a fee-shifting provision, corporations should consider engaging with their stockholders to educate them on the benefits of doing so.  Boards should assess their corporation’s stockholder base and consult with their investor relations and proxy solicitation advisors as part of that consideration.

The full and original memo was published by Gibson, Dunn & Crutcher LLP on May 13, 2014 and is available here.