Delaware Supreme Court upholds a one-way fee-shifting bylaw

October 2014 | EXPERT BRIEFING | LITIGATION & DISPUTE RESOLUTION

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It has become an ingrained expectation that almost any merger or sale transaction at an American company leads to a lawsuit. This is particularly so for Delaware companies, by far the leading state of incorporation and the legal home of much M&A activity. Such litigiousness is a direct consequence of the economic incentives surrounding shareholder suits. There is little downside risk for plaintiffs’ attorneys – often the main drivers of such suits – and the potential for fees, either through settlement or litigation, is high. The corporate defendants in these cases, though, face the trouble and expense of litigating claims which, although often weak, create deal risk, distraction and cost. Settlement of even the weakest claims has become the safest route, a sort of ‘deal insurance’ that buys peace (and releases of claims) for a price often less than the cost of defending the lawsuit.

But a recent decision by the Delaware Supreme Court, ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), may signal a fundamental shift in those incentives. For that reason, the case has stirred immediate controversy and prompted calls for legislative action to reverse the result. Given the unclear future of fee-shifting bylaws, and other risks of adopting such provisions – including triggering the displeasure of some stockholders and proxy services – the ‘wait and see’ approach will be the most sensible path for most companies for the time being.

Background to fee-shifting

Historically, under the ‘American Rule’, parties bear their own litigation costs, and courts do not award attorneys’ fees to a prevailing party absent statutory authority or some special circumstance, such as bad faith prosecution of claims. Arbitrium (Cayman Islands) Handels AG v. Johnston, 705 A.2d 225, 231 (Del. Ch. 1997) aff’d, 720 A.2d 542 (Del. 1998); see 10 Del. C. § 5106. In the case of shareholder litigation, plaintiffs who are either successful in court or who settle claims are presumptively entitled to a fee under an exception to the American Rule known as the ‘common fund’ doctrine, which provides that a party winning a benefit common to all stockholders is entitled to have its costs (including attorneys’ fees) covered by that benefit. That creates a strong incentive for the plaintiffs’ bar to bring even the weakest claims, with little downside risk. For plaintiffs’ attorneys this means an almost certain settlement and the attendant payment of attorneys’ fees.

ATP may affect that balance by permitting Delaware companies to adopt fee-shifting provisions in their bylaws that apply to intra-corporate litigation, creating a new downside never before faced by plaintiffs: the risk that they will have to pay defence fees in unsuccessful cases.

The case involved ATP Tour, Inc. (ATP), a Delaware membership corporation that operates a global professional men’s tennis tour (the Tour). In 2007, ATP’s board voted to change the Tour schedule and format. As a result, tournaments sponsored by the plaintiffs, the German and Qatari tennis federations, were downgraded from the highest tier of tournaments and moved from the spring season to the summer season. Upset with the change, the federations sued ATP and six of its board members in the Federal District of Delaware, alleging both Federal antitrust claims and Delaware fiduciary duty claims.

After a jury trial in Federal District Court, ATP was successful on all claims. ATP then moved to recover its attorneys’ fees based on Fed. R. Civ. Proc. 54 and Article 23.3(a) of its bylaws, a novel fee-shifting provision adopted in 2006 under a charter provision permitting the board to unilaterally adopt bylaws: “(a) In the event that (i) any [current or prior member or Owner or anyone on their behalf (‘Claiming Party’)] initiates or asserts any [claim or counterclaim (‘Claim’)] or joins, offers substantial assistance to or has a direct financial interest in any Claim against the League or any member or Owner (including any Claim purportedly filed on behalf of the League or any member), and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the League and any such member or Owners for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) (collectively, ‘Litigation Costs’) that the parties may incur in connection with such Claim.”

Unsure as to whether this provision was valid under Delaware law, the Federal District Court in Delaware used a procedure known as ‘certification’, whereby Federal courts may pose unresolved questions of state law to a state supreme court.

In answering the certified questions, the Delaware Supreme Court declined to decide whether the ATP bylaw in particular was valid and enforceable, because it lacked an adequate factual record and in any case was answering only questions of law. But as to the legal question in general, the Court broadly held that: (i) fee-shifting bylaws are presumptively valid under Delaware law; (ii) a fee-shifting bylaw would, like any other bylaw, be unenforceable if adopted for an improper purpose, which requires a fact-specific inquiry (but, the Court noted, “[t]he intent to deter litigation, however, is not invariably an improper purpose”); and (iii) a bylaw amendment, including adding a fee-shifting provision, is enforceable against members who join the corporation before its enactment.

To be sure, this holding leaves many questions unanswered: for example, what does it mean to ‘substantially achieve’ an objective in a litigation; what are the circumstances where adoption of a fee-shifting bylaw does or does not represent an ‘improper purpose’; and how might the analysis differ for stock corporations rather than membership corporations such as ATP? To that end it is worth noting that ATP involved the enforcement of a fee-shifting claim amongst members in ATP, not plaintiffs asserting fiduciary duty claims against defendants who were directors of stock corporations. Future plaintiffs therefore might argue that ATP is inapplicable to fiduciary duty claims because imposing the risk of fee-shifting (the argument would go) inequitably undermines the ability of stockholders to enforce the fiduciary duties owed by directors to corporations and their stockholders.

Even so, the basic principle endorsed in ATP – that corporate defendants can collect fees from unsuccessful plaintiffs – creates a new, powerful disincentive to weak claims, and to the ‘business as usual’ practice of ubiquitous transactional litigation.

Reaction to ATP

This potential for a monumental shift prompted swift calls for legislation to prohibit fee-shifting bylaws in Delaware companies. Within a week of the Supreme Court’s decision in ATP, the Corporate Law Section of the Delaware State Bar Association approved (in a divided vote) proposed amendments to the Delaware General Corporation Law (DGCL) that would prohibit any Delaware stock corporation from adopting a fee-shifting provision in its charter or bylaws. Proposed DGCL § 331 would limit the ATP decision’s reach by stating that a corporation’s charter and bylaws may not impose monetary liability or responsibility for any of a corporation’s debts on its stockholders, except as expressly permitted by 8 Del. C. §§ 102(b)(6) (providing for a charter to provide for stockholders to be personally liable for corporate debts under certain circumstances) and 202 (providing for restrictions on the transfer of stock under certain circumstances).

The proposed amendments were sent to the Delaware General Assembly for consideration, where swift passage was expected. But the US Chamber of Commerce’s Institute for Legal Reform, as well as other members of the business community, resisted, asking that approval of the proposed amendments be delayed so that the impact of them can be better understood. E.I. du Pont Nemours & Co., which is the only Fortune 250 company actually based in Delaware and which has a ubiquitous presence in Wilmington, has lobbied against the legislation. A DuPont spokesman has confirmed publicly that the company opposes the legislation. See Liz Hoffman, Delaware Fight over Corporate Legal Bills On Hold, Wall St. J. L Blog (18 June 2014, 7:18pm). At the same time, it is anticipated that shareholder services groups and some institutional investors will present opposition to fee-shifting bylaws. See Steven Davidoff Soloman, A Ruling’s Chilling Effect on Corporate Litigation, N.Y. Times Dealbook blog (23 May 2014, 5:01pm). The bill was subsequently withdrawn to permit the General Assembly to further consider it during its next session, which will likely take place sometime in early 2015. See Hoffman. This leaves the future of fee-shifting bylaws unclear.

Given the legal uncertainty that the delayed action by the General Assembly creates, as well as the potential for resistance by the proxy services and other shareholder groups, the ‘wait and see approach’ will likely be the right one for most Delaware companies. Once the final terms of any amendment to the DGCL are clear, companies will be in a better position to assess the potential risks and rewards of a fee-shifting bylaw. Any fee-shifting bylaw adopted now may be quickly invalidated by legislation – even those ‘work-around’ bylaws drafted to accommodate the proposed amendment as presently drafted. There have been companies that have adopted fee-shifting bylaws tailored to ongoing disputes, including Biolase, Inc. and Hemispherix Biopharma, Inc. (Biolase became one of the first public companies in Delaware to adopt a ‘loser pays’ fee-shifting bylaw. That suit has since been voluntarily withdrawn. Pignatelli v. Biolase, Inc., C.A. No. 9920-VCN (Del. Ch. 2014)). But these provisions still must pass muster in light of specific scrutiny on their terms and the purposes of their adoption. They are likely to remain exceptions until at least after the Delaware General Assembly’s meeting early next year.

Peter L. Welsh is a partner, and C. Thomas Brown and Elizabeth Downing Johnston are associates, at Ropes & Gray LLP. Mr Welsh can be contacted on +1 (617) 951 7865 or by email: peter.welsh@ropesgray.com. Mr Brown can be contacted on +1 (617) 951 7464 or by email: thomas.brown@ropesgray.com. Ms Johnston can be contacted on +1 (617) 951 7737 or by email: elizabeth.johnston@ropesgray.com.

Peter L. Welsh, C. Thomas Brown and Elizabeth Downing Johnston

Ropes & Gray LLP