I BY-LAWS MAKING M&A SHAREHOLDER LITIGATION MORE EFFICIENT
Shareholder litigation in response to M&A activity remains ubiquitous. In its most recent annual survey of US M&A litigation, Cornerstone Research determined that 93 per cent of M&A transactions valued at over US$100 million attracted shareholder lawsuits, roughly the same percentage as in the previous few years.2 That said, 2015 began to see a decline in the overall number of merger-related shareholder cases as the Delaware Chancery Court started to reject certain kinds of settlements in an effort to discourage the high level of nuisance litigation being brought in connection with each and every transaction.3 For the first time since 2008, however, the majority of M&A transactions litigated in 2014 and 2015 involved filings in a single court. By comparison, in 2012 over 60 per cent of litigated M&A transactions involved lawsuits in at least two jurisdictions, and suits in three or more jurisdictions were not uncommon,4 imposing significant additional litigation costs and otherwise complicating the resolution of shareholder claims.
This return to single-forum litigation in a majority of cases is likely the result of forum selection by-laws that have been adopted by over 400 US corporations during the past few years, specifying that litigation relating to the corporation’s internal affairs – generally embracing all challenges to sales of corporate control by public companies – must be brought in a single, designated forum.5 Along with fee-shifting by-laws that some Delaware corporations have recently enacted (discussed more fully below), forum selection by-laws – which have largely withstood challenge in the courts – represent a growing effort by corporations to control the costs of shareholder litigation, which is widely seen as an unwarranted tax on doing business, especially purchases of US quoted companies.
II FORUM SELECTION BY-LAWS
Forum selection by-laws received a significant endorsement in mid-2013, when they were held not to be invalid per se by then-Chancellor Strine of the Delaware Court of Chancery. In Boilermakers Local 154 Retirement Fund v. Chevron Corporation, the Court reviewed similar by-laws adopted by the respective boards of Chevron and Federal Express, each of them incorporated in Delaware, which provided that Delaware would be the exclusive forum for litigation involving internal affairs-type claims.6 While the ultimate power to adopt by-laws rests with shareholders, Delaware law provides that a corporation’s certificate of incorporation may confer upon a board of directors the power to amend by-laws, and in this case both boards of directors had been so empowered.7 The shareholder plaintiffs nonetheless asserted that the forum selection by-laws in question were facially invalid, contending that they exceeded the scope of the boards’ statutory authority, and that they were unenforceable as a matter of contract law in relation to the shareholders because they had been unilaterally adopted by the boards without further shareholder participation.
Chancellor Strine rejected both arguments. First, as to the contention that forum selection by-laws went beyond the statutory powers of a board, the Court observed that Delaware law provides that a corporation’s by-laws may contain, inter alia, ‘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 [...] the rights and powers of its stockholders’.8 Because the by-laws in question regulated only derivative suits brought by shareholders in the name of the corporation, fiduciary duty suits, suits under the Delaware General Corporations Law, and suits relating to the corporations’ internal affairs, the Court held that it was evident ‘as a matter of easy linguistics’ that their subject matter fell squarely within the statutorily prescribed scope, and governed only where the shareholders might bring suit, without limiting what remedies were available to shareholders.9 Second, as to the contention that the shareholders could not be contractually bound by by-laws unilaterally adopted by the board, the Court held that shareholders in a Delaware corporation do not merely assent to the by-laws as they exist when they purchase their stock, but instead are on notice of an ‘overarching statutory and contractual regime’ that permits boards of directors to amend by-laws unilaterally when so empowered by the shareholders, and thus shareholders ‘assent to not having to assent’ to such board-adopted by-laws.10 Put another way, by-laws represent part of an ‘inherently flexible contract’ between shareholders and the corporation.11 To hold otherwise, the Court concluded, would have hewed to a ‘vested rights’ doctrine prohibiting boards from diminishing pre-existing shareholder rights, a theory rejected by the Delaware courts decades ago.12
Because the Boilermakers Court was considering only the plaintiffs’ facial challenges to the forum selection by-laws, and not the application of the by-laws to specific factual circumstances, it repeatedly declined to rule on hypothetical scenarios offered by the plaintiffs in an effort to demonstrate that forum selection by-laws could potentially be abused.13 Whether it would be inequitable to enforce otherwise valid by-laws in the circumstances of specific cases would be for future courts to decide on the facts presented to them.14 The Court noted, however, that the stated purpose of the by-laws at issue was to address the inefficiencies (and ultimate cost to shareholders) of the corporation having to defend against similar claims in multiple courts, including potential lawsuits in both a company’s state of incorporation and the state of its principal place of business, sometimes compounded by simultaneous suits in both state and federal courts.15 The Court further supported its conclusion that the by-laws before it were not facially invalid by observing that both the by-laws in question and Delaware’s statutory scheme provided further protections to shareholders that cut against any finding of invalidity. For example, the by-laws each contained a ‘fiduciary out’ permitting the boards to waive the requirement that suit be brought in Delaware if their duties to shareholders so required in a particular instance, and shareholders retained the power to repeal the by-laws by majority vote if they disapproved of them, or even to remove the directors responsible for the by-laws.16 In addition, then-Chancellor Strine observed, because a corporation could only enforce forum selection by-laws by invoking them in court (i.e., in the event that the corporation was sued in other than the designated forum), judicial scrutiny of such by-laws was assured.17
In the summer of 2014, Chancellor Strine’s successor upheld the enforcement of another forum selection by-law in City of Providence v. First Citizens Bancshares, Inc, in the face of both a facial challenge to the validity of the by-law and the contention that the board’s directors had breached their fiduciary duties by adopting it during the course of an allegedly self-interested merger transaction for the benefit of controlling shareholders.18 The principal difference between the by-laws previously upheld in Boilermakers and the one at issue in First Citizens was that the latter designated North Carolina – where the corporation had its principal place of business, rather than Delaware, where it was incorporated – as the sole forum for litigating internal affairs-type claims. Chancellor Bouchard held that nothing in Boilermakers dictated against the board designating North Carolina, the ‘second most obviously reasonable forum’ after Delaware, as the corporation’s preferred forum for such litigation.19 The Court also held that the plaintiff’s breach of fiduciary duty claim was meritless on its face, despite the fact that the by-law had been adopted on the same day as the challenged merger transaction and the allegation that the defendants’ motivation in selecting North Carolina as a forum was thus to further the interests of the controlling shareholders. Even assuming that the transaction was problematic in some way, the Court reasoned, there was no basis upon which to doubt the integrity of the courts of North Carolina, and thus the forum selection by-law did not have the effect of insulating the transaction from effective judicial review.20 Accordingly, the board’s decision to adopt the by-law was subject to deferential review under the business judgment rule, and the plaintiff had failed to rebut the presumption of legitimacy under that deferential standard.21
The power of Delaware corporations to adopt forum selection by-laws has since been affirmed by the Delaware Supreme Court in United Technologies Corporation v. Treppel (in an opinion written by now Chief Justice Strine), which also held that it was not per se impermissible to condition a shareholder’s right to review the corporation’s books and records upon the shareholder’s promise not to sue in a forum other than that designated by the board.22 Although the Supreme Court left it to the Chancery Court on remand to decide, in the first instance, whether the corporation’s effort to limit the plaintiff’s access to its books and records had been proper in that particular case, it noted that the Chancery Court would be entitled to weigh, as factors in the corporation’s favour, the fact that plaintiff was seeking to file an additional lawsuit relating to conduct that was already the subject of a separate suit before the Court of Chancery, that the corporation had a legitimate interest in obtaining consistent rulings on issues of Delaware law and having such rulings made by a Delaware court, that the board’s forum selection by-law represented a ‘non-case specific’ determination that internal affairs litigation should proceed in a single forum, and that the corporation had already made a substantial investment in defending the similar lawsuit in Delaware.23 The Court described these factors – the same that have motivated the adoption of forum selection by-laws generally – as the corporation’s ‘legitimate concern[s]’.24
Courts in California, Illinois, Louisiana, New York, Ohio and Texas have now enforced by-laws (and an analogous provision in a partnership agreement adopted without the involvement of all limited partners) that specified Delaware as the exclusive forum for certain litigation, further indicating that such by-laws have become a permanent feature of the legal landscape.25 While a few of the non-Delaware courts have held or hinted that the timing of the adoption of a by-law can weigh against its enforcement,26 Chancellor Bouchard’s decision in First Citizens, discussed above, has since made clear that the adoption of a forum selection by-law on the same date as a transaction involving alleged breaches of fiduciary duty should not weigh against enforcement of the by-law where the courts of the selected forum can provide the plaintiff with a fair hearing.27 In North v. McNamara, an Ohio federal court similarly enforced a forum selection by-law even though the by-law had been adopted after the alleged wrongdoing that was the subject of the suit, holding that such timing did not invalidate an otherwise ‘reasonable and fair’ by-law under the reasoning in Boilermakers and First Citizens.28
III FEE-SHIFTING BY-LAWS
Delaware corporations also have endeavoured to control shareholder litigation costs through non-reciprocal fee-shifting by-laws, which deviate from the usual American Rule by providing that a less than fully successful plaintiff will be required to reimburse the legal fees and costs of the corporation and its officers and directors. The Delaware Supreme Court has held that such provisions ‘can be valid and enforceable’ in the context of the intra-company claims of a non-stock corporation,29 ruling that fee-shifting by-laws (like forum selection by-laws) are not facially invalid and are enforceable even against members who join the corporation before the by-laws are adopted.30 Further, although enforcement may be denied in a given case if a fee-shifting by-law has been adopted or employed for an improper purpose, ‘[t]he intent to deter litigation [...] is not invariably an improper purpose.’31
The Delaware Chancery Court has, however, recently signalled which circumstances might render a fee-shifting by-law unenforceable for equitable reasons, although it was able to resolve the case on other grounds. In Strougo v. Hollander, a corporation’s former shareholder who was cashed out of his equity interest by a 10,000-to-1 reverse stock split as part of a going-private transaction filed a class action against the corporation and its directors, alleging that the transaction was unfair. The board adopted a fee-shifting by-law four days after the reverse stock split, and the defendants subsequently asserted that the by-law applied even as to the plaintiff, relying on reasoning similar to that in Boilermakers to argue that the provision was both within the board’s power and enforceable against both current and former shareholders.32 The flaw in the defendants’ argument, Chancellor Bouchard held, was that because the plaintiff ceased to be a shareholder on the date of the reverse stock split, he was no longer a party to the ‘flexible contract’ including the corporation’s by-laws on the date that the fee-shifting provision was adopted, and thus it could not be enforced against him.33
Although the Court thus did not need to decide the issue, it paused to note the ‘serious policy questions’ raised by fee-shifting by-laws of this sort adopted by a stock corporation. Because, arithmetically, none of the cashed-out former shareholders had held greater than an $84,000 individual interest in his shares at the time of the reverse stock split, ‘no rational shareholder – and no rational plaintiff’s lawyer – would risk having to pay the Defendants’ uncapped attorneys’ fees to vindicate the rights of the Company’s minority stockholders’. Thus, enforcement of the by-law in this case would likely have insulated the transaction at issue from judicial review, even though the allegedly self-interested behaviour of the corporation’s directors should have subjected them to the most exacting standard of scrutiny.34
IV THE LEGISLATIVE RESPONSE
The same month that Chancellor Bouchard issued his decision in Hollander, the Corporation Law Council of the Delaware State Bar Association proposed legislation precluding Delaware stock corporations from adopting fee-shifting provisions via a by-law or certificate of incorporation (although leaving the Supreme Court’s decision relating to non-stock corporations intact), and responding to Chancellor Bouchard’s First Citizens decision by requiring that any forum selection provision adopted via a by-law or in a certificate of incorporation must in all circumstances include the Delaware courts as a permissible forum for ‘intracorporate’ claims (and not, as in First Citizens, solely designate the courts of a foreign state as the exclusive forum).35 In requiring that the Delaware courts be among the fora permitted by a Delaware corporation’s by-laws and articles of incorporation, the draft legislation also barred Delaware stock corporations from requiring mandatory arbitration via those devices. A memorandum from the Corporation Law Council of the Delaware State Bar Association explaining the legislative proposal made clear the Council’s view that shareholder litigation has been an indispensable curb on management and director misconduct, that the decisions of Delaware courts in response to such litigation have played an essential ‘gap filling’ role with respect to the Delaware General Corporations Law and by developing and clarifying the common law of fiduciary duty, and that the in terrorem effect of fee-shifting by-laws means that judicial review cannot be counted upon to limit their enforcement to truly meritless cases.36
The Council’s legislation was subsequently passed by the Delaware General Assembly, with strong support in the Senate and not a single vote cast against the bill in the House of Representatives. Delaware’s governor has now signed the bill into law, making these changes to the Delaware General Corporations Law effective as of August 2015.
Nevertheless, some open issues still remain. In April 2016, shareholders of Delaware corporation StemCells Inc filed suit in Delaware Chancery Court challenging the company’s fee-shifting by-law enacted on the day the Delaware Senate voted to ban the practice in June 2015, but before the changes became effective.37 At issue is whether fee-shifting by-laws enacted before the ban would be grandfathered in, something that the new legislation did not address. Five days after the lawsuit was filed, however, StemCells Inc announced in a filing with the Securities and Exchange Commission that it had repealed its by-law. Other lawsuits testing the reach of the Delaware legislation have since been brought against other companies,38 indicating that this is an issue that is not yet resolved.
1 Mitchell A Lowenthal is a senior counsel and retired partner and Roger A Cooper is a partner at Cleary Gottlieb Steen & Hamilton LLP.
2 Cornerstone Research, Shareholder Litigation Involving Acquisitions of Public Companies: Review of 2014 M&A Litigation (2015) at 2: www.cornerstone.com/GetAttachment/897c61ef-bfde-46e6-a2b8-5f94906c6ee2/Shareholder-Litigation-Involving-Acquisitions-2014-Review.pdf.
3 See Barbara L Borden, ‘Top M&A Developments and Trends for 2016’, Harvard Law School Forum on Corporate Governance and Financial Regulation: corpgov.law.harvard.edu/2016/02/11/top-ma-developments-and-trends-for-2016.
4 Cornerstone Research, at 3.
5 As Borden notes (footnote 3): ‘Delaware exclusive forum selection bylaws, which require fiduciary duty claims to be heard in Delaware, are also having an effect in reducing unmeritorious multi-forum litigation.’
6 Boilermakers Local 154 Ret Fund v. Chevron Corp, 73 A3d 934 (Del Ch 2013).
7 Id. at 941 (citing 8 Del C Section 109(a)).
8 Id. at 950 (quoting 8 Del C Section 109(b)).
9 Id. at 952-53.
10 Id. at 955-56.
11 Id. at 957.
12 Id. at 955 (citing Kidsco Inc v. Dinsmore, 674 A2d 483, 492 (Del Ch 1995)).
13 Id. at 947-49, 958-62.
14 Id. at 949.
15 Id. at 943-44, 953.
16 Id. at 954, 956-57.
17 Id. at 954; see also id. at 957.
18 City of Providence v. First Citizens Bancshares, Inc, 99 A3d 229 (2014).
19 Id. at 235.
20 Id. at 237.
21 See id.
22 United Techs Corp. v. Treppel, 109 A3d 553, 557-59, 561 nn 39 & 40 (Del 2014).
23 Id. at 560.
25 See North v. McNamara, 47 F Supp 2d 635, 640-46 (SD Ohio 2014); Melissa’s Trust v. Seton, No. 14 C 02068, 2014 WL 3811241, at *5-7 (ND Ill 31 July 2014); Groen v. Safeway Inc, No. RG14716641, 2014 WL 3405752, at *2 (Cal Super Ct 14 May 2014); Miller v. Beam Inc, No. 2014 CH 00932, Tr of Oral Arg at 38-47 (Ill Cir Ct 5 March 2014); Genoud v. Edgen Grp, Inc, No. 625,244, 2014 WL 2782221 (La Dist Ct 17 January 2014); Hemg Inc v. Aspen Univ, No. 650457/13, 2013 WL 5958388, at *2-3 (Sup Ct NY Cnty 4 November 2013); In re MetroPCS Commc’ns, Inc, 391 SW3d 329, 338-41 (Tex App 2013); see also Katz v. CommonWealth REIT, No. 24-C-13-001299, slip op at 23-29 (Md Cir Ct Balt Cnty 19 February 2014) (relying on the Boilermakers decision in enforcing a mandatory arbitration provision in trustee-adopted by-laws under Maryland law); see also William Savitt, ‘Forum-Selection Bylaws—Another Brick in the Wall’, Harvard Law School Forum on Corporate Governance and Financial Regulation: corpgov.law.harvard.edu/2016/04/10/forum-selection-bylaws-another-brick-in-the-wall/#more-72772 (reporting on California Court’s enforcement of RealD by-law selecting Delaware).
26 See Roberts v. TriQuint Semiconductor, Inc, CA No. 1402-02441, slip op at 8-10 (Or Cir Ct 14 August 2014) (declining to enforce forum selection by-law adopted in anticipation of the very lawsuit that resulted, noting that there was no real opportunity for shareholders to repeal the by-law); Miller, No. 2014 Ch 00932, Tr of Oral Arg at 45-46 (noting absence of any allegation of wrongdoing at the time the by-law was adopted that could have weighed against enforcement).
27 First Citizens, 99 A3d at 237; see also ATP Tour, Inc v. Deutscher Tennis Bund, 91 A3d 554, 555 (Del 2014) (discussed below, indicating in the context of a fee-shifting by-law that ‘an intent to deter litigation would not necessarily render the by-law unenforceable in equity’, but declining, in the absence of a sufficient factual record, to fully answer the question of whether the adoption of a by-law adopted with the intent to deter legal challenges to board action then under consideration would render such a by-law unenforceable).
28 McNamara, 47 F Supp 2d at 643-44.
29 ATP Tour, 91 A3d at 555.
30 Id. at 558, 560.
31 Id. at 560.
32 Strougo v. Hollander, 11 A3d 590, 596 (Del Ch 2015).
33 Id. at 597-99.
34 Id. at 595.
35 An Act to Amend Title 8 of the Delaware Code Relating to the General Corporation Law, Senate Bill No. 75, Delaware State Senate, 148th General Assembly (2015): legis.delaware.gov/legislature.nsf/FSMain?OpenFrameset&Frame=right&src=/LIS/lis148.nsf/byal. Legislation prohibiting stock corporations from adopting fee-shifting by-laws previously had been proposed near the end of the 2014 legislative session, but the Delaware General Assembly deferred consideration of the proposal.
36 Corporation Law Council of the Delaware State Bar Association, Explanation of Council Legislative Proposal: www.delawarelitigation.com/files/2015/03/Council-Second-Proposal-Explanatory-Paper-3-6-15-U0124513.docx.
37 Guardino v. StemCells Inc, Del Ch CA No. 12266 (Del Ch 2016)
38 See, e.g., Solak v. Sarowitz, Del Ch CA No. 12299 (Del Ch 2016).