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Directors Governance Center

May 19, 2014

Fee-Shifting Bylaws: What Directors Need to Know

Authored by: Warren Pope andDavid Meadows

On May 8, 2014, the Delaware Supreme Court held that fee-shifting provisions in a non-stock corporations by-laws can be enforceable under Delaware law. , No. 534 (Del., May 8, 2014). Directors should be aware of the recent decision because:

*It opens the door for Delaware stock corporations to adopt fee-shifting by-laws which would bind even those shareholders who purchased stock before the by-laws adoption;

*The adoption of fee-shifting by-laws could potentially deter shareholder litigation by adopting a loser pays model; and

*Although deterring litigation can be a proper purpose for adopting a fee-shifting by-law, a board should carefully consider such a by-law and consult with its advisors and relevant stakeholders before adopting it.

involved a suit by two members of ATP Tour, Inc., a Delaware non-stock corporation which operates a mens professional tennis tour. The plaintiffs alleged that six of ATP Tour, Inc.s board members breached their fiduciary duties under Delaware law by approving certain changes to the Tours schedule. The defendants prevailed at trial in federal district court, and then sought to recover their defense costs under a fee-shifting provision in ATP Tour, Inc.s by-laws. That provision requires ATP Tour, Inc. members who sue the Tour or any of its owners to reimburse the defendants for all fees, costs, and expenses of any kind if the plaintiffs do not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought.

After an appeal and a remand, the federal district court certified several legal questions to the Delaware Supreme Court, including: whether Delaware law permits a board to adopt a fee-shifting by-law, whether such a by-law can be enforced against an unsuccessful plaintiff, and whether the by-law binds members who joined after the by-law was adopted.

The Delaware Supreme Court held that fee-shifting by-laws are facially valid so long as they are not expressly prohibited by the adopting corporations charter. The Court found that nothing in Delaware law prohibits the adoption of fee-shifting by-laws, which constitute a permissible contractual exception to the American rule under which parties to litigation bear their own costs. The Court also held that fee-shifting by-laws can be authorized by a corporate charter, either expressly or implicitly by silence. Accordingly, it appears that a corporation may validly adopt a fee-shifting by-law unless expressly prohibited by the corporate charter. Although the Supreme Courts decision dealt specifically with a non-stock corporation, the Courts holding should apply with equal force to Delaware stock corporations, which are governed by the same provisions of the Delaware General Corporation Law.

Relying on a long line of Delaware decisions concerning the enforcement of by-laws generally, the Court also held that fee-shifting by-laws cannot be enforced when adopted or invoked for an inequitable purpose. The Court made clear that an intent to deter litigation is not invariably an improper purpose, though it stopped well short of suggesting that such an intent will always justify enforcement. In short, any attempt to enforce a fee-shifting by-law will require an inquiry into the purposes for which the corporation initially adopted the by-law and the purposes for which it seeks to enforce the by-law in a particular case.

Finally, the Court held that ATP Tour, Inc.s by-law was potentially enforceable (subject to the inequitable purpose inquiry described above) against members who joined the Tour before the by-laws adoption.

Although the effects of will take time to evaluate, fee-shifting by-laws could prove to be an effective deterrent to shareholder litigation. Directors considering the adoption of such by-laws should, in consultation with the corporations advisors, consider the following:

*Because enforceability depends on the purposes for which a board adopts a fee-shifting by-law, the board should carefully evaluate and document those purposes. The intent to deter litigation can be a proper purpose, but efforts to impact specific disputes are less likely to pass muster. Boards should consider adopting such provisions, if at all, on a clear day with no specific litigation or entrenchment purposes in mind.

*Directors should give attention to the scope and design of a fee-shifting provision. appears to apply to the full range of potential intra-corporate disputes, but does not require that a fee-shifting bylaw have any particular form or scope.

*In most instances, the articles of incorporation allow the board of directors to amend the corporations by-laws, without any action of the shareholders. For some companies, however, shareholder approval may be required to amend the by-laws. Even if the board is able to adopt a fee-shifting by-law without shareholder approval, for most companies, the shareholders retain the right to amend the by-laws, so that shareholders could seek to un-do the provision adopted by the board.

*Even if allowed, directors should consider that such by-laws may prove to be controversial among stockholders or proxy advisors and may lead to adverse recommendations from proxy advisors or competing proposals by stockholders.