By: Tina Calilung
As the debate over highly controversial fee-shifting bylaws rages on[1], the Delaware Chancery Court has weighed in to clarify at least one point on the matter: Delaware General Corporate Law (DGCL) does not permit companies to adopt bylaws that purport to regulate the rights or powers of former stockholders. Thus, in Struogo v. Hollander[2], the Chancery Court held that a corporation could not apply a non-reciprocal fee-shifting bylaw adopted after a stockholder’s interest in the company was extinguished to create fee exposure for the former stockholder when he or she brings a subsequent fiduciary challenge.
Struogo is a former stockholder of First Aviation Services, Inc., a company that provides repair and overhaul services to the aviation industry. Shares of First Aviation, a non-SEC reporting company, were traded on the OTC US Market Exchange. In 2014, the company’s board approved and executed a 10,000-to-1 reverse stock split in order to make First Aviation a privately held company. The reverse stock split had the effect of involuntarily cashing out minority stockholders, like Struogo, who owned less than 10,000 shares. Shortly after executing the reverse stock split, First Aviation’s board of directors adopted a new bylaw that imposes joint and several liability for the reimbursement of the company’s legal expenses on any current or prior stockholders or anyone acting on their behalf (i.e., their lawyers) who bring forth unsuccessful lawsuits against the company. Struogo challenged both the reverse stock split and the fee-shifting bylaw in a class action lawsuit brought on behalf of stockholders whose ownership interests were extinguished by the transaction.
While a challenge to the facial validity of non-reciprocal fee-shifting bylaws was not presented to the Struogo court, the case illustrates the hotly debated policy implications emanating from such bylaws. The court expressed concern that the bylaw effectively immunized the reverse stock split from judicial review as no rational stockholder, whose interest is limited to his individual investment, would risk liability for uncapped attorney’s fees to vindicate the rights of minority stockholders. In dicta, the court mused that the reverse stock split “appears to be precisely the type of transaction that should be subject to Delaware’s most exacting standard of review to protect against fiduciary misconduct.”[3] The court, however, left for another day the question of “whether it would be statutorily permissible and/or equitable to adopt bylaws that functionally deprive stockholder of an important right: the right to sue to vindicate their interests as stockholders.”[4]
The court drew on contract law principles to determine that the fee-shifting bylaw did not apply to Struogo’s case as the plaintiff was no longer a stockholder when the bylaw was adopted. Corporate bylaws are contracts among a corporation’s shareholders;[5] as such, once a stockholder’s equity interest in the corporation is eliminated in a cash-out transaction, the former stockholder becomes non-party to the flexible contract embodied by the bylaws. Delaware contract law is premised in the principle that only parties to a contract are bound by the agreement. Thus, Struogo’s actions cannot be regulated by corporate bylaws that were adopted or amended after he ceased to be a part to the corporate contract. Instead, the court held that the governing bylaws that apply to Struogo’s case are those that were in effect when his equity interests were eliminated.
The Chancery Court further found that Delaware corporate law does not authorize a corporation to adopt bylaws that seek to regulate the rights of former investors. Section 109(b) of the DGCL authorizes bylaws that regulate the rights or powers of a “stockholder,” meaning investors who own the corporation’s stock at or after the time a bylaw is adopted. The logical corollary is that § 109(b) does not authorize the adoption of bylaws that purport to regulate the rights or powers of former stockholders. The court refused read an implicit grant of such power into the statute because the Delaware General Assembly could have granted corporations the authority to regulate former stockholders, but it chose not to do so.
Thus, while many questions regarding the ultimate enforceability of non-reciprocal fee-shifting bylaws remain, the Delaware Chancery Court has made it clear that at minimum, corporations cannot retroactively apply such bylaws to former stockholders who owned no shares at the time the bylaws were adopted or amended.
[1] Yaron Nili, Delaware Proposes (Again) Sledgehammering Fee-Shifting Bylaws, Harvard Law School Forum on Corporate Governance and Regulation (Mar. 12, 2015, 9:08 AM), https://blogs.law.harvard.edu/corpgov/2015/03/12/delaware-again-proposes-sledgehammering-fee-shifting-bylaws/ (reporting that Delaware will vote on a proposal to prohibit fee-shifting bylaw in April 2015).
[2] Struogo v. Hollander, C.A. No. 9770-CB, slip op. at 21–22 (Del. Ch. Mar. 16, 2015).
[3] Id. at 8.
[4] Id. at 8–9.
[5] Id. at 11 (quoting Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A.3d 1182, 1188 (Del. 2010).
