Recently, there has  been some unusual excitement in the corporate bar in Delaware after the Supreme Court of Delaware held that a nonstock corporation could adopt a bylaw requiring a losing plaintiff in a lawsuit involving the governance of the corporation to pay the corporation's legal fees (although the court left open the possibility that the bylaw could be invalid depending on the circumstances surrounding its adoption and use).1  Interest in the subject significantly increased when the Delaware Bar Association quickly moved to propose legislation invalidating that type of bylaw.  The U.S. Chamber of Commerce weighed in on the other side from the bar association and the Delaware Legislature then pushed off consideration of the issue until next year.2

We believe that the reasons cited by the Supreme Court of Delaware that validate a fee-shifting bylaw adopted by a Delaware corporation will also validate a fee-shifting bylaw adopted by a Pennsylvania corporation.  But we also believe that Pennsylvania corporations should seriously consider the same issues that are being debated in Delaware before acting.

Background on the Delaware Decision

In its decision in ATP Tour, Inc. v. Deutscher Tennis Bund, the Supreme Court of Delaware held that a nonstock corporation's bylaws may contain a fee-shifting provision and that such a provision could be enforceable against members who joined the corporation before as well as after the adoption of the bylaw.

ATP Tour Inc. ("ATP") was formed in the 1990s, and its membership consisted of various entities operating professional tennis tournaments.  In 2006, the board of directors of ATP adopted a fee-shifting bylaw applicable to intra-corporate disputes that required a plaintiff member to reimburse the corporation for its legal fees if the plaintiff "[did] not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought."  After successfully defending litigation brought against the company by some of its members, ATP sought to recover its legal fees under this bylaw provision.  The federal district court handling the litigation between ATP and the losing members certified several questions of law to the Delaware Supreme Court relating to the validity and enforceability of the bylaw.

The Supreme Court of Delaware concluded that it did not have enough of a factual basis to determine whether the ATP bylaw was valid as adopted and applied in the pending lawsuit.  However, the court answered the question in the abstract, holding that a fee-shifting bylaw was facially valid under Section 109(b) of the Delaware General Corporation Law (the "DGCL") and that the bylaw would be enforceable against members who joined before the adoption of the bylaw so long as the bylaw was not adopted or used for an improper purpose.

Delaware law presumes that a corporation's bylaws are valid and the courts will seek to uphold the bylaws in a manner consistent with law rather than strike them down.  DGCL § 109(b) provides that a bylaw may contain any provision that is "not inconsistent with law or with the certificate of incorporation, relating 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."  Applying the first part of that provision, the Delaware Supreme Court found that there is no statute or principle of common law forbidding the enactment of a fee-shifting bylaw.  The court further found that a bylaw that allocates the risk among parties in intra-corporate litigation relates to the business of the corporation and thus satisfies the second part of the requirement of Section 109(b).

Delaware law considers corporate bylaws to be a contract between the corporation and its stockholders.  Additionally, Delaware follows the "American Rule," which allows parties to agree by contract to allocate the cost of litigation.  Combining the two principles of law, the court found that a fee-shifting bylaw would not be prohibited under Delaware common law so long as the bylaw was not adopted or used for an inequitable purpose.

Lastly, the court held that because Section 109(a) provides that a corporation "may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors," the stockholders will be bound by bylaws adopted unilaterally by the board.3

An important aspect of the ATP case is the fact that it involved a nonstock corporation – what most other states call a nonprofit corporation.  Most states other than Delaware have a separate statute applicable to nonprofit corporations, but Delaware follows the unusual approach of having its General Corporation Law apply to both business corporations and nonprofit corporations.  Although the ATP decision does not involve a fee-shifting bylaw adopted by a Delaware business corporation, the logic of the court is equally applicable to business corporations because DGCL § 109 applies to both stock (business) corporations and nonstock (nonprofit) corporations.  The court, in fact, says nothing in its opinion to suggest that the result would be different if the bylaw had been adopted by a stock corporation instead of a nonstock corporation.

Applying the Delaware Rationale in Pennsylvania

Permissible contents of bylaws.  As in Delaware, the Pennsylvania Business Corporation Law (the "BCL") in Section 1504(a) permits a corporation to include in its bylaws "any provision for managing the business and regulating the affairs of the corporation not inconsistent with the law or the articles."  Thus, Pennsylvania and Delaware essentially look at the same two issues when evaluating the validity of a bylaw:

  1. Is the bylaw inconsistent with law and the corporate charter?
  2. Does the bylaw relate to the business and affairs of the corporation?

Given the close similarity between DGCL § 109 and BCL § 1504, we believe that a Pennsylvania court would likely conclude that a fee-shifting bylaw is facially valid based on the same principles as in Delaware.

Assuming that a fee-shifting bylaw would be valid under Pennsylvania law, the next question is whether a fee-shifting bylaw would apply to persons who are already shareholders at the time of the bylaw's adoption.

Which shareholders are bound by a bylaw amendment.  Perhaps the most influential Pennsylvania case on the enforceability of a bylaw against the shareholders of a Pennsylvania corporation is Bechtold v. Coleman Realty Co., which addressed the validity of a provision in corporate bylaws that imposed transfer restrictions on the corporation's shareholders.4

Bechtold affirmed that under Pennsylvania law certain types of bylaws are a contract between the corporation and its shareholders.  The Bechtold court also created a doctrine in Pennsylvania that distinguished between two kinds of bylaw provisions in Pennsylvania: (i) those that govern the conduct of the internal affairs of the corporation; and (ii) those that are designed to vest property rights among shareholders.5 Bechtold held that bylaws adopted in the first category may be amended under the usually applicable rules for amending the bylaws, but an amendment of a bylaw in the second category will not bind a shareholder that has not agreed to the amendment. 

We believe that a fee-shifting bylaw does not impact a property right vested in the shareholders and, therefore, would not fall under the second Bechtold bylaw category.  Rather, a fee-shifting bylaw seeks to govern the relationship between a corporation and its shareholders, and how to allocate the financial risk associated with an internal dispute regarding the affairs of the corporation.  Applying the Bechtold framework, we believe that a Pennsylvania court would likely agree with the conclusion of the Delaware Supreme Court that a properly adopted fee-shifting bylaw of a Pennsylvania corporation can apply to all of its shareholders.

Giving the board authority to amend the bylaws.  In order for the board of directors of a Delaware corporation to have the power to amend the bylaws, the board must be given that authority in the certificate of incorporation.  The Delaware Supreme Court in ATP noted that if the members have agreed to give authority to the board to amend the bylaws, then bylaws adopted by the board must be binding on the members.  Under BCL § 1504(a), the board of directors of a Pennsylvania corporation must also be given the authority to amend the bylaws, although the BCL permits the grant of authority to be contained in either the articles of incorporation or the bylaws.  The similarity between Delaware and Pennsylvania law on this issue is another reason why we believe that a Pennsylvania court would likely conclude that a fee-shifting bylaw will be binding on all of the shareholders of the corporation. 

Application of the American Rule in Pennsylvania.  Pennsylvania follows the American Rule on fee-shifting,6 which permits attorneys' fees in litigation to be shifted by statutory authorization, a clear agreement of the parties or some other established exception to the general rule that fees will be borne by the parties that originally incurred them.7  Pennsylvania courts interpret the phrase "clear agreement" to mean the language relied on to shift fees must be clear, and they analyze whether the fee-shifting provision clearly describes the agreement of the parties.8  If the bylaw clearly describes the agreement between the parties as to how the fee-shifting would occur, Pennsylvania courts would likely find the bylaw to be valid.

Final Considerations

While we believe there is clear support for the validity of fee-shifting bylaws under Pennsylvania law, we also believe there are practical considerations that should be evaluated by a Pennsylvania corporation before adopting a fee-shifting bylaw.  Those considerations include the following:

  • The potential reactions of shareholders and proxy advisory firms to the adoption of a fee-shifting bylaw.  Initial speculation by commentators is that these groups will be opposed to fee shifting bylaws in light of their opposition to bylaws that fix the exclusive forum for litigation regarding the internal governance of corporations.  If the opposition of proxy advisory firms becomes significant, adoption of a fee-shifting bylaw will need to be evaluated in the context of any other governance issues those firms have raised with respect to the corporation.
  • Related to the preceding consideration is the shareholder profile of the corporation and past issues the corporation may have faced with proxy advisory firms.
  • Whether other Pennsylvania corporations are adopting fee-shifting bylaws.
  • The timing of the adoption of the fee-shifting bylaw and whether the corporation is facing any issues that may lead to a question of improper purpose.  For example, if the bylaw is adopted shortly before or during a sale of the corporation, the bylaw may be challenged on the basis that the purpose of the bylaw is to forestall challenges to the sale transaction.
  • Continued discussion of the issue under Delaware law and what happens with respect to the delayed legislative action to amend the DGCL.  The Delaware Bar Association and the U.S. Chamber of Commerce are continuing to debate whether these types of provisions properly balance the interests of corporations in protecting themselves against meritless litigation and the interests of stockholders in enforcing the fiduciary duties of the board.  The lawyers argue that fee shifting bylaws are a dangerous compromise of the fundamental principle of corporate law that stockholders are not liable for debts of their corporation, while business interests see the lawyers motivated simply by their self-interested desire that litigation not be discouraged.

Footnotes

1  ATP Tour, Inc. v. Deutscher Tennis Bund, No. 534, 2013 (Del. May 8, 2014).

2  Liz Hoffman, Delaware to Weigh Who Pays Legal Fees in Corporate Litigation, The Wall Street Journal (June 10, 2014). The proposed Delaware amendment would explicitly limit the liability of stockholders to their investment and bar any bylaw or article of incorporation from expanding their potential liability. The text of the proposed legislative amendment can be found here.

3 No. 534, 2013 at 14 (citing Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934, 956 (Del. Ch. 2013)).

4 Bechtold v. Coleman Realty Co., 367 Pa. 208 (1951) (recently abrogated in part by an amendment to BCL § 1529 on the issue of transfer restrictions).

5 Id. at 213.

6  See McMullen v. Kutz, 985 A.2d 769, 775 (Pa. 2007) (affirming that under the American Rule "each side is responsible for the payment of its own costs and counsel fees absent bad faith or vexatious conduct" (quoting Lucchino v. Commonwealth, 809 A.2d 264, 267 (Pa. 2002))).

7 "This Court has consistently followed the general, American rule that there can be no recovery of attorneys' fees from an adverse party, absent an express statutory authorization, a clear agreement by the parties or some other established exception." Merlino v. Del. Cnty, 728 A.2d 949, 951 (Pa. 1999).

8 See Trizechahn Gateway LLC v. Titus, 976 A.2d 474, 482 (Pa. 2008) (in which an agreement by which a tenant agreed "to pay a reasonable attorney's fee if legal action is required to enforce performance by Tenant of any condition, obligation or requirement" was enforceable in an action to recover on a lease default).

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