Delaware Court of Chancery Invalidates Fee-Shifting By-Law Imposing Liability for Contravening Forum-Selection By-Law | Practical Law

Delaware Court of Chancery Invalidates Fee-Shifting By-Law Imposing Liability for Contravening Forum-Selection By-Law | Practical Law

The Delaware Court of Chancery ruled in Solak v. Sarowitz ("Paylocity") that a corporation's fee-shifting by-law was facially invalid under Section 109(b) of the DGCL even though the bylaw only purported to shift legal fees to the stockholder plaintiff if the plaintiff wrongfully filed suit outside of Delaware in contravention of the corporation's forum-selection by-law.

Delaware Court of Chancery Invalidates Fee-Shifting By-Law Imposing Liability for Contravening Forum-Selection By-Law

by Practical Law Corporate & Securities
Published on 05 Jan 2017 • Delaware, USA (National/Federal)
The Delaware Court of Chancery ruled in Solak v. Sarowitz ("Paylocity") that a corporation's fee-shifting by-law was facially invalid under Section 109(b) of the DGCL even though the bylaw only purported to shift legal fees to the stockholder plaintiff if the plaintiff wrongfully filed suit outside of Delaware in contravention of the corporation's forum-selection by-law.
On August 1, 2015, amendments to the Delaware General Corporation Law became effective authorizing Delaware corporations to adopt by-laws designating Delaware as the exclusive forum for internal corporate claims (Section 115 of the DGCL) and prohibiting Delaware corporations from adopting by-laws that would purport to shift attorney fees and expenses of the corporation to a stockholder in connection with an internal corporate claim (Section 109(b) of the DGCL). For an example of a forum-selection by-law, see Standard Clause, By-Laws or Certificate of Incorporation: Delaware Forum Selection. For discussion of the forum-selection and fee-shifting by-law amendments, see Legal Update, DGCL Amendments on Fee-Shifting and Forum Selection Passed by Delaware General Assembly.
On December 27, 2016, the Delaware Court of Chancery invalided a fee-shifting by-law adopted by the board of a Delaware corporation that purported to shift the corporation's attorney fees and expenses to a stockholder only in the limited circumstance in which the stockholder had brought an internal corporate claim outside Delaware, thereby violating the corporation's exclusive-forum by-law (Solak v. Sarowitz et al. ("Paylocity"), (Del. Ch. Dec. 27, 2016)). The court held that the language of the statute does not make room for any distinctions in fee-shifting by-laws and unambiguously prohibits any provision that would shift the corporations' fees to a stockholder plaintiff in connection with an internal corporate claim.

Background

On February 2, 2016 (several months after the effectiveness of the DGCL amendments), the board of Paylocity Holding Corporation adopted two amendments to its by-laws. The first by-law was a typical forum-selection by-law designating Delaware as the corporation's exclusive forum for internal corporate claims. The by-law used language similar to the Standard Clause linked above. The second by-law was a limited fee-shifting by-law that read as follows:
"Extra-Forum Claims. To the fullest extent permitted by law, in the event that (A) any current or former stockholder of the corporation acting as such ('Claiming Party') initiates, joins or asserts any Action in a court, tribunal or other arbitral or judicial body, in each case other than in a Chosen Court (an 'Extra-Forum Claim'), or offers substantial assistance to, or has a direct financial interest in (other than simply in such person's capacity as a stockholder of the corporation), any Extra-Forum Claim against the corporation and/or any current or former director, officer, employee or agent of the corporation (collectively, an 'Aligned Party'), (B) the corporation does not consent in writing to waive applicability of this bylaw to a specified Extra-Forum Claim and (C) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Extra-Forum 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 corporation and any such Aligned Party the greatest amount permitted by law of all fees, costs and expenses of every kind and description (including but not limited to, all reasonable attorneys' fees and other litigation expenses) that the parties may incur in connection with such Extra-Forum Claim. (As defined above, the 'Fee-Shifting Bylaw')."
By its terms, the fee-shifting by-law would operate only against a stockholder who brought a claim against the corporation outside Delaware in violation of the forum-selection by-law and who failed to obtain judgment on the merits.
On May 5, 2016, a stockholder plaintiff filed suit on behalf of a putative class of Paylocity stockholders, requesting a declaratory judgment from the Chancery Court that the fee-shifting by-law violated the new Section 109(b) of the DGCL. The plaintiff made two other claims as well, asserting that the by-law violated Section 102(b)(6) of the DGCL (which states that stockholders are not liable for the corporation's debts) and that the board breached its fiduciary duties by adopting the by-law and failing to disclose the statutory framework relating to it when it disclosed the adoption of the by-law itself. The court dismissed the latter two claims; this Legal Update focuses on the claim that the by-law violated Section 109(b).

Outcome

The Chancery Court held that the fee-shifting by-law was invalid under Section 109(b) of the DGCL.

Dispute Is Ripe

The court first addressed the defendant board's contention that the suit was not ripe for judgment because no stockholder had actually brought an internal corporate claim outside Delaware in violation of the forum-selection by-law, a necessary step for triggering the fee-shifting by-law. The court rejected this reasoning, holding that the suit was ripe by virtue of the deterrent effect already activated by the by-law. As the court explained, the "practical reality" of the by-law's adoption was that so long as it remained in place, a rational stockholder would not file an internal corporate claim outside Delaware and expose itself to the risk of personal liability. Consequently, for the court to decline to review the by-law's validity until a stockholder challenges it by directly violating its terms risking significant loss would mean, as a practical matter, that the by-law would never become subject to review.
The court's description for why the dispute was ripe for judgment raises the question of why it should be concerned about a stockholder who wishes to violate the forum-selection by-law. The board raised this argument in the form of an affirmative defense based on the unclean-hands doctrine, insisting that the court should dismiss the complaint because the only possible motivation for the lawsuit was to pave the way for a future violation of the forum-selection by-law. The court rejected this defense on the grounds that a court only dismisses a complaint based on an affirmative defense if the plaintiff can prove no set of facts to avoid that defense. Here, however, the plaintiff did have another purpose for requesting a declaration on the validity of the by-law, which was to make sure that the by-law undergoes judicial review. The unclean-hands defense was therefore unavailing.
The court added that it did not intend to suggest that a stockholder who blatantly violated Paylocity's valid forum-selection by-law would suffer for having to litigate in Delaware, nor that the court would condone a stockholder taking that course of action. Nevertheless, the court held that the stockholders of Paylocity would suffer a detriment if the validity of the fee-shifting by-law were never subject to judicial review.

Statute Prohibits All Fee-Shifting By-Laws

Having decided that the dispute was ripe for judgment, the court analyzed the fee-shifting by-law under Section 109(b) of the DGCL. The court noted that the statute provides that Delaware by-laws may not contain "any provision that would impose liability on a stockholder for the attorneys' fees or expenses of the corporation or any other party in connection with an internal corporate claim." The court read this language as unambiguously prohibiting the inclusion of "any provision" in a corporation's bylaws that would shift the corporation's attorney fees "in connection with an internal corporate claim," regardless of where the claim was filed. Consequently, even though Paylocity's fee-shifting by-law would be triggered only if an internal corporate claim were filed outside Delaware, it was still invalid under Section 109(b)'s blanket prohibition on fee-shifting by-laws.
The court addressed the defendant board's several other arguments in defense of the by-law, including that the state's simultaneous passage of Section 115 and Section 109(b) should be understood as having carved out an exception to the prohibition against fee-shifting by-laws for by-laws that are triggered specifically by a lawsuit brought in violation of a forum-selection by-law. The court rejected this defense, noting that nothing in the language of the statute implied a connection between the two sections, and that on the contrary, the phrase "any provision" in Section 109(b) implied no exceptions at all.

Practical Implications

The decision in Paylocity unequivocally stands for the principle that under Section 109(b) of the DGCL, no fee-shifting by-law, no matter how limited its application, may be adopted by the board into the by-laws of a Delaware corporation. The facts of Paylocity address a fee-shifting by-law triggered by a violation of the corporation's forum-selection by-law, but other creative variations on fee-shifting by-laws would be held equally invalid. For example, a by-law purporting to shift the corporation's fees to a stockholder who held the corporation's stock for a short period of time, or to a stockholder who violated a charter provision by bringing an internal corporate claim outside Delaware, would be invalid under Paylocity (barring overturn by the Delaware Supreme Court).
An immediate consequence of the decision is that a stockholder considering bringing an internal corporate claim in a non-Delaware court now has one less obstacle in its way. It remains up to non-Delaware courts to respect a Delaware corporation's forum-selection by-law and dismiss a claim wrongly brought outside Delaware. In fact, courts in several jurisdictions have had opportunities to enforce Delaware corporations' forum-selection by-laws and have done so. For further discussion of these decisions, see Standard Clause, By-Laws or Certificate of Incorporation: Delaware Forum Selection: Drafting Note, Enforceability.
As noted in the Paylocity decision and in the Delaware General Assembly's synopsis of the statutory amendment, the statute does not affect the enforcement of a stockholders agreement or other writing signed by the stockholder that includes a fee-shifting provision. A corporation is permitted to enter into an agreement with a stockholder and contract for a fee-shifting provision as between the corporation and that stockholder.