Fee Shifting Bylaws in Delaware: The Facts on the Ground (Part 3)

We are discussing fee shifting bylaws.

Perhaps the most interesting bylaw involves the one adopted by the board at Hemispherx (and challenged in Kastis v. Carter).  The bylaw was adopted after litigation had been filed by shareholders.  The bylaw provided: 

  • (a) In the event that, after the date of adoption of this Section 5.7, (i) any current or former security holder of the Company (the “Claimant”) who initiates, asserts, maintains or continues against the Company any litigation, claim or counter-claim (“Claim”) (each such Claimant, together with any other person who joins with the Claimant, offers substantial assistance to the Claimant, or has a direct financial interest in any Claim, being herein collectively referred to as the “Claiming Party”) against the Company or against any current or former director, officer or security holder (including any Claim purportedly filed on behalf of or in the right of the Company or any security holder) arising in whole or in part out of any Internal Matter (as defined below), and (ii) the Claimant 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 Company and any such current or former director, officer or security holder for 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 Company and any such current or former director, officer or security holder have incurred in connection with such Claim. 

The provision, therefore, applied to the instigation of a claim, but to the maintenance and continuation of a claim.  The provision, therefore, on its face applied to the litigation against the company had had already been initiated by shareholders.  

The provision also made explicitly clear that the fee shifting bylaw applied to causes of action under the federal securities laws.  The bylaw defined an internal matter as follows:   

  • For purposes of this Section 5.7, the term “Internal Matter” shall mean and include (i) any derivative action or proceeding brought on behalf of or in the right of the Company, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of the Company to the Company or the Company’s security holders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, (iv) any action asserting a claim arising pursuant to any provision of the federal securities laws, and any regulation promulgated pursuant thereto, or (v) any action asserting a claim governed by what is known as the internal affairs doctrine. 

Shareholders in a derivative suit in Delaware challenged the bylaw, arguing that it was "invalid, inapplicable and unenforceable."  They asserted that the provision threatened to impose costs on counsel. 

  • The Bylaw imposes liability not only on stockholders but also on anyone who offers substantial assistance to the stockholders or who has a direct financial interest in a claim. Therefore, the Bylaw threatens Plaintiffs’ counsel, who are prosecuting this case on a contingent basis, with liability for Defendants’ fees and costs.

To the extent that the court declined to do so, counsel asked that an order be granted "voluntarily dismissing this action" and that counsel be allowed to withdraw.  Moreover, any further effort to "continue" the litigation would create the "threat of retroactive liability for all defense costs since the commencement of the action on June 18, 2013."

At a hearing on the subject, counsel noted that any continuation of the litigation while the bylaw was in place potentially threatened its clients with the imposition of fees.  As counsel stated: 

  • But right now, we can't do anything about that, because if we do anything, under this bylaw, it subjects our clients to liability that the defendants say they've incurred hundreds of thousands of dollars of fees so far. And so while we were carrying out the process that Zapata mandates for dismissal of a derivative case in a demand excused context, this bylaw comes in and, basically, we can't continue with the Zapata process. We can't do anything because there would be crippling financial liability that would attach to our clients, including a bond requirement and liability for all defendants' legal fees and expenses if plaintiffs continue or maintain this litigation and do not obtain a judgment on the merits essentially for all the relief sought. 

Moreover, counsel asserted that the standard in the bylaw for shifting fees was met even where shareholders were successful.   

  • I've litigated many cases on behalf of stockholders in my 36 years at the bar, and very few result in a judgment on the merits. Fewer still a judgment on the merits for plaintiffs. And of those few, my firm has had some success in obtaining actual judgments on the merits in favor of stockholders. But even in that handful of cases, we would not have met the success standard of the Hemispherx bylaw. 

Where these types of bylaws existed, shareholders would not bring suit. 

  • if a bylaw may apply to these plaintiffs, they cannot -- and virtually no stockholder can [maintain an action], particularly in a derivative case. You have no direct interest in any recovery and your indirect interest is going to be minimal. That's why there are derivative cases, is because the Delaware courts have recognized that, otherwise, people would not bring a case challenging a corporate action because they wouldn't have a sufficient economic interest. It's only if you can bring it on a representative basis. 

Moreover, counsel indicated that the act of challenging the bylaw arguably triggered the provision and potentially subjected shareholders to the imposition of fees.  We'll continue this discussion in the next post.  

Primary materials, including the hearing transcript, in Kastis v. Carter can be found at the DU Corporate Governance web site.    

J Robert Brown Jr.