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From Securities Regulation Daily, March 16, 2015

Troubling fee-shifting bylaw not binding on former shareholders

By Anne Sherry, J.D.

In a matter of first impression, the Delaware Chancery Court held that a fee-shifting bylaw did not bind a former shareholder who was cashed out before the bylaw was adopted. The court decided based on principles of contract law but expressed policy concerns surrounding fee-shifting bylaws more generally (Strougo v. Hollander, March 16, 2015, Bouchard, A.).

Background. The plaintiff, a former shareholder of First Aviation Services, Inc., was cashed out in a 10,000-to-1 reverse stock split completed on May 30, 2014. On June 3, the First Aviation board adopted a non-reciprocal fee-shifting bylaw. On June 14, the plaintiff initiated a class action challenging the fairness of the reverse stock split. The defendant company and directors argued that the bylaw is both facially valid and enforceable, so that, unless the plaintiff obtains a full judgment in his favor, he will be liable for the defendants’ legal fees. The plaintiff then amended his complaint to challenge the bylaw and not just the reverse stock split.

Bylaws as contract. The court held that the bylaw did not apply in this case for the same reason that a nonparty to a contract is not bound by the terms of that contract. Delaware case law establishes that corporate charters and bylaws are contracts among a corporation’s shareholders, and a fundamental principle of Delaware contract law is that only parties to a contract are bound by that contract. A stockholder whose equity interest is eliminated is not subject to, or bound by, bylaw amendments adopted after his interest in the corporation has been eliminated. The court also concluded that Section 109(b) of the Delaware General Corporation Law does not authorize the adoption of bylaws to regulate the rights or powers of former stockholders whose interests in the corporation already have been eliminated.

In this case, the court held that the governing bylaws are those in effect when the former stockholder’s interest as a stockholder was eliminated. The former stockholder is not subject to any bylaw amendments occurring after his interest was eliminated. In this case, the plaintiff would not be bound by the fee-shifting bylaw adopted after the reverse stock split, even though the bylaw was in effect before he filed his lawsuit. Despite the defendants’ arguments, the plaintiff was not estopped from challenging the fee-shifting bylaw because he was not picking and choosing which bylaws applied to him; rather, his interest as a former stockholder remained subject to all the bylaws in effect at the time of the reverse stock split.

Policy concerns. The propriety of fee-shifting bylaws was not before the court, but it expressed “serious policy questions” implicated by such bylaws in general. As a practical matter, the court noted, applying the bylaw in this case would have the effect of immunizing the reverse stock split from judicial review because no rational stockholder would risk having to pay the defendants’ uncapped attorney fees to vindicate the rights of the company’s minority stockholders, none of whom received more than $84,000 in the transaction. Yet the reverse stock split appears to be precisely the type of transaction that should be subject to exacting review to protect against fiduciary misconduct, the court opined. The court questioned whether it would be statutorily permissible or equitable to adopt bylaws that functionally deprive stockholders of the right to vindicate their interest as stockholders.

The case is No. 9770-CB.

Attorneys: Sidney S. Liebesman (Montgomery McCracken Walker & Rhoads LLP) and Gustavo F. Bruckner (Pomerantz LLP) for Robert Strougo. Francis G. X. Pileggi (Eckert Seamans Cherin & Mellott, LLC) for Aaron P. Hollander and First Aviation Services, Inc.

Companies: First Aviation Services, Inc.

MainStory: TopStory CorporateGovernance DelawareNews

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