We’ve seen some interesting and potentially important developments in Delaware recently. Two of them affect how shareholders sue corporations.

You may think, “no way, not us!” Let us remind you that 98% of all deals in 2013 attracted at least one lawsuit. So, read on.

Delaware courts now allow companies to require all corporate litigation to proceed in a single specified state (exclusive forum). They also allow companies to require shareholders that lose a lawsuit to pay the company’s costs (fee-shifting). The former doesn’t bother us too much, while the latter could pose a problem, if companies pursue it further. Both illustrate the contractual nature of corporate bylaws.

Exclusive Forum, No Big Deal

Shareholders litigate three types of matters with companies:

1. ❖derivative lawsuits
   

2. ❖breach of fiduciary duty
   

3. ❖violation of state corporate laws or company bylaws.
   

To pursue such a matter, a shareholder needs to sue the corporation somewhere. You’d sue a Delaware corporation in Delaware, a New York corporation in New York, and so forth.

Some shareholders, though, sue corporations in other places. Wachtell highlights one case where investors sued in multiple states, and it’s messy. While we deeply resent how Delaware law favors corporations, it seems foolish to shop for a better venue than the state of incorporation.

Last year, Delaware courts decided a company can specify the venue in its bylaws. The court affirmed that the bylaws represent a contract among shareholders, executives, and directors. Like any contract, it can specify the venue for litigation.

We don’t worry too much about this, seeing as it mostly affirms what investors already expect. We can think of much worse bylaw amendments.

Fee Shifting, A Bigger Deal

In most civil litigation in the US, courts follow the American Rule: each party pays its own costs, such as legal fees and expert witnesses. In many other countries, the loser pays the winner’s costs - hence, the “American” rule.

The parties to a lawsuit can preempt the American Rule, and agree to some other way to deal with the costs. So, for example, a vendor and a customer can agree in a sales contract that the customer will always pay the legal fees of the vendor, say if the vendor needs to sue the customer to collect.

Earlier this year, the Delaware court affirmed that corporations and shareholders can “agree” to another method besides the American Rule. A corporation can require if shareholders lose a suit, then they pay the corporation’s’ costs. It need not run the other way, though - if a corporation loses, it doesn’t have to pay the shareholder’s costs.

Delaware allows corporations to do this through the bylaws. So, at least 24 Delaware companies have amended their bylaws such that if shareholders lose a lawsuit, they pay the company’s costs. The new Alibaba IPO is the most notable instance.

Again, this idea considers bylaws as a contract among shareholders, executives, and directors. Delaware corporate code currently allows the corporation to rewrite that contract without shareholder consent. And, it can rewrite it to require shareholders to pay the company’s legal fees in losing cases.

This is bad - the New York Times says so. While it might deter frivolous litigation, it also limits worthwhile efforts to discipline companies through the courts.

Two efforts have emerged to respond to this situation. First, the

Delaware legislature has considered a change to the statute that allows corporations to amend bylaws for this purpose. It appears that the legislature will take it up next year.

Second, some observers urge the SEC to preempt Delaware law. The new Delaware decision conflicts with how Federal courts operate, as Federal securities law follows the American Rule. These observers urge the SEC to apply this reasoning to Delaware.

Read The Contract!

Both these developments remind us that bylaws are a contract among investors, executives, and directors. Unfortunately, Delaware allows generally one party, directors, to amend the contract without the consent of another party, the shareholders.

As with any transaction, we’d study the contract carefully before we finalize the deal. Read the bylaws before buying the shares.