Strougo v. Hollander: Chancery Court Declines to Apply Fee-shifting By-law Against Former Stockholders | Practical Law

Strougo v. Hollander: Chancery Court Declines to Apply Fee-shifting By-law Against Former Stockholders | Practical Law

The Delaware Court of Chancery held in Strougo v. Hollander that a by-law adopted after a stockholder has been cashed out cannot be applied against the stockholder.

Strougo v. Hollander: Chancery Court Declines to Apply Fee-shifting By-law Against Former Stockholders

by Practical Law Corporate & Securities
Published on 19 Mar 2015 • Delaware
The Delaware Court of Chancery held in Strougo v. Hollander that a by-law adopted after a stockholder has been cashed out cannot be applied against the stockholder.
On March 16, 2015, the Delaware Court of Chancery held that a fee-shifting by-law adopted by the board after a reverse stock split could not be enforced against plaintiffs who were no longer stockholders when the by-law was adopted (Strougo v. Hollander, C.A. 9770-CB, (Del. Ch. Mar. 16, 2015)). This case presented an issue of first impression under Section 109(b) of the DGCL and would apply to any type of by-law amendment.

Background

First Aviation Services, Inc., a Delaware corporation based in Connecticut, announced on May 16, 2014, that it had established a special committee, consisting of two inside directors, to consider a potential reverse stock split. Later that day, the company announced that the board had approved a 10,000-to-1 reverse stock split at a pre-split price of $8.40 per share.
The reverse stock split was completed on May 30, 2014, and made First Aviation a privately owned company by cashing out the plaintiff stockholder, Robert Strougo, and other similarly situated stockholders. Both directors on the special committee and Aaron Hollander, the CEO, Chairman of the board and controlling stockholder, held enough stock to remain stockholders of First Aviation following the split.
On June 3, 2014, the First Aviation board adopted a fee-shifting by-law modeled on the by-law that was the subject of the ATP Tour decision (see ATP Tour: Delaware Supreme Court Upholds Fee-shifting By-laws if Adopted for Proper Purpose). By its terms, the by-law required both current and former stockholders, and anyone on their behalf, to reimburse the corporation for all fees, costs and expenses incurred in connection with the stockholder's claim if the stockholder did not obtain a judgment on the merits substantially in his favor.
Later that month, the plaintiff initiated an action against the board, challenging the fairness of the reverse stock split and alleging breaches of fiduciary duties by both the board and Hollander as the company's de facto controlling stockholder. The plaintiff was subsequently informed by the board that it had adopted a fee-shifting by-law. On learning of the by-law's adoption, the plaintiff amended his complaint to challenge the validity and fairness of the fee-shifting by-law.
At issue on summary judgment was the narrow question of whether the fee-shifting by-law should apply specifically against stockholders who were cashed out following the reverse stock split. The plaintiff's other claims regarding the validity of a fee-shifting by-law as a general matter and the substantive fairness of the transaction were not addressed (though the Court provided a brief discussion, in dicta, on those issues).
The plaintiff argued that the fee-shifting by-law should not apply to the present lawsuit because:
  • By-laws are understood to be corporate contracts between the corporation and the stockholder. When the reverse stock split was completed and caused the plaintiff to no longer be a stockholder of First Aviation, he ceased to be a party to the corporate contract. Future amendments to the by-law therefore could not be enforced against the plaintiff as an ordinary matter of contract law.
  • Section 109(b) of the DGCL does not permit a by-law to regulate the rights or powers of individuals or entities who were no longer stockholders when the by-law was adopted.
  • Applying the by-law against this lawsuit, even though the by-law had been adopted after the reverse stock split, would be inconsistent with Delaware public policy.
The defendants argued in response that:
  • When the plaintiff became a stockholder, he implicitly consented to the board's power to unilaterally amend the by-laws at any time, including after he ceased to be a stockholder.
  • To disallow application of the by-law to former stockholders would resurrect the "vested rights doctrine" that Delaware courts have rejected (see Kidsco, Inc. v. Dinsmore, 674 A.2d 483 (Del. Ch. 1995)). The vested rights doctrine is the theory that a stockholder has the right to proceed under the by-laws as they were written at the time of the event that the stockholder is challenging, even if a corporation's by-laws were subsequently amended.
  • Applying the by-law is not inconsistent with public policy because the lawsuit was filed after the by-law had been adopted.

Outcome

After considering both Delaware and contract law, the Court held that the by-law should not apply to the plaintiff's lawsuit because:
  • The reverse stock split eliminated the plaintiff's interest in First Aviation.
  • Delaware law prohibits a by-law from regulating the rights or powers of former stockholders who were no longer stockholders when the by-law was adopted.

Contractual Scheme of By-laws

Section 109(b) of the DGCL permits a corporation's by-law to contain any provision, not inconsistent with law, relating to the rights or powers of its stockholders. The Court compared the language of Section 109(b) with that of Section 145 of the DGCL, which mandates indemnification of a "present or former director." As the Court noted, if the Delaware legislature had wanted Section 109(b) to apply to former stockholders, it could have used similar language as that used in Section 145. Because Section 109(b) does not refer to "present or former stockholders" and instead refers only to "stockholders," the legislature limited its application to present stockholders only. As further evidence, the Court referenced the definition of "stockholder" in Section 220(a)(1) of the DGCL, where the books and records statute clearly contemplates the term "stockholder" to refer only to current stockholders.
The Court also analyzed Delaware contract law to determine whether Section 109(b) applies to former stockholders. Citing its decision to uphold forum-selection by-laws in Boilermakers Local 154 Retirement Fund v. Chevron Corp., the Court noted that a corporation's by-laws are treated as flexible contracts between the corporation and its stockholders if the corporation's charter permits the board to unilaterally amend its by-laws (73 A.3d 934 (Del. Ch. 2013)). However, only parties to the contract are bound by that contract. Once a stockholder's equity interests are eliminated, the stockholder is no longer a party to the contract and no longer subject to any by-law amendments adopted after that time.
The Court acknowledged that a former stockholder would still be subject to the corporation's by-laws as they were written before the stockholder's equity interest ceased. In that vein, stockholders also do not lose their right to challenge the fairness of a transaction simply because the transaction cashed them out. Consequently, the plaintiff maintained the right to sue over the fairness of the reverse stock split, but under the by-laws as they existed at the time that he was a stockholder.

Vested Rights Doctrine Inapplicable

The Court rejected the defendants' claim that not enforcing the fee-shifting by-law in this action would resurrect the vested rights doctrine that was rejected in Kidsco. The Kidsco court had held that if the stockholder was on notice that the by-laws may be unilaterally amended, he does not have vested rights in the original version of the by-laws, even if the stockholder relied on the by-laws as written before they were amended. As a party to the corporate contract, the stockholder acknowledges that the by-laws may change, and with them his rights.
Here, however, the plaintiff had not argued that he had a vested right to challenge the reverse stock split based on the by-laws as they existed at the time of the transaction in and of itself. Rather, the plaintiff argued that the amendment to the by-laws could not apply to him because he was no longer a party to the corporate contract when the contract was amended. Had the plaintiff remained a stockholder even after the transaction and the by-laws then been amended, the plaintiff would not have been able to argue that the form of the by-laws in effect at the time of the transaction should apply to him. That is the doctrine that was rejected in Kidsco. In this case, though, the plaintiff was not relying on that doctrine, but on the contractual principle that the only contract he should be held to is the by-laws as written when he was still a stockholder.

Practical Implications

Strougo v. Hollander settles the question of first impression about whether, under Section 109(b), an amended by-law can be applied against former stockholders who had no equity interest in the corporation when the by-laws were amended. Not all that surprisingly, the Court held that it cannot.
Insofar as the decision relates to fee-shifting by-laws, its significance may be somewhat short-lived. Recently proposed legislation would, if adopted as written, prohibit the type of fee-shifting by-law at issue in this case (see Legal Update, DGCL Amendments Proposed on Fee-shifting, Forum Selection and Appraisal Rights). While the Court did not rule on the merits of the fee-shifting by-law itself (or on the entire fairness of the transaction), it was critical of the by-law in the context of a controlling stockholder who takes a company private and receives differential treatment in the process.
In dicta, the Court cautioned that even if fee-shifting by-laws were not ultimately prohibited, it would most likely be inequitable to permit their application in a case such as this. The fee-shifting by-law here would have had the practical effect of shielding the controlling stockholder transaction from judicial review, because the risk to the challenging stockholder of paying the defendants' uncapped attorneys' fees would substantially outweigh any potential recovery to any one stockholder. This immunizing effect is all the more problematic, the Court added, in the context of a transaction that would otherwise be subject to Delaware's strict entire fairness standard of review.