Delaware, a state often considered an incorporation “mecca” with its favorable tax laws, preeminent business court and unified body of corporate law, has recently enacted a controversial statute that may call the state’s corporation-friendly reputation into question. On June 11, 2015, the Delaware General Assembly approved legislation to effectively prohibit fee shifting bylaw provisions in the context of stockholder litigation related to corporate governance and merger and acquisition transactions. This law effectively thwarts efforts to curb unwarranted and frivolous stockholder litigation. It will also block any attempts to quell the large runaway verdicts in directors and officers (D&O) matters in Delaware.

Will this statute—which will undoubtedly encourage derivative class action lawsuits against corporate management— incentivize companies to reconsider Delaware as the state of their incorporation?

Amendments to the Delaware General Corporation Law

The Delaware fee-shifting bylaw prohibition statute was introduced as SB 75 and passed on June 11, 2015, with an effective date of Aug. 1, 2015. Through the statute, the Delaware General Assembly, among other things, amended the Delaware General Corporation Law (DGCL) (the amendments) to nullify the effectiveness of corporate bylaws that allowed fee-shifting in the context of intra-corporate litigation such as stockholder derivative actions.

Specifically, the statute added a new subsection (f) to Section 102 of the DGCL, which states that the certificate of incorporation “may not contain any provision that would impose liability on a stockholder for the attorney fees or expenses of the corporation or any other party in connection with an internal corporate claim.” Similarly, Section 109(b) of the DGCL has been amended to provide that “[t]he bylaws may not contain any provision that would impose liability on a stockholder for the attorney fees or expenses of the corporation or any other party in connection with an internal corporate claim, as defined in Section 115 of this title.”

The amendments prohibit Delaware stock corporations from imposing liability on a stockholder for attorney fees or expenses pertaining to an “internal corporate claim” in their bylaws or certificate of incorporation. Section 115 of the DGCL defines an “internal corporate claim” as any claim, including those brought on behalf of a corporation, “that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or as to which [the DGCL] confers jurisdiction upon the [Delaware] Court of Chancery.”

Exceptions to the Amendments

The statute is not without limits; there are exceptions to the reach of the new legislation. Notably, the amendments do not prohibit the shifting of fees in stockholders’ agreements or other written agreements signed by stockholders. The amendments also do not apply to alternative business entities not governed by the DGCL, such as partnerships, limited partnerships or limited liability companies, as in In re El Paso Pipeline Partners, LP Derivative Litigation, C.A. No. 7141- VCL, n. 38 (Del. Ch. Dec. 2, 2015) (“The [Delaware] LP Act does not contain provisions analogous to Sections 102(f) and 109(b)”). The amendments implicate only Delaware corporations, which are subject to the DGCL.

In addition, amended Section 114(b)(2) of the DGCL specifies that the prohibition of fee-shifting provisions in a certificate of incorporation or bylaws do not apply to Delaware non-stock corporations. This exception ensured that the rationale of the Delaware Supreme Court, in its May 2014 decision ATP Tour v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), would not be disturbed. In ATP Tour, the high court answered questions of law certified to it from the U.S. District Court for the District of Delaware, and held that fee-shifting provisions in a Delaware non-stock corporation’s bylaws are not per se invalid. There, ATP Tour’s bylaws provided that if a member brought an action against it but did not obtain a judgment on the merits that “substantially achieved” the remedy sought, the member would be required to reimburse ATP Tour for all of its attorneys’ fees, costs and expenses. ATP Tour was then sued for antitrust violations and breach of fiduciary duty. The company and its directors prevailed and moved to recover fees and costs under the amended bylaws.

Following the Supreme Court’s ruling in ATP Tour, there was uncertainty and speculation as to whether the decision would apply to Delaware stock corporations as well, including public companies. The amendments clarified the issue, providing for a distinction between stock and non-stock corporations in terms of the enforceability of fee-shifting provisions.

Finally, nothing in the amendments to the DGCL would serve to prevent Delaware courts from issuing sanctions or shifting fees under the bad-faith exception to the American rule that otherwise requires each party to pay their own attorneys’ fees. However, if the Delaware General Assembly had permitted fee-shifting, it would have resulted in the courts’ having a greater arsenal to defeat frivolous stockholder actions.

Impact of the Amendments

To date, there are no Delaware cases interpreting or applying the amendments to the DGCL. At this juncture, just months removed from the Aug. 1, 2015 effective date, it is too early to tell what effect, if any, the amendments will have on either: decisions of corporations to incorporate or remain in Delaware; or corporate management of Delaware corporations that are subject to the reach of the statute (i.e., stock corporations).

Clearly, the exceptions to the statute are not insignificant, as the amendments have no bearing upon alternative entities or nonstock corporations, which are free to enact fee-shifting provisions in their governing documents. Thus, it would be prudent for Delaware entities, concerned with the potential for intra-corporate litigation, to consider the use of alternative entities where possible and appropriate should they choose to implement fee-shifting provisions in their governing documents.

Ultimately, however, it will not be possible or practical for many corporations, such as publicly traded companies for example, to change their internal structures simply to avoid the implication of these amendments. It will remain to be seen the extent to which other jurisdictions, which are constantly competing with Delaware to acquire corporate charters, will enact legislation expressly allowing for fee-shifting in the bylaws of stock corporations in order to attract such entities. Were this to be the case, the Delaware General Assembly would be wise to consider whether the gains from limiting the liability of corporate stockholders and promoting intra-corporate lawsuits outweigh the potential for the perception of Delaware as a corporation friendly state to be called into question, and the unintended consequences resulting therefrom. In this vein, the Delaware Court of Chancery recently rendered an opinion of import rejecting “disclosure settlements,” in which supplemental disclosures are exchanged for broad releases to company management, as in In re Trulia Inc. Stockholder Litigation, C.A. No. 10020-CB, slip op. At 19 (Del. Ch. Jan. 22, 2016) (“Given … the mounting evidence that supplemental disclosures rarely yield genuine benefits for stockholders … the court’s historical predisposition toward approving disclosure settlements needs to be reexamined.”)

Given the recent massive settlement awards approved by the Delaware Court of Chancery over the past several years—including the $275 million stockholder derivative settlement of In re Activision Blizzard, Inc. Stockholder Litigation, Cons. C.A. No. 8885- VCL (Del. Ch. May 20, 2015), and the $154 million stockholder derivative settlement of In re Freeport-McMoRan Copper and Gold Inc. Derivative Litigation, C. A. No. 8154-VCN (Del. Ch.)—coupled with the recent amendments nullifying bylaw fee-shifting, directors and officers of Delaware stock corporations must continue to understand the risks of potential litigation in connection with any merger, transaction, or other stockholder dispute, and seek adequate legal representation to minimize the potential for intra-corporate litigation.

Reprinted with permission from the February 23, 2016, edition of The Legal Intelligencer © 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877.257.3382 –reprints@alm.com or visit www.almreprints.com.

Carl D. Neff is a partner with the law firm of Fox Rothschild LLP.  Carl is admitted in the State of Delaware and regularly practices before the Delaware Court of Chancery, with an emphasis on shareholder disputes. You can reach Carl at (302) 622-4272 or at cneff@foxrothschild.com.