Loser Pays Provisions – Here to Stay? Will We Be Seeing Them In Texas Corporations and LLC’s?

A recent decision by the Delaware Supreme Court upholding the validity of “loser pays” provisions is making waves in corporate shareholder circles, and not just in Delaware.   See ATP Tour, Inc., et al. v. Deutscher Tennis Bund, et al., Supreme Court of Delaware, C.A. No. 07-178, May 8, 2014.  The Court’s decision is notable, and it hearkens back to Justice Potter’s quote on the subject of pornography 50 years ago, i.e., I know it when I see it.[1]   In ATP Tour, the Court approved a corporate board’s authority to adopt a loser pays bylaw, but the Court also noted this type of bylaw could be invalidated if circumstances suggested that it was adopted for inequitable or improper purposes.  The Court did not offer specific guidance, however, as to what specific circumstances would make the bylaw either acceptable or improper. 

In its ATP decision issued on May 8, the Delaware Supreme Court answered four certified questions from the US District Court in Delaware.  The Court held that the board of a Delaware non-stock company could enact a loser pays bylaw that would require a shareholder who sued the company and/or other members to pay all defense fees and costs incurred by the prevailing party if the shareholder lost his lawsuit.  The Court’s decision applied to a non-stock corporation, but nothing set forth in the Court’s holding indicated that it would not apply equally to a stock corporation. 

The Delaware Court framed the question this way:  whether a corporate board can adopt a fee-shifting provision applicable to intra-corporate lawsuits when the claimant fails to obtain a judgment on the merits that substantially achieves, in both substance and amount, the full remedy the shareholder sought in filing the lawsuit.  

The Court started with the premise that, under Delaware law, a corporation’s bylaws are presumed valid.  It found this bylaw to be facially valid and also held that there was no common law principle that prohibited directors from enacting fee-shifting bylaws.  The Court observed that Delaware follows the American Rule, which requires parties in litigation to pay all of their own legal fees and costs.   The Court pointed out, however, that nothing in Delaware law or common law prevents contracting parties from modifying the American Rule to obligate the losing party to pay the prevailing party’s fees.  Thus, a validly enacted bylaw that calls for the payment of legal fees to be shifted falls within a contractual exception to the American Rule.

Importantly, the Court also stated that the enforceability of a fee-shifting provision “depends on the manner in which it was adopted and the circumstances under which it was invoked.” Id.  The Court then went on to cite cases in which Delaware courts have held that the board’s purpose in adopting the bylaw was to “perpetuate itself in office” and “obstruct [] the legitimate efforts of dissident shareholders in the exercise of their rights to undertake a proxy contest against management.”  Schnell v. Chris-Craft Industries, 285 A.2d 437 (Del. 1971); Hollinger International, Inc. v. Black, 844 A.2d 1022 (Del. Ch. 2004), aff’d sub. nom., Black v. Hollinger, Int’l Inc., 872 A.2d 559 (Del. 2005).  The ATP Court quoted what it described as the “famous statement” from the Schnell Court as follows: “inequitable action does not become permissible simply because it is legally possible.” Id. at 439.

The Court emphasized that it was answering a certified question, and was not applying the law to the facts of a specific case.  Therefore, the Court hedged its bet by stating that “the enforceability of a facially valid bylaw may turn on the circumstances surrounding its adoption and use. “  Id.   

The negative reaction and response to the ATP decision was swift.  Members of the Delaware Bar representing both plaintiffs and defendants proposed legislation to overturn the decision’s application to stock corporations. The proposed amendments would prevent fee-shifting provisions from inclusion in the company’s organizational documents.   The Corporate Law Section of the Delaware State Bar Association approved the amendments on May 29, 2014 with a proposed effective date of August 1, 2014.  If approved by the Executive Committee of the Bar Association, the amendments would be sent to the State legislature.  The Delaware legislature generally follows recommendations from the State Bar Association regarding any proposed legislation and the enactment of these amendments is therefore widely expected.

In Texas, there is no decision equivalent to the ATP case upholding a fee shifting bylaw.  Yet, there is nothing in the Texas Business Organization Code that would prohibit a corporate board from adopting a loser pays bylaw.  Thus, it is unclear whether a Texas court would enforce either an original or amended bylaw requiring the losing party to pay the prevailing party’s legal fees and costs in shareholder litigation.  Given the importance of Delaware law in shareholder lawsuits, the ATP decision would likely have some influence with Texas courts construing this type of bylaw.  That influence will be largely muted, however, if the Delaware legislature passes a statute that forbids stock corporations from including loser pays provisions in their bylaws.

[1] See Jacobellis v. Ohio, 378 U.S. 184 (1964).