On Dec. 27, 2016, the Delaware Court of Chancery invalidated a fee-shifting bylaw adopted by payroll service provider Paylocity Holding Corp. that was applicable only to stockholders who violated a valid Delaware forum-selection bylaw. The decision in Solak v. Sarowitz, et al. confirms that any fee-shifting bylaw related to internal corporate claims is likely to be declared invalid.
In 2015, Section 115 was added to the Delaware General Corporation Law (DGCL) and allowed Delaware corporations to adopt bylaws requiring that internal corporate claims be filed exclusively in Delaware. At the same time, Section 109(b) of the DGCL was amended to provide that bylaws of Delaware corporations “may not contain any provision that would impose liability on a stockholder for the attorneys’ fees or expenses of the corporation or any other party in connection with an internal corporate claim.”
About six months after the DGCL amendments went into effect, Paylocity’s board of directors adopted two provisions to its bylaws. The first a was forum-selection bylaw requiring internal corporate claims be filed in a court in Delaware. The second purported to shift Paylocity’s litigation expenses, including attorneys’ fees, to any stockholder who brings an internal corporate claim outside Delaware and does not obtain a judgment that “substantially achieves the full remedy sought.” In other words, in order to trigger the fee-shifting bylaw, the stockholder must first violate the forum-selection clause.
John Solak, a stockholder, filed a lawsuit seeking a declaration that the fee-shifting bylaw was invalid under the DGCL and claimed members of Paylocity’s board should be liable for breaching their fiduciary duties by adopting the bylaw and by failing to disclose certain information when the company publicly disclosed its adoption. Paylocity moved to dismiss the action, arguing the case was unripe because because no stockholder had filed a corporate claim outside of Delaware. The company also said the plaintiff had failed to state a claim that the fee-shifting bylaw was invalid.
Deciding the case was ripe for review, Chancellor Andre G. Bouchard said as long as the fee-shifting bylaw was in place it was unlikely that a stockholder would file a corporate claim outside Delaware. As such, the judge said there was a very real possibility that the bylaw would likely never be subject to judicial review if it was necessary to wait for the it to be triggered.
On the merits, the judge said the bylaw violates Section 109(b) because the statute “unambiguously” prohibits the inclusion of any provision in a corporation’s bylaws that would shift a corporation’s litigation expenses to a stockholder, irrespective of where a claim is filed. “Thus, even though the Fee-Shifting Bylaw is triggered only when an internal corporate claim has been filed outside of Delaware, it is invalid under the blanket prohibition on such bylaws contained in Section 109(b).”
Paylocity had argued, in part, that the amendment of Section 109(b) and simultaneous adoption of Section 115 must be “read in tandem” to mean that Section 109(b) was not intended to prohibit fee-shifting for corporate claims filed outside Delaware when a corporation adopts an exclusive forum bylaw requiring that such claims be filed in Delaware. Rejecting this argument, the judge said Section 109(b) made no distinction between internal corporate claims filed inside or outside Delaware.
Paylocity’s bylaw also included a savings clause, which said the bylaw was enforceable only “[t]o the fullest extent permitted by law.” But the judge said in order for a savings clause to negate a facial challenge to the validity of a bylaw, “there logically must be something left in the challenged provision for the savings clause to save. Here, there is not.” In sum, the court held that Paylocity’s fee-shifting bylaw could not operate lawfully under any circumstances.
The court did, however, dismiss the plaintiff’s claim that the bylaw violated Section 102(b)(6) of the DGCL. That section says that absent approval in the certificate of incorporation, stockholders “shall not be personally liable for the payment of the corporation’s debts except as they may be liable by reason of their own conduct or acts.” The judge said Solak hadn’t provided any authority interpreting the term “debts” as used in that section. The breach of fiduciary claim was also rejected. Paylocity’s certificate of incorporation contained a provision exculpating its directors from liability for breaches of the duty of care and the judge said the plaintiff failed to show the directors acted in bad faith.
The decision, the first to interpret Delaware’s fee-shifting statute, suggests courts will take a broad interpretation of the law and find that any fee-shifting bylaw adopted by a stock corporation and related to internal corporate claims will be found invalid.
It also underscores the challenges for plaintiffs in proving a breach of fiduciary duty claim on the basis of bad faith. The plaintiff argued the defendants must have known they were violating the law when they approved the bylaw, six months after the 2015 DGCL Amendments took effect. But the court said the complaint lacked factual allegations about the process the board undertook when considering the proposal. “Nowhere does the Complaint plead facts suggesting, for example, that the directors harbored some nefarious purpose, that they did not deliberate diligently, or that they failed to receive (or ignored) legal advice.” Corporations may be able to use this as guidance on how to satisfy a judicial inquiry into a board’s process in connection with matters of governance.