Last month, the Delaware Court of Chancery issued an important decision via memorandum opinion on a variety of issues arising out of a Stockholders Agreement. The Court held that a contract provision requiring the loser in litigation to pay the prevailing party’s legal fees was valid.
In Manti Holdings, LLC, et al. v. Authentix Acquisition Company, Inc., the Court considered the enforceability of three clauses within Authentix’s Stockholders Agreement: (1) an agreement not to challenge any future merger approved by the board; (2) an agreement not to exercise appraisal rights with respect to such transaction; and (3) the enforceability of a prevailing party attorneys’ fee provision.
The case arose out of an agreement reached when the initial entity, Authentix, Inc., merged into Authentix Acquisition Company Inc. (“Authentix”) with two new shareholders– The Carlyle Group and J.H. Whitney & Co. (“Carlyle”)– as the new majority owners. The Petitioners were former stockholders in the target of an acquisition, and the Respondent was the surviving corporation.
Pursuant to the initial merger, in 2008, a new Stockholder Agreement was negotiated, which included the following terms:
In the event of a company sale, which is approved by the Board,
The stockholders would agree to the sale (not raising any objections);
The stockholders would waive their appraisal rights, with respect to the transaction;
The agreement would terminate upon the completion of the sale; and
Pursuant to a prevailing party attorney fee provision, if any litigation arose over the terms of the agreement, the prevailing party or parties would be entitled to recover reasonable attorneys’ fees.
In September of 2017, the Board approved a merger, and Petitioners attempted to assert their rights to appraisal, eventually resulting in litigation which upheld all of the terms of the Stockholders Agreement. Petitioners were then faced with a staggering attorney bill, which they challenged.
The Petitioners contended that while the prevailing party clause was unambiguous, it shouldn’t be enforceable against them because stockholders’ statutory rights can’t be superseded by a contractual obligation for various reasons including public policy, equity concerns, etc.
The Court engaged in a brief overview of the American Rule, whereby each party pays its own costs pursuant to litigation. However, it continued, the Delaware Supreme Court reaffirmed in ATP Tour, Inc. v. Deutscher Tennis Bund, that a prevailing party fee provision is enforceable as between contracting parties.
Following the ATP decision, the Delaware legislature added Sections 102(f) and 109(b) to the Delaware General Corporation Law, which prohibits bylaws from establishing the liability of the stockholders for attorneys’ fees or expenses of the corporation or any other party pursuant to litigation relating to any internal corporate claims. The changes were intended to prevent the potential chilling effect that such provisions might have against stockholders bringing suit to enforce fiduciary duties.
The Petitioners attempted to argue that the intent of Sections 102(f) and 109(b) was to prevent any contractual fee-shifting provisions with regard to stockholders. Petitioners argued that the provisions in the DGCL prohibit any agreements they entered into, even if willingly, due to logic similar to the doctrine of supremacy. Namely, since the Stockholders Agreement is lower on the hierarchy rungs than the DGCL, and since the DGCL states that bylaws cannot contain fee shifting provisions, the Stockholders Agreement violates their legal hierarchy theory, and should be deemed unenforceable.
The Court rejected the argument on the basis of the plain language of both Sections 102(f) and 109(b), referring not to contracts, but solely to certificates of incorporation and bylaws. An analysis of the legislative intent revealed a desire to carve out Stockholder Agreements from these statutory prohibitions, leaving room for freedom to contract. For example, the legislative history explicitly stated that those statutory provisions were “not intended…to prevent the application of…[fee-shifting] provisions pursuant to a stockholders agreement or other writing signed by the stockholder against whom the provision is to be enforced.”
Corporate charters and bylaws, are perceived as being analogous to contracts of adhesion, meaning that stockholders rarely have the ability to meaningfully challenge or negotiate the terms. Thus, it would make sense that the legislature would need to take a protective role against a potentially lopsided fee-shifting provision in a formation document.
Next, the Court looked to the core of the reason the Petitioners were attempting to dodge the fee-shifting provision. The underlying suit was over a contractual term to waive appraisal rights, which was not within the purview of the legislature’s concern in enacting the protective statutes. The issue was not an allegation of a breach of fiduciary duty. For perhaps obvious reasons, having a fee-shifting provision in a corporation’s bylaws or charter document might have the undesirable effect of interfering with the stockholders’ ability to enforce their rights of loyalty and care by corporate fiduciaries. In contrast, the instant litigation was pursuant to an agreement by the stockholders to waive their right to a statutory appraisal. As it fell outside of the prohibition, the argument was summarily rejected.
Lastly, having found that the fee shifting provision was legally enforceable, the Court turned one last time to the issue of whether the corporation could properly enforce the Stockholders Agreement. It rejected the Petitioners’ argument that the surviving corporation could not enforce the agreement since (based on its prior decisions) it was made a party to the Stockholders Agreement due to the plain terms of the agreement, and it thus has the right to enforce all of the terms of the Stockholders Agreement, consistent with that contractual intent.
This case offers an obvious example of the importance of thoroughly understanding your rights pursuant to a Stockholders Agreement, which I have written about before on this blog. If you need guidance on stockholders agreements and appraisal rights, or why they are an important tool for any start-up, please get in touch.