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Solak v. Sarowitz: Court of Chancery Grants Declaratory Judgment as to Facial Invalidity of Fee-Shifting Bylaw

January 12, 2017

In Solak v. Sarowitz, 2016 WL 7468070 (Del. Ch. Dec. 27, 2016), the Court of Chancery denied in part a motion to dismiss a declaratory judgment and breach of fiduciary duty action challenging a fee-shifting bylaw adopted by the board of directors of Paylocity Holding Corporation (“Paylocity” or the “Company”). The Court rejected a ripeness challenge and held on the merits that the fee-shifting bylaw was facially invalid under Section 109(b) of the General Corporation Law of the State of Delaware (the “DGCL”), which the Court read as creating a blanket prohibition on “‘any provision’ that would shift fees ‘in connection with an internal corporate claim’ without regard to where such a claim is filed.”

The Delaware General Assembly amended Section 109(b) of the DGCL after the Delaware Supreme Court’s ruling in ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), in which the Delaware Supreme Court held that a bylaw adopted by the board of directors of a Delaware nonstock corporation that shifted litigation expenses in an “intra-corporate litigation” to a plaintiff who failed substantially to obtain the relief sought was facially valid under the DGCL. As amended, Section 109(b) prohibits “any” bylaw “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.” Effectively limiting ATP to nonstock corporations, the amendment, which became effective on August 1, 2015, addressed concerns that stock corporations would adopt similar bylaws and that stockholders would be deterred from enforcing otherwise meritorious claims as a result. New Section 115 of the DGCL, which permits a corporation to include a mandatory Delaware forum selection provision in its certificate of incorporation or bylaws in respect of internal corporate claims, was adopted and become effective concurrently with the amendment to Section 109(b).

On February 2, 2016, the Paylocity board amended its bylaws to adopt new Article VIII, which contained two provisions. New Section 8.1 added an exclusive forum provision designating the Delaware courts as the “sole and exclusive forum” for internal corporate claims. New Section 8.2 contained a fee-shifting provision requiring any stockholder who became involved in an action in another forum (absent a written waiver of the applicability of the fee-shifting bylaw by the Company), and failed to obtain a judgment on the merits that substantially achieved the full remedy sought, to reimburse Paylocity for its litigation expenses, including attorneys’ fees. On February 5, 2016, Paylocity filed a Form 8-K with the Securities and Exchange Commission disclosing the adoption of Article VIII. On May 5, 2016, plaintiff brought an action seeking a declaratory judgment that the fee-shifting bylaw violated Sections 109(b) and 102(b)(6) of the DGCL, and alleging that the Paylocity directors breached their fiduciary duties in adopting the fee-shifting bylaw.

Defendants moved to dismiss the complaint under Court of Chancery Rule 12(b)(1) for lack of subject matter jurisdiction, on the theory that plaintiff’s claims were not ripe for review because no Paylocity stockholder had filed an action outside of Delaware triggering the fee-shifting bylaw and plaintiff had not pled an intent to do so. Rejecting this argument, the Court reasoned that the fee-shifting bylaw would likely inhibit any stockholder from filing a claim that might trigger it. Declining review under these circumstances would thus mean that the validity of Paylocity’s fee-shifting bylaw might never be subject to judicial review, despite the likelihood that other corporations would adopt similar, potentially invalid bylaws. The risk of “perpetuating uncertainty concerning the permissibility of fee-shifting bylaws,” especially in light of the recent amendments to the DGCL, compelled the Court to review the validity of the fee-shifting bylaw.

Defendants also advanced several arguments in favor of the validity of the fee-shifting bylaw under Section 109(b). The Court rejected defendants’ argument that the simultaneous amendment of Section 109(b) and enactment of Section 115 required those provisions to “be read in tandem” such that the Section 109(b) provision would permit fee-shifting only for actions filed in violation of a forum selection provision adopted pursuant to Section 115. The Court determined that nothing in the plain text of Section 109(b) or Section 115 indicated that the legislature intended to create such an exception to Section 109(b).

The Court reached a similar conclusion with regard to defendants’ argument that fee-shifting remains permissible at common law. Distinguishing the case relied upon by defendants, El Paso Natural Gas Co. v. TransAmerican Natural Gas Corp., 669 A.2d 36 (Del. 1995), the Court found that existing common law pertaining to fee-shifting provisions applies to contractual provisions, not bylaws. The Court also ruled that the amendment to Section 109(b) was in direct conflict with the common law as established in ATP, negating any inference that stock corporations were permitted to adopt fee-shifting bylaws. The Court then turned to defendants’ argument that the savings clause in Paylocity’s fee-shifting bylaw “carve[d] out all interpretations inconsistent with Delaware law” and likewise rejected it, holding that a savings clause cannot negate a facial challenge to the validity of a bylaw where the bylaw has been found entirely invalid.

The Court then granted defendants’ motion to dismiss with respect to plaintiff’s remaining allegations. In particular, the Court held that plaintiff failed to state a claim for breach of fiduciary duty. Paylocity’s directors were exculpated from breaches of the duty of care pursuant to a Section 102(b)(7) provision in its certificate of incorporation, and plaintiff did not plead that any of the directors were interested or lacked independence. Thus, the Paylocity directors would be subject to personal liability only if they were found to have acted in bad faith. The Court found that the bare allegation that the fee-shifting bylaw was adopted after the Section 109(b) provision took effect was insufficient by itself to support a reasonable inference of scienter. Furthermore, although the presence of the savings clause could not resuscitate the facially invalid fee-shifting bylaw, it negated any inference that the directors knew they would be violating the law in adopting it.