85 Years – The Case That Quashed Fee-Shifting Bylaws
POMERANTZ MONITOR | JULY AUGUST 2021
By The Editors
In celebration of the founding of the Pomerantz Firm 85 years ago, the Monitor continues its look back at highlights from its history.
On May 30, 2014, First Aviation Services, Inc. completed what was virtually a hostile takeover, executing a 10,000-to-1 reverse stock split that effectively took the company private by involuntarily cashing out every investor holding less than 10,000 shares. When the dust settled, Aaron Hollander, First Aviation’s Chief Executive Officer and controlling shareholder, had effectively taken ownership of the company without needing to lay out any capital. Adding insult to injury, within four days of the stock split coup, First Aviation adopted a fee-shifting bylaw that required any stockholder who challenged the ouster of their investment to pay the company’s legal fees unless they succeeded in obtaining “a judgment on the merits that substantially achieves ... the full remedy sought.” Unless any challenger prevailed on every issue that they argued, they would be forced to pay the uncapped legal fees incurred by the company.
Setting the stage for a showdown, the Delaware Supreme Court took on the issue of fee-shifting bylaws in a 2014 case named ATP Tour, Inc. v. Deutscher Tennis Bund. ATP, the operator of a professional men’s tennis tour, had successfully defeated litigation by two member federations that arose from changes made to the format and scheduling of the tour, and sought to recover its legal fees per its fee-shifting bylaw. The Delaware Supreme Court ruled that “[u]nder Delaware law, a fee-shifting bylaw is not invalid per se, and the fact that it was adopted after entities became members will not affect its enforceability.”
The same year, Pomerantz was approached by a client seeking to stop the forced liquidation of his investment in First Aviation. With a genuine interest in the company and its financial prospects, the investor had no interest in being forced to divest his shares, especially at a rate that was several dollars below what the stock had recently traded at. Although the classwide damages were modest, Pomerantz considered the issue important, and took on the case on behalf of this client and approximately 200 other investors who were just two weeks away from being booted as shareholders.
After the complaint against First Aviation (Strougo v. Hollander) was filed, a series of ‘after the fact’ revelations raised the stakes of the case on several levels. First, the company revealed that it had received a large government contract — one that it knew about before the reverse stock split was announced but failed to disclose to the market — and one from which the now cashed-out investors would not realize any benefit. Second, First Aviation revealed the existence of the fee-shifting bylaw that placed the plaintiffs in substantial potential financial jeopardy. And, later in the litigation, as we will recount, a third revelation provided the key to victory.
While Pomerantz was uncovering the true depth of the deception surrounding the reverse stock split, the plaintiffs’ bar at large took notice of this modest securities case. The potential recovery was just a few hundred thousand dollars, but an adverse ruling that saw such bylaws being sustained threatened the future viability of securities litigation as we know it. The adoption of fee-shifting bylaws would be the death knell for shareholder litigation, as no plaintiff would risk being on the hook for legal fees and expenses.
With those stakes in the balance, the attention on this case was intense. Pomerantz partners Gustavo Bruckner, Marc Gross and Jeremy Lieberman were deluged with missives from other plaintiffs’ firms attempting to persuade them to either not litigate Hollander, or to allow larger firms to step in to find some solution ... any solution ... other than a judicial decision.
Under tremendous pressure not to risk an adverse ruling, Pomerantz saw an opening — ask the court to stay its ruling on the complaint itself but split out the issue of the bylaw first for a ruling on its validity. Recognizing the larger issue at hand, the Court agreed.
It was at this stage that Pomerantz made a shocking discovery — the yet-to-be seen bylaw had been adopted a mere four days after the stock split and applied retroactively to all shareholders, even those who were cashed out in the transaction.
This revelation drew the map for a pathway to victory without jeopardizing the foundation of securities litigation. Pomerantz asked the Court to further limit its ruling to one question — is a bylaw adopted after a former stockholder has already cashed out still binding on them? Clearly, bylaws are binding on all current shareholders at the time of adoption and those who buy stock afterwards. But, based on the principle of Delaware law that has positioned the stockholder-corporation relationship as akin to a contract, that ‘contract’ would end as soon as the stock is either sold or taken away — as in the situation of a cashed-out reverse stock split. It followed that a fee-shifting bylaw, adopted after the investor is no longer holding stock in the company, would not apply to them.
As a result, in March 2015, Chancellor Bouchard of the Delaware Court of Chancery ruled that “[A] stockholder whose equity interest in the corporation is eliminated in a cash-out transaction is, after the effective time of that transaction, no longer a party to [the] flexible [corporate] contract. Instead, a stockholder whose equity is eliminated is equivalent to a non-party to the corporate contract, meaning that former stockholder is not subject to, or bound by, any bylaw amendments adopted after one’s interest in the corporation has been eliminated.”
On the effect of fee-shifting bylaws, the Chancellor further wrote that “the Bylaw in this case would have the effect of immunizing the Reverse Stock Split from judicial review because, in my view, no rational stockholder— and no rational plaintiff’s lawyer—would risk having to pay the Defendants’ uncapped attorneys’ fees to vindicate the rights of the Company’s minority stockholders, even though the Reverse Stock Split appears to be precisely the type of transaction that should be subject to Delaware’s most exacting standard of review to protect against fiduciary misconduct.”
Simultaneously, as Pomerantz sought to sway the court, it also spearheaded efforts to find a legislative solution that would forestall any fallout in the event of an adverse decision in Hollander. The Firm campaigned to educate Delaware’s governor, Supreme Court, and legislature in regard to the scope of the threat that fee-shifting bylaws posed to shareholder rights and the balance of the corporate ecosystem — an issue very germane in the state that is the home of the most newly formed corporations every year.
After discussions between prominent legal academics, members of Delaware’s executive, judicial, and legislative branches, and the representatives of the plaintiffs’ bar, examining the effect that fee-shifting bylaws would likely have on shareholders’ rights and their ability to mount legal challenges to corporations in court, Delaware realized it needed to act. On June 11, 2015, the Delaware General Assembly passed Senate Bill 75, a statute which amended the Delaware General Corporation Law to effectively prohibit fee-shifting bylaws. Governor Jack Martell signed the bill into law on June 25, 2015.