Delaware Supreme Court Decision Slashing Investors’ Rights Based on Mistaken Notions of What a Contract Is
Modified image courtesy LetLifeHappen.
By Paul Bland
Imagine this: I go to my neighbor, and offer to mow her lawn for $20. She says, “O.K., but I retain the unilateral right to alter, amend, re-write or change the terms of this deal at any time that I want.” Did we agree to anything? The obvious answer is “no.” I could mow her lawn and get paid the $20, or perhaps she’d say “Oh, you’re getting portly, you needed the exercise, so I amended the deal and now you owe ME $20.” Would I really owe her the money under the theory I’d “agreed” to it? The answer is obviously “no.” When one party says “I agree to do A, B and C,” and what the other party says is “I agree to do whatever I want, based upon what I feel down the road at some point, and I can change whatever I want whenever I feel like it,” that is NOT a contract.
On May 8, 2014, the Delaware Supreme Court lost track of this basic idea of contract law. It decided ATP Tour, Inc. v. Deutscher Tennis Bund, a case where it held that a corporation may unilaterally adopt a bylaw imposing a very harsh “loser-pays rule” on stockholders. This was supposedly O.K. because the stockholders had “agreed” to the bylaw as a contract. The idea that this huge term adopted by one side after a deal constitutes a “contract” ignores the core idea of what a contract is.
Before I set out the problem under contract law, let me make sure everyone follows the stakes by explaining what this “loser-pays” rule does. If a stockholder plaintiff brings a lawsuit alleging that the corporation, or its directors and officers, have breached their fiduciary duties, committed securities fraud or violated the antitrust laws, and the plaintiff fails to win “in substance and amount, the full remedy sought” (which means a total victory in the lawsuit), the shareholder is liable for all of the attorneys’ fees of the corporation, and its directors and officers.
How did all this come about? Well, the case had started in a federal district court, which had sensibly held that the loser-pays rule violated the antitrust laws (which do give attorneys’ fees to defendants whenever a plaintiff fails to win 100 percent of their claim). The corporate defendant had appealed, though, and rather than decide the issue under the antitrust laws, the Court of Appeals asked the Delaware Supreme Court whether this kind of loser-pays rule could ever be allowed under Delaware corporate law.
To the surprise of most observers, the Delaware Supreme Court gave a general answer of “yes,” even though the Court acknowledged that the “nature” of a loser-pays provision is to “deter litigation.” In other words, the Court acknowledged that the entire point of a corporation adopting this kind of by-law is to scare its shareholders into not bringing a suit when their legal rights are violated, but it still said that in general this kind of provision is enforceable.
The Delaware Supreme Court left open some types of challenges, but the upshot of the decision is that it is now far easier for corporations to insulate themselves from accountability if they cheat shareholders or break the law. By contrast, the vast majority of courts in the U.S. disapprove of this kind of loser-pays provision (look at pages 48-50 of this brief).
But I want to focus here on a second, separate troubling issue. And that is that while the Delaware Supreme Court justifies the ATP Tour decision in part on the idea that a by-law is an agreement, “a contract among a corporation’s shareholders,” that justification is completely hollow. The Court wants to say “hey, it’s O.K. if the corporation is pounding its stockholders, because the stockholders agreed to it.”
But where is the agreement when a by-law is adopted by the corporation after someone buys the stock?
To claim that something is a contract, when one party to it can unilaterally re-write the terms after the deal was reached, without the other party agreeing to the terms, is to toss overboard basic principles of contract law. In the example at the beginning of this post, what did my neighbor actually PROMISE to do? Nothing, not a single thing. Her statement was the opposite of a promise. Under normal rules of contract law, there’s a word for this kind of deal: “illusory.” (Please look at pp. 12-13). This, of course, means that there’s no deal at all.
The ATP Tour decision isn’t just an assault on stockholder’s rights, declaring open season on investors. It’s also an assault on the basic idea of what a contract means. It undermines the idea of an agreement, by giving legal effect to something that is one sided, arbitrary, and without any binding content.
When a corporation can create a binding contract by saying only “we’ll do what we feel like doing,” then the very idea of a contract has lost all meaning. Letting one party just add a major term to a contract AFTER the agreement, and treating that term as enforceable, is counter to the entire architecture of contract law. It is hard to imagine a Court going further towards the idea that the people running corporations can do pretty much whatever they want.