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Directors Cannot Adopt Bylaw Making Delaware Chancery Court Exclusive Venue for Derivative Actions

By Jim Hamilton

In a case of first impression, a federal judge (ND CA) has ruled that corporate directors cannot control the venue for shareholder derivative actions brought against them by adopting a bylaw purporting to require that such cases be filed in the Delaware Chancery Court. While the federal common law allows parties to contract for a venue, noted Judge Seeborg, a bylaw unilaterally adopted by directors stands on a different footing, especially when they are the named defendants in the derivative action and the bylaw was adopted after the alleged wrongdoing took place. There is no element of mutual consent to the Delaware forum choice, said the court, at least with respect to shareholders who purchased their shares before the bylaw was adopted. Galaviz v. Berg, ND CA, No. C 10-3392-RS.

No court has previously ruled on the enforceability of a venue provision for derivative actions contained in corporate bylaws. Such bylaws are reportedly a recent phenomenon, noted the court, apparently occasioned by a passing comment in In re Revlon, Inc. Shareholders Litigation, 990 A.2d 940, 960 (Del. Ch., 2010), to the effect that, if directors believe that a particular forum would provide an efficient and value-promoting locus for dispute resolution, companies are free to respond with charter provisions selecting an exclusive forum for intra-entity disputes.

Modern federal law does favor the enforcement of contractual venue clauses, said the judge, and a court merely gives effect to a bilateral agreement between the parties that any disputes they may have arising out of that agreement will be litigated in a particular forum. In contrast, the Chancery Court venue provision here was unilaterally adopted by directors who are defendants in the derivative action after the majority of the purported wrongdoing is alleged to have occurred and without the consent of existing shareholders who acquired their shares when no such bylaw was in effect.

The court did not decide whether the adoption of the venue bylaw was within the directors? powers as a matter of Delaware law. But even assuming that the directors had the power to adopt such a bylaw, said the court, the enforceability of a purported venue requirement is a matter of federal common law. The company has not shown that federal law requires or even permits the federal courts to defer to any provision of state corporate law that might purport to give directors the power to unilaterally control venue under the circumstances of this case.

The federal court did say that the argument to enforce exclusive Chancery Court venue for derivatives actions would be much stronger if a majority of the company?s shareholders were to approve a charter amendment limiting venue to Delaware courts. Judge Seeborg noted that the comment in Revlon that appears to have precipitated the unilateral bylaw amendment here specifically referred to charter provisions selecting an exclusive forum for intra-entity disputes.

Full post as published by Jim Hamilton's World of Securities Regulation on January 06, 2011 (boomark / email).