What If You Are Sued

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What If You Are Sued

As counsel to sundry private clubs and trade associations we have often been asked this question. The context may be a contemplated board action with potentially adverse impact on some members or may be a concern over imposing discipline on a member or denying a member a benefit the member believes is hers. Other concerns abound.

Most directors and officers of mutual benefit organizations[1] are aware personal liability may attach to their actions or failures to act. For this reason, responsible boards insist that the entity afford them directors and officers errors and omissions liability insurance as a condition of service. Especially, this insurance should be a requirement for service if the office held is without compensation as it is with most mutual benefit nonprofits such as private clubs and trade associations.

However, liability insurance is not a panacea. Insurance companies are not in business to lose money and often attempt to settle disputes to avoid larger losses when the insured doesn’t believe settlement is justified. Or, insurers may deny coverage in a case where they believe denial is justified under the insurance policy given the facts. For example, the insured may have failed to timely comply with a notice provision in the insurance policy.

An entity incorporated in a state which follows the Model Nonprofit Corporation Act[2] and is not a charitable corporation may eliminate director liability by a provision of the articles of incorporation that a director shall not be liable to the corporation or its members for money damages for any action taken, or any failure to take any action, as a director (with certain exceptions). However, the exceptions[3] and a potential claim of a non-member are not covered by the liability exoneration provision.

Thus, for example, in Georgia, a nonprofit corporation may include in its articles of incorporation a provision eliminating or limiting the liability of a director to the corporation or its members for monetary damages for any action taken, or any failure to take any action, as a director with the exception of any appropriation, in violation of his or her duties, of any business opportunity of the corporation; of acts or omissions which involve intentional misconduct or a knowing violation of law; for a director’s conflicting interest transaction; or for any transaction from which the director received an improper personal benefit.[4]

Also, in Georgia as in many other jurisdictions adopting the Model Act, a nonprofit corporation may indemnify directors or officers for their actions or failures to act who is a party to a proceeding because he or she is or was a director against liability incurred in the proceeding if: (i) they acted in good faith; and (ii) reasonably believed: (A) in the case of conduct in an official capacity, that the conduct was in the best interests of the corporation; and (B) in all other cases, that the individual’s conduct was at least not opposed to the best interests of the corporation; and (iii) in the case of any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful; or (2) the individual engaged in conduct for which broader indemnification has been made permissible or obligatory under a provision of the articles of incorporation.[5]

A difficulty with these permissive statutory provisions which a nonprofit entity may incorporate into their governing documents is the exceptions. A familiar bromide, “the exception proves, [ i.e., tests] the rule” is apropos. That is, it is possible if not likely if a director or officer is sued, the claimant will assert the person was acting in bad faith or the conduct was not reasonably believed to be in the best interest of the entity or the action complained of involved intentional misconduct, a knowing violation of law, a director’s conflicting interest transaction or for a transaction from which the director received an improper personal benefit.

In view of all these exceptions to exoneration or indemnification, a prudent director or officer should inquire of the entity’s counsel about opportunities to discourage claims especially specious claims.

One defensive technique for the discouragement or avoidance of litigation or third party dispute resolution is by providing in the entity’s governing documents for a “fee shifting clause”, i.e., assessment of the directors, officers and the entity’s court or arbitration costs and attorneys fees against the member who sues them if the member loses the litigation or arbitration. This technique is analogous to an in terrorem clause in a last will and testament providing for the disinheritance of a beneficiary or heir who contests a will.

We have for many years employed this technique for use in private club, trade association and other mutual benefit entities. Until very recently we did not envision the notion of  a fee shifting clause might be suspect under American jurisprudence if the entity’s members had agreed or were deemed to have agreed to the entity bylaws or articles in which it is embedded. That is, assuming a member agreed upon admission to be governed by the organization’s bylaws and articles in existence at the date of admission or as thereafter amended, then the member has agreed to the fee shifting clause if incorporated into the bylaws or articles.

Recently, however, a case decided in the Delaware Supreme Court[6] brought some focus to the issue of whether a fee shifting clause is fair and reasonable under the circumstances. ATP Tour, a Delaware non-stock corporation had the following provision in its bylaws:

(a) In the event that (i) any [current or prior member or Owner or anyone on their behalf (“Claiming Party”) ] initiates or asserts any [claim or counterclaim (“Claim”) ] or joins, offers substantial assistance to or has a direct financial interest in any Claim against the League or any member or Owner (including any Claim purportedly filed on behalf of the League or any member), and (ii) the Claiming Party (or the third party that received substantial assistance from the Claiming Party or in whose Claim the Claiming Party had a direct financial interest) does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought, then each Claiming Party shall be obligated jointly and severally to reimburse the League and any such member or Owners for all fees, costs and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses) (collectively, “Litigation Costs”) that the parties may incur in connection with such Claim.

 

The plaintiff, a member of ATP Tour, sued ATP and six of its board members in the United States District Court for the District of Delaware, alleging both federal antitrust claims and Delaware fiduciary duty claims. , the plaintiff did not prevail on any claim. ATP then moved to recover its legal fees, costs, and expenses under Rule 54 of the Federal Rules of Civil Procedure. ATP grounded its motion on the above quoted provision of ATP’s bylaws. The District Court denied ATP’s Rule 54 motion because it found Article 23.3(a) to be contrary to the policy underlying the federal antitrust laws. The District Court effectively ruled that “federal law preempts the enforcement of fee-shifting agreements when antitrust claims are involved.”

 

ATP appealed, and the United States Court of Appeals for the Third Circuit vacated the District Court’s order. The Third Circuit found that the District Court should have decided whether Article 23.3(a) was enforceable as a matter of Delaware law before reaching the federal preemption question. On remand, the District Court reasoned that the question of Article 23.3(a)’s enforceability was a novel question of Delaware law that should be addressed in the first instance by the Supreme Court of Delaware Court. The District Court certified the following four questions of law:

 

1. May the Board of a Delaware non-stock corporation lawfully adopt a bylaw (i) that applies in the event that a member brings a claim against another member, a member sues the corporation, or the corporation sues a member (ii) pursuant to which the claimant is obligated to pay for “all fees, costs, and expenses of every kind and description (including, but not limited to, all reasonable attorneys’ fees and other litigation expenses)” of the party against which the claim is made in the event that the claimant “does not obtain a judgment on the merits that substantially achieves, in substance and amount, the full remedy sought”?

 

To this question the Delaware court responded the fee shifting provision is facially valid. That is, Delaware follows the American Rule, under which parties to litigation generally must pay their own attorneys’ fees and costs. But it is settled that contracting parties may agree to modify the American Rule and obligate the losing party to pay the prevailing party’s fees. Because corporate bylaws are “contracts among a corporation’s shareholders,” A fee-shifting provision contained in a nonstock corporation’s validly-enacted bylaw would fall within the contractual exception to the American Rule. Therefore, a fee-shifting bylaw would not be prohibited under Delaware common law.

 

However, the court cautioned whether the specific ATP fee-shifting bylaw is enforceable depends on the manner in which it was adopted and the circumstances under which it was invoked. Bylaws that may otherwise be facially valid will not be enforced if adopted or used for an inequitable purpose. The Court cited the example where it set aside a board-adopted bylaw amendment that moved up the date of an annual stockholder meeting to a month earlier than the date originally scheduled. The Court found that the board’s purpose in adopting the bylaw and moving the meeting was to “perpetuat[e] itself in office” and to “obstruct the legitimate efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest against management.”[7]

 

We conclude from the foregoing Delaware Court’s discussion that circumstances may justify the non-enforcement of a fee shifting clause. For example, was a dispute already in progress before the organization’s board adopted a bylaw fee shifting provision? Was the member who brought the action against the board provided with a copy of the bylaws containing the fee shifting provision either at the time of admission to membership or if adopted subsequently furnished with the fee shifting provision at the time of its proposed adoption and given an opportunity to vote either for or against it?

 

 2. May such a bylaw be lawfully enforced against a member that obtains no relief at all on its claims against the corporation, even if the bylaw might be unenforceable in a different situation where the member obtains some relief?

 

The Delaware Court characterized this question as asking whether a more limited version of the ATP bylaw would be valid. Article 23.3(a) states that it can be invoked against any plaintiff who does not obtain a judgment “that substantially achieves, in substance and amount, the full remedy sought.” Since there might be difficulty applying the “substantially achieves” standard, the question asks whether the bylaw would be enforceable, at least, where plaintiff obtains “no relief at all against the corporation.”  Subject to the limitations set forth in its answer to the first certified question, the Court answered the second question in the affirmative.

 

We point out at this juncture that Delaware courts enjoy a wide acceptance in matters of corporate law among the courts of other states. This acceptance applies especially to the Delaware Court of Chancery “a tribunal that for historically curious reasons is the preeminent arbiter of U.S. company law.”[8]

 

 3. Is such a bylaw rendered unenforceable as a matter of law if one or more Board members subjectively intended the adoption of the bylaw to deter legal challenges by members to other potential corporate action then under consideration?

 

The Delaware Court stated legally permissible bylaws adopted for an improper purpose are unenforceable in equity. It opined, however, the intent to deter litigation is not invariably an improper purpose. Fee-shifting provisions, by their nature, deter litigation. Because fee-shifting provisions are not per se invalid, an intent to deter litigation would not necessarily render the bylaw unenforceable in equity.[9] Note again the cautionary “are not per se invalid” language. It presages facts and circumstances of a particular case may vitiate the adoption of a fee shifting bylaw in the face of a pending or existing controversy not yet ripened into a lawsuit or arbitration proceeding.

 

4. Is such a bylaw enforceable against a member if it was adopted after the member had joined the corporation, but where the member had agreed to be bound by the corporation’s rules “that may be adopted and/or amended from time to time” by the corporation’s Board, and where the member was a member at the time that it commenced the lawsuit against the corporation?

 

This is a question we have frequently encountered. Many directors are familiar with the distinction between bylaws existing at the date of a member’s admission to the organization and those adopted by its governing board or even its members subsequent to the member’s admission. The Delaware Supreme Court’s response to this question was predictable. The Delaware General Corporation Law permits a corporation to, “in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors.” If directors are so authorized, “stockholders [or members]will be bound by bylaws adopted unilaterally by their boards.”[10]

 

Assuming the applicable state statute permits a governing board to adopt or amend bylaws and the bylaws so stated at the date of admission of a complaining member, then there would seem little argument the member is bound by the fee shifting bylaw provision adopted subsequent to his or her admission. An even stronger case is made if the bylaw amendment was adopted by the members themselves.

 

However, in the intriguing essay by Professor Hamermesh cited above, he raises a concern about what he characterizes as “meaningful consent”. That is, whether there are charter and bylaw provisions that should be deemed contrary to law and not the product of meaningful consent?

 

How could a bylaw that imposes intolerable risk on the member’s decision to sue directors for breach of fiduciary duty be consistent with reasonable  expectations? And worse yet, such a bylaw is one that is essentially self-enforcing: even if there were some evidence that its adoption was improperly motivated, a lawsuit challenging it would likely be too risky for any stockholder to undertake because anything less than total success in that litigation would result in the stockholder having to pay the corporation’s costs of defense.[11]

 

The essay postulates the fee shifting clause in ATP Tour as a perhaps rare example of a provision that contravenes what might be called the constitutional limits of corporate law. Fortunately, however, we do not perceive this postulation as the existing law in any of the jurisdictions with which we are familiar.

 

In summary, a nonprofit organization concerned with whether it and its directors and officers face potential liability exposure for potential claims by its members should ensure it has exoneration and indemnification provisions in its governing documents consistent with applicable state law, obtain and maintain directors and officers liability and errors and omissions insurance[12], and consider adopting a fee shifting provision in its bylaws.

 

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[1] A mutual benefit nonprofit corporation is formed primarily for the benefit of its members or persons engaging in a particular business or activity, rather than for broader public purposes.  It serves a smaller group of people because its activities tend to be of a limited nature. Defined by state statutes, it is usually a non-profit corporation which by default does not qualify to be either a religious or public benefit corporation.   Mutual benefit corporations typically include, e.g., trade associations, social and recreational clubs and homeowners associations. http://www.nationwide-incorporators.com/educ-nonprofit-corp-overview;

http://www.smallbiz.com/functions/bizterminfo.cfm/Mutual%20Benefit%20Corporation.htm.
[2] The Model Nonprofit Corporation Act, Third Edition ( 2008 American Bar Association: Business Organizations- Nonprofit Organizations: available at http://apps.americanbar.org/dch/committee.cfm?com=CL580012&ct=c74a7520b22e3fc7829863f9705c63eec07118ebd380863eb871161faf3c6e55d974d9fb61f8f9e5b74fbcb78984d5bc8495f9118e2f5786006cd14212e95bf0
[3] the amount of a financial benefit received by the director to which the director is not entitled; an intentional infliction of harm; unlawful distributions; or an intentional violation of criminal law. See Model Nonprofit Corporation Act § 2.02 (b)(8).
[4] Ga. Code 14-3-202(b)(4).
[5] Model Nonprofit Corporation Act § 8.51. Cf. GA. Code 14-3-851 Option to indemnify directors.
[6]  ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014).
[7] Schnell v. Chris–Craft Industries, 285 A.2d 437 (Del.1971).
[8] Consent in Corporate Law, Lawrence A. Hamermesh (The Business Lawyer 161; Vol. 70, Winter 2014-2015) [Hereafter “Hamermesh”].
[9] Cited with approval in North ex rel Chemed v. McNamara, Case No.: 1:13-cv-833 US District Court SD.OH (September 19, 2014)
[10] ATP Tour, Inc. v. Deutscher Tennis Bund, 91 A.3d 554 at 560 (Del. 2014) [citations omitted].
[11] Hamermesh at 171.
[12] There is a distinction between the two types of insurance policies. Trade associations should be aware of this distinction and inquire whether their activities warrant obtaining both policy types.



Copyright 2016

Fred l. Somers, Jr., P.C

Atlanta, GA 30338