The prevalence of stockholder suits places a tax on the economy and harms both public and private corporations. Like the Barbary Pirates of old, stockholder plaintiffs demand a ransom for each public M&A transaction and for many private transactions. Although perhaps not as effective as sending in the Marines to the “Shores of Tripoli,” two lines of responses have developed to address these suits.

One can be seen in Alibaba’s initial public offering (IPO), and the other can be seen in the development of the Delaware law relating to corporate bylaws. Bylaws are dry boilerplate, often overlooked by entrepreneurs and investment professionals, but getting the bylaws right today can deter frivolous stockholder suits in the future.

One approach for a company to deal with stockholder suits is to opt out of the U.S. corporate legal regime by organizing as a non-U.S. entity. This approach, by avoiding the legitimate protections of state corporate law, may make the company less appealing to financing sources.

Alibaba, the largest IPO in history, was structured as an offering of American depositary receipts by a Cayman Islands company. One of the reasons for this structure was likely a desire to avoid stockholder suits. In the IPO prospectus, Alibaba makes clear that, as a Cayman Island company, stockholders do not have the right to inspect its books and records (which they would if it were a Delaware corporation) and that “in principle . . . a derivative action may not be brought by a minority stockholders.” In addition, Alibaba warns IPO investors that, “You may face difficulties in protecting your interests, and your ability to protect your rights through the U.S. federal courts may be limited.”

Unless your company has the size and market power of Alibaba, going offshore may not be a practical solution for addressing stockholder suits. The better approach for companies is to take advantage of the evolving practice of using corporate bylaws to protect against nonmeritorious stockholder suits.

Recent Developments in the Use of Bylaws to Protect Against Stockholder Suits

Recent court decisions interpreting corporate bylaws provide corporations with tools to deter and reduce the cost of stockholder suits. Bylaws are typically adopted by a corporation’s board of directors and can be amended by its stockholders; although they infrequently are. Delaware courts have recently upheld two types of bylaws that can be used to prevent future, frivolous stockholder suits:  forum selection and fee-shifting.

Forum Selection Bylaws

A forum selection bylaw is a bylaw that requires stockholders to bring suit relating to the corporation’s internal affairs only in specified courts, usually in the jurisdiction of the corporation’s organization. Even though a corporation may be organized in one state, in the absence of a forum selection bylaw, there is little to stop a stockholder from filing suit in another state.

Courts generally respect forum selection bylaws. A Delaware court recently upheld the forum selection bylaw of a Delaware corporation that provided that all suits had to be litigated in North Carolina, which is where the company’s principal business operations were located. A properly drafted and implemented forum selection bylaw prevents suits in many different jurisdictions over a single transaction. Similarly, a forum selection bylaw prevents a stockholder from obtaining a “home field advantage” in a plaintiff-friendly jurisdiction.

It would seem prudent for almost any corporation to include a forum selection bylaw in its corporate documents. Similar provisions can also be used in limited liability companies, limited partnerships and other business enterprises.

Fee-Shifting Bylaws

Fee-shifting bylaws are a response to the explosion of stockholder suits. A fee-shifting bylaw provides that in a stockholder suit against a corporation, in certain circumstances, the fees of the corporation are “shifted” to the plaintiff stockholder to deter frivolous and nonmeritorious stockholder suits.

The Delaware Supreme Court recently upheld, in principle, a bylaw that shifted the cost of a stockholder lawsuit to the stockholder plaintiff unless the stockholder plaintiff had a total victory in the lawsuit.

Now there are a couple of things to be aware of in connection with fee shifting bylaws that may limit their utility:

1. The Delaware Supreme Court only approved a fee-shifting bylaw in principle. Would the court enforce a fee-shifting bylaw in a particular situation? Two factors that would affect that determination are likely to be:

• Was the bylaw adopted on a “clear day” when no suit was pending or foreseen, or was it adopted in the face of a particular suit?

• Will the bylaw have the effect of deterring meritorious stockholder suits? I believe a “loser pays” bylaw is more likely to be upheld than a bylaw which provides that a winning stockholder must pay the company’s expenses if it is not a complete victory.

2. The Delaware Bar has proposed amendments to the Delaware General Corporation Law that would reverse the Supreme Court’s decision.

3. There is a perception that institutional investors will not approve of fee shifting bylaws and will demand that their investees not include them.

4. There is also a belief that, for public companies, proxy advisory services will view these bylaws unfavorably.

Notwithstanding these factors, a properly drafted fee-shifting bylaw is a powerful tool to deter frivolous stockholder suits. This provision, when coupled with a forum selection bylaw, may have the effect of shifting the balance of power between companies and strike-suit stockholder plaintiffs. Overall, there would seem to be little downside and much upside in including these provisions in corporate bylaws or similar organization documents.

Editor’s note: This blog post is intended as general information on the law and legal developments, and is not legal advice as to any particular situation. Under New York ethical rules, please note that this post may constitute “attorney advertising.”