The Delaware Supreme Court on July 11 partially reversed the Delaware Court of Chancery decision in Kellner v. AIM ImmunoTech, which had held that certain advance notice bylaw provisions were “facially invalid,” holding instead that the majority of provisions under review were facially valid but nonetheless unenforceable in equity.
As we discussed in our March 6, 2024 LawFlash, the Delaware Court of Chancery’s finding of facial invalidity paved the way for plaintiffs’ firms to launch copycat lawsuits and litigation demands arguing that similar advance notice provisions are facially invalid as a matter of law, with the objective of obtaining a fee award after the company amended its bylaws in response.
The supreme court’s decision, effectively affirming the court of chancery’s results but for different reasons, clarified the standards of judicial review for advance notice bylaws, making clear the court should undertake a dual inquiry into (1) facial validity, focused on whether the bylaw is, in the abstract, legally authorized; and (2) an equity analysis focused on whether the bylaw was adopted or being enforced in conformity with the board’s fiduciary obligations under the circumstances of the case.
While the decision will undoubtedly make challenges of facial invalidity less likely, it left the overarching threat by plaintiffs’ firms seeking mootness fees intact—albeit refocused on equitable issues surrounding the adoption and enforcement of the bylaws. Following the supreme court’s decision, public corporations with advance notice bylaws, even adopted on a clear day, would be well advised to initiate a review of both their advance notice bylaws’ substantive requirements as well as the board-level record surrounding their adoption.
THE COURT OF CHANCERY’S KELLNER DECISION
In its December 2023 decision, the Court of Chancery held that certain advance notice bylaws that were vague, difficult, or impossible to comply with did not serve the recognized dual legitimate purposes of such bylaws—first, to promote disclosure, and second, to ensure orderly stockholder meetings—and were thus facially “invalid.” The Court of Chancery’s decision placed any company with bylaw provisions substantially similar to those found facially invalid in Kellner at risk of receiving a similar challenge—the usual result of which would be an amendment to the bylaws that moots the claim and a payment of a “mootness fee” to the plaintiffs’ firm for providing the purported benefit of legally compliant bylaws to the company and its stockholders.
In March, we discussed our expectation that the Court of Chancery’s decision would prompt plaintiffs’ firms to bring complaints and issue litigation demand letters arguing that certain types of common “wolf pack” and “daisy chain” advance notice provisions were invalid in the wake of Kellner. When companies amended the offending provisions as a result of these complaints and letters, plaintiffs’ firms would be entitled to (and would seek) a mootness fee under Delaware law.
Several such complaints were thereafter filed, and while the number of companies that received nonpublic litigation demands is unknowable, we estimate the number is not insignificant. To break the chain of causation required for entitlement to the mootness fee, we advised that companies should recognize this issue and take steps to correct it in advance of receiving a complaint or demand letter. At minimum, we advised that companies should review their advance notice bylaws to determine whether they contained vulnerable provisions and document that this review was being undertaken in light of the Kellner decision.
THE DELAWARE SUPREME COURT CLARIFIES THE STANDARD
On July 11, the Delaware Supreme Court affirmed the Delaware Court of Chancery’s Kellner decision in part and reversed in part, clarifying that a challenge to the enforceability of advance notice bylaws must follow a two-part inquiry: first, an analysis of whether the bylaw is facially invalid; second, an analysis as to whether the board’s adoption of the bylaw was equitable—that is, in compliance with fiduciary duties.
With respect to the first prong, the supreme court explained that “[a] facially valid bylaw is one authorized by the Delaware General Corporation Law (DGCL), consistent with the corporation’s certificate of incorporation, and not otherwise prohibited.” For purposes of the facial validity inquiry, it is not enough that a bylaw might conflict with Delaware law or the certificate of incorporation under certain circumstances—rather, given the “immense freedom” offered to corporations under the DGCL to organize their internal affairs, corporate bylaws are presumed to be valid and will not be found invalid unless the plaintiff can demonstrate that the bylaw “cannot operate lawfully under any set of circumstances.”
Second, the bylaw must be reviewed in equity. Because advance notice bylaws can be misused to entrench existing boards and frustrate stockholder democracy, they must “‘be reasonable in their application’ and not unfairly interfere with stockholder voting.” Applying enhanced scrutiny under Coster v. UIP Cos. Inc., the supreme court analyzed (1) whether there was a legitimate threat to an important corporate interest serving as motivation for the bylaws, as opposed to “selfish or disloyal motive[s]” and, if so (2) whether the bylaws were a reasonable and proportionate response to that threat and not unduly coercive to the stockholder franchise.
The supreme court found that the Court of Chancery had confused these two analyses by conducting an enhanced scrutiny review to incorrectly declare the advance notice bylaws at issue facially “invalid,” rather than inequitable. Conducting its own de novo review, the supreme court found that only one of the four advance notice bylaws at issue—a single 1,099-word run-on sentence with 13 separate parts—was facially invalid because it was “indecipherable,” and such an “unintelligible” bylaw could not be lawfully applied under any circumstances.
For the other three bylaws, the supreme court credited the Court of Chancery’s findings that, while there did exist a legitimate threat to the company’s interests which the advance notice bylaws were ostensibly meant to address, the provisions at issue went so far beyond what could be justified in the interest of “thorough disclosure” that they suggested that the board’s motives in adopting them were to undercut the company’s pending proxy contest entirely and entrench the current board.
For example, one provision required disclosure of all arrangements, agreements, or understandings with respect to a board nomination—including, based on the definition of certain terms in the bylaws, agreements among a theoretically unlimited number of third parties, even those unknown to the nominating stockholder. The other two bylaws at issue likewise required extensive and unreasonable disclosure based not just on the nominator but also of “an ill-defined daisy chain of persons” potentially associated with him or her. The supreme court agreed with the Court of Chancery that these provisions appeared more as a “tripwire” than a promotion of legitimate objectives, “suggest[ing] an intention to block the dissidents’ effort.”
Accordingly, the supreme court reached effectively the same conclusion as did the Court of Chancery—holding bylaws unenforceable—but it did so based upon whether the record demonstrated that the board’s motivations in adopting them were in service of advancing the two recognized legitimate interests that advance notice bylaws serve—disclosure and orderly stockholder meetings—as opposed to motives of self-interested entrenchment. Importantly, the court held that the same findings that animated the Court of Chancery’s findings of facial invalidity—i.e., that the bylaws’ requirements were overbroad with respect to their legitimate objectives—served to compel a finding that they were improperly motivated, and thus unenforceable in their entirety:
The unreasonable demands of most of the Amended Bylaws show that the AIM board’s motive was not to counter the threat of an uninformed vote. Rather, the board’s primary purpose was to interfere with Kellner’s nomination notice, reject his nominees, and maintain control. As the product of an improper motive and purpose, which constitutes a breach of the duty of loyalty, all the Amended Bylaws at issue in this appeal are inequitable and therefore unenforceable. [1]
WHAT COMPANIES SHOULD DO NOW
Critically, while Kellner was decided in the context of a live stockholder activist dispute, as opposed to a more typical “mootness fee”-type challenge to bylaws in the abstract, the supreme court’s decision preserves and potentially expands the grounds by which entrepreneurial plaintiffs’ firms might bring such “mootness fee” challenges. Even bylaws that could be enforceable as drafted may be subject to challenge based upon deficiencies in the record regarding the process by which they were adopted or the board’s motivation in adopting them.
In effect, while the supreme court’s decision will likely shift the focus on plaintiffs’ challenges from an analysis of the bylaws in the abstract to the board’s process and rationale for adopting them, the imprimatur of unreasonableness with respect to bylaws of the same ilk as at issue in Kellner may now be relied upon as evidence of fiduciary breaches of the duty of loyalty, compelling broad-based invalidation. Commentary by plaintiffs’ firms regarding the supreme court’s decision confirm that the opinion has been viewed as strengthening the basis for continued challenges.
Kellner thus counsels several practical considerations for companies with advance notice bylaws that seek to avoid paying “mootness fees” to plaintiffs’ firms for having done little more than brought the Kellner problem to the company’s attention. Because the equitable analysis focuses in large part on the board’s motives and processes in adopting challenged bylaws, plaintiffs’ firms pursuing mootness fee awards will likely first seek to inspect the board’s record in these respects through a DGCL Section 220 books and records demand—a form of pre-suit discovery with minimal requirements for stockholders to satisfy to be entitled to inspection.
Those board level records will be scrutinized to evaluate whether the board considered appropriate objectives in adopting the bylaws and sought to tailor the bylaws to those objectives, and any deficiencies in the record will be exploited as alleged evidence of improper motivations in support of a claim of broad-based unenforceability, even in situations where the scope of the bylaws might otherwise be deemed reasonable in the service of legitimate objectives.
Regarding bylaws similarly drafted as those at issue in Kellner, plaintiffs may argue that the bylaws themselves belie an improper motivation for adopting them. Public corporations with advance notice bylaws would therefore be well served by initiating a review of both the scope of the bylaws and the record regarding their adoption before receiving a DGCL Section 220 demand by plaintiffs’ firms, granting themselves an opportunity to rectify Kellner issues first and thus blunting claims that the changes were caused by plaintiffs’ firms seeking mootness fees. Our team stands ready to assist with this review.
[1] Kellner v. AIM Immunotech, C.A. No. 2023-0879, slip op. at 51 (Del. 2024) (emphasis added).
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