A Circuit Split Emerges on the Enforceability of Exclusive-Forum Bylaws That Limit Derivative Actions to State Court | USA

Shareholders of public companies have the ability, upon satisfying certain requirements, to assert derivative claims against directors and officers for damage to the corporation resulting from materially false or misleading proxy solicitations under Section 14(a) of the Securities Exchange Act of 1934 and Rule 14a-9 thereunder. While federal courts have exclusive jurisdiction over such claims, there is a strong presumption that forum-selection clauses entered into in freely negotiated contracts are valid and enforceable. What then happens when a corporation adopts a bylaw – considered a contract between the corporation and its investors – that on its face limits all derivative claims, including under Section 14(a), to a state court that lacks jurisdiction to hear the claims? In two decisions this year, the Seventh and Ninth Circuits both considered the question, reaching opposite results.

Section 14(a) and Rule 14a-9 prohibit the solicitation of proxies – the power to exercise voting rights associated with securities – by means of materially false or misleading statements. Almost 60 years ago, in J.I. Case Company v Borak, 377 U.S. 426 (1964), the Supreme Court recognised that shareholders have a private right of action for violations of Rule 14a-9. Notably, Borak held that the right of action exists for both derivative claims, whereby a minority stockholder seeks to recover damages on behalf of the corporation, and direct claims, for damage inflicted directly upon the shareholder.

The distinction between direct and derivative Section 14(a) claims came to the forefront in Seafarers Pension Plan v Bradbury, 23 F.4th 714 (7th Cir. 2022). There, a Boeing Company shareholder asserted derivative Section 14(a) claims in Illinois federal court against Boeing officers and directors for allegedly causing the company, which is incorporated in Delaware, to issue false and misleading statements about the development and operation of the 737 MAX airliner prior to fatal crashes in Indonesia and Ethiopia in 2018 and 2019. The defendants moved to dismiss on the basis of a bylaw adopted by Boeing’s board of directors providing that “the Court of Chancery of the State of Delaware shall be the sole and exclusive forum” for any derivative claims brought on behalf of the company.

A divided panel of the Seventh Circuit held that the bylaw was unenforceable as applied to Section 14(a) derivative claims. The majority grounded its decision in Section 115 of the Delaware General Corporation Law, which prohibits bylaws that are inconsistent with “applicable jurisdictional requirements.” In the majority’s view, the Boeing bylaw conflicted with jurisdictional requirements because Section 27 of the Exchange Act confers upon federal courts exclusive jurisdiction over Exchange Act claims, and Section 29(a) of the Exchange Act deems void contractual waivers of compliance with the requirements of the Exchange Act. As the majority explained, enforcement of the bylaw would effectively waive compliance with Section 14(a) in violation of Section 29(a) because it would force plaintiffs to raise their claims in a Delaware state court not empowered to hear those claims.

Long-serving Judge Frank Easterbrook dissented. In Judge Easterbrook’s view, Section 29(a) applies only to the substantive standards of the Exchange Act, not to questions of jurisdiction or forum. According to Judge Easterbrook, the Boeing bylaw was “just another forum-selection clause” that permissibly limited claims to a forum freely selected by the contracting parties. Therefore, Judge Easterbrook would have enforced the bylaw and dismissed the case from federal court.

Judge Easterbrook’s contrarian view in Seafarers won the day in the subsequent case Lee v Fisher, 34 F.4th 777 (9th Cir. 2022). There, a shareholder of the Gap, Inc. asserted derivative Section 14(a) claims in California federal court, alleging that statements in the company’s proxy statements concerning its commitment to diversity were false and misleading because the company allegedly failed to create meaningful diversity on its board of directors and executive management team. The defendants sought to dismiss the action based on an exclusive-forum bylaw almost identical to Boeing’s limiting derivative claims to Delaware state court.

A unanimous panel of the Ninth Circuit held that the bylaw was enforceable and ordered the case dismissed. In contrast to the Seafarers majority, the Lee court emphasised Supreme Court precedent holding that a freely negotiated forum-selection clause creates a strong presumption in favour of transferring a case. That presumption, the court explained, would only be overcome in “extraordinary” circumstances, such as when the selected forum would pose such hardship that the plaintiff would “for all practical purposes be deprived of his day in court.” The court found that this was not the situation in the case before it, because, even if precluded from bringing Section 14(a) derivative claims, the plaintiff retained the ability to assert functionally equivalent derivative claims for breach of fiduciary duty in Delaware.

Seafarers and Lee are significant for public companies incorporated in Delaware and elsewhere that have adopted – or are considering whether to adopt – exclusive-forum bylaws that restrict all derivative claims to state court. If enforceable, such bylaws can serve as an effective means of reducing costly and duplicative derivative lawsuits against officers and directors in multiple forums, under state and federal law, based on the same underlying allegations. Although Delaware courts generally have enforced forum-selection bylaws, they have not considered the interplay with the exclusive-jurisdiction and non-waiver provisions of the Exchange Act, leaving the question as a matter of first impression for federal courts.

For now, a circuit split exists between the Ninth Circuit, where exclusive-forum bylaws are presumptively enforceable, and the Seventh Circuit, where they are not. As a result, where corporations have adopted exclusive-forum bylaws, derivative plaintiffs likely will stay clear of the Ninth Circuit and, when possible, attempt to steer Section 14(a) litigation to circuits that refuse to enforce such bylaws (the Seventh) or have not yet addressed the issue. A patchwork of approaches will likely rule the day until either the Delaware or the US Supreme Court weigh in.