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Legal Update

California Court Rules that Directors Cannot Change Bylaws to Protect Themselves After Alleged Wrongdoing Occurs

3 February 2011
Mayer Brown Legal Update

Judge Richard Seeborg of the Northern District of California recently considered the question of whether corporate directors may control the venue for shareholder derivative actions brought against them by adopting a bylaw—after the alleged wrongdoing—requiring such cases to be filed in a particular forum. In denying Oracle Corporation’s (Oracle) motion to dismiss a shareholders derivative lawsuit for improper venue, Judge Seeborg ruled that they may not. The court observed that “the venue provision was unilaterally adopted by the directors who are defendants in this action, after the majority of the purported wrongdoing is alleged to have occurred and without consent of the existing shareholders who acquired their shares when no such bylaw was in effect.” Prince v. Berg, 3:10-cv-094233 (N.D. Cal. Jan. 3, 2011)

In Berg, the plaintiff-shareholders alleged that between 1998 and 2006, Oracle made sales of software and licenses to the US government totaling approximately $1.08 billion. They further alleged that through a variety of fraudulent and improper practices, Oracle failed to apply certain discounts to which the government was contractually and legally entitled, resulting in millions of dollars of overcharges.1 As a result, plaintiffs sued the Oracle directors for breach of fiduciary duty and abuse of control.

In 2006—after the alleged overbilling scheme took place, but before this action was filed—Oracle’s Board of Directors amended the corporate bylaws to add a provision requiring derivative lawsuits to be brought exclusively in Delaware Chancery Court. Notably, all of the directors subsequently named as individual defendants in the above-referenced action were present at the meeting and approved the resolution.

The defendants argued that the corporate bylaws should be treated as any other contract, and they relied on the Ninth Circuit’s presumption of enforceability of forum-selection clauses in contracts. According to this presumption of enforceability, forum-selection clauses must be given effect unless there is a showing that: (i) its incorporation into the contract was the result of fraud, undue influence or overweening bargaining power; (ii) the selected forum is so gravely difficult and inconvenient that the complaining party will for all practical purposes be deprived of its day in court; or (iii) enforcement of the clause would contravene a strong public policy of the forum in which the suit is brought. These factors are referred to as the so-called Argueta factors.2

The court rejected the defendants’ argument. Although, under contract law, a party’s consent to a written agreement may serve as consent to all the terms therein, including a venue selection clause, “it does not follow that a contracting party may thereafter unilaterally add or modify contractual provisions.” The court noted that “[t]o whatever degree bylaws may generally be contractual in nature, however, Oracle here seeks to rely on principles of corporate law with respect to how its bylaws could be amended.” (emphasis in original)

The defendants could not cite any contract case upholding a venue provision that was inserted by unilateral amendment into an existing contract, and the court observed that “Oracle cannot persuasively contend that its bylaws are like any other contract … while simultaneously arguing that it was permitted under corporate law to amend those bylaws in a manner that it could not have achieved under contract law.” Unlike a true bilateral contract, the court continued, “the venue provision was unilaterally adopted by the directors who are defendants in this 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.”

As this is a case of first impression, future decisions will clarify the law in this area, particularly if the Delaware Chancery Court opines on the matter. But for now, if a board of directors wishes to adopt a protective venue provision, it should not wait until it becomes aware of the possibility of derivative claims.

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Footnotes:
  1. The alleged overbilling scheme is the subject of a qui tam action filed in May 2007 against Oracle in the Eastern District of Virginia, in which the government has intervened.
  2. R.A. Argueta v. Banco Mexicano, S.A., 87 F.3d 320, 325 (9th Cir. 1996).

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