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Corporate Governance: Can We Change the Bylaws to Eliminate a Shareholder Lawsuit?

In general, corporations are governed by their bylaws. The bylaws are adopted by a vote of the shareholders when the corporation is formed and, generally speaking, the shareholders can change the bylaws at any time by a vote of the controlling shareholders. However, there are some limitations. For example, shareholders cannot change the bylaws in order to eliminate a lawsuit that has been filed against the corporation by a group of shareholders. If your corporation finds itself dealing with dissident shareholders, you should seek the advice and counsel of an experienced San Diego corporate attorney.

The case of Cobb v. Ironwood Country Club, 233 Cal. App. 4th 960 (Cal. App. 4th Dist. 2015) illustrates some of the legal principles. Essentially, concepts of fair dealing and good faith prevent a corporation from changing its bylaws and applying those changes retroactively if a lawsuit or other proceeding is pending. Cobb involved a lawsuit by various members of the Ironwood Country Club (the “Club”) with respect to a loan that had been made by various members in 1999. According to the members, the Club was in breach of the loan agreement and the members brought suit in California State Court. About four months later, the Club’s board of directors adopted a bylaw mandating arbitration for any disputes, including the dispute over the 1999 loan agreement. The bylaws were also changed to provide that members waived any right to sue for consequential and/or punitive damages.

Thereafter, the Club asked the court to compel arbitration. The plaintiffs objected arguing that adopting a new bylaw to essential evict them from State court was unfair and not legal. The trial court agreed and refused to apply the new bylaws retroactively.

In affirming the trial court’s decision, the Court of Appeals noted that corporate bylaws are similar in many ways to written contracts. The bylaws establish the expectations of the members and stakeholders in the corporation. The court then applied the principles of good faith and fair dealing to reject any contention that the corporation could change the bylaws mid-stream and oust the plaintiffs from state court. Since the bylaws could be changed only by the board of directors, that discretionary power was one-sided. As such, the power could only be exercised in good faith and without any appearance of self-dealing. Given that the case had already been filed and given that the issue was a loan made by the shareholders to the corporation, the board could not self-deal in such a manner.

In general, retroactive application of any change cannot take away rights and privileges that have already vested or accrued. That is, since the lawsuit had already been filed, the plaintiffs had exercised rights that they had under the original bylaws. A new set of bylaws could not divest them of those vested rights. This was particularly true since the bylaw changes were not limited to requiring arbitration. Had the changes been limited to that procedural mechanism, the result might have been different, but the bylaws sought to divest the plaintiffs of their rights to sue for consequential and punitive damages after the case had already been filed. That is not allowed.

Contact San Diego Corporate Law

For more information, call Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard focuses his practice on business law, transactional, and corporate matters, and he proudly provides legal services to business owners in San Diego and the surrounding communities. Mr. Leonard can be reached at (858) 483-9200 or via email. Like us on Facebook.

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