Delaware Supreme Court Issues Opinion on Shareholder-adopted Bylaws

We have received communications from several of our guest contributors.

Ted Mirvis of Wachtell, Lipton, Rosen & Katz writes:

The Delaware Supreme Court much-awaited decision on the AFSCME stockholder bylaw proposal did not disappoint. It is a thoughtful and important treatment of the intersection of stockholder and director authority. The director-centric view won. Here is our memo on the decision.

John F. Olson of Gibson, Dunn & Crutcher LLP offered a different perspective:

While the Delaware Supreme Court’s unanimous opinion, responding to the SEC’s two certified questions, is a clear victory for CA, Inc., and the SEC has already issued the requested no action release, the opinion of the Court provides a road map for different mandatory by-laws dealing with the election of directors that can be adopted by shareholders without offending Delaware law, even if some corporate expense is involved. The key is to leave room for director fiduciary discretion to prevent abuses. Thus, there is something for both sides to cheer about and, in Delaware, the fun has just begun.

J.W. Verret of George Mason University School of Law, who posted with us on the case here, offered the following comments:

For more analysis on this issue, see my essay on SEC Certification to the Delaware Supreme Court here. The verdict is in. First, let’s review the issues. The SEC certified two questions to the Delaware Supreme Court:

1) Is the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?

2) Would the AFSCME Proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

The Court’s ruling is an affirmative answer to both questions. Shareholder proposals like the one at issue in this case are a proper subject of shareholder action, and are not invalid encroachments on Board authority merely because they mandate a payment of money. Yet, as the Court could conceive of a way in which mandated payment could cause the Board to violate its fiduciary duty to the shareholders, the bylaw is illegal under Delaware Corporate Law for lack of a “fiduciary-out” exception.

My prior post, and an analysis from Professor Bainbridge here, describes the recursive loop between DGCL 141 and DGCL 109(a). More commentary from Larry Ribstein, and his compilation of links to other commentators, can be
found here. Rather than avoiding the question, as both counsel invited them to do, the Court faced this paradox head on. Boards and shareholders are both granted the right to amend the bylaws in the DGCL. Shareholder authority to amend bylaws is limited by 141, but the extent of that limitation has been mired in uncertainty. The Court also rejected CA’s argument that any limitations on Board’s authority must be contained in the Certificate of Incorporation.

The Court has given us its first look into the contours of 141’s limit on 109(a). The Court rested in a process/substance distinction outlined in previous Court of Chancery opinions. Bylaws mandating substantive business decisions are impermissible, but bylaws altering the process whereby Boards make decisions are permitted. In analyzing this bylaw, the Court announced “We conclude that the Bylaw, even though infelicitously couched as a substantive-sounding mandate to expend corporate funds, has both the intent and the effect of regulating the process for electing directors of CA.”

As to the second question, the Court held that, because of conceivable circumstances in which the bylaw could require the Board to reimburse insurgents running solely for personal reasons, there are conceivable situations in which the bylaw would require the Board to violate its fiduciary duty. This relied on similar holdings in Quickturn and Paramount v. QVC. The Court was unconvinced that the fact that limitation was shareholder adopted reduced the impact on the board’s ability to discharge its fiduciary duties. (Though including this mandate in the Certificate of Incorporation would be permissible.) The Court relied on its prior holding in Hibbert v. Hollywood Park for the proposition that only reimbursement for contests involving substantive differences about corporation policy are permitted.

Technically this is a loss for AFSCME, but the opinion should be considered a measured victory for the shareholder activist community. A reimbursement bylaw with a fiduciary duty out exception does not eliminate all of the risk associated with funding a proxy campaign. Only proxy access to the corporate ballot can do that. But such a bylaw would significantly reduce the risk associated with funding a proxy campaign. There is a good chance that a Board’s decision to withhold reimbursement through claims that its fiduciary duty requires it would be subject to heightened review under Blasius, since the Court has accepted that this bylaw is intimately connected with the election process and candidate’s incentives to run for election.