Bylaw Amendments, Shareholder Activism, and Flying Close to the Sun

Kai H. E. Liekefett and Derek Zaba are Partners, and Leonard Wood is a Senior Managing Associate at Sidley Austin LLP. This post is based on a Sidley piece by Mr. Liekefett, Mr. Zaba, Mr. Wood, and Beth E. Berg. This post is part of the Delaware law series; links to other posts in the series are available here.

A case presently before the Delaware Court of Chancery challenging a corporation’s advance notice bylaw amendments, initiated by activist investor Politan Capital Management LP in October 2022,[1] brings to mind the storied Icarus. In the legend, a master craftsman creates wings of feathers and wax for himself and his son to escape danger. He cautions his son Icarus not to fly too close to the sun, lest the wings melt. Icarus, carried away with this device figuratively and literally, flies too high and tumbles into the sea.

The defendant is a Delaware corporation that, facing a potential proxy battle with activist fund Politan, adopted several of the most aggressive advance notice bylaw provisions considered (and previously dismissed) by shareholder activism defense legal practitioners. These bylaws require that, for any shareholder’s notice of dissident director nominations to be valid, the shareholder’s notice of nominations to the company must identify, among other things, the investment fund’s limited partners, all understandings between the fund’s limited partners and any of their respective family members and cohabitants, and any plans the fund has to nominate directors at other public companies in the next 12 months.

While time will tell if these bylaw amendments can sustain the court’s scrutiny, they are doubtlessly flying close to the sun. When companies adopt these types of bylaws, and particularly if they do so in the face of an imminent proxy contest, they run a risk of undermining reasonable and appropriate advance notice bylaws.

The Importance and Legitimacy of Advance Notice Bylaws

Public companies rely on advance notice bylaws to protect the interests of all shareholders by ensuring a fair process regarding the nomination of director candidates. Advance notice bylaws are, essentially, requirements that shareholders must satisfy in order to submit valid director nominations for shareholder meetings. Such bylaws require a nominating shareholder to provide certain information about itself, certain associated parties, and its director nominees within a reasonable period of time prior to a shareholder meeting. For annual meeting purposes, this window is frequently between 90 and 120 days prior to the anniversary of the previous year’s annual meeting.

There is little debate in corporate America over the principle that advance notice bylaws fulfill a valid and reasonable purpose. The Delaware General Corporation Law (DGCL) provides no comparable default rules that would apply for corporations that have no advance notice bylaws. As such, in the absence of advance notice provisions, shareholders would be able to nominate and solicit votes for director candidates while providing only the barest of information to the company and other shareholders with little to no advance warning ahead of the shareholder meeting. At most companies, employees at almost every level need to submit applications and make representations to be hired. It stands to reason that candidates for the board of directors—the senior-most function in a corporation—should provide fulsome information to the company and its shareholders, with enough advance notice to permit the information to be properly evaluated and considered by the company and its shareholders, as a prerequisite for running for election.

Delaware Permits Advance Notice Bylaws, Within Limits

Two key questions presented in Politan are when is it legal to adopt sophisticated advance notice bylaw amendments and what kinds of advance notice bylaw amendments are over the line from a legal perspective. These are already well-trodden topics in Delaware case law. Delaware courts have afforded corporations ample room to adopt thorough advance notice bylaws, but they have also put limits on this freedom. The evolution of this case law is largely about the contours of these limits, which have been heavily dependent upon the specific facts in the cases.

In laymen’s terms, Politan alleges that the company’s advance notice bylaws go too far. In legal terms, Politan alleges the amendments serve “no legitimate corporate purpose” and that their sole purpose is, instead, to preclude shareholders from exercising their “fundamental right to nominate individuals for election” to the company’s board of directors. Politan argues, in essence, that the bylaws are so onerous as to preclude an investment fund from satisfying the disclosure requirements in question, some which we will discuss below.

On this basis, the plaintiff is calling for the application of the demanding Blasius standard to the adoption of the amendments, under which the adoption is “presumptively inequitable and will be invalidated” unless the directors can rebut this presumption by showing a “compelling justification” for the adoption. [2] In Blasius Industries, Inc. v. Atlas Corp., the Delaware Court of Chancery held that even if a board is acting in good faith, if it acts with the primary purpose of interfering with the fundamental right to elect directors, the board must show it had compelling justification for doing so.[3] The company has argued that the amendments were not, in fact, adopted for the purpose of interfering with the right to elect directors and that the heightened standard of Blasius therefore does not apply. According to the company, the purpose of the amendments was to protect the company from having directors with potential undisclosed conflicts of interests, increase transparency in the director election process, and protect long-term shareholder value.

Timing Is Important: Rainy Day vs. Clear Day

Delaware courts frequently uphold advance notice bylaws,[4] but particularly so when they are adopted on a “clear day” (i.e., in the absence of an impending threat of a proxy contest).[5] By contrast, Delaware courts subject advance notice bylaws adopted in response to a dissident campaign (i.e., on a “rainy day”) to greater judicial scrutiny.

In In re Ebix, Inc. Stockholder Litigation, at the motion to dismiss phase, the court ruled that certain bylaw amendments adopted on a “rainy day” may be deemed defensive measures in the face of a perceived threat and, accordingly, would be subject to heightened scrutiny under Unocal Corporation v. Mesa Petroleum Co. rather than under the business judgment rule.[6] Although the trial court ultimately determined that these particular amendments were adopted on a “clear day,” the court confirmed that enhanced scrutiny under Unocal applies “whenever the record reflects that a board of directors took defensive measures in response to a perceived threat to corporate policy and effectiveness which touches on issues of control.”[7] Under the Unocal standard, directors bear the burden of proving they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed and that the bylaw amendments were reasonable in relation to the threat posed.

Thus, certain bylaw amendments having “defensive value” could, in certain situations, be subject to a Unocal review.[8] The court in Ebix at the motion to dismiss phase paid particular attention to bylaws that “prevent elections from occurring.”[9]

Certain Advance Notice Bylaws Are More Likely to Be Held Unlawful

The courts have recognized that advance notice bylaws generally “serve[] the proper purpose of assuring that stockholders and directors will have a reasonable opportunity to thoughtfully consider nominations . . . and to allow for full information to be distributed to stockholders.”[10] Delaware courts may, however, invalidate advance notice bylaw amendments if the amendments “unduly restrict the stockholder franchise or are applied inequitably.”[11] Accordingly, to be upheld, advance notice provisions must not unreasonably infringe on the right of shareholders to nominate directors and “must, on [their] face and in the particular circumstances, afford shareholders a fair opportunity to nominate candidates.”[12] Advance notice bylaws must be used for proper purposes consistent with directors’ fiduciary duty of loyalty.[13]

Depending upon the circumstances, the Delaware Court of Chancery has applied a form of enhanced scrutiny to the review of a board’s adoption and/or enforcement of advance notice bylaws. In a recent decision related to the application of advance notice bylaws, the court observed that enhanced scrutiny, “Delaware’s intermediate standard of review . . . [w]hether labeled as Unocal or Blasius,” applies in cases of “inherent conflicts of interest that arise when a board of directors acts to prevent shareholders from effectively exercising their right to . . . replace the incumbent board members in a contested election.”[14] Another decision, however, explained:

At their core . . . cases enjoining advance notice bylaws are context-specific applications of the Delaware Supreme Court’s opinion in Schnell v. Chris-Craft Industries, Inc. and its oft-quoted statement that ‘inequitable action does not become permissible simply because it is legally possible.’ The clearest set of cases providing support for enjoining an advance notice bylaw involves a scenario where a board, aware of an imminent proxy contest, imposes or applies an advance notice bylaw so as to make compliance impossible or extremely difficult, thereby thwarting the challenger entirely.[15]

Whether framed as emanating from Unocal, Blasius, or Schnell, the circumstances of a board’s adoption or enforcement of an advance notice bylaw may be reviewed under one of these forms of enhanced scrutiny.[16]

Plaintiff’s Concerns About the Bylaws Adopted in Politan

The bylaws at issue in Politan are alleged to have been adopted on what the Delaware court would deem a “rainy day.” The activist first disclosed its 8.4% stake in the company in a Schedule 13D filing in August 2022, in which it disclosed an intent to engage with management. During a meeting between the activist and the company on September 2, the activist fund indicated that it could possibly launch a proxy contest. On September 9, the board adopted bylaw amendments. On these facts, it is fair to suspect that the adoptions may be subject to some form of enhanced judicial scrutiny. Furthermore, the plaintiff is alleging that the demands of the new bylaws go well beyond what is seen in advance notice bylaws upheld by Delaware courts and effectively preclude the nomination of alternative director candidates. Although we do not take a position as to the ultimate validity of each advance notice requirement, we discuss certain of the more far-reaching requirements below.

Information About Passive Investors

The defendant company’s bylaw amendments require an investment fund wishing to nominate director candidates to identify the names and addresses of its limited partners and to describe whether any of those limited partners in turn hold investments in any key competitor to, or litigation adversary with, the company. More specifically, the amendments require the nominating shareholder to disclose the identity of any limited partner or other investor who owned 5% or more of the investment fund, as well as all investors in any sidecar vehicle. Along with the nominating shareholder and its nominees, these persons are considered “Covered Persons” to whom various disclosure obligations apply. The plaintiff argues, among other things, that this requirement creates a severe and intended obstacle for activists because it is axiomatic in the investment fund industry to keep the identity of limited partners confidential, and identities of an investment fund’s outside investors are valuable trade secrets. The plaintiff argues it would be impossible, as a practical matter, for an investment fund to comply with these disclosure requirements.

This advance notice bylaw as drafted goes well beyond the vast majority of bylaws that relate to this topic. A comparable bylaw, which poses less risk of legal challenge and seeks to obtain the most relevant information, could distinguish between investors in a special purpose vehicle (SPV) for a specific campaign and investors in a “general” activist fund (let alone a general multi-strategy fund). The formation of an SPV represents a purposeful decision to profit from a specific activist campaign and, in some cases, could be used as a mechanism to evade the Schedule 13D disclosure requirements for the “group” that comprises the investors in the SPV. Advance notice bylaws that effectively seek information about undisclosed investors taking actions that impact the targeted company have been specifically upheld by the Delaware courts, such as in the recent case of Rosenbaum v. CytoDyn Inc.[17] Moreover, the adoption of the bylaw on a “rainy day” in the face of an activist campaign makes such a bylaw vulnerable since, as is the case in Politan, an activist is likely subject to preexisting contractual obligations of confidentiality. An activist might argue that this leaves an activist with an impossible choice: breach its duties to its investors or abandon its nominations.

Information About “Family Members”

The bylaw amendments also provide that a nominating shareholder must disclose to the company information concerning the investment holdings of “Family Members” of each Covered Person, which is itself defined broadly to include far-flung limited partners. The bylaws define “Family Member” to include not only immediate family members living in a person’s household but also mothers-in-law, fathers-in-law, brothers-in-law and sisters-in-law living outside the person’s household, as well as “anyone . . . who shares the person’s home.” As implied by the plaintiff in its complaint, this provision can be read to require detailed information about the interests, objectives, and agreements of and between even the roommates of limited partners of a fund who live anywhere in the world.[18] The plaintiff contends this information is “practically impossible for a nominating stockholder to collect.”

Although it is appropriate to require such information from close family members or cohabitants in certain circumstances (e.g., where the dissident is an individual and not an entity), it is more challenging to argue the relevance of the detailed information required regarding family members and cohabitants of a fund’s limited partners.

Information About Planned Nominations at Other Companies

The bylaw amendments require a nominating shareholder to disclose any “plans or proposals” for that shareholder, or any person with whom it is “acting in concert,” to nominate directors at other public companies within the next 12 months. The plaintiff asserts that such plans and strategies of funds are highly confidential and proprietary, and represent a fund’s confidential thesis for growth. The plaintiff regards this as an “attempt to block investment fund shareholders from nominating candidates for election to the Board.”

Plans to nominate directors at other companies in the future (as opposed to in the past) are among an activist fund’s most highly confidential and valuable information. It is also more challenging to argue the relevance of an activist’s future plans at other companies with no relationship to the company or its industry.

Observations

We provide the following practical guidance for consideration:

  • Companies should not lose sight of the desirability of adopting or amending advance notice bylaws on a “clear day.” Adopting on a “rainy day” invites the specter of enhanced scrutiny review. Defensive bylaws adopted in the context of an activist campaign are more susceptible to review under a heightened degree of scrutiny.
  • Adopting bylaw amendments that frustrate or preclude altogether shareholders’ ability to run a proxy contest increases the likelihood of this more onerous standard of review. The Delaware courts have stated that the clearest set of cases providing support for enjoining an advance notice bylaw involves a scenario in which a board, aware of an imminent proxy contest, adopts an advance notice bylaw so as to make compliance impossible or extremely difficult.[19]
  • When adopting advance notice bylaws, engage counsel with experience amending corporate bylaws for advance notice provisions. The considerations for the adoption of various bylaw provisions are rapidly evolving and will continue to do so for the foreseeable future.

As lawyers dedicated to shareholder activism defense, we routinely advise companies in adopting advance notice bylaws, having drafted advance notice bylaws for over a hundred U.S. public companies in recent years, across industries and across the market capitalization spectrum. We view rigorous advance notice bylaws as absolutely essential for protecting the interests of companies and all of their shareholders. As but one example of their important function, rigorous advance notice bylaws can, with good reason, compel nominating shareholders to disclose hidden group members and supporting shareholders, as confirmed in the recent Delaware cases of Rosenbaum v. CytoDyn Inc.[20] and Jorgl v. AIM Immunotech. [21] At the same time, it is crucial for companies to evaluate and understand which advance notice requirements best protect these corporate interests and to appreciate that the circumstances surrounding their adoption may give rise to risk from a litigation standpoint, as well as from a public and investor relations perspective.

Endnotes

1Politan Capital Management LP, 2022 WL 14813970 (Del. Ch.).(go back)

2Id., Complaint, at ¶ 143 (citing Hubbard v. Hollywood Park Realty Enters., Inc., No. Civ. A. 11779, 1991 WL 3151, at *8 (Del. Ch. Jan. 14, 1991)); see also Blasius Indus., Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).(go back)

3Blasius, 564 A.2d at 661.(go back)

4Nomad Acquisition Corp. v. Damon Corp., No. Civ. A. 10173, 1988 WL 383667, at *8 (Del. Ch. Sept. 20, 1988) (finding, in the context of a preliminary injunction, that plaintiffs failed to show a reasonable probability of success in their challenge to the validity of a bylaw requiring shareholders to provide 60 days’ notice prior to submitting a nomination for election to the board); see also Hubbard, 1991 WL 3151, at *11 (interpreting Nomad as “upholding the facial validity of [an] advance notice by-law”).(go back)

5Strategic Inv. Opportunities LLC v. Lee Enters., Inc., C.A. No. 2021-1089-LWW, 2022 WL 453607, at *18 (Del. Ch. Feb. 14, 2022) (“The Bylaws were validly enacted on a clear day.”); Rosenbaum v. CytoDyn Inc., No. CV 2021-0728-JRS, 2021 WL 4775140, at *2 (Del. Ch. Oct. 13, 2021) (upholding the board’s decision to reject nominations made pursuant to nomination notices that lacked all information required under the pre-existing advance notice bylaw); BlackRock Credit Allocation Income Trust v. Saba Capital Master Fund, Ltd., 224 A.3d 964, 980 (Del. 2020) (“[W]e are reluctant to hold that it is acceptable to simply let pass a clear and unambiguous deadline contained in an advance-notice bylaw, particularly one that had been adopted on a ‘clear day.’”); AB Value Partners, LP v. Kreisler Mfg. Corp., No. CV 10434-VCP, 2014 WL 7150465, at *3 (Del. Ch. Dec. 16, 2014) (discussing that a company adopted its advance notice bylaws on a “‘clear day’ long before the present proxy challenge was contemplated by” the activist); see also Jonathan Thomas Jorgl v. AIM Immunotech, No. 2022-0669-LWW, 2022, WL 16543834 (Del. Ch. Oct. 28, 2022) (denying a plaintiff’s motion for preliminary mandatory injunction where the plaintiff claimed the company improperly rejected the plaintiff’s nomination notice on the basis of alleged omission of information required under the company’s advance notice bylaws).(go back)

6In re Ebix, Inc. S’holder Litig., No. CV 8526-VCN, 2016 WL 208402 (Del. Ch. Jan. 15, 2016); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985). See also Kai Liekefett & Leonard Wood, In re Ebix: Corporate Defenses and Activist Engagement, Harvard Law School Forum on Corporate Governance, Apr. 13, 2016, https://corpgov.law.harvard.edu/2016/04/13/in-re-ebix-corporate-defenses-and-activist-engagement/.(go back)

7In re Ebix, Inc. S’holder Litig., No. CV 8526-VCS, 2018 WL 3545046, at *7 (Del. Ch. July 17, 2018).(go back)

8In re Ebix, 2016 WL 208402, at *19 (holding that “enhanced scrutiny under Unocal . . . applies to the Board’s approval of the Bylaw Amendments”); Mentor Graphics Corp. v. Quickturn Design Sys., Inc., 728 A.2d 25, 38–43 (Del. Ch. 1998) (applying Unocal to a bylaw amendment that gave the board of directors authority to set a time and place for special meetings called by shareholders and required that such meetings take place “not less than ninety (90) nor more than one hundred (100) days after the receipt and determination of the validity” of the shareholder request); Kidsco v. Dinsmore, 674 A.2d 483, 487–89, 494–97 (Del. Ch. 1995) (applying Unocal to a bylaw amendment that extended the minimum allowable time for calling a shareholder-initiated special meeting from 35 days to 60 days).(go back)

9In re Ebix, 2016 WL 208402, at *19.(go back)

10R. Franklin Balotti & Jesse A. Finkelstein, The Delaware Law of Corporations and Business Organizations § 7.7, 2006 WL 2452420 (citing Hubbard, 1991 WL 3151, at *13). The summary of law in this section follows the summary of Balotti & Finkelstein(go back)

11Goggin v. Vermillion, Inc., No. 6465-VCN, 2011 WL 2347704, at *4 (Del. Ch. June 3, 2011) (quoting Openwave Sys. Inc. v. Harbinger Cap. Partners Master Fund I, Ltd., 924 A.2d 228, 239 (Del. Ch. 2007)).(go back)

12Hubbard, 1991 WL 3151, at *11.(go back)

13Healthcor Mgmt., L.P. v. Allscripts Healthcare Sols., Inc., C.A. No. 7557-CS, at 3–4 (Del. Ch. May 25, 2012) (Transcript) (“[T]he board is subject to . . . review for how it uses a[n advance notice] by-law and whether it’s using it for proper purposes consistent with its duty of loyalty.”)(go back)

14Strategic Inv. Opportunities LLC, 2022 WL 453607, at *18 (quoting MM Cos. v. Liquid Audio, Inc., 813 A.2d 1118, 1129 (Del. 2003)).(go back)

15AB Value Partners, LP, 2014 WL 7150465, at *3 (emphasis added).(go back)

16Whether bylaw amendments would be evaluated by the Delaware Court of Chancery separately or collectively is not clear. We believe it would be most appropriate for a court to separately evaluate bylaw amendments on an individual basis except when there is a clear and specific nexus between the substantive requirements underlying separate provisions.(go back)

172021 WL 4775140, at *2 (“Applying the unambiguous terms of the advance notice bylaw, it is clear . . . Plaintiffs were obliged to disclose who was ‘supporting’ their efforts . . . .”). See also Sidley Secures Trial Win; Court of Chancery Enforces Advance Notice Bylaw Where Stockholders Failed To Supply Required Information, Enhanced Scrutiny, Oct. 21, 2021, https://ma-litigation.sidley.com/2021/10/sidley-secures-trial-win-court-of-chancery-enforces-advance-notice-bylawwhere-stockholders-failed-to-supply-required-information/.(go back)

18Politan, 2022 WL 14813970, Complaint at ¶¶ 103, 149(go back)

19AB Value Partners, LP, 2014 WL 7150465, at *3.(go back)

20See note 18.(go back)

212022 WL 16543834, at *16 (finding that an advance notice bylaw amendment, requiring disclosure regarding “arrangements or understandings” between a nominating shareholder and “each proposed nominee and any . . . persons . . . pursuant to which the nomination(s) are to be made” was “not unreasonable”).(go back)

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