The Fallout of Delaware’s Bylaw Decision

The Delaware Supreme Court dealt shareholder activists a setback last month when it ruled that software giant CA could indeed exclude a shareholder proposal on reimbursement for proxy fights from this year’s proxy statement.

Unfortunately for Corporate America, the court also explained in its ruling when such resolutions can be included in the proxy statement—so companies should expect more such proposals to come fast and furious.

Allen

“This is a pretty big deal,” says Claudia Allen, head of the corporate governance practice at the law firm Neal Gerber & Eisenberg. “While CA won, the court also created a roadmap for shareholders who want to propose future bylaw amendments.”

Michael Barry, partner at the law firm Grant & Eisenhofer, which often works with activists, says the decision, CA v. AFSCME, marks the first time the Delaware Supreme Court has squarely addressed the rights of shareholders to adopt bylaws against directors’ obligation to manage the corporation responsibly. “This is a central issue of corporate governance that has been the subject of debate for many years,” he says.

The case stemmed from a shareholder resolution submitted by the American Federation of State County and Municipal Employees to force CA to reimburse the union for the cost of proxy fights, should the union’s director candidates win at least one spot on the board. CA, which opposed the idea, asked the Securities and Exchange Commission to issue a no-action letter giving CA permission to ignore the request.

The SEC, however, used a new technical procedure to hand off the question directly to the Delaware Supreme Court—since that’s where contentious questions of securities law usually end up anyway. Delaware amended its constitution last year to allow the court to answer certified questions from the SEC, rather than subject all parties to lengthy litigation in Delaware Chancery Court.

The SEC asked the court to rule on two questions: Was AFSCME’s reimbursement proposal a proper subject for action by shareholders as a matter of Delaware law? And if CA shareholders did ultimately adopt such a plan, would that cause CA to violate any part of Delaware corporation law?

The court split on the two questions. A reimbursement bylaw cannot force the company to pay back dissident shareholders in all cases, the court said, since that would contradict the board’s fiduciary responsibility to act in shareholders’ best interests. But assuming the shareholder resolution includes a “fiduciary out” clause to account for that—then yes, reimbursement of expenses in a proxy contest is fair game for stockholder action because the proposed bylaw relates to the “process for electing directors.”

“The decision makes clear that bylaws may not mandate how the board should decide specific substantive business decisions, but may ‘define the process and procedures by which those decisions are made,’” according to a legal bulletin from the firm Sullivan & Cromwell, which argued CA’s case. “Where the line will be drawn between those bylaws … likely will be decided by the Delaware courts on a case-by-case basis in the future.”

“I am quite certain that these unsettled questions will result in continued litigation in the future.”

— Michael Barry,

Partner,

Grant & Eisenhofer

Specifically, the court reasoned that since shareholders in a Delaware corporation have the right to participate in selecting the contestants for election to the board, “The shareholders are entitled to facilitate the exercise of that right by proposing a bylaw that would encourage candidates other than board-sponsored nominees to stand for election.”

The Fiduciary Out

Richard Ferlauto, AFSCME’s director of corporate governance, calls the decision a clear victory for activists despite the specific loss to CA—which he describes as “a technicality” AFSCME will promptly correct when it resubmits the resolution. The real battle, he says, was whether activists could submit reimbursement questions at all; Delaware’s highest court has now said they can. “That was the motivation—to clarify that rule,” he says.

Ferlauto

Several consequences are likely to follow now. First, Ferlauto and others expect a slew of “short slate” contests, where dissident groups field only a few candidates rather than enough to replace the whole board. Activists will also submit more reimbursement proposals that include the fiduciary-out clause the court required. (Not that shareholders are exactly clamoring for such rights; in July, such a proposal at Dell drew shareholder support of only 33 percent.)

Activists also expect the SEC to feel new pressure to solve the question of proxy access—the right for shareholders to put director nominations into the proxy statement—once and for all. They argue that since Delaware has now endorsed shareholder resolutions related to director elections at least broadly, the SEC must now give a firm answer on proxy-access resolutions specifically. The Commission has tried to do that several times before and always failed. Corporate America detests the idea.

The ruling might complicate activists’ lives as well, particularly when they file binding resolutions. Lucian Bebchuk, for example, is an activist notorious for filing binding resolutions to prohibit a board from adopting or implementing a poison pill. Is that permissible, or an improper attempt to handcuff a board’s fiduciary responsibilities? Some legal experts believe the Delaware ruling could be interpreted to mean that such bylaw proposals are out of order.

The questions don’t end there. What happens to existing mandatory bylaws that include the expenditure of money, such as indemnifying directors and officers or keeping offices in certain locations? Theoretically, any mandate contained in the bylaws could restrict the discretion of boards of directors, and run afoul of the logic behind the CA decision. “The implications could be far wider,” says Barry, they and might make directors think twice before serving on a board.

Just as important are questions about how the case reached the Delaware Supreme Court in the first place. What other questions of securities law might the SEC hand off to Delaware? How often? “Is the SEC ceding any authority to the state courts?” Ferlauto asks. Right now, nobody knows. Barry and others suspect that at least some answers will only come through further litigation, legislation (at the state or federal level, if not both), and SEC action.

Barry

For example, the court ruled that shareholders’ ability to adopt bylaws on any subject (Section 109 of the Delaware General Corporation Law) ends when those bylaws impinge on management’s ability to run the corporation (Section 114 of the DGCL). In the exact words of the ruling: “Shareholders’ statutory power to adopt, amend, or repeal bylaws is not coextensive with the board’s concurrent power, and is limited by the board’s management prerogatives under Section 141(a).”

The problem? The CA opinion doesn’t identify at what point bylaws adopted under Section 109 impinge on Section 141. “The court did not say where the line was drawn,” Barry says. “I am quite certain that these unsettled questions will result in continued litigation in the future.”