May 22, 2006

Union’s Pill Proposal Could Set Precedent

From ISS’ “Corporate Governance” Blog: A labor union proposal regarding takeover defenses at Hilton Hotels has the potential to establish a legal precedent that could help clarify issues surrounding “binding bylaw” proposals. The proposal by Unite Here’s pension fund would amend Hilton’s bylaws to state the “corporation shall not maintain a shareholder rights plan, rights agreement or any other form of ‘poison pill’ making it more difficult or expensive to acquire large holdings of the corporation’s stock, unless such plan is first approved by a majority shareholder vote.”

The bylaw proposal also states that a “majority of shares voted shall suffice to approve such a plan.” The proposal calls on Hilton to “redeem any such rights now in effect,” and states, “notwithstanding any other bylaw, the Board may not amend the above without shareholder ratification.” If the binding proposal is approved, Delaware-incorporated Hilton has said that it would refuse to recognize the bylaw change, arguing that the proposal is contrary to basic principles of Delaware law giving boards of directors the power to manage the business and affairs of a corporation.

Hilton has obtained a legal opinion from Richards Layton & Finger, a Delaware law firm, in support of this position. The company did not ask the U.S. Securities and Exchange Commission (SEC) for permission to exclude the proposal from its proxy statement. A paucity of legal decisions on the issue of binding bylaw proposals cloud the issues related to the Unite Here proposal, but the resolution could lead to new precedent clarifying some of these issues. While Delaware courts have not addressed the issue, two other courts have done so.

In Int’l Brotherhood of Teamsters Gen. Fund v. Fleming Cos. (1999), the Oklahoma Supreme Court upheld a binding bylaw on poison pills, interpreting an Oklahoma statute that closely resembles Delaware’s. However, in Invacare Corp. v. Healthdyne Technologies Inc. (1997), a federal judge in Georgia declared invalid a binding bylaw amendment to require a company to remove “dead-hand” pill features, which typically permit a pill to be redeemed only by “continuing directors.” The court in that case relied heavily on the existence of “continuing director” provisions in Georgia corporate law that are not found in Delaware corporate law.

In addition, the lack of settled law on binding bylaw proposals has led the SEC to adopt a “hands off” approach on no-action requests by companies seeking to exclude binding poison-pill proposals from their proxy statements. (Under federal proxy rules, a company may omit a shareholder proposal that would violate state law.)

The SEC has held this position since its 1997 no-action ruling at PLM International. After PLM sought to exclude a binding bylaw proposal setting a time limit on the company’s use of a poison pill without shareholder approval, the SEC held that, “whether the proposal is an appropriate matter for shareholder action appears to be an unsettled point of Delaware law…[and thus there is not a] basis for excluding the proposal from the company’s proxy materials.” Since this ruling, the SEC generally has made it a practice not to take positions on unsettled questions of state corporation law relating to poison pill bylaws.

In their opinion, Hilton’s Delaware lawyers argue that “Absent an express provision in a corporation’s certificate of incorporation to the contrary, [Delaware General Corporation Law (DGCL) Section 141(a)] vests in the board of directors the authority to manage the corporate enterprise. Among the powers conferred upon directors under Section 141(a) is the power to adopt and maintain defensive measures prior to or in response to a takeover proposal.” The lawyers also argue that, “adopting a stockholder rights plan is a function specifically assigned” to the board by Section 157 of the DGCL. “Absent a provision in the corporation’s certificate of incorporation to the contrary, a board . . . cannot be directed by a stockholder-adopted bylaw to exercise such authority in a particular way or delegate to stockholders or others the authority to exercise such power,” the Hilton lawyers argue.

However, many companies, including Hilton, provide concurrent power to both directors and shareholders to amend bylaws. Hilton’s view of Delaware law carries the risk that any shareholder-promulgated bylaw amendment could be seen as infringing on a board’s authority. This, however, would lead to a result–that all shareholder adopted bylaw amendments are invalid–that is contrary to the express authority set forth in Delaware law for shareholders to amend bylaws. Also, it is not clear that Hilton has the legal authority to deny that its bylaws have been amended. Alternatively, the company could ask a judge to rule that the proposal is invalid. If the bylaw proposal is approved, Unite Here may have to go to court to ensure that the company complies with the bylaw change and to confirm that it does not violate Delaware law.

There is a definite possibility that Unite Here may be able to obtain shareholder approval of its proposal, as Hilton does not have any supermajority voting rules for bylaw amendments that would make shareholder approval of the proposal unrealistic to obtain. The Unite Here proposal would require approval by a majority of the company’s outstanding shares.

Investors generally vote in favor of shareholder proposals regarding poison pills. In 2005, the average level of support for those proposals was 60.1 percent of votes cast. Given that many shareholders fail to vote at annual meetings, the labor pension fund likely will have to obtain significantly more than a majority of votes cast to constitute a majority of Hilton’s outstanding stock. If that happens and Unite Here and Hilton end up in court, investors and companies should watch closely.