Some pretty fine analysis – and quick – from Travis Laster: Yesterday, the Delaware Supreme Court issued its much anticipated decision in CA, Inc. v. AFSCME Employees Pension Plan, No. 329, 2008 (Del. July 17, 2008), which resolved two questions of law certified to the Court by the SEC. AFSCME proposed for inclusion on CA’s proxy statement a bylaw that would require the CA board of directors to reimburse the reasonable fees of any stockholder that sought to elect less than 50% of the board (i.e. a short slate) and succeeded in electing at least one director. Here is the court opinion and the related Corp Fin no-action response.
The Delaware Supreme Court split the baby on the two certified questions. Answering the first in the affirmative, the Court held that the bylaw was a proper subject for stockholder action. Answering the second in the negative, the Court held that if adopted the bylaw would violate state law. The net result is that the bylaw can be excluded from CA’s proxy statement under SEC Rule 14a-8(i)(2).
This is a very significant decision that will prompt much practitioner commentary and scholarly discussion. It is also a decision with implications that will take time and future decisions to work out. Here are some highlights:
As a threshold matter, the Supreme Court cut the recursive loop between Section 109 and Section 141(a) of the DGCL. Section 109(a) gives stockholders the statutory right to adopt bylaws, and Section 109(b) provides that the bylaws may contain “any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.” Section 141(a) vests the power to manage the business and affairs of every corporation in the board of directors, except as otherwise provided in the DGCL or in the certificate of incorporation. This has led to a running debate as to whether a bylaw under Section 109(b) can limit a board’s power under Section 141(a).
Consistent with Delaware’s historic model of director-centric governance, the Supreme Court makes clear that Section 141(a) has primacy over Section 109(b). After quoting Section 141(a), the Supreme Court notes that “[n]o such broad management power is statutorily allocated to the shareholders.” (p. 7).
The Court then holds “[t]herefore, the 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).” (p. 7). In footnote 7, the Court addresses the statutory language of Sections 109 and 141(a), stating that Section 109 is not an “except[ion] … otherwise specified in th[e] [DGCL]” to Section 141(a). “Rather, the shareholders’ statutory power to adopt, amend or repeal bylaws under Section 109 cannot be ‘inconsistent with the law,’ including Section 141(a).”
In addressing the first certified question (whether the bylaw was a proper subject for stockholder action), the Supreme Court established an initial test for bylaw validity: “whether the Bylaw is one that establishes or regulates a process for substantive director decision-making, or one that mandates the decision itself.” The Court recognized that a bylaw that is appropriately process oriented can have some implications for board decision-making and the expenditure of corporate funds, giving as an example a bylaw that would require that all board meetings take place at the corporation’s headquarters and thereby necessitate expenditures for travel. (p. 16). Applying this test, the Court found that the primary function of reimbursement bylaw was process oriented. Although it called for the expenditure of funds, it sought to regulate “the process for electing directors –a subject in which shareholders of Delaware corporations have a legitimate and protected interest.” Based on this analysis, the Court held that the bylaw was a proper subject for stockholder action, thus answering the first questioning the affirmative.
In addressing the second certified question, the Supreme Court held that the mandatory reimbursement bylaw as drafted by AFSCME was facially invalid because it could require a board to reimburse expenses in a situation where it could breach the board’s fiduciary duties to do so. Citing its QVC and Quickturn precedents, the Court held that a bylaw could not require the Board to breach its fiduciary duties. Despite the fact that the reimbursement bylaw permitted the board to determine what expenses were “reasonable,” the Court held that that language “does not go far enough, because the Bylaw contains no language or provision that would reserve to CA’s directors their full power” to deny all expenses. (p. 23). In other words, because there were hypothetical situations in which the bylaw could require a board to breach its fiduciary duties, the Court held the bylaw facially invalid.
Each of these holdings potentially has big implications for the future. Although many will likely view this as a loss for stockholders, I believe they should view the case as a significant win. Yes, the director-reimbursement bylaw was held invalid, but the Court held that the election process was a proper subject for stockholder action. A bylaw mandating the inclusion of stockholder nominees on the company’s proxy statement should fare much better under a CA analysis.
Outside the election process, the case is generally negative for stockholder-adopted bylaws. For example, the strong QVC/Quickturn analysis should doom any substantive component to a pill redemption bylaw, such as a requirement that directors not adopt or renew any pill that could be in place longer than a year.
In the unforeseen consequences department, CA opens the door to the broad use of facial challenges by creating a regime where it is actually easier to make a facial challenge than an as-applied challenge. Under the approach articulated in CA, a facial challenge must be granted and a bylaw stricken if there is any situation in which the bylaw could be held invalid. In contrast, in an as-applied challenge, the CA court noted that a bylaw is presumed valid. Traditionally in a facial challenge, a provision would be upheld if there are circumstances in which it could be valid, such that invalidity can only be tested in an as-applied context. The CA court reverses this approach.
Also in the unforeseen consequences department, directors may find that the CA decision’s broad extension of a fiduciary trump card causes more problems than it solves. Under the CA analysis, mandatory bylaws may no longer be mandatory. They rather appear to be subject to the directors’ overarching fiduciary duties. Directors who take action in reliance on a mandatory bylaw therefore can now be second-guessed on fiduciary duty grounds.
The most obvious circumstance where this can arise is with a bylaw providing for mandatory advancements. The Delaware courts have consistently enforced mandatory advancement bylaws, even if the board of directors believes the recipient of the advancements is a bad actor and that it would be a breach of the board’s duties to provide the advancements. Under CA, a board can argue that a mandatory advancement bylaw cannot trump its fiduciary duties, and therefore it has the discretion not to pay. The converse, however, is also true, and a board that advances funds pursuant to a mandatory advancement bylaw is now open to a claim that their fiduciary duties required them not to advance.
This could be particularly problematic for sitting directors, because a permissive decision to provide advancements is a self-interested transaction subject to entire fairness. While I expect that the Delaware courts will find a way to uphold mandatory advancement bylaws, they will have to distinguish CA to do it.
Similar arguments could arise in less obvious circumstances. For example, a common defensive bylaw eliminates the right of stockholders to call a special meeting. Under CA, if a stockholder asks the board to call a special meeting, it could be argued that the board cannot simply rely on the bylaw and inform the stockholder that it has no right to the call. Because the bylaw cannot trump the board’s fiduciary duties, the board must consider as a matter of fiduciary discretion whether to call the meeting notwithstanding the bylaw.
Here again, I expect that the Delaware courts will support boards who act in accordance with mandatory bylaws. The CA Court was careful to leave itself wiggle room for the future, cautioning that it could not “articulate with doctrinal exactitude a bright line” rule for stockholder-adopted bylaws (p. 12) and stressing that “[w]hat we do hold is case specific” (n.14). In the near term, however, CA may open directors up to fiduciary challenges on decisions that previously were not subject to challenge.
There is not inconsiderable tension between the holding that the reimbursement provision was procedural and thus a proper subject of stockholder action and the holding that the same provision was invalid because it mandated substantive board action without a fiduciary carve out. CA is thus a decision that simultaneously gives and takes away. It gives stockholders the ability to propose bylaws addressing the election process. At the same time, it takes away the ability to adopt mandatory bylaws (or at least those providing mandaotry reimbursements) by holding such bylaws invalid if they could force the board to violate its fiduciary duties. Only future decisions will reveal how this tension plays out.