SRZ frequently issues a report on activist investing developments for their clients. The most recent issue (which also features this article) can be viewed here. Other items covered in the issue include recent developments in stockholder's rights to demand inspection of books and records along with 13D disclosure requirements for buying and selling stock.
We’re pleased to have Marc contribute to our blog and look forward to additional posts from him in the future.The Permissible Scope of Bylaws: CA, Inc. v. AFSCME Employees Pension Plan
By Marc Weingarten and William F. Cassin
THERE ARE SURPRISINGLY few actions that stockholders, including activist stockholders, can take directly to influence corporate governance at the company they own.2 Most significantly, they lack the power to amend the company’s charter on their own initiative, as charter amendments must first be declared advisable by the board in order to be considered by the stockholders.3 Their most powerful right, of course, is to elect directors, though even this right may be substantially circumscribed through staggered-board provisions and the elimination of the right to take action by consent or to call a special meeting, as well as the application of advance notification bylaws. One of the stockholders’ few other powerful rights is to adopt or amend bylaw provisions. Section 109(a) of the Delaware General Corporation Law (the “DGCL”) in effect provides that “both the board and the stockholders, independently and concurrently, possess the power to adopt, amend and repeal the bylaws.”4 However, even this power is not absolute. It is subject to Section 141(a) of the DGCL, which provides that:
The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation.
Presumably, therefore, a bylaw provision that “took management out of the board” could not be adopted by the stockholders.
On July 17, 2008, the Delaware Supreme Court issued a decision in CA, Inc. v. AFSCME Employees Pension Plan, No. 329, 2008 (Del. Supr. July 17, 2008) squarely addressing the permissible scope of a bylaw provision in view of these two statutory provisions.
The case arose in the context of an effort by CA, Inc. (“CA” or the “Company”) to exclude a stockholder proposal submitted by the AFSCME Employees Pension Plan (“AFSCME”) under Rule 14a-8 of the Securities Exchange Act of 1934 (the “Exchange Act”) for inclusion in CA’s 2008 proxy materials. The proposed bylaw amendment would require reimbursement by the corporation of reasonable expenses incurred by a stockholder in connection with the successful nomination of a candidate to the board of directors in a contested election.5
The opinion, written to answer two distinct questions posed by the Securities and Exchange Commission (the “SEC”) to the Delaware Supreme Court, supported the Company’s exclusion of AFSCME’s proposed bylaw and could therefore be viewed as a defeat for both AFSCME and stockholder rights in general. However, the court’s fairly expansive holding as to the scope of permissible bylaw provisions, as well as its clear articulation of the rather narrow deficiency of the AFSCME bylaw, actually represents a significant affirmation of stockholder rights and, we believe, opens the door to creative bylaw proposals from stockholders.
Background to the Decision and the Current Law Regarding Proxy Solicitation Expense Reimbursement
As noted above, the CA, Inc. case arose out of a proposed bylaw amendment submitted by AFSCME for inclusion in CA’s 2008 proxy materials pursuant to Rule 14a-8 of the Exchange Act. This rule provides a stockholder owning a relatively small amount of a company’s securities with an opportunity to have its proposal included in a company’s proxy materials alongside those of management for presentation to a vote at the annual meeting of stockholders. The rule generally requires the company to include the proposal unless the stockholder has not complied with the rule’s procedural requirements or the proposal falls within one of 13 categories specifically enumerated in the rule.6 If a company believes a proposal falls within one of these categories, it may inform the SEC of its desire to exclude the proposal and request a no-action letter stating that the SEC will not recommend an enforcement action against the company based on the proposed exclusion. The SEC then reviews the request and the proposal and either issues the requested no-action letter or states that it declines to do so.7 Companies receiving their requested no-action letters will typically exclude the proposal from their proxy materials, while companies failing to receive the letter will include the stockholder proposal.
AFSCME’s proposed bylaw, if voted on and passed by CA stockholders, would have required the Company’s board of directors to reimburse a stockholder or a stockholder group soliciting proxies in support of a short slate of director nominees (i.e., a slate of directors comprising less than a majority of the board) for its reasonable costs incurred in the solicitation, so long as at least one nominee on the short slate was successfully elected to the board. As most stockholders interested in effecting change at the board level are well aware, the almost universal rule of proxy solicitations is that expenses incurred by a corporation’s board of directors to solicit proxies for the election of the company’s nominees are paid by the corporation; such expenses are viewed much like the expenses of preparing and distributing the corporation’s annual report—as just one of the many costs associated with running a company. The practical result, however, is that a proxy solicitation conducted by an incumbent board is essentially free to the incumbent board and to the candidates nominated by the board—and remains so whether these candidates win or lose their election. In contrast, a proxy solicitation conducted by a “dissident” stockholder must be paid for by the stockholder, and, in general, the stockholder has no right to reimbursement for the cost of such solicitation, even if the stockholder’s candidate is elected.8 And if the stockholder fails to win election for any of its candidates, there is virtually no chance of reimbursement.
The economic burden placed on stockholders undertaking a proxy solicitation operates as a significant disincentive to stockholders contemplating seeking board representation, and clearly favors incumbent boards. AFSCME’s proposed bylaw, by mandating reimbursement to successful candidates, would have mitigated the financial disincentive faced by stockholders to some extent, arguably leveling the playing field somewhat between incumbents and dissident slates.
CA’s Grounds for Exclusion and the Questions Posed to the Delaware Supreme Court
In its request for a no-action letter, CA sought to exclude the AFSCME proposal from its proxy materials on two principal grounds:9 (i) the AFSCME proposal was not a proper subject for action by stockholders of a Delaware corporation, and (ii) AFSCME’s proposed bylaw, if adopted, would cause CA to violate Delaware law. Not surprisingly, AFSCME disagreed with CA’s view. Both AFSCME and CA’s Delaware counsel submitted opinions to the SEC supporting their respective positions, and in the face of these conflicting legal opinions, the SEC formally certified these issues to the Delaware Supreme Court for guidance.
Is the Question of Proxy-Expense Reimbursement a Proper Subject for Stockholder Action?
The Delaware Supreme Court first addressed the question of whether the AFSCME proposal was a proper subject for stockholder action. The court discussed the interplay between Sections 109(a) and 141(a), and concluded that while stockholders are entitled to adopt bylaws, their power to do so is not “coextensive” with that of the board of directors, but is limited by the board’s prerogatives under Section 141(a). In other words, there are areas of corporate power that exclusively pertain to the board, and stockholders are prohibited from infringing on board power in these areas. However, the court rejected CA’s argument that any bylaw that infringes on the power of the board of directors automatically falls outside of the scope of permissible bylaws.
The court then turned to the two central questions of the case: Where is the line between permissible stockholder action and improper intrusion on the board’s power to manage the corporation, and on which side of this line does the question of proxy solicitation expense reimbursement, as embodied by AFSCME’s proposed bylaw, fall? While it explicitly declined to provide a bright line answer to the first question, the court stated that “[i]t is well established Delaware law that a proper function of bylaws is not to mandate how the board should decide specific substantive decisions but rather to define the processes and procedures by which those decisions are made.” Having determined that the proper focus of its inquiry is whether the AFSCME bylaw was process-related, the court analyzed the proposed bylaw and concluded that while it calls for an expenditure of money, it nevertheless “has the intent and effect of regulating the process for electing directors” and, accordingly, that it is a proper subject for stockholder action.
Would the AFSCME Bylaw Proposal Cause CA to Violate Delaware Law?
The Delaware Supreme Court then turned to the second question posed to it by the SEC: whether AFSCME’s proposed bylaw, if adopted, would cause CA to violate Delaware law. The court held that it would. In reaching its conclusion, the court focused on the mandatory nature of AFSCME’s proposed bylaw, which would require reimbursement of election expenses incurred by outside stockholders in all instances of a successful election. Because it mandated reimbursement in all cases, the court reasoned, there could be situations in which compliance with AFSCME’s proposed bylaw would cause a board to breach its fiduciary duties. Reimbursement could be improper, reasoned the court, in situations where the proxy contest for which reimbursement was sought was “motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation.” As a result, the AFSCME-proposed bylaw would violate the well-established prohibition against contractual arrangements that preclude a board from fully discharging its fiduciary duties. For these reasons, the court held that the bylaw, if enacted by stockholders, would violate Delaware law, thereby providing the grounds on which CA could permissibly exclude it from its 2008 proxy materials.
Implications of the CA Decision
From a stockholder-rights perspective, the CA decision has a number of positive implications.
The Delaware Supreme Court reaffirmed the principle that a bylaw should not mandate the board’s substantive business decisions, but rather should define the process and procedures by which these decisions are made. However, the court also held that “whether or not a bylaw is process related must necessarily be determined in light of its context and purpose.” The court found that the context of the AFSCME proposed bylaw was the process for electing directors and, accordingly, that even though the bylaw mandated reimbursement by the board with the expenditure of corporate funds, it was nevertheless a proper subject for stockholder action. Thus, a bylaw provision need not specify process exclusively; it simply must contextually relate to process. This holding opens the door to a wide array of potential bylaw provisions to be adopted at the initiative of stockholders.
While holding that the CA bylaw would have violated Delaware law, the state’s high court specified the cure for its infirmity: the inclusion of a “fiduciary out.” As indicated above, the court gave examples where the grant of reimbursement could violate fiduciary duties, such as where the dissident was motivated by personal or petty concerns, or sought to promote interests that did not further, or were adverse to, those of the corporation. While the latter seems somewhat expansive, the accompanying footnote indicates that such a circumstance may arise where a stockholder group affiliated with a competitor sought to elect candidates “committed” to using their director position to pass proprietary information to the competitor. Narrow grounds indeed, that would seem to disqualify not a single proxy contest within memory. And the court warned that, of course, “[a] decision by directors to deny reimbursement on fiduciary grounds would be judicially reviewable.” While incumbent board members might well argue against a reimbursement request submitted by a newly elected dissident board member on the grounds that the dissident’s agenda did not further the corporation’s interests, the success of such an argument seems highly unlikely in view of the majority stockholder approval implicit in the election of the dissident to the board.
The aspect of the court’s holding that defines the permissible scope of a bylaw may also be used by activist stockholders as a sword as well as a shield. It is not beyond boards to adopt bylaws seeking to restrict stockholder rights or powers, and the language of this decision should provide courts with the necessary ammunition to invalidate such provisions, even though board-approved.
The court noted in this decision that it has, in the past, upheld a bylaw requiring that board decisions be unanimous in order to be effective. A bylaw of this nature would be extremely powerful to an activist when coupled with the election of a minority slate, or even one director. The court also noted that it has, in the past, upheld the power of stockholders to abolish board-created committees. This raises some interesting questions. Could stockholders mandate the creation of a board committee? Possibly more significantly, could they identify which members of the board were to sit on the newly created committee?
The court declined to adopt a bright-line test dividing bylaws into those that stockholders may unilaterally adopt and those that they may not. This lack of predictability will, unfortunately, mean more litigation, with boards again utilizing the corporate treasury to fight dissidents who must finance their cause out of their own pockets. This very lack of predictability, however, also opens the door to stockholders willing to craft, with a view to the court’s guidance, bylaw proposals that will withstand challenge. More case law undoubtedly will be forthcoming. ■
1. Marc Weingarten heads the business transactions group at Schulte Roth & Zabel LLP. His practice focuses on mergers and acquisitions, leveraged buyouts, activist investing and investment partnerships. He can be reached at 212.756.2280 or firstname.lastname@example.org. William F. Cassin, a senior associate in the business transactions group, contributed to the preparation of this article.
2. This article presumes the application of Delaware corporate law.
3. DGCL § 242(b).
4. CA, Inc. v. AFSCME Employees Pension Plan, No. 329, 2008 (Del. Supr. July 17, 2008).
5. As discussed below, while the expenses incurred by incumbent directors are usually paid by the company, outside stockholders must bear their own expenses, which can be considerable, in connection with nominating directors.
6. The categories include, among others, (i) if the proposal is not a proper subject for stockholder action under the laws of the jurisdiction in which the company is incorporated; (ii) if the proposal would cause the company to violate any state, federal or foreign law to which it is subject; (iii) if the proposal relates to a personal grievance against the company; and (iv) if the proposal deals with a matter relating to the company’s ordinary business operations.
7. During the 2006–07 proxy season, the SEC responded to approximately 360 Rule 14a-8 no-action requests, according to the SEC.
8. While a newly elected member or members of a board are free to request reimbursement for the expenses incurred by the stockholder responsible for his or her election, under the law of most jurisdictions, including Delaware, the majority is equally free to reject the request. If a stockholder successfully nominates and elects a majority of the board of directors, the stockholder may be able to recoup its expenses, assuming such reimbursement is approved by the new majority of the board, but reimbursement may also be subject to approval by stockholders.
9. As noted above, both of the grounds cited by CA are among those listed in Rule 14a-8 as permissible grounds for excluding a stockholder proposal.