New Developments

Delaware Supreme Court on stockholder adopted bylaws

The Delaware Supreme Court has held that that a stockholder-proposed bylaw that requires reimbursement to dissidents who elect a short slate of directors is a proper subject for stockholder action and might cause the company to violate Delaware law.

In CA, Inc. v. AFSCME Employees Pension Plan (listen to oral argument here), AFSCME submitted a shareholder proposal to CA, Inc., a public company. The proposal would amend CA’s bylaws to require the board to cause the company to reimburse stockholders for their reasonable expenses incurred in a successful contested election for a short slate of directors.

CA requested a no-action letter from the SEC on the grounds that the proposal could be excluded under Rule 14a-8(i)(1) and (2). The SEC, in turn, certified two questions of law, which tracked the Rule, to the Delaware Supreme Court. That is, the SEC asked first whether the proposal is a proper subject for action by stockholders and, second, whether the proposal would cause the company to violate any Delaware law.

Justice Jacobs, speaking for a unanimous, en banc, court, held “yes” and “yes”. On the first question, Justice Jacobs framed the inquiry as determining the reach of stockholder power to amend bylaws under §109(a) given that the DGCL does not give the stockholders the same kind of broad management power it gives to the board in §141(a). He started by observing that both the board and stockholders may amend the bylaws under DGCL §109(a). But the DGCL does not give the stockholders the same kind of broad management power it gives to the board in §141(a), suggesting that the difference in management power affects the scope of the stockholders’ power to amend bylaws. Thus he held that the stockholders’ power to amend bylaws is not coextensive with that of the board, even though reading §109(a) alone suggests that both groups have identical power to amend.

From here, Justice Jacobs relies on implications from caselaw and citations to several provisions in the DGCL (§§141(b); 141(f); 211(a), (b), and (d); 216; and 222) to conclude that a (not the) function of bylaws is to comprise the process and procedures by which substantive corporate decisions are reached. The discussion at page 13 of the opinion is a very nice one that marshals the DGCL sections dealing with permissible bylaw provisions. With admirable, though slightly indirect, honesty, Justice Jacobs acknowledges that this dichotomy doesn’t resolve the issue because each side plausibly argues that the proposal here is either substantive or procedural. The touchstone for categorizing the proposal is its intent and effect. Both the intent and the effect of the proposal are to regulate the process of electing directors so the proposal is a proper bylaw provision, which may be adopted by the stockholders. The intent is to promote the integrity of the director election process by making it easier for dissident stockholders to nominate directors and that intent is realized by the proposal’s requirement for reimbursement.

On the second question, though, Justice Jacobs held that the proposal would cause the company to violate Delaware law. Because this is a certified question rather than actual litigation, the court must decide whether any possible set of circumstances could render the proposal invalid. There is, indeed, such a set of circumstances. Where the board determines that the dissident stockholders who nominated a successful short slate of directors did not honestly believe that their actions were in the best interest of the corporation, then the board would breach its duty of loyalty if it reimbursed the dissidents. The board would only be relieved of liability if the reimbursement requirement were in the Certificate of Incorporation rather than in the bylaws.

Footnote 14 declines to locate the bright line between the stockholders’ power to make bylaws and the board’s plenary power under 141(a). It is a wonderful tenure-generating footnote and surely the currently untenured corporate law profs will make much of this opportunity relatively quickly. One intriguing question is whether this case is the Erie of corporate law. Will bylaws now be subject to challenge because they contain substantive rules rather than procedural regulations? Justice Jacobs is clear that defining the processes and procedures by which decision are made is a function, not the function of bylaws but he gives no real clue about what other functions the bylaws may properly serve.

On the merits of this decision, I’m not at all sure that the court is correct when it holds (p.14) that the purpose and effect of the bylaw is to regulate the process of electing directors. It’s difficult for me to believe AFSCME’s intent is to reform process rather than to reduce the risk of running a short slate of directors. My guess is that AFSCME want to run (or has a sense that other CA shareholders would run) a short slate but would be much more assured in doing so if it would recoup at least some of its costs should they prevail. It’s not process reform, but substantive reform that the dissidents want. However, the court is not wrong in the way it describes the mechanism by which that reform is to be implemented.

This case could be taught in Chapter 15 after the third full paragraph on page 544. This opinion presents a You Draft It possibility. Redraft the following bylaw to make it clear that it regulates only the procedural aspects of electing directors:

The board of directors shall cause the corporation to reimburse a stockholder or group of stockholders (together, the “Nominator”) for reasonable expenses (“Expenses”) incurred in connection with nominating one or more candidates in a contested election of directors to the corporation’s board of directors, including, without limitation, printing, mailing, legal, solicitation, travel, advertising and public relations expenses, so long as (a) the election of fewer than 50% of the directors to be elected is contested in the election, (b) one or more candidates nominated by the Nominator are elected to the corporation’s board of directors, (c) stockholders are not permitted to cumulate their votes for directors, and (d) the election occurred, and the Expenses were incurred, after this bylaw’s adoption. The amount paid to a Nominator under this bylaw in respect of a contested election shall not exceed the amount expended by the corporation in connection with such election.

This case has generated commentary by Steve Bainbridge (here, there, over there, around here, and right here), Larry Ribstein (here and there), Francis Pileggi (here), and Lisa Fairfax at The Conglomerate (here and there).

Delaware Court of Chancery on inspecting books and records before share ownership

The Delaware Court of Chancery has held that a shareholder may inspect books and records related to acts occurring before the shareholder owned shares where the purpose is to assemble facts showing demand futility rather than to investigate misdeeds the stockholder would have no standing to assert. In Melzer v. CNET Networks, Inc., plaintiff filed a derivative complaint in federal court. The District Court dismissed without prejudice for failure to plead demand futility and stayed the proceedings to allow a books and records request under DGCL § 220. Mr. Melzer filed an action in the Court of Chancery when CNET resisted his demand as to documents related to facts that pre-date Mr. Meltzer’s share ownership. CNET’s primary argument against inspection is that plaintiff would not have standing to assert any claims uncovered by documents predating his share ownership.

Chancellor Chandler permitted inspection. He premised his decision on the idea that, “A stockholder must be given sufficient access to books and records to effectively address the problem of backdating through derivative litigation.” Under Stone v. Ritter, one way to show demand futility is to allege a Caremark claim. The standard of review for such a claim is a sustained or systematic failure to exercise oversight. To allow plaintiff to effectively address that claim, he is entitled to inspect documents that pre-date his stock ownership.

This opinion is noteworthy because it’s a nice synopsis of the Delaware Court of Chancery’s approach to books and records requests. It’s a good applied example of the Supreme Court’s recent Seinfeld decision, which was primarily theoretical. It also suggests that Caremark claims may be more useful that one might think at first blush. In Caremark and Stone, and perhaps other opinions, the Delaware courts have observed that a failure to monitor claim is extraordinarily difficult to maintain, in large part because the standard of review is so high. The board is liable only if it intentionally engaged in a sustained or systematic failure to monitor. However, this opinion suggests that plaintiff might be able to use a colorable Caremark claim to inspect books and records beyond those the plaintiff might ordinarily inspect because those broader records are germane to whether the board exhibited a sustained or systematic failure to monitor. Obviously the real effect of this opinion will depend on how the Court of Chancery bench shape their orders permitting inspection. I suspect this will be a subject of warm contention for a while until an aesthetic of inspection for Caremark claims emerges.

The Chancellor was clearly annoyed with CNET’s resistance. He began the opinion by observing, “This should have been a very easy case.” With wonderful symmetry, he ends with another pithy statement: “It is about time defendant … gets ‘going, going / back,

back / to Cali, Cali,’ ” citing, of course, to The Notorious B.I.G.

This case could be taught in Chapter 15 along with Seinfeld. Francis Pileggi was kind enough to send me this case and, as ever, had a good post here.

Delaware Court of Chancery on nominating directors

The Delaware Court of Chancery has held that being dilatory in figuring out somewhat confusing bylaws is not a ground for excusing compliance with those bylaws. In Openwave Systems Inc. v. Harbinger Capital Partners Master Fund I, Ltd., Openwave called its annual meeting of stockholders on December 1, 2006, with the meeting to be held January 17, 2007. Under Openwave’s bylaws, advance notice of nominations for directors had to be given to the corporation by the close of business on December 11th.

Harbinger, which owned about 10% of Openwave, decided to run a slate of nominees for the two open seats on Openwave’s board. Harbinger submitted its nominees to Openwave on December 28th and simultaneously changed from a 13G to a 13D filing. Openwave allowed the two nominees to appear on the ballot but reserved its right to challenge their nomination and election. The two highest vote-getters were one of Harbinger’s nominees and one of Openwave’s nominees. Hilarity (read, litigation) obviously ensued.

After a one day trial, Vice Chancellor Lamb held that Harbinger’s nominees had not been properly nominated, thus the two Openwave management nominees were the validly elected directors. The Vice Chancellor did not believe testimony that Harbinger’s principals were diligent but confused about the application of Openwave’s bylaws and so were unable to nominate candidates by December 11th. Rather, he found that Harbinger was simply lax in deciding whether to run a slate at all and, by the time it decided to do so, had missed the bylaw deadline. Although Harbinger sought legal advice about the effect of Openwave’s bylaws, it did not receive that advice before mid-December, after the December 11th deadline.

Vice Chancellor Lamb certainly decided this case correctly. Pedagogically, this case could be taught in conjunction with McKesson Corp. v. Derdiger (casebook page 546).

The bylaws in effect when this case arose are here.

As usual, Francis Pileggi has good posts on this case here and here.

Delaware Court of Chancery on cancelling a shareholder meeting

The Delaware Court of Chancery has held that a new board chair has the power to rescind a prior chair’s valid calling of a special stockholder meeting. In Perlegos v. Atmel Corp., the plaintiff was chairman, president, and CEO of the defendant. Following an internal investigation, a special committee of the board resolved to terminate plaintiff for cause because he obtained personal travel at corporate expense. The special committee also requested plaintiff to resign from the board.

The committee emailed notice of Perlegos’ termination as president and CEO to his lawyer. A few hours later, plaintiff, as chairman of the board, called a special meeting of stockholders for the purpose of amoving the directors on the special committee. The next day, the board elected Sugishita as “non-executive chairman”, although it did not remove plaintiff as chairman. The board also authorized and directed Sugishita to rescind plaintiff’s call of the special meeting, which he did. Plaintiff brought suit against the company and board seeking, among other things, an order that the special meeting be held.

Vice Chancellor Noble, after a trial on the merits, held that the special meeting must be held. Although plaintiff had been terminated from employment earlier that day, he remained the chairman when he called the special meeting. He had the power to act because, under the company bylaws, the board, the chairman, or the president may call special meetings of stockholders. The Vice Chancellor rejected defendants’ argument that plaintiff’s motivation in calling the meeting was inequitable, although that surely was a close call. The Vice Chancellor ruled that electing Sugishita as non-executive chairman had the effect of removing plaintiff as chairman, even though the resolution did not explicitly remove plaintiff from that office. This is so because the company’s bylaws clearly anticipate only one chairman.

The Vice Chancellor then faced two other questions. First, whether a properly called stockholder meeting can be canceled and, second, whether the cancellation here was consistent with the duty of loyalty. As to the first question, Vice Chancellor Noble held, in essence, that a board chair can’t make a rock so heavy he or she can’t lift it. Thus, Sugishita had the power to rescind the meeting notice even in the absence of an explicit grant in the bylaws. This is surely consistent with Omnicare, which the Vice Chancellor cites.

On the second question, the Vice Chancellor pretty much held that Blasius, in its original incarnation, applied. As a fallback, he held that the defendants could not pass muster under Unocal, either. He did not acknowledge that Blasius has been subsumed under Unocal, in practical effect, at least since MM Companies, if not much earlier. Here, the compelling justification test applied because canceling the meeting had the effect of precluding a vote on replacing the defendants until the next annual meeting.

The Vice Chancellor didn’t buy defendants’ argument that the effect was postponing (permitted) rather than preventing (not permitted) a shareholder vote. I think the Vice Chancellor was incorrect in that holding. Regardless of whether the vote is one to amove directors at a special meeting or elect the board at an annual meeting, the stockholders will have an unfettered opportunity to vote on retaining the defendants as directors. The trigger is whether the defendants’ action would “interfere with or impede the effective exercise of” the franchise. In my view, the defendants’ actions would do neither.

In any event, whether the compelling justification test is considered part of Blasius alone or Blasius under Unocal, the defendants fail. The stated reasons for canceling the meeting were that the board had been elected only three months previously, the time and expense of the meeting would distract management, and the meeting could confuse stockholders and employees. A post-hoc reason was concern that amoving the directors would put the company’s NASDAQ listing in jeopardy. I think the Vice Chancellor was clearly right on this. None of those reasons is compelling justification.

Alternatively, the Vice Chancellor held that the defendants fail Unocal, as well. Although the opinion is not explicit, it seems likely that the defendants failed the second prong of the test. That is, they likely showed that they had reasonable grounds to perceive a danger to corporate policy and effectiveness but did not show that their response was reasonable in relation to the threat posed. More precisely, the Vice Chancellor held that the corporation could have implemented “a less preclusive and more reasoned response”. The word “preclusive” is, as the corporate cognoscenti know, a term of art. It’s one of the two ways to show that a response is “Draconian” and therefore impermissible. It’s less clear whether, if not Draconian, the response would be within the range of reasonableness, as required by Unitrin. “[M]ore reasoned” is not the same as outside the range of reasonableness.

The court is arguably right here, but I’m not completely convinced. The threat can be seen as punishing independent directors by removal because they properly performed a special committee function. That punishment is likely to have a chilling effect on board members in this corporation. The response is neither coercive nor preclusive and certainly reasonable. Thus I think the decision to rescind the call was proper.

Francis Pileggi has a very good post (here) on this case.

Delaware Supreme Court, en Banc, hews to inspection standard

The Delaware Supreme Court has reaffirmed that the standard for shareholder inspection of books and records (rather than inspection of the stock ledger or list of stockholders) under DGCL § 220(b) is whether the shareholder has produced some evidence to suggest a credible basis from which the court can infer that waste or mismanagement may have occurred. In Seinfeld v. Verizon Communications, Inc., (listen to oral argument) Seinfeld sought limited inspection to investigate mismanagement and waste in connection with the compensation of three executives. Seinfeld admitted he had no factual basis for his claim. He urged the court to permit inspection based upon “suspicions, reasonable beliefs, and logic arising from public disclosure”.

After oral argument, before Holland, Berger, and Ridgely, JJ., the panel referred the case to the court en Banc. Presumably this referral was pursuant to Internal Operating Procedure VII that permits en Banc consideration when there is a reasonable likelihood that a prior decision may be modified or overruled. The court asked for supplemental briefs on whether the inspection standard should be whether “the stockholder has a rational basis for the stated purpose and no other purpose that would militate against inspection”. The court also invited the parties to suggest another standard that reduced the current standard. After supplemental briefing, the court en Banc affirmed its existing standard.

Justice Holland, for a unanimous court, held that the existing standard appropriately balances the interests of stockholders in stemming mismanagement and the interests of directors in managing the business of the corporation. He noted that Delaware courts have rejected Seinfeld’s proposed standard. As an empirical matter, Justice Holland observed that Seinfeld’s litigation was only the second since the adoption of the current standard in 1996 and 1997 in which no credible basis at all was found in contrast to at least 15 cases in which at least some inspection was ordered. At bottom, Justice Holland grounded the retention of the rule in the finding that it “maximizes stockholder value by limiting the range of permitted stockholder inspections to those that might have merit”.

Starting with Grimes v. Donald in 1996, a § 220 books and records request is always referred to as “one of the ‘tools at hand’” that plaintiffs should use to assemble evidence to survive a motion to dismiss. Plaintiffs who do not make use of this avenue are typically chastised for not doing so. Since Grimes, books and records litigation has increased and some inspection has been ordered in nearly all instances. However, it is clear that at least some Justices were of the view that the current standard is too restrictive. This view was substantial enough to warrant referring the case to the court en Banc and ordering supplemental briefing after oral argument. It’s unclear to me why some members of the court viewed the current standard as too strict, given that litigation has increased and is nearly always successful. The opinion is also interesting in that it suggests that the standard might be changed if empirical studies show that the current rule is suboptimal in terms of shareholder returns. That is, the opinion suggests that the rule is entirely economically based rather than anchored in a theoretical understanding of the appropriate balance between managers and shareholders.

Delaware court of chancery on Schnell and advance notice bylaw

The Delaware Court of Chancery has refused to invoke the Schnell doctrine to invalidate the announcement of the annual meeting of stockholders that was given in a way “intended to limit the rights of some stockholders” and that precluded “a contested election for the board.” In Accipiter Life Sciences Fund v. Helfer, LifePoint Hospitals, Inc.’s advance notice bylaw requires a stockholder proposal to be submitted “not later than “the 10^th day following the day on which public announcement of the date of such annual meeting is first made.”

LifePoint intended to hold its annual meeting on May 8, 2006. On January 12, 2006, LifePoint received a stockholder proposal and desired to avoid further proposals. On February 1^st, an associate at LifePoint’s outside counsel, Waller Lansden in Nashville, suggested announcing the May 8^th annual meeting date immediately to establish the deadline for shareholder proposals as early as possible. The Waller Lansden partner forwarded the suggestion to the company, which approved the tactic on February 2nd. The company decided to make the announcement in its fourth quarter earnings press release, which was released on February 6^th (read the press release). The announcement of the annual meeting was paragraph seven of the press release and neither the title of the press release nor any subheading made any allusion to the annual meeting.

Unbeknownst to LifePoint, Accipiter, a large stockholder, intended to wage a proxy fight to elect a slate of dissident directors. Two Accipiter financial analysts read the February 6^th press release but did not notice the annual meeting announcement. Accipiter formally nominated a slate of directors on March 31^st, which LifePoint rejected as untimely.

Vice Chancellor Lamb held that Schnell should be invoked only “where compelling circumstances suggest that the company unfairly manipulated the voting process in such a serious way as to constitute an evident or grave incursion into the fabric of the corporate law.” Although the Vice Chancellor found LifePoint’s actions to be “troubling”, he declined to exercise his equitable powers to provide relief. Perhaps most importantly, the Vice Chancellor found that LifePoint had no reason to know of the proposed dissident slate and thus did not intend to limit such contest for director positions. Nor did the notice render Accipiter’s challenge “extremely difficult or impossible”, presumably not warranting that uniquely Delawarean epithet, Draconian, which no doubt would have impelled relief. Moreover, there was no affirmative decision to omit mention of the meeting in the headline or a subhead, simply a failure to consider whether the announcement should have been highlighted. Finally, and perhaps at bottom, it is undisputed that Accipiter could have met the deadline had its employees simply read the press release carefully.

This case is no doubt rightly decided and raises at least two teaching possibilities. One is reinforcing the importance of careful attention to statutory requirements (by LifePoint and its counsel) and of careful attention to corporate documents (by Accipiter). In that sense this case is a very nice compliment to McKesson Corp. v. Derdiger, (page 546) in which inattention to detail made the company’s annual meeting date arguably invalid. The second teaching point is the ethical one. One could start with the motivations behind, and ethics of, advance notice bylaws. More prominent, of course, is the action of the lawyers: the associate who first spotted the possibility, the partner who forwarded the idea to the company, and the company general counsel who approved the idea.