- The Delaware Supreme Court Rules in CA, Inc. v. AFSCME: A New Framework for Analyzing Bylaws and Shareholder Proposals
- August 10, 2008
- Law Firm: O'Melveny & Myers LLP - Office
The recent Delaware Supreme Court decision in CA, Inc. v. AFSCME Employees Pension Plan, No. 329, 2008 (Del. July 17, 2008) provides the first insight into the intersection of the Delaware law provision that grants shareholders the ability to adopt, amend, or repeal bylaws with the Delaware law provision that provides the board of directors with the sole authority to manage the business and affairs of the corporation. While the decision confirms the director-focused concepts of Delaware corporate law, it also provides a significant opportunity for shareholders to recommend and adopt bylaws that impact the director-election process. However, the decision also outlines strong bases upon which a company may resist shareholder proposed bylaws.
Rule 14a-8 under the Securities Exchange Act of 1934 -- the “shareholder proposal rule” -- requires public companies to include shareholder proposals in their proxy materials so long as the procedural requirements of the rule are satisfied and the proposal does not fall within one of 13 subject matter exclusions. Two of the subject matter exclusions relate directly to state law -- a proposal may be excluded if it is not a proper subject for action by shareholders under the laws of the company’s organizational jurisdiction (Rule 14a-8(i)(1)) or, if adopted, it would cause the company to violate any state, federal, or foreign law to which it is subject (Rule 14a-8(i)(2)).
The American Federation of State, County, and Municipal Employees Pension Plan submitted a proposal to CA, Inc. for inclusion in CA’s proxy materials. That proposal called for a bylaw amendment that would require the board of directors to cause the company to reimburse shareholders for reasonable expenses incurred in running a contested election for less than a majority of the board (often referred to as a “short slate”) where at least one shareholder nominee is elected to the board. CA wrote to the staff of the Securities and Exchange Commission seeking its view as to whether it was permitted to exclude this proposal from its proxy materials in reliance on the two subject matter exclusions noted above.
The SEC, in turn, asked the Delaware Supreme Court to express its views. Specifically, the SEC “certified” the following two questions to the Delaware Supreme Court:
- Is the proposal a proper subject for action by shareholders as a matter of Delaware law?
- Would the proposal, if adopted, cause the company to violate any Delaware law to which it is subject?
In answering these questions, the Delaware Supreme Court was faced with the ill-defined distinction between Section 109 and Section 141(a) of the Delaware General Corporation Law. In this regard:
- Section 109(a) provides stockholders the statutory right to adopt bylaws;
- 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”; and
- 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.
The Delaware Supreme Court answered each of the SEC’s questions in the affirmative. Because the Delaware Supreme Court determined that the proposal, if adopted, would cause CA to violate Delaware law, the SEC held that CA could exclude the bylaw proposal from its proxy statement in reliance on Rule 14a-8(i)(2).
The Delaware Supreme Court Decision
The analysis of the interaction between Section 109 and Section 141(a)
In its decision, the Delaware Supreme Court noted that the “broad management power” granted to the board by Section 141(a) is not “allocated to the shareholders.” As such, the Court continued, “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).” Importantly, the Court stated that, rather than being an exception to Section 141(a), “the shareholders’ statutory power to adopt, amend or repeal bylaws under Section 109 cannot be ‘inconsistent with the law,’ including Section 141(a).”
These broad statements affirm the power of the directors to manage the business and affairs of a corporation under Delaware law. In this regard, the Court confirmed that the board’s authority to manage the corporation is “a cardinal precept” of Delaware law.
The process/decision analysis for determining whether a bylaw is proper shareholder action
In its consideration of whether the proposed bylaw was a proper subject for stockholder action, the Delaware Supreme Court established the following process/decision analysis:
“The process-creating function of bylaws provides a starting point to address the Bylaw at issue. It enables us to frame the issue in terms of whether the Bylaw is one that establishes or regulates a process for substantive director decision making, or one that mandates the decision itself.”
Applying this analysis, the Court held the proposed bylaw to be process oriented.
Bylaws relating to the “process for electing directors” are appropriate for shareholder action
On its face, the proposal seeks to cause the board to require an expenditure of funds by CA. The Court, however, stated that the proposal sought to regulate “the process for electing directors -- a subject in which shareholders of Delaware corporations have a legitimate and protected interest.” Accordingly, the Court held that the proposed bylaw was a proper subject for stockholder action.
By answering the SEC’s first question in the affirmative, the Court staked out a significant category of shareholder proposals -- those relating to the “process of electing directors” -- that may not be excluded from a company’s proxy materials in reliance on Rule 14a-8(i)(1).
Shareholder proposed bylaws that do not provide the board a “fiduciary out” violate Delaware law
The Court held that the proposed bylaw would violate Delaware law because it could require a board to reimburse expenses in a situation where doing so could cause the board to breach its fiduciary duties. Specifically, while the 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.
Based on this analysis, the Court answered the SEC’s second question in the affirmative. In accordance with this holding, the SEC staff provided CA with a letter indicating that it could exclude the proposal in reliance on Rule 14a-8(i)(2).
The Court reasoned very broadly in this area, indicating that the analysis of a bylaw should include a consideration of whether there are any hypothetical situations in which the bylaw could cause the board to breach its fiduciary duties. The Court’s holding on the second question gives significant breadth to the exclusion in Rule 14a-8(i)(2) -- to rely on the exclusion, a company must merely show that there is a hypothetical situation in which a mandatory bylaw could cause the board to violate its fiduciary duties or otherwise violate Delaware law.
What to Expect as a Result of the Delaware Supreme Court Decision
At its core, the CA decision holds that a proxy contest reimbursement bylaw may be a proper subject for stockholder action (i.e., it is procedural and relates to the election of directors), but the bylaw may be invalid if it mandates substantive board action without the inclusion of a “fiduciary out.” This decision will have a significant impact on shareholder and board action regarding bylaw proposals.
What to expect from shareholder bylaw proposals -- Future bylaw proposals by shareholders likely will focus on board processes (particularly those relating to the election of directors) and provide the board with an opportunity to exercise its fiduciary duties.
What to expect in response to shareholder bylaw proposals -- In response to shareholder proposals, companies likely will increase their reliance on Rule 14a-8(i)(1) and Rule 14a-8(i)(2) in seeking to exclude those proposals from their proxy materials:
- Companies may increase their reliance on the argument that proposed bylaws would address the substance of board decisions (as opposed to the process for reaching those decisions) and, as such, can be excluded in reliance on Rule 14a-8(i)(1).
- Companies may increase their reliance on the argument that proposed bylaws that do not provide a “fiduciary out” can be excluded under Rule 14a-8(i)(2). Because the Court did not indicate that the ability of the Board to repeal a bylaw it deemed inconsistent with its fiduciary duties negated the absence of a “fiduciary out” in the bylaw, it does not appear that this argument could be used to rebut a company’s argument for exclusion in reliance on Rule 14a-8(i)(2).
- The Court’s finding that a bylaw may be stricken if there is any situation in which it could be invalid, and its blessing of the use of hypothetical bases for finding a proposal invalid, will increase the breadth of the Rule 14a-8(i)(2) exclusion for companies. In this regard, the Court’s position is consistent with a number of SEC staff positions regarding the breadth of the exclusions in Rule 14a-8(i)(2) and Rule 14a-8(i)(6) exclusions (e.g., proposals relating to required maintenance of independent directors) and strengthens those exclusions significantly.
What to expect with regard to particular types of proposals --
- “Precatory” or “non-binding” proposals -- Because the SEC considers “precatory” or “non-binding” proposals on an “if adopted” basis, companies may increase their reliance on Rule 14a-8(i)(2) as a basis for excluding those proposals.
- “Social issue” proposals -- Under the Court’s process/decision analysis, the likelihood that a board’s substantive decisions could be impacted by a proposed bylaw is likely to be a determining factor as to the validity of that proposed bylaw under Delaware law. This analysis could have a significant negative impact on a number of “social” proposals, as it increases the opportunity for companies to argue that proposals that would require a board to undertake any action (e.g., action to curb global warming, focus on sustainability, or adopt health care principals) would be invalid.
- “Director election” proposals -- Proposals regarding “proxy access” are going to change their focus. The Court’s broad holding on the validity of shareholder proposed bylaws relating to the director election process likely will lead to a significant increase in shareholder proposals in that regard. While the SEC’s recent actions regarding the Rule 14a-8(i)(8) exclusion are not impacted by the Court’s decision, the Court’s holding will significantly narrow Rule 14a 8(i)(1) as a limitation on these types of shareholder-proposed bylaws.
- “Poison pill” proposals -- The Court’s holding regarding mandatory bylaws that could force the board to violate its fiduciary duties may lead more companies to argue that shareholder-proposed bylaws that would prohibit a board from adopting or implementing a poison pill can be excluded in reliance on Rule 14a-8(i)(2).