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August 20, 2008

CA v. AFSCME: Teaching Notes

Posted by Gordon Smith

CA v. AFSCME is a fascinating case, and it will be fun to teach. I am writing a law review article examining the issues raised by the case, and the following notes are from an early draft of the article.

The ultimate issue presented in this case was whether CA, Inc. would be allowed to exclude a proposal for a shareholder-adopted bylaw from its proxy statement on the ground that the proposed bylaw would be an improper subject for shareholder action under Delaware law or, alternatively, that the bylaw would cause CA to violate Delaware law. The proposal sought to amend CA’s bylaws as follows:

RESOLVED, that pursuant to section 109 of the Delaware General Corporation Law and Article IX of the bylaws of CA, Inc., stockholders of CA hereby amend the bylaws to add the following Section 14 to Article II:

"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, 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."

The board of directors of CA opposed the bylaw and requested a no-action letter from the SEC. In connection with its no-action request, CA submitted an opinion letter from the Delaware law firm of Richards, Layton & Finger P.A. stating, "in our opinion the Proposal is not a proper subject for stockholder action and, if implemented by the Company, would violate the General Corporation Law." In response, AFSCME submitted an opinion letter from the Delaware law firm of Grant & Eisenhofer P.A. stating, "Our Opinion [is that] the Proposed Bylaw is valid under Delaware law [and that] Delaware law recognizes stockholders' ability to enact bylaws such as the one contained in the Proposal."

The SEC certified the following questions to the Delaware Supreme Court:

(I) Is the AFSCME Proposal a proper subject for action by shareholders as a matter of Delaware law?

(II) Would the AFSCME Proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

As a matter of Delaware law, these questions implicated Sections 109 and 141(a) and forced the Delaware Supreme Court to address the interplay of those sections. Section 109 empowers shareholders to adopt, alter, or repeal bylaws, which 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." Meanwhile, section 141(a) empowers a board of directors to manage the "business and affairs of every corporation…, except as may be otherwise provided in this chapter or in its certificate of incorporation." Jeffrey Gordon has described these two sections as linked in a "recursive loop": the shareholder power to adopt, alter, or repeal bylaws is limited by "law," which includes the power of the board of directors to manage or supervise the management of the corporation; meanwhile the board's power to manage or supervise the management of the corporation is limited by other provisions in the DGCL ("this chapter"), which include the shareholder power to adopt, alter, or repeal bylaws.

Given the insoluble tension between Sections 109 and 141(a), the resulting opinion was inevitably somewhat contradictory, and the issue will undoubtedly require additional litigation in future cases, unless the Delaware legislature decides to amend the DGCL to resolve some of the lingering issues. I will focus the students on two novel and somewhat startling assertions made by the Court: (1) that "the DGCL has not allocated to the board and the shareholders the identical, coextensive power to adopt, amend and repeal the bylaws"; and (2) "It is well-established Delaware law that a proper function of bylaws is not to mandate how the board should decide specific substantive business decisions, but rather, to define the process and procedures by which those decisions are made."

The first assertion seems plausible enough on the face of Section 109, which states without qualification that the shareholders of a corporation are invested with the power to "adopt, amend or repeal bylaws," while the directors have no statutory "power to adopt, amend or repeal bylaws," but only such power as is conferred upon them by the certificate of incorporation. The concluding sentence of Section 109(a) seems designed to drive the point home that shareholders have an immutable statutory power, whereas the power of directors is dependent on the certification of incorporation,  which the Delaware courts routinely treat as a contract.

Whether the source of the bylaw power is the DGCL or the certificate of incorporation probably should not matter, but remember that we are trying to make sense of the Court’s assertion, "the DGCL has not allocated to the board and the shareholders the identical, coextensive power to adopt, amend and repeal the bylaws." In light of the foregoing analysis of Section 109(a), it may seem surprising that the Court intended to draw exactly the opposite inference from the language of the statute, namely, that the bylaw power of the shareholders was not as broad as the bylaw power of directors.

To reach this result, the Court observed that Section 109(a) "does not exist in a vacuum," but it must be read together with Section 141(a). After quoting that section, which grants to the board of directors the authority to manage or supervise the management of the "business and affairs of every corporation," the Court asserted:

No such broad management power is statutorily allocated to the shareholders. Indeed, it is well-established that stockholders of a corporation subject to the DGCL may not directly manage the business and affairs of the corporation, at least without specific authorization in either the statute or the certificate of incorporation. Therefore, 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).

In observing that the principle of director primacy  is "well-established," the Court cited a raft of cases, the earliest of which was Aronson v. Lewis, Justice Moore's enigmatic decision articulating the standard (though incoherent) definition of the business judgment rule.  In that case, Justice Moore stated, "[a] cardinal precept of the General Corporation Law of the State of Delaware is that directors, rather than shareholders, manage the business and affairs of the corporation."

The CA Court relied on Aronson's "cardinal precept" in another footnote to escape the recursive loop of Sections 109(a) and 141(a). The Court reasoned:

Because the board's managerial authority under Section 141(a) is a cardinal precept of the DGCL, we do not construe Section 109 as 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 law," including Section 141(a).

Although bylaws adopted under Section 109 are invalid if they are inconsistent with Section 141(a), the Court rejected CA;s argument that "any bylaw that in any respect might be viewed as limiting or restricting the power of the board of directors automatically falls outside the scope of permissible bylaws." The Court correctly observed, "That reasoning, taken to its logical extreme, would result in eliminating altogether the shareholders' statutory right to adopt, amend or repeal bylaws." Thus, the Court was left with a nasty "split the difference" problem.

Before turning to the Court's solution, we pause the highlight the fundamental flaw in the Court's reasoning, namely, that the "cardinal precept" was articulated and propagated in cases deciding the appropriate scope of shareholder intervention via litigation. These are not cases in which shareholders deliberately intervened in corporate governance ex ante, but rather cases in which the shareholders attempted to undo a board action ex post.

With regard to the second assertion mentioned above, that the "proper function of bylaws" is to lay down procedural rules, not to make substantive decisions. The Court made this assertion as part of its "split the difference" analysis. The assertion seems problematic in light of the broad description of bylaws in Section 109(b), which reads in relevant part:

[B]ylaws 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.

The only authorities cited for the Court’s distinction between procedural and substantive bylaws are two Court of Chancery opinions, neither of which even remotely supports the notion that bylaws are exclusively procedural. But the more problematic aspect of this part of the opinion is that the Court has now invited litigation of the nature of bylaws without much guidance on how to distinguish procedural and substantive bylaws.  The Court characterized various bylaws as "purely procedural," then concluded that the AFSCME bylaw proposal, "though infelicitously couched as a substantive-sounding mandate to expend corporate funds, has both the intent and the effect of regulating the process for electing directors of CA." As a result, the bylaw was a "proper subject for shareholder action" under Rule 14a-8.

Despite being a "proper subject for shareholder action" under Rule 14a-8 (the first certified question), the AFSCME bylaw was still "inconsistent with law" (the second certified question) because "the board of directors would breach their fiduciary duties if they complied with the Bylaw." In my view, the Court misapprehended the proper relationship between shareholder-adopted bylaws and fiduciary duty.

To explain the difficulties with the Court's opinion, I invoke the analogy of an agency relationship in which the shareholders are the "principal" and the board of directors is the "agent." The very definition of an agency relationship contemplates the right of control by the principal, and the agent has a concomitant duty of obedience. It is axiomatic that the agent does not breach its duty by following the principal's orders.

Following this line of reasoning in the corporate context, I contend that the Court in CA erred by reaching the following conclusion:

[T]he Bylaw, as drafted, would violate the prohibition, which our decisions have derived from Section 141(a), against contractual arrangements that commit the board of directors to a course of action that would preclude them from fully discharging their fiduciary duties to the corporation and its shareholders.

As with its analysis of Aronson’s "cardinal precept," the Court again failed to account for the unique factual context presented by shareholder-adopted bylaws. The Court extracted the fiduciary principle from Paramount Communications, Inc. v. QVC Network, Inc.,  in which the Delaware Supreme Court invalidated a deal protection device in a merger agreement. In that case, the board of directors of Paramount Communications, Inc. approved the device to protect a merger agreement between their company and Viacom from any hostile interventions by QVC Network, Inc. The Court held that the "Paramount directors could not contract away their fiduciary obligations."

The Court in CA also cited Quickturn Design Systems, Inc. v. Shapiro,  in which the Delaware Supreme Court invalidated a "delayed redemption provision" in a poison pill. According to the Quickturn Court, the delayed redemption provision was invalid because it "prevent[ed] a newly elected board of directors from completely discharging its fundamental management duties to the corporation and its stockholders for six months."

The CA Court recognized the obvious distinction between these two cases and the case at bar, namely, that QVC and Quickturn both involved actions by the board of directors to limit their own authority, whereas CA involved an action by shareholders to limit the board's authority. But the Court called this "a distinction without a difference":

The reason is that the internal governance contract – which here takes the form of a bylaw – is one that would also prevent the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to deny reimbursement to a dissident slate. That this limitation would be imposed by a majority vote of the shareholders rather than by the directors themselves, does not, in our view, legally matter.

It's hard to imagine how the Court found this argument persuasive. The form of the argument transparently circular, and, if taken seriously, it would prohibit all bylaws. After all, as the Court recognized earlier in its opinion, every bylaw impinges to some extent on the power of the board of directors,  thus "prevent[ing] the directors from exercising their full managerial power in circumstances where their fiduciary duties would otherwise require them to" act. The Court had properly framed the issue as requiring it to decide "what is the scope of shareholder action that Section 109(b) permits yet does not improperly intrude upon the directors' power to manage corporation's business and affairs under Section 141(a)," but its conclusory resolution of that issue is unsatisfactory because it unwittingly concludes that there is no scope of shareholder action. The result in CA is the latest chapter in a long history of cases in which the Court has enshrined "director primacy."

Shareholder Bylaws | Comments (1)

Comments

Gordon,

I'm seeing this late as I'm just about to turn to teaching the case. Incredibly helpful comments (and I'm looking forward to your article). I plan to push students one step further in thinking about the practical implications of the last part of the opinion. I'll ask "how would you draft a bylaw to avoid this problem?" The answer I hope to get (or lead them to): include a "fiduciary out" clause. Indeed, that's what I expect shareholders to do from now on. This should lead them to realize that although the case looks like a defeat for shareholders, if they draft around it the first part of the case has actually given them a pretty significant victory.

Posted by: Brett McDonnell | Feb 18, 2009 2:07:06 PM

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