Paying your own way

A lawsuit disputed in Delaware this past summer might dramatically alter the way dissident proxy campaigns are run and whether or not companies have to pay in the event of a successful vote. In CA vs American Federation of State, County and Municipal Employees (AFSCME) Pension Plan, the Delaware Supreme Court ruled that a binding bylaw proposed by AFSCME – mandating that CA (formerly known as Computer Associates) reimburse the Union’s costs in running a separate slate of directors if any of AFSCME’s nominees were elected – would violate state law.

The court did state, however, that the proposal was a ‘proper subject for action’ and that intrusive bylaw changes proposed by dissident shareholders could be, in some circumstances, allowable under Delaware law, which enabled both parties to claim victory.

Shareholders are not managers

Delineating an analytical framework, the court looked at the tensions created between sections 109 and 141 of the Delaware general corporate law (DGCL) to assess when and how shareholders can limit a director’s authority and relied on recent holdings in QVC and Quickturn. In theory, since power is vested under Section 109 in both the board and shareholders, this power could be coextensive. Practically speaking, and in looking at the facts at hand, the court reasoned that the coextensive powers of 109 are limited because it must be read with Section 141(a), which is very specific in reserving that ‘the business and affairs … shall be managed by or under the direction of a board of directors, except as may be otherwise provided.’ The Delaware Supremes reaffirmed this position: ‘It is well-established that stockholders of a corporation subject to the DGCL may not manage the business and affairs of the corporation, at least without specific authorization in either the statute or certificate of incorporation.’

In developing a threshold test for bylaw validity, the court assessed ‘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 held that the bylaw was process-oriented and did not mandate an outcome in the election of directors, and that shareholders of Delaware corporations have a legitimate and protected interest in the processes of director elections.

As proposed, the bylaw was a binding requirement that directors reimburse proxy expenses. The mandatory reimbursement proposal was held to be invalid because it could, in some cases, require directors to reimburse dissidents when they believed it to be against the best interests of shareholders and counter to the exercise of their fiduciary duties.

A delicate power-sharing arrangement

This landmark governance case will have broad implications. It is the first time the SEC has used a recent Delaware constitutional amendment to certify questions to the state court. And the court made plain that it did not accept the point implicit in CA’s argument, stating that this would mean ‘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. That simply cannot be. That reasoning, taken to its logical extreme, would result in eliminating altogether the shareholders’ statutory right to adopt, amend or repeal bylaws… The question left unanswered is 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).’ The court further indicated that it developed no bright-line test for determining when a bylaw limits directors’ authority.

CA requested a no-action letter from the SEC on April 18 to allow the company to mail proxy materials excluding the AFSCME proposal. They also sent a letter from Delaware counsel opining that the bylaw was not a proper subject for stockholder action and that it would violate the DGCL if it were implemented. On May 21 AFSCME and its Delaware counsel responded to CA’s request with their views. The SEC certified two questions on June 27 asking the court to decide whether the proposed bylaw was a proper subject for shareholder action and whether adoption of the proposal would cause CA to violate Delaware law. The Delaware Supremes accepted certification on July 1, expedited briefing and heard arguments on July 9 and on July 17, saying yes to both questions.

CA argued that it should not be required to pay for proxy fights by dissident shareholders, that printing and mailing could cost millions of dollars and that the proposed bylaw could cause it to fail in its fiduciary duties to shareholders. 

The SEC issued CA a no-action letter immediately following the ruling, allowing CA to proceed with its proxy mailing.

According to Robert Giuffra of Sullivan & Cromwell, CA’s attorney blogging on businessassociationsblog.com, the decision ‘reaffirms the bedrock principle of Delaware corporate law, that the directors of a corporation, not the shareholders, manage the business and affairs of the corporation. The decision confirms that shareholder bylaws may not prevent the directors from fulfilling their fiduciary duties.’ 

AFSCME’s director of pension investment policy, Richard Ferlauto, sees many facets to the decision. ‘The whole process of certification or appeal from the SEC to the Delaware Supreme Court is more than groundbreaking. It changes the SEC’s mediation role on shareholder proposals.’

In the past, an objecting company would request a no-action letter, the shareholder (AFSCME in this case) would file their view and the SEC’s division of corporation finance would look at both, make a ruling and then withdraw from the process. Companies would have to decide whether to open themselves up to litigation by excluding a proposal; more often than not, companies tended to include them. ‘If they excluded [a proposal], it was up to the shareholder opponent to litigate and then appeal up – a cumbersome, time-consuming and expensive route,’ notes Ferlauto. ‘This circumvents that.’

Losing the battle, winning the war

‘We didn’t win on a technical drafting issue, but we got 90 percent of what we wanted on our point of law,’ Ferlauto continues. ‘Our main point of law is the continuation of our fight for proxy access. Our goal for the litigation was to establish the shareholder franchise in director elections under Delaware law. The court definitively established those shareholder rights regarding  processes that influence elections.

‘The court’s concern with the proposal was a technical drafting problem. Our drafting didn’t give directors enough flexibility to meet their fiduciary duties. But it provided us with a road map for how to more narrowly draft future proposals that will meet the Delaware standard.’

According to Ferlauto, AFSCME’s next steps will likely be redrafting and resubmitting its proposal at companies it has in its sights: ‘We plan to use the momentum from this case to establish procedures regarding election of directors while keeping an eye on proxy access. We’d like to establish a SEC rule that allows shareholders a process for establishing proxy access.’

Although the court hedged its bets by saying the holdings were ‘case specific’, AFSCME and some of its fellow activists are preparing a raft of cases following this groundbreaking ruling; they believe that the implications of this decision can be applied to a range of other governance issues.

‘Given the flexibility that Delaware wants to give directors to establish fiduciary duties to the company,’  says Ferlauto, ‘certain types of proposals on other issues regarding judgment will clearly be disallowed now. The court has basically spoken regarding poison pills.’