Publications
Article

Delaware Supreme Court Answers SEC's Cert. Request in CA v. AFSCME

Wall Street Lawyer

Court Holds that a Bylaw Mandating Reimbursement of a Dissident Shareholder’s Proxy Solicitation Expenses Is a Proper Subject for Unilateral Shareholder Action but as Proposed Violates Delaware Law.

On July 17, the Supreme Court of the State of Delaware, in CA, Inc. v. AFSCME Employees Pension Plan,1  issued its first decision arising from the certification by the Securities and Exchange Commission (SEC) to the Court of questions of Delaware law.2 In that case, the Court ruled that a bylaw that had been proposed by a shareholder for consideration and approval by the other shareholders that would require the company to reimburse a dissident shareholder for its expenses incurred in connection with nominating a “short” slate of candidates (a slate of director candidates that would not comprise a majority of the board of directors if so elected) and soliciting proxies in support of their election to the company’s board of directors, as proposed, is a proper subject for shareholder action. In so ruling, the Court held that the process for electing directors is a subject in which shareholders of Delaware corporations have a legitimate and protected interest and that shareholders are entitled to propose a bylaw that facilitates the ability of shareholders “to participate in selecting contestants for election to the Board”3 by encouraging “candidates other than board-sponsored nominees to stand for election.”4 Notwithstanding its conclusion that the proposed bylaw was a proper subject for shareholder action, the Court held that it would nevertheless violate Delaware law if enacted by the company’s shareholders because the proposed bylaw would, in the Court’s view, “require a board to act or not act in such a fashion that would limit the exercise of their fiduciary duties,”5 and because the proposed bylaw “contains no language or provision that would reserve to directors their full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case, to award reimbursement at all.”6

Background 

On March 13, the Employees Pension Plan of the American Federation of State, County and Municipal Employees (AFSCME) notified software development company CA, Inc. (CA—formerly known as Computer Associates, Inc.) that, pursuant to Rule 14a-8 under the Exchange Act,7 it planned to present a proposal at CA’s 2008 Annual Meeting of Shareholders and, accordingly, was seeking to have such a proposal included in CA’s 2008 Annual Meeting Proxy Statement and on the related proxy card. AFSCME’s proposal was to have shareholders adopt the following amendment to CA’s bylaws:

RESOLVED, that pursuant to section 109 of the Delaware General Corporation Law and Article IX of the bylaws of CA, Inc., shareholders 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 shareholder or group of shareholders (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 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) shareholders are not permitted to cumulate their votes for directors, and (d) the election occurred, and the Expenses were incurred, after the 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.”

In the supporting statement that was included in its letter to CA, AFSCME attributed the scarcity of short-slate proxy contests to the unavailability, as a practical matter, of reimbursement of direct election campaign expenses for such proxy contests.8 As AFSCME noted, since a company’s board of directors approves the reimbursement of expenses incurred by the dissident shareholder in connection with its direction election campaign, such expenses are, as a practical matter, only reimbursed when the dissident is seeking control of the board and is successful in electing at least a majority of the directors.9

On April 18, CA notified the Staff of the SEC that it was proposing to exclude the shareholder proposal that it received from AFSCME from its 2008 Annual Meeting Proxy Statement and the related proxy card under various grounds provided for under Rule 14a-8 of the Exchange Act and asking the Staff to confirm in a no-action letter that it would not recommend any enforcement action to the SEC if CA did exclude the proposal.10 CA cited the following grounds for excluding AFSCME’s proposal:  

  1. That the proposal conflicts with the SEC’s proxy rules, particularly Rule 14a-7, which requires shareholders to bear the cost of mailing their own proxy solicitation materials, and, accordingly, may be excluded under Rule 14a-8(i)(3);11
  2. That the proposal relates to a procedure for the election of directors and, accordingly may be excluded under Rule 14a-8(i)(8);12
  3. That the proposal was not a proper subject for action by shareholders under the laws of the State of Delaware, CA’s jurisdiction of organization, and, accordingly, may be excluded under Rule 14a-8(i)(1);13 and
  4. That the proposal would, if implemented, cause CA to violate the Delaware General Corporation Law (DGCL) and, accordingly, may be excluded under Rule 14a-8(i)(2).14

On June 27, the Office of the Chief Counsel of the SEC’s Division of Corporation Finance responded to CA’s no-action letter request and indicated that it was unable to concur with CA’s view that it could exclude AFSCME’s proposal from its proxy materials in reliance on either Rule 14a-8(i)(3) (the argument being that the proposal conflicts with the proxy rules) or Rule 14a-8(i)(8) (the argument being that that proposal relates to a procedure for the election of directors).15However, with respect to the other grounds cited by CA for excluding AFSCME’s proposal, which relate to issues of Delaware law, the SEC, taking advantage, for the first time, of its ability to have the Court hear and determine questions of Delaware law, certified to the Court the following questions of law:

  1. Is the AFSCME proposal a proper subject for action by shareholders as a matter of Delaware law?
  2. Would the AFSCME proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

In its decision, the Court addressed each question separately.

Question 1—Is the AFSCME proposal a proper subject for action by shareholders as a matter of Delaware law? 

In beginning its analysis of the first question presented, the Court parsed this question as being whether the bylaw proposed by AFSCME could be enacted by shareholders without the concurrence of the CA’s board of directors or, in other words, what is the lawful scope of the shareholders’ power to unilaterally adopt, amend and repeal bylaws. While, pursuant to Section 109(a)16 of the DGCL, both the shareholders of CA and the board are empowered to concurrently adopt, amend and repeal the bylaws, the Court noted that “… the DGCL has not allocated to the board and the shareholders the identical, co-extensive power to adopt, amend and repeal the bylaws.”17 According to the Court, the shareholders’ power to adopt, amend or repeal bylaws pursuant to Section 109(a) of the DGCL must be reconciled with Section 141(a) of the DGCL which provides in relevant part as follows:

“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.”

CA had attempted to argue that since, pursuant to Section 141(a), the board possesses the full power and authority to manage the business and affairs of the company except as otherwise provided for in such statutory provision, any shareholder-proposed bylaw that attempts to dilute or limit such power and authority is not permissible.18 That is, unless such a limitation of power or authority, is included in the company’s certificate of incorporation, it is not valid. The Court was not prepared to accept CA’s proposed line of demarcation with respect to the permissibility of shareholder-proposed bylaws. As the Court noted:

“… Section 109(a) carves out an area of shareholder power to adopt, amend or repeal bylaws that is expressly inviolate. Therefore, to argue that the Bylaw at issue here limited the board’s power to manage the business and affairs of the Company only begins, but cannot end, the analysis needed to decide whether the Bylaw is a proper subject for shareholder action.”19

 Rather, the Court sought to reframe the issue in terms of whether the proposed bylaw “establishes or regulates a process for substantive director decision- making, or one that mandates the decision itself.”20 That is, if the bylaw is purely procedural in nature, and does not predetermine the decision for the board, it would not be seen as impermissibly interfering with the board’s power and authority to manage the business and affairs of the company. As the Court noted:

“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.”21

The Court’s opinion is replete with examples of process-oriented bylaws or provisions (e.g., the number of directors on the board, the number of directors required for a quorum, vote requirements for certain board actions, the date and place of the annual meeting, conditions for the calling of special meetings of shareholders, etc.) that do not improperly encroach upon the board’s managerial authority under Section 141(a) and, accordingly, are appropriate for shareholders to propose. Before concluding that the proposed bylaw is a proper subject for shareholder action, the Court takes a somewhat tortious path to determining that the proposed bylaw does not mandate a specific decision by the board and, instead, is actually a purely procedural bylaw that does not improperly encroach upon a board’s managerial authority. The Court concedes that the bylaw is “infelicitously couched as a substantive-sounding mandate” to expend corporate funds.”22 Nevertheless, the Court indicates that the wording of the bylaw, “although relevant, is not dispositive of whether or not it is process-related” since it could have been worded differently “to emphasize its process, as distinguished from its mandatory payment component.” 23 The Court also suggests that a bylaw will not be disqualified as being process-related solely on the basis that it requires the expenditure of corporate funds.24 In addition to looking past the proposed bylaw’s mandate to expend corporate funds and the substantive-sounding nature of the bylaw, the Court adopts a rather broad perspective of the proposed bylaw in assessing whether it is process-related. “Whether or not a bylaw is process-related must necessarily be determined in light of its context and purpose.”25 Applying its broad perspective of the context and purpose of the proposed bylaw, the Court concludes that the proposed bylaw had “both the intent and effect of regulating the process for electing directors of CA” by facilitating the ability of shareholders “to participate in selecting contestants for election to the Board”26 and by encouraging “candidates other than board-sponsored nominees to stand for election.”27 Accordingly, the Court held that the proposed bylaw, being one that relates to the process of electing directors, is a proper subject for unilateral shareholder action.28

Question 2—Would the AFSCME proposal, if adopted, cause CA to violate any Delaware law to which it is subject?

Having concluded that AFCME’s proposed bylaw was an appropriate subject for unilateral shareholder action and that it did not invade the exclusive managerial authority of the board as provided for under the DGCL, the next question for the Court to answer was whether the proposed bylaw, if adopted, would cause CA to violate any Delaware law to which it is subject. The Court likened the proposed bylaw to contractual arrangements (e.g., “no-shop” provisions in merger agreements, delayed redemption provisions in shareholder rights plans or “poison pills,” etc.) that have been invalidated by the Court because they commit the board of directors to take or not take specific actions, and that prevent the board from taking or not taking other actions, that would otherwise be required for the board to fully discharge its fiduciary duties.29 The Court articulated a number of situations where it envisioned that the board’s fiduciary duties could compel that reimbursement of a dissident shareholder’s proxy contest expenses be denied and yet the board would have “contracted” away its right to exercise its discretion to so act. As the Court noted:

“It is in this respect that the proposed Bylaw, as written, would violate Delaware law if enacted by CA’s shareholders. As presently drafted, the Bylaw would afford CA’s directors full discretion to determine what amount of reimbursement is appropriate, because the directors would be obligated to grant only the “reasonable” expenses of a successful short slate. Unfortunately, that does not go far enough, because the Bylaw contains no language or provision that would reserve to CA’s directors their full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case, to award reimbursement at all.” 30

Accordingly, the Court concluded that the proposed bylaw, as written, would violate Delaware law, if enacted by CA’s shareholders. Implicit in the Court’s holding was that the proposed bylaw may have been acceptable if there was included therein language, similar to what is common today in a merger agreement’s “no-shop” provision, providing that reimbursement of the dissident’s expenses is mandatory except where the board determines in good faith that such reimbursement would cause the board to breach its fiduciary duties to the company’s shareholders. In addition, the Court indicates, in the second to last sentence of its decision, that the substance of the proposed bylaw would have also been permissible under Delaware law if it was enacted as an amendment to CA’s certificate of incorporation.31

While this decision can be seen a significant victory for dissident and activist shareholders, it leaves many questions unanswered

In holding that a bylaw that has “the intent and effect of regulating the process for electing directors” is a proper subject for shareholder action32 and that shareholders are entitled to facilitate the exercise of their right to “participate in selecting the contestants for election to the board”33 by proposing a bylaw that would encourage “candidates other than board-sponsored nominees to stand for election,”34 the Court has delivered a significant victory to dissident and activist shareholders. As a result of this decision, activist shareholders may be emboldened to make bylaw proposals that facilitate their future proxy contests against a company, particularly in the context of staggered or classified boards, where it may take at least two successive annual meetings to obtain sufficient representation on a company’s board of directors to claim and assert control over the company. While the Court ultimately concludes that the proposed bylaw provision mandating reimbursement of a dissident’s proxy contest expenses, if adopted, would violate Delaware law, it suggests that if the proposed bylaw contained a “fiduciary out,”—a provision allowing for denial of reimbursement expenses if the board determines in good faith that such reimbursement would cause the board to breach its fiduciary duties—a different result would have ensued. Accordingly, we can expect to see such a bylaw, as enhanced by the “fiduciary out” reappear in the near future, either as a Rule 14a-8 proposal or in connection with a proxy contest.

Notwithstanding the significant victory provided to shareholder activists, the Court’s decision does leave many questions unanswered about the line of demarcation between permissible bylaw proposals and bylaw proposals that would be invasive of the Board’s prerogatives to manage the business and affairs of the corporation. As discussed above, the Court is willing to carve out procedural or “process-oriented” bylaws as being types of bylaws that do not “improperly encroach upon the board’s managerial authority” under the DGCL and is willing to hold that bylaws that have the “the intent and effect of regulating the process for electing directors” are process-oriented, and accordingly are a proper subject for shareholder action.35 Nevertheless, the Court avoids articulating with “doctrinaire exactitude” a bright line that divides those bylaws that shareholders may unilaterally adopt from those which they may not since they would encroach upon the board’ s power and authority to manage the business and affairs of the company. As the Court noted: 

“We do not attempt to delineate the location of that bright line in this Opinion. What we do hold is case specific; that is, wherever may be the location of the bright line that separates the shareholders’ bylaw- making power under Section 109 from the directors’ exclusive managerial authority under Section 141(a), the proposed Bylaw at issue here does not invade the territory demarcated by Section 141(a).”36 

Accordingly, we now know that dissident or other activist shareholders can unilaterally propose process-related bylaws, which the Court holds as including, among others, bylaws that (i) have the “intent and effect of regulating the process for electing directors,”37 or (ii) encourage candidates other than board-sponsored nominees to stand for election;38 and that bylaws that mandate the expenditure of funds are not “automatically deprived of their process-related character.” 39 However, the Court deliberately leaves us with little clarity and certainty as to how to discern whether a given bylaw is one that is process- related because it “establishes or regulates a process for substantive director decision-making” and, therefore, is appropriate to be proposed by shareholders or is one that by mandating the decision is necessarily substantive and, therefore, would be invasive of the managerial prerogatives of the board. In addition, we are not aided in our quest for clarity by the Court’s tortious and attenuated path in casting AFSCME’s proposed bylaw as being process-oriented, even though the Court itself concedes that the proposed bylaw is worded as a substantive-sounding mandate. The framework created by the Court for analyzing the permissibility of shareholder proposed bylaws will likely have the effect of creating more questions (and future certifications of questions of law from the SEC to the Court). Given the substantial number of bylaw amendments that are proposed each year by dissident shareholders, pursuant to Rule 14a-8, for inclusion in the proxy statements of public companies, the SEC is likely to have its work cut out for it. The SEC will have to decide in these cases whether to concur with a company’s view that a given bylaw amendment proposal may be excluded from the company’s proxy statement on the basis that it is not a proper subject for action by shareholders under applicable law since it fails to meet the “test” of being a bylaw that “establishes or regulates a process.” One can expect that dissident shareholders will take extra care to wordsmith and couch their bylaw amendment proposals as either “having the intent and effect of regulating the process for electing directors” or to emphasize their procedural nature and deemphasize any hint that they are, in the least part, substantive in nature or can be construed as mandating a specific decision. While this decision represented the first time that the SEC certified issues of law to the Delaware Supreme Court, it would not be surprising if the SEC returned to the Court in the very near future for additional clarity on the demarcation between permissible and impermissible bylaw proposals, particularly those that arise in the context of Rule 14a-8 proposals. 

Conclusion 

As noted above, this case represented the first time that the SEC certified questions of law for the Court to hear and determine. It would be difficult for anyone not to be extremely impressed with the Court’s ability to issue its opinion on two complicated issues of law in less than three weeks after first receiving the SEC’s certification. Given this new resource that has been made available to the SEC, the larger question raised by this case is how frequently and under what circumstances will the SEC now turn to the Court to hear and determine questions of law and under what circumstances will the Court accept such questions on the basis that “that there are important and urgent reasons for an immediate determination of such questions by it.”40

Notes 

  1. CA, Inc. v. AFSCME Employees Pension Plan, N o. 329, 2008 (Del. Sup. Ct. July 17, 2008).
  2. In 2007, the Delaware Constitution was amended to authorize the Securities and Exchange Commission to bring critical and urgent questions concerning Delaware law to the Delaware Supreme Court. The amendment is intended to provide the SE C with access to expedited decisions and greater certainty with regards to matters of Delaware corporate law. Previously, only federal courts and other state Supreme Courts were able to certify questions of law to Delaware’s Supreme Court. 76 Del. Laws 2 007, ch 37 , §1, effective M ay 3, 2007.
  3. CA, Inc. v. AFSCME Employees Pension Plan, N o. 329, 2008 at 17.
  4. CA, Inc. v. AFSCME, at 17.
  5. CA, Inc. v. AFSCME, at 19.
  6. CA, Inc. v. AFSCME, at 23.
  7. Rule 14a-8 provides the circumstances under which a company must include a shareholder’s proposal in its proxy statement and identify the proposal in its form of proxy when the company holds an annual or special meeting of shareholders. In order to be eligible to submit a proposal, a shareholder must have continuously held at least $2,000 in market value, or 1%, of the company’s securities entitled to be voted on the proposal at the meeting for at least one year by the date the proposal is submitted and must continue to hold those securities through the date of the meeting. Under specified circumstances, the company is permitted to exclude the shareholder’s proposal from its proxy statement and the related proxy card, but only after submitting its reasons to the SEC and requesting a no-action letter from the Staff of the SE C that it would not recommend enforcement action to the SE C if the proposal was excluded for the stated reasons.
  8. Letter from Gerald W . McEntee, Chairman, the American Federation of State, County and Municipal Employees, to CA, Inc., attaching a shareholder proposal pursuant to Rule 14a-8 of the Securities Exchange Act of 1934 (March 13, 2008) at 2.
  9. McEntee Letter, at p.2
  10. Letter from Sullivan & Cromwell LLP, on behalf of CA, Inc., to the Office of the Chief Counsel, Division of Corporation Finance, Securities and Exchange Commission (April 18, 2008).
  11. Sullivan & Cromwell Letter, at 8 - 9.
  12. Sullivan & Cromwell Letter, at 3 - 6.
  13. Sullivan & Cromwell Letter, at 6 - 8.
  14. Sullivan & Cromwell Letter, at 6 - 8.
  15. Response of the Office of Chief Counsel of the SEC’s Division of Corporation Finance of the SE C (June 27, 2008).  
  16. Section 109(a) of the DGCL provides as follows: “The original or other bylaws of a corporation may be adopted, amended or repealed by the incorporators, by the initial directors if they were named in the certificate of incorporation, or, before a corporation has received any payment for any of its stock, by its board of directors. After a corporation has received any payment for any of its stock, the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote, or, in the case of a nonstock corporation, in its members entitled to vote; provided, however, any corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors or, in the case of a nonstock corporation, upon its governing body by whatever name designated. The fact that such power has been so conferred upon the directors or governing body, as the case may be, shall not divest the stockholders or members of the power, nor limit their power to adopt, amend or repeal bylaws.”
  17. CA, Inc. v. AFSCME Employees Pension Plan, N o. 329, 2008, at 6.  
  18. Legal O pinion Letter of Richards, Layton & Finger to CA, Inc. (April 17, 2008), at 3.  
  19. CA, Inc. v. AFSCME Employees Pension Plan, N o. 329, 2008, at 11.  
  20. CA, Inc. v. AFSCME, at 14.  
  21. CA, Inc. v. AFSCME, at 12.  
  22. CA, Inc. v. AFSCME, at 14.
  23. CA, Inc. v. AFSCME, at 15.
  24. CA, Inc. v. AFSCME, at 15 -16.
  25. CA, Inc. v. AFSCME, at 16.
  26. CA, Inc. v. AFSCME, at 17.
  27. CA, Inc. v. AFSCME, at 17.
  28. CA, Inc. v. AFSCME, at 14.
  29. CA, Inc. v. AFSCME, at 19 - 20.
  30. CA, Inc. v. AFSCME, at 23.
  31. CA, Inc. v. AFSCME, at 24.
  32. CA, Inc. v. AFSCME, at 14.
  33. CA, Inc. v. AFSCME, at 17.
  34. CA, Inc. v. AFSCME, at 17.
  35. CA, Inc. v. AFSCME, at 14.
  36. CA, Inc. v. AFSCME, at 12.
  37. CA, Inc. v. AFSCME, at 14.
  38. CA, Inc. v. AFSCME, at 17.
  39. CA, Inc. v. AFSCME, at 15.
  40. Article IV, Section 11(8), of the Constitution of the State of Delaware. 76 Del. Laws. 2 007, ch. 37 §1