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CA v. AFSCME: Precommitments

In recent years, the Delaware supreme court (and, in fairness, the chancery court) has painted itself intosomething of a corner.

In Quickturn Design Sys., Inc. v. Mentor Graphics Corp., 721 A.2d 1281 (Del. 1998), the Delaware supreme court invalidated a so-called no hand poison pill. According to the court’s opinion, Delaware law “requires that any limitation on the board’s authority be set out in the” articles of incorporation. The no hand pill limited a newly elected board’s authority by precluding redemption of the pill—and thereby precluding an acquisition of the corporation—for six months. Consequently, the no hand pill tended “to limit in a substantial way the freedom of [newly elected] directors’ decisions on matters of management policy.” Accordingly, it violated “the duty of each [newly elected] director to exercise his own best judgment on matters coming before the board.” Absent express authorization of such a limitation in the articles, the no hand pill was invalid as beyond the board’s authority.

Notice that there are two distinct doctrines at play here. First, as in Quickturn, a claim that Delaware General Corporation Law section 141(a) “requires that any limitation on the board’s authority be set out in the” articles of incorporation. Second, as implied in Quickturn and confirmed in Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003), the supreme court has imposed on directors “a continuing fiduciary obligation,” in that case with respect to a sale of the company.  Hence, the court explained, the board must “discharge its fiduciary duties at all times” even “as circumstances change.” In dissent, Justice Steele aptly criticized the majority for adopting “proscriptive rules that invalidate or render unenforceable precommitment strategies negotiated between two parties to a contract who will presumably, in the absence of conflicted interest, bargain intensely over every meaningful provision of a contract after careful cost benefit analysis.”

As Steele’s dissent points out, the Delaware court has made it tough for corporate directors to use precommitment strategies by which the board of directors commits in advance to a particular strategy.

The validity of precommitment strategies is a potential issue in the CA v. AFSCME case. The bylaw amendment proposed by AFSCME basically commits the board of directors and shareholders to reimburse a successful dissident who conducts a proxy contest.

Lisa Fairfax reports that the issue came up in oral argument:

… counsel for CA argued that the by-law provision improperly took away directors’ discretion to determine whether the payment of expenses in any particular instance would be inconsistent with directors’ fiduciary obligation.  This conversation focused on the hypothetical situation of a successful candidate who runs exclusively for personal reasons.  At one point there seemed to be some type of consensus building for the notion that payment of such a candidate’s expenses would violate a director’s fiduciary obligations, prompting justices to ask why it made sense to approve a by-law provision that could lead to a director violating her fiduciary duty.  However, as the conversation evolved, two counter arguments were raised.  First, counsel for AFSCME contended that since the by-law provision was mandatory, it did not implicate a director’s fiduciary duty because it did not involve the exercise of any judgment.  Second, it was suggested that the relevant inquiry for fiduciary duty purposes was not whether a particular payment violated a director’s duty, but rather if a directors’ rationale for approving the by-law itself comported with her fiduciary responsibilities.  On this question, Justice Berger asked whether or not it would be appropriate for a director to decide that it was in the best interest of the corporation to reimburse proxy expenses because such a reimbursement could facilitate people running for the board.  In addition, there was some discussion regarding the impact of the fact that any expenses paid had to be “reasonable.” That is, could it be argued that a payment that would violate a director’s fiduciary duty would not be reasonable?  If so, then the fact that the by-law provision only mandated the payment of “reasonable” expenses may do away with any concerns regarding a director’s fiduciary duty in making the payment.

I’m not a fan of this bylaw, but I think the Delaware court needs to take advantage of this case to clarify the extent to which boards of directors may use precommitment strategies. (See generally my article Precommitment Strategies in Corporate Law: The Case of Dead Hand and No Hand Pills, 29 Journal of Corporation Law 1 (2003).)

In The Odyssey, Homer tells a classic story of using a precommitment strategy to achieve a desired goal. Circe warned Odysseus that his course would lead him past the Sirens, whose song famously enchanted all who passed near them. Once trapped, the passerby would be warbled to death by the sweetness of their song. Following Crice’s advice, Odysseus adopted a plan by which he would be able to hear the Sirens’ song but still escape their trap. Odysseus charged his men to lash him to the mast of their boat and not to release him until they were far beyond the Sirens. Odysseus then stopped up his sailor’s ears with beeswax, so they could hear nothing. As his ship passed the Sirens, their song overwhelmed Odysseus’ will power and he tried desperately to get his men to approach the Sirens. Unable to hear the song, and thus being free of its enchantment, however, his men merely tied him even more tightly to the mast and sailed on. Only once they were safely past the Sirens did they release Odysseus.

Homer’s tale illustrates the use of a precommitment strategy to solve the problems known to behavioral economists as time inconsistent discount rates and multiple selves.  The discount rate an individual applies when making net present value calculations often declines as the date of the reward recedes. Professors Korobkin and Ulen offer the following example: “Suppose that an individual is to choose between Project A, which will mature in nine years, and Project B, which will mature in ten years. Suppose, further, that an individual who compares the two projects across all their different dimensions prefers Project B to A. Now suppose that we bring the dates of maturity of the two projects forward while maintaining the one-year difference in their maturity dates. Because discount rates increase as maturity dates get closer, it is possible that the individual’s preference will switch from Project B to Project A as the dates of maturity decline (but preserving the one-year difference).” One effect of time inconsistent discount rates is that people “always consume more in the present than called for by their previous plans.”

The somewhat related multiple selves phenomenon posits that individuals do not have a single utility function, but rather multiple competing utility functions. Because each “self” orders preferences differently, there is an ever-present risk that the self predominating at a given moment may make decisions not in the complete individual’s best interest. Again, Korobkin and Ulen explain: “A stiff tax on cigarettes, to take an obvious example, can be viewed as aiding the future-oriented self in its battle with a more present-oriented self that values immediate gratification over long-term health. . . . Today’s self can attempt to make commitments that either will completely bind tomorrow’s self or, at least, raise the cost of taking action that today’s self wishes to avoid.” In Homer’s tale, Odysseus had himself lashed to the mast precisely so that his present-oriented self could not satisfy its desire to prolong exposure to the Sirens’ song. Being lashed to the mast was a precommitment strategy by which he avoided making an unwise decision in the future. Hence, Odysseus privileged the desires of his farsighted “planner” self, who was concerned with lifetime utility, over those of his myopic and selfish “doer” self. Bank Christmas Clubs are predicated on the same idea. By prohibiting the withdrawal of funds until late November, Christmas Clubs prevent people from acting on hyperbolic discounting proclivities, and assure the future availability of funds to pay for Christmas presents. In general, precommitment strategies are desirable because they disempower the myopic “doer” self. As such, “people rationally chose to impose constraints on their own behavior.”

Accordingly, there are many situations in which both individuals and organizations make enforceable precommitments.  Such precommitments are beneficial because they protect ourselves against passion and time inconsistency. In using contractual devices to make a precommitment, the incumbent board likewise binds itself—and future boards—to a particular strategy. In striking down the dead hand and no hand poison pills on authority grounds, the Delaware courts seemingly have limited the use of such precommitment strategies by adopting a broad principle that boards have an ongoing duty to constantly re-evaluate their decisions.

Boards commonly enter into contracts limiting their future authority to varying degrees. Bond indentures commit the board to long-term obligations that will continue to bind future boards for many years. To be sure, the constraint on the authority of future boards is relatively modest, as such boards could always choose to breach the contractual obligations imposed by the indenture, but it nevertheless remains the case that their authority has been constrained.

Merger agreements likewise commonly contain provisions by which the board of directors binds itself to particular courses of conduct. A best efforts clause, for example, obliges the target’s board to use its “best efforts” to consummate the transaction. No shop clauses prohibit the target corporation from soliciting a competing offer from any other prospective bidders. The no negotiation covenant, a variant on the no shop theme, goes further to prohibits negotiations with unsolicited bidders.

Fair price shark repellents commonly include continuing director provisions. Like the dead hand pill, the continuing director provision of a fair price shark repellent allows a bid to go forward only if approved by those members of the board of directors who were on the board when the acquirer first triggered the defensive provision. If the fair price shark repellent was included in the articles of incorporation, rather than the bylaws, it might satisfy the supreme court’s view that “any limitation on the board’s authority be set out in the” articles of incorporation.  Query, however, whether a typical fair price provision would contain language explicitly authorizing a limitation of the board’s authority and whether the Delaware courts would require an explicit statement to that effect.

All such corporate actions would be vulnerable to an authority-based challenge if the supreme court’s reference to “any limitation on the board’s authority” is to be taken literally. Yet, if the word “any” is not to be taken literally, where is the firebreak between permissible and impermissible limitations? A better solution to the problem would begin with the sweeping grant of authority made by DGCL § 141(a): “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors . . . .” To be sure, DGCL § 141(a) authorizes such exceptions to the board’s authority as may set forth in the statute or the corporation’s articles of incorporation. But why read that authorization as a negative prohibition of self-imposed limitations?

In fact, the most plausible reading of DGCL § 141(a) is that the statute simply does not address the problem at hand. In pertinent part, the statute provides: “If any such provision is made in the certificate of incorporation, the powers and duties conferred or imposed upon the board of directors by this chapter shall be exercised or performed to such extent and by such person or persons as shall be provided in the certificate of incorporation.” This language clearly reflects a concern with the special problems of close corporations, whose articles often include provisions allowing the corporation’s shareholders to run the firm as though it were a partnership. Taken as a whole, DGCL § 141(a)’s language regarding exceptions to the board’s authority is concerned with ensuring the validity of such close corporation governance provisions. On its face, nothing in the statute compels a conclusion that the board cannot create self-imposed limitations on its authority.

As for the pernicious doctrine of a continuing fiduciary duty to constantly reassess prior commitments, it ought to be taken out in the courtyard and have a stake driven through its heart. Then the corpse ouught to be burnt and the ashes scattered to the wind. It simply makes no sense.

In Phelps Dodge Corp. v. Cyprus Amax Minerals Co., for example, Chancellor Chandler opined that no shop clauses “are troubling precisely because they prevent a board from meeting its duty to make an informed judgment with respect to even considering whether to negotiate with a third party.” But this begs the question of why the board cannot make an informed decision to tie itself to the mast. Suppose the board of directors makes an informed decision that the merger proposal on the table is the best deal they are likely to get for their shareholders and that granting a no shop clause is necessary and appropriate to induce the prospective acquirer to make a formal bid. The board recognizes that a no shop clause will impede its ability to negotiate with any competing bidders who subsequently emerge, but the board decides to accept that risk and go forward. In doing so, the board relies on the old adage that a bird in the hand is worth two in the bush. So long as the decision to enter into the no shop clause was an informed one, why should a board of directors have an on-going fiduciary duty to constantly reevaluate its decision?