Professor Bainbridge...on law, politics, religion, culture & food

CA v AFSCME: DGCL § 109 versus § 141

Lisa Fairfax reports that the oral argument in CA v. AFSCME raised interesting issues with respect to mandatory bylaws:

First, counsel for CA appeared to be arguing that the fact that the by-law was mandatory and unqualified violated Delaware law because, by requiring the reimbursement of all successful candidates, it improperly took away directors’ discretion to determine how to allocate corporate funds.  Indeed, counsel indicated that the by-law would be improper even if the board approved it.  When they were questioned on this issue, counsel for AFSCME insisted that such mandatory payments did not violate Delaware law, but instead were consistent with other forms of payments required to by made by the corporation such as those indemnifying directors and officers.  Related to this issue was a conversation about whether a distinction should be made between provisions in the by-law and those in the charter.

Second, 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.

JW Verret reports that Counsel for CA argued that:

As a mandated payment of expenses it relates to control of the corporate treasury, part of the business and affairs of the corporation as defined in Rule 141(a). As such, limitations on the Board’s authority may only appear in its Certificate of Incorporation, not its bylaws. Second, he argued that the Board must be permitted to make a determination of whether a reimbursement was consistent with its fiduciary duty, where this bylaw mandated payment under all circumstances.

Verret also reports that both counsel “skillfully argued that the Court need not permanently resolve any looming contradiction between section 109 and section 141(a) to rule in their favor.”

I don’t see how the court can avoid the issue. The bylaw purports to mandate board action, including board action that might violate its fiduciary duties. There is a clear conflict with the grant of power under DGCL § 141(a).

Delaware General Corporation Law ("DGCL") § 109(b) imposes an important limitation on the otherwise sweeping scope of permissible bylaws:

“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.”

Clear conflicts between the statute or articles and the bylaws present little difficulty. But what if the bylaw nominally complies with the letter of the law, but conflicts with its spirit?

The critical issue here is whether shareholder-adopted bylaws may limit the board of directors’ discretionary power to manage the corporation. There is an odd circularity in the Delaware code with respect to this issue. On the one hand, DGCL § 141(a) provides that “[t]he business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors.” A bylaw that restricts the board’s managerial authority thus seems to run afoul of DGCL § 109(b)’s prohibition of bylaws that are “inconsistent with law.” On the other hand, DGCL § 141(a) also provides that the board’s management powers are plenary “except as may be otherwise provided in this chapter.” Does an otherwise valid bylaw adopted pursuant to § 109 squeeze through that loophole?

In Teamsters v. Fleming Companies, 975 P.2d 907 (Okla. 1999), the Oklahoma supreme court upheld a bylaw limiting the board of directors’ power to adopt a poison pill (a type of corporate takeover defense). The bylaw provided:

“The Corporation shall not adopt or maintain a poison pill, shareholder rights plan, rights agreement or any other form of ‘poison pill’ which is designed to or has the effect of making acquisition of large holdings of the Corporation’s shares of stock more difficult or expensive… unless such plan is first approved by a majority shareholder vote. The Company shall redeem any such rights now in effect.”

The board argued that shareholders could not adopt a bylaw imposing such mandatory limitations on the board’s discretion. The court rejected that argument. Absent a contrary provision in the articles of incorporation, shareholders therefore may use the bylaws to limit the board’s managerial discretion.

Although the relevant Oklahoma and Delaware statutes are quite similar, dicta in at least one Delaware chancery court opinion is inconsistent with Fleming. In General DataComm Industries, Inc. v. State of Wisconsin Investment Board, 731 A.2d 818, 821 n.2 (Del. Ch. 1999), Vice Chancellor Strine observed:

“[W]hile stockholders have unquestioned power to adopt bylaws covering a broad range of subjects, it is also well established in corporate law that stockholders may not directly manage the business and affairs of the corporation, at least without specific authorization either by statute or in the certificate or articles of incorporation. There is an obvious zone of conflict between these precepts: in at least some respects, attempts by stockholders to adopt bylaws limiting or influencing director authority inevitably offend the notion of management by the board of directors. However, neither the courts, the legislators, the SEC, nor legal scholars have clearly articulated the means of resolving this conflict and determining whether a stockholder-adopted bylaw provision that constrains director managerial authority is legally effective.”

The Vice Chancellor is doubtless correct that there is no clear doctrinal answer under Delaware law. Yet, the relevant policy considerations are quite straightforward.

Analysis must begin with the basic principle that shareholders do not own the corporation. Instead, they are merely one of many corporate constituencies bound together by a complex web of explicit and implicit contracts. As such, the normative claims associated with ownership and private property are inapt in the corporate context. (This is known as the nexus of contracts model of the corporation.)

The directors thus are not agents of the shareholders subject to the control of the shareholders. To be sure, shareholders elect the board and exercise certain other control rights through the franchise. Yet, shareholder voting is not an integral part of the corporate decision-making apparatus. Although corporate law grants shareholders exclusive electoral rights, those rights are quite limited. Instead, shareholder voting is merely one accountability mechanism among many—and one to be used sparingly at that. Put another way, the board of directors functions as a sort of Platonic guardian—a sui generis body that serves as the nexus for the various contracts making up the corporation. The board’s powers flow from that set of contracts in its totality and not just from shareholders. The board’s exercise of its discretionary authority therefore may not be unilaterally limited by any corporate constituency, including the shareholders.

This model is not inconsistent with the spirit of Delaware corporate law. As the Delaware Supreme Court recently opined:

“One of the most basic tenets of Delaware corporate law is that the board of directors has the ultimate responsibility for managing the business and affairs of a corporation. Section 141(a) requires that any limitation on the board’s authority be set out in the certificate of incorporation.” Quickturn Design Systems, Inc. v. Shapiro, 721 A.2d 1281, 1291 (Del. 1998).

Note that, read literally, this dictum clearly precludes the result reached in Fleming.

The board’s primacy has a compelling economic justification. The separation of ownership and control mandated by corporate law is a highly efficient solution to the decision-making problems faced by large corporations. Because collective decision-making is impracticable in such firms, they are characterized by authority-based decision-making structures in which a central agency (the board) is empowered to make decisions binding on the firm as a whole.

To be sure, this separation of “ownership” and control results in agency costs. Those costs, however, are the inevitable consequence of vesting discretion in someone other than the residual claimant. We could substantially reduce, if not eliminate, agency costs by eliminating discretion; that we do not do so confirms that discretion has substantial virtues. Given those virtues, one ought not lightly interfere with management or the board’s decision-making authority in the name of accountability.

This line of argument explains much of corporate law. It is the principle behind such diverse doctrines as the business judgment rule, the limits on shareholder derivative litigation, the limits on shareholder voting rights, and the board’s power to resist unsolicited corporate takeovers. Here it justifies strong skepticism as to the validity of shareholder-adopted bylaws that restrict management discretion. Indeed, absent an express statutory command to the contrary, courts should invalidate such bylaws.

For more on the validity of such bylaws, see pages 45-48 of my CORPORATION LAW AND ECONOMICS text. For more on director primacy, see my THE NEW CORPORATE GOVERNANCE IN THEORY AND PRACTICE.