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Director Primacy and Bylaws

In reviewing my work on director primacy, a friend recently noted that I haven’t had much to say about bylaws. This may eventually be article-worthy, but at the moment it’s at least blog worthy.

Bylaws are the rules a corporation adopts to govern its internal affairs. Bylaws tend to be far more detailed than the articles of incorporation, for three reasons: (1) bylaws need not be filed with the state government, which means they are not part of any public record; (2) bylaws are more easily amended than articles of incorporation (see below); and (3) officers and directors tend to be more familiar with bylaws than with the articles, which makes them a ready repository of organizational rules. In the event of a conflict between a bylaw and the articles, the latter controls.

The bylaws typically deal with such matters as number and qualifications of directors, board vacancies, board committees, quorum and notice requirement for shareholder and board meetings, procedures for calling special shareholder and board meetings, any special voting procedures, any limits on the transferability of shares, and titles and duties of the corporation’s officers.

Adoption and amendment

The corporation’s initial bylaws are adopted by the incorporator or the initial directors at the corporation’s organizational meeting. At early common law, only shareholders had the power to amend the bylaws. Many states thereafter adopted statutes allowing shareholders to delegate the power to amend the bylaws to the board of directors. DGCL § 109(a) typifies this approach: It provides that only shareholders have the power to amend bylaws, unless the articles of incorporation expressly confer that power on the board of directors. An article provision authorizing the board to amend the bylaws, moreover, does not divest the shareholders of their residual power to amend the bylaws.

In contrast, the MBCA reflects a modern trend of vesting the power to amend the bylaws in both the directors and the shareholders. MBCA § 10.20(b) allows the directors to amend the bylaws unless (1) the articles of incorporation give that power solely to the shareholders or (2) the shareholders amend the bylaw in question and provide that the directors cannot thereafter further amend the bylaw. By implication, MBCA § 10.20(a) authorizes the shareholders to amend the bylaws even though the directors also have that power. Notice that amendment of the bylaws is one of the few corporate actions the shareholders are entitled to initiate. Unlike the articles of incorporation, where an amendment must first be recommended by the board, no prior board action is required on a bylaw amendment. As a practical matter, however, in public corporations, shareholders must rely on SEC Rule 14a-8, which authorizes inclusion of shareholder-initiated proposals in the company’s proxy statement, to effect a bylaw amendment.

The concurrent power of both shareholders and boards to amend the bylaws raises the prospect of cycling amendments and counter-amendments. Suppose the shareholders adopted a bylaw limiting the number of terms a board member can serve. Disliking that limitation, the board repeals the new bylaw provision using its concurrent power to amend the bylaws. The MBCA allows the shareholders to forestall such an event. As noted, MBCA § 10.20(b)(2) authorizes the board to adopt, amend, and repeal bylaws unless “the shareholders in amending, repealing, or adopting a bylaw expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw.” In the absence of such a restriction, however, the board apparently retains its power to amend or even repeal the bylaw. If the board does so, the shareholders’ remedies presumably are limited to readopting the term limit amendment, this time incorporating the necessary restriction, and/or electing a more compliant board.

Delaware § 109 is more problematic, as it lacks any comparable grant of power to the shareholders. Worse yet, because the board only has power to adopt or amend bylaws if that power is granted to it in the articles of incorporation, a bylaw prohibiting board amendment would be inconsistent with the articles and, therefore, invalid. In American Int’l Rent a Car, Inc. v. Cross, 1984 WL 8204 (Del. Ch. 1984), the Delaware chancery court suggested that, as part of a bylaw amendment, the shareholders “could remove from the Board the power to further amend the provision in question.” Dicta in several other Delaware precedents, however, is to the contrary. In General DataComm Industries, Inc. v. State of Wisconsin Investment Board, for example, Vice Chancellor Strine noted the “significant legal uncertainty” as to “whether, in the absence of an explicitly controlling statute, a stockholder-adopted bylaw can be made immune from repeal or modification by the board of directors.” In Centaur Partners, IV v. National Intergroup, Inc., 582 A.2d 923, 929 (Del. 1990), the Delaware supreme court addressed a shareholder-proposed bylaw limiting the number of directors. As proposed, the bylaw contained a provision prohibiting the board from amending or repealing it. Noting that the corporation’s articles gave the board authority to fix the number of directors through adoption of bylaws, the supreme court opined that the proposed by law “would be a nullity if adopted.” Consequently, it seems doubtful that restrictions on the board’s power over the bylaws will pass muster in Delaware or other states likewise lacking a MBCA-style provision.

On the other hand, board amendments to bylaws adopted by the shareholders may run afoul of the Delaware supreme court’s famous holding in Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437, 439 (Del. 1971), that “inequitable action does not become permissible merely because it is legally possible.” To be sure, Schnell dealt with a slightly different problem. The board had amended the bylaws to change the date of the corporation’s annual meeting, which was a legally permissible amendment, for the equitably impermissible purpose of defeating a proxy contest in which insurgent shareholders sought to oust the incumbent board. Yet, many courts have applied the principle in a variety of contexts. Under Schnell, a court thus likely would examine the purpose for which the board amended or repealed the shareholder-adopted bylaw. If the board did so to disenfranchise shareholders and/or entrench itself in office, for example, the action likely would not pass muster. Cf. Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) (invalidating board action undertaken “for the primary purpose of preventing the effectiveness of a shareholder vote”). See also Coalition to Advocate Public Utility Responsibility, Inc. v. Engels, 364 F. Supp. 1202 (D. Minn. 1973) (holding that otherwise lawful board action becomes impermissible if undertaken in the midst of an election campaign for the purpose of obstructing a legitimate effort by dissident shareholders to obtain board representation).

Legality

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.

MBCA § 2.06(b) contains a comparable limitation.

Clear conflicts between the statute or articles and the bylaws present little difficulty. What if the bylaw nominally complies with the letter of the law, but conflicts with its spirit, however? As noted in the preceding section, Delaware courts not infrequently invoke the equitable doctrine that legally permissible actions nevertheless can be barred if undertaken for improper purposes. In a variety of settings, Delaware courts therefore have reviewed bylaws to determine whether they have a permissible purpose. See generally Allen v. Prime Computer, Inc., 540 A.2d 417 (Del. 1988) (holding that court may review reasonableness of a bylaw); In re Osteopathic Hospital Ass’n, 191 A.2d 333 (Del. Ch. 1963) (holding with respect to nonprofit corporation that “a bylaw which is unreasonable, unlawful, or contrary to public policy may be declared void though adopted by legitimate procedures”); see, e.g., Allen v. Prime Computer, Inc., 540 A.2d 417 (Del. 1988) (invalidating bylaw intended to impede use of written consents by shareholders); Frantz Manufacturing Co. v. EAC Industries, Inc., 501 A.2d 401 (Del. 1985) (upholding shareholder-adopted bylaws intended to prevent disenfranchisement of majority shareholder); Datapoint Corp. v. Plaza Securities Co., 496 A.2d 1031 (Del. 1985) (invalidating board-adopted bylaw intended to impede use of written consents by shareholders); Phillips v. Insituform of North America, Inc., 1987 WL 16285 (Del. Ch. 1987) (granting preliminarily injunction against board-adopted bylaws intended to prevent one class of shareholders from controlling corporation); see also AHI Metnall, L.P. v. J.C. Nichols Co., 891 F. Supp. 1352 (W.D. Mo. 1995) (granting a preliminary injunction to plaintiffs who argued that a board-adopted bylaw imposing a 20% shareownership requirement for proposing board candidates or other business at a shareholder meeting was an unreasonable response to a pending takeover bid); Coalition to Advocate Public Utility Responsibility, Inc. v. Engels, 364 F. Supp. 1202 (D. Minn. 1973) (invalidating board-adopted bylaws intended to block election of minority director).

A 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. Complete exposition of those policies would anticipate material to be covered in subsequent chapters, but a brief summary here seems useful.

Analysis must begin with the basic precepts of the contractarian model. 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. See generally my article, The Board of Directors as Nexus of Contracts, 88 Iowa Law Review 1 (2002).

In this model, 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. See generally my article, The Case for Limited Shareholder Voting Rights, 53 UCLA Law Review 601 (2006).

This model is not inconsistent with the spirit of Delaware corporate law. As the Delaware supreme court opined in Quickturn Design Systems, Inc. v. Shapiro, 721 A.2d 1281, 1291 (Del. 1998):

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.

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. Recall that 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. See generally my article, Director Primacy: The Means and Ends of Corporate Governance, 97 Northwestern University Law Review 547 (2003).

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.

A useful analogy may be drawn to shareholder agreements that restrict board discretion. At one point, such agreements were per se invalid. See, e.g., McQuade v. Stoneham, 189 N.E. 234 (N.Y. 1934). The modern trend is to allow such agreements, but only in close corporations. See, e.g., MBCA § 7.32; Galler v. Galler, 203 N.E.2d 577 (Ill. 1964).

All of these problems would go away if state corporation codes treated bylaws the same way as articles of incorporation or, for that matter, virtually every other corporate action. The shareholder power to initiate bylaw amendments without prior board action is unique. It is also a historical anachronism states unthinkingly codified from old common law principles lacking either rhyme or reason. There simply is no good reason to treat bylaws differently than articles of incorporation.