Corporate Governance

As Predicted: The SEC and the Further Denial of Shareholder Access (The Myth of Amendments to the Certificate of Incorporation) (Part 13)

By J. Robert Brown

We have been listening to the oral argument in CA v. AFSCME and offer some comments. The oral argument is publicly available and can be found on the Delaware Supreme Court web site.

Some of the discussion indicated that the mandatory reimbursement provisions were better off in the certificate rather than the bylaws, as if this was a good thing for shareholders (by making them more permanent).  Giuffra, counsel for CA, conceded that the language of the bylaw would have been valid if included in the certificate of incorporation. As one Justice characterized:

• “So if the shareholders acting alone that is without concurrent director approval adopt this bylaw your position is that contravenes Delaware law. Similarly, if the directors were to do the same thing that would contravene Delaware law. But if the directors and the shareholders acting together voted to adopt this bylaw but as part of the certificate of incorporation that would be alright.”

Giuffra agreed with the characterization but disagreed that the "difference is purely formal." Nonetheless, the position got traction among some on the Court. Thus, the following exchange occurred:

• JUSTICE: "So if you want something that’s authoritative and more permanent you put it in a constitution or you put it in the certificate of incorporation. Not a bylaw, not a statute.”
• COUNSEL: "That’s correct. Because the majority of the moment could enact a bylaw and tie the board’s hands and actually to the detriment of the minority shareholders which would be one of the vices we would see in this particular bylaw.”

In other words, some on the Court seemed to take solace from the fact that even if they struck down the bylaw they were not precluding the use of mandatory reimbursement bylaws, only requiring that they be in the certificate. But if this is the way the Court comes out, it will as a practical matter be the death knell for the provisions.

The idea that somehow the certificate is a "contract" (a term used repeatedly throughout the oral argument) that is subject to negotiation between shareholders and directors is a fiction. As we point out in Opting Only In: Contractarians, Waiver of Liability Provisions and the Race to the Bottom, management entirely dominates the process of drafting and amending the certificate. Amendments cannot be introduced by shareholders, only managers. Managers, therefore, introduce what they want, not what shareholders want. Moreover, as the paper empirically shows, management drafts the amendments and uses language most advantageous to its own interests.

In the area of waiver of liability provisions, essentially all companies in the top 100 had them (Pepsi a notable example) and all of them waived liability to the fullest extent permitted by law. In other words, the article provisions showed none of the diversity that would occur if there was really some back and forth process with shareholders or the compromises that is sometimes supposedly necessary to obtain shareholder approval.

The same will happen with respect to reimbursement provisions.  It stands to reason that boards will have no incentive to propose amendments to the certificate that would provide for mandatory reimbursement of shareholders who run a competing slate.

The second point is that much was made during the argument by Giuffra that this bylaw could disadvantage minority shareholders.

• “Because the majority of the moment could enact a bylaw and tie the board’s hands and actually to the detriment of the minority shareholders which would be one of the vices we would see in this particular bylaw.”

But a bylaw can be changed with relative ease, particularly where the board has the authority to adopt and repeal bylaws.  On the other hand, Giuffra's contention that the bylaw could be inserted into the certificate raises the same problem and poses a solution even worse for minority shareholders.  The amendment to the articles can pass with a majority of shares voting for it, over the opposition of minority shareholders.  Moreover, once in the articles, the minority shareholders would have no ability to repeal the provision since they cannot propose amendments to the articles.  Thus, Giuffra accepts that the bylaw could be harmful (a vice, actually) but proposes that the vice be permanent rather than temporary.

The primary materials, including the briefs, are posted on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on July 15, 2008 (boomark / email).