Del. court responds to SEC’s first certified questions

By William D. Johnston
Published: September 29, 2008

My July 2007 article in Atlantic Coast In-House described then-recent amendments to the Delaware State Constitution and the Rules of the Delaware Supreme Court that would permit the Securities and Exchange Commission to certify questions of law to the Delaware Supreme Court.

The article ended with a question: When would the SEC accept the invitation and how would the process unfold?

That question was answered recently when the Commission certified two questions of law to the Supreme Court, which the court answered en banc in CA, Inc. v. AFSCME Employees Pension Plan, 2008 Del. LEXIS 329 (July 17, 2008).

In CA, the SEC posed two questions of Delaware law regarding a proposed bylaw submitted by the AFSCME Employees Pension Plan for inclusion in the proxy materials of CA, Inc. for the company’s 2008 annual stockholders’ meeting.

Notable were the Supreme Court’s rapid handling of the SEC’s inquiry, the substance of the court’s response, and the fact that the decision was unanimous (5-0).

On the process side, the SEC made its request on June 27. The court accepted certification on July 1 and, after expedited briefing, the matter was argued on July 9.

The court issued its decision on July 17.

All of this was against a backdrop of the scheduling of the CA annual meeting for Sept. 9, and of CA’s intention to file its definitive proxy materials with the SEC on July 24.

As to the substance of the court’s decision, at issue was whether the AFSCME bylaws proposal was a proper subject for action by shareholders as a matter of Delaware law, and, whether the proposal, if adopted, would violate any Delaware law.
The Supreme Court answered both questions in the affirmative.

Background

The proposal by AFSCME (a CA stockholder) would have amended the company’s bylaws to provide that the CA board of directors would cause the company to reimburse a stockholder or group of stockholders for reasonable expenses incurred in nominating one or more candidates in a contested election to the board of directors where: (a) the election of fewer than 50 percent of the directors to be elected is contested in the election; (b) one or more candidates nominated by the stockholder or group of stockholders are elected to the board; (c) stockholders are not permitted to cumulate their votes for directors; and (d) the election occurred, and the expenses were incurred, after the bylaw’s adoption.

In addition, the proposal provided that the amount of expenses reimbursed would not exceed the amount expended by the company in connection with the election of directors.

CA notified the SEC’s Division of Corporation Finance of its intention to exclude the proposed bylaw from its proxy materials.
In turn, the Division was faced with an opinion from AFSCME’s counsel that took the opposite position. The SEC, at the Division’s request, certified the two questions of law.

Proper subject for shareholder action

The court said the proposed bylaw would be a proper subject for shareholder action, i.e., that it may be proposed and enacted by CA’s shareholders without the concurrence of the company’s board of directors.

Looking to Sections 109 and 141 of the Delaware General Corporation Law and to provisions of the CA certificate of incorporation, the court held that “the shareholders’ statutory power to adopt, amend, or repeal bylaws is not coextensive with the board’s concurrent power and is limited by the board’s management prerogatives.”

The court said it must determine the scope or reach of the shareholders’ power to adopt, alter or repeal the bylaws of a Delaware corporation and, then, whether the bylaw fell within the permissible scope – an inquiry described by the court as an “elusively difficult task” when the proposed bylaw is one that limits director authority.

The court emphasized that its holding was case specific: “[T]hat 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).”

The court found that “the Bylaw, even though infelicitously couched as a substantive-sounding mandate to expend corporate funds, has both the intent and the effect of regulating the process for electing directors of CA.”

Accordingly, the court held that the proposed bylaw was a proper subject for shareholder action.

Importantly, the court commented, “The context of the Bylaw at issue here is the process for electing directors – a subject in which shareholders of Delaware corporations have a legitimate and protected interest.

“The shareholders of a Delaware corporation have the right ‘to participate in selecting the contestants’ for election to the board,” the court continued. “The shareholders are entitled to facilitate the exercise of that right by proposing a bylaw that would encourage candidates other than board-sponsored nominees to stand for election. The Bylaw would accomplish that by committing the corporation to reimburse the election expenses of shareholders whose candidates are successfully elected. That the implementation of that proposal would require the expenditure of corporate funds will not, in and of itself, make such a bylaw an improper subject matter for shareholder action.”

Violation of Delaware law

The Supreme Court considered whether the bylaw, if adopted, would violate any common law rule or precept. Noting that it was required by the certified questions to determine the validity of the proposed bylaw in the abstract, the court said it “must necessarily consider any possible circumstance under which a board of directors might be required to act.”

The court reasoned that, at least under one hypothetical, board members would breach their fiduciary duties if they were to comply with the bylaw.

The hypothetical described by the court was “where the proxy context is motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation, the board’s fiduciary duty could compel that reimbursement be denied altogether.”

The court found that the “reasonableness” language of the bylaw in connection with the amount of expenses to be reimbursed could not be read as reserving to the CA 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.”

Practical upshot

The legal and practical upshot of the court’s decision is that the proposed bylaw could be excluded from the CA proxy statement under SEC Rule 14a-8.

Interestingly, the court on more than one occasion referred to the proposed bylaw “as presently drafted” or as “currently drafted.”

And the court, in footnote 20, detailed how the bylaw “could have been phrased more benignly.” But, in the same footnote, the court emphasized that any such bylaw “would also need to contain a provision that reserves the directors’ full power to discharge their fiduciary duties.”

The court ended its decision with the following: “In arriving at this conclusion, we express no view on whether the Bylaw as currently drafted, would create a better governance scheme from a policy standpoint. We decide only what is, and is not, legally permitted under the DGCL.

“That statute, as currently drafted, is the expression of policy as decreed by the Delaware legislature. Those who believe that CA’s shareholders should be permitted to make the proposed Bylaw as drafted part of CA’s governance scheme, have two alternatives. They may seek to amend the Certificate of Incorporation to include the substance of the Bylaw; or they may seek recourse from the Delaware General Assembly.”

It would seem the first alternative would be the more practicable – amendment of the corporate charter to include the substance of the bylaw. Section 242 of the DGCL would call for the board to first adopt a resolution declaring the advisability of the amendment and providing for consideration of the amendment by stockholders at either a special meeting or an annual meeting. But board members presumably would not object to such an amendment so long as it would include the full reservation of board power to which the court referred in CA.

When the Delaware Constitution and the Rules of the Delaware Supreme Court were modified slightly more than a year ago to permit certification of questions of law by the SEC, General Counsel of the Commission Brian G. Cartwright said, “In our constitutional system, federal and state law coexist side by side, each with its distinctive role. As a result, the administration of the federal securities laws often requires interpretation of state laws. I am delighted that the SEC now has this new ability to obtain definitive answers to important questions of Delaware law.”

Following the CA decision, John W. White, Director of the SEC’s Division of Corporation Finance, said of the certification procedure: “As you can imagine, this is a very useful tool to have as we review the hundreds of no-action requests we receive each year on shareholder proposals. Proposals can be excluded if the proposal is not a proper subject for shareholder action under state law, or it violates state law if implemented. If the staff receives dueling opinions of counsel on state law, we have traditionally deferred to the proponent, but we can now, in appropriate circumstances, go to the source – Delaware – for the answer.”

If Mr. White’s reaction to the CA decision is any indication, the peaceful coexistence of federal and state laws has been furthered by the enhanced certification opportunity.

Virginia Lawyers Weekly

Del. court responds to SEC’s first certified questions

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