Regime Change and the SEC's Corporate Governance Agenda: #6 Disavow Delaware Referral Authority

Perhaps the only lasting legacy of Paul Atkins, a commissioner relentlessly hostile to shareholder interests (he opposed access) and strong enforcement (particulary his antagonism towards the imposition of penalites on companies), was to induce the Commission to refer the legality of a shareholder proposal to the Delaware Supreme Court.  It occurred in CA v. AFSCME.

The decision, involving a shareholder proposal under Rule 14a-8, was predictably disastrous for two reasons.  First, it allowed state courts to have some say in the SEC's interpretation of its own rules.  Second, and more importantly, it was all but designed to reduce the rights of shareholders.  The outcome was predictable (the Delaware Court would rule in favor of management).  The result was that an agency ostensibly charged with the responsibility of looking out for the interests of shareholders did the opposite. 

The issue involved the use of authority set out in Delaware law.  Supreme Court Rule 41 provides that the Securities and Exchange Commission "may, on motion or sua sponte, certify to this Court for decision a question or questions of law arising in any matter before it prior to the entry of final judgment or decision if there is an important and urgent reason for an immediate determination of such question or questions by this Court and the certifying court or entity has not decided the question or questions in the matter."

The certification invovled a shareholder proposal submitted by AFSCME.  The proposal would have required the payment of reimbursement expenses in a proxy contest but only where the insurgent nominated a short slate of directors and one or more members of the slate actually won.  The staff in the past refused to allow such proposals to be excluded.  This time, however, the Commission asked the Delaware Supreme Court whether the proposal violated state law.

The outcome was predictable.  This could be seen first by the fact that the Court violated its own rule in accepting the certified question.  Second, the reasoning used by the Court was likely to be pro-management, even if the conclusion required legal legerdemain.  In fact, the Supreme Court did exactly that, writing an opinion that deliberately ignored outcome determinative issues that favored shareholders. 

The Court ultimately held that the proposal violated state law because it did not have a "fiduciary out."  The board needed to have the authority to deny the payment of expenses "where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not further, or are adverse to, those of the corporation."

In so holding, the Court completely ignored the argument that the motive for the contest was rendered irrelevant by the actual election of the director, a precondition for reimbursement under the AFSCME proposal.  The Court also ignored the board's existing authority to repeal the bylaw if it would have resulted in a violation of fiduciary obligations.  Counsel for AFSCME conceded that the reimbursement bylaw could be repealed by the board if repeal was consistent with the board's fiduciary duties.  Finally, the proposal provided for reimbursement of "reasonable" expenses.  The Court completely ignored the argument that payments in violation of fiduciary obligations were not reasonable.   These were all arguments raised in briefs or at the oral argument.  Yet the Court did not address any of them in its opinion.

The decision provides companies with additional ammunition in efforts to omit shareholder proposals under Rule 14a-8.  While it will have the clearest impact on proposals concerning the reimbursement of proxy expenses, it is likely to extend into other areas such as the mandatory removal of poison pills.

With regime change, the Commission should make it clear that the days of referring questions to the Delaware Supreme Court for anti-shareholder opinions on the legality of proposals are over.