Delaware and the Consequences of an Excessively Management Friendly Approach to Corporate Governance (Part 2)
The notion that Section 109 permitted bylaws that regulated judicial (or presumably regulatory) process opened the door to bylaws that went well beyond those that shifted fees.
Nothing in the analysis prohibited a company from adopting a bylaw that, for example, imposed fees on shareholders that submitted an unsuccessful proposal under Rule 14a-8.
Nothing in the analysis prevented the adoption of a bylaw that shortened the time period for a shareholder to answer a counterclaim. None of these areas truly involved the internal affairs of a corporation and were, therefore, beyond the realm of regulation in bylaws. Yet Delaware imposed no such limit.
The results of this approach can be seen from the bylaw adopted by Imperial Holdings. Rather than adopt a fee shifting bylaw, the company adopted a bylaw that restricted derivative actions by shareholders by imposing a minimum ownership threshold to bring an action. As the provison provides:
- Representative Claims. Except where a private right of action at a lower threshold than that required by this bylaw is expressly authorized by applicable statute, a current or prior shareholder or group of shareholders (collectively, a “Claiming Shareholder”) may not initiate a claim in a court of law on behalf of (1) the corporation and/or (2) any class of current and/or prior shareholders against the corporation and/or against any director and/or officer of the corporation in his or her official capacity, unless the Claiming Shareholder, no later than the date the claim is asserted, delivers to the Secretary written consents by beneficial shareholders owning at least 3% of the outstanding shares of the corporation as of (i) the date the claim was discovered (or should have been discovered) by the Claiming Shareholder or (ii), if on behalf of a class consisting only of prior shareholders, the last date on which a shareholder must have held shares to be included in the class.
The provision applies to derivative actions but also apparently applies to federal class action lawsuits under the federal securities laws (since these are brought against the corporation). Moreover, the provision breaks new ground by providing that, as a condition for filing a law suit in state or federal court, plaintiffs must deliver proof of ownership to the company.
According to the company's press release, the bylaw was designed to "ensure that any shareholder filing a lawsuit on behalf of the company or a class of shareholders has a minimum degree of shareholder support and adequately represents shareholders' interests." The company indicated that the bylaw would be submitted "to shareholders for ratification at the next annual meeting." As the release set out:
- Phillip Goldstein, Imperial's chairman and a principal of Bulldog Investors, its largest shareholder commented: "The Board has noticed a disturbing trend of lawsuits brought by shareholders with very small stakes in publicly traded companies against the companies, their directors, and their officers, purportedly on behalf of a class of shareholders or on behalf of the company. These lawsuits often result in other shareholders receiving no meaningful benefit and indirectly incurring the cost of the plaintiff's lawyer and the company's lawyer. The Board believes it is in the best interest of the company to require a shareholder claiming to represent a class of shareholders or the company to demonstrate a minimum level of shareholder support."
This provision may not survive a judicial challenge (it should cause significant pause even in Delaware). The courts will likely take a dim view of limits on their jurisdiction that take the form of mandatory filings with the corporation. Moreover, the bylaw effectively eliminates the right of small shareholders to bring derivative and securities class action law suits, at least for shareholders and former shareholders who lack the resources needed to obtain the necessary consent.
Nonetheless, the bylaw demonstrates the consequences of an approach taken by Delaware courts that authorized bylaws affecting judicial process. It suggests that companies will use this new found discretion to adopt a wide variety of bylaws that seek to restrict access to the courts. Moreover, these bylaws impose costs. In marginal cases, shareholders may not bring actions. In other instances, they raise the costs associated with litigation, either through the need to assemble a 3% block or through the need to challenge the validity of the bylaw.
There are two ways out of this quagmire. First, the Delaware courts can impose meaningful limits on these types of bylaws. The idea that anything goes under Section 109 could and should be revisited and serious limits imposed on bylaws that effectively restrict access to the courts. While the Delaware courts will probably impose some limits eventually, there is no reason to believe that they will be meaningful.
The other way out is through federal preemption. Congress can have, at the ready, a provision that prohibits bylaws that interfere with judicial process. The law ought to apply to all public companies (the say on pay model) but could also be applicable to exchange traded companies (the audit/compensation committee approach). In any event, the management friendly approach taken by the Delaware courts with respect to these bylaws invites further federal preemption, an unfortunate but obvious consequence of the interpretation.