TCS Daily

Activist Shareholder Proposals, Totally Unfit

By Stephen Bainbridge - January 3, 2006 12:00 AM

A group of Bally Total Fitness shareholders is pressing a proposal to amend Bally's corporate bylaws. The action would:

  • Allow shareholders the right to remove the company's Chief Executive Officer and President by the affirmative vote of a majority of the company's outstanding stock,
  • Prevent the board of directors from acting unilaterally to amend the new bylaw provision,
  • Remove the incumbent CEO Paul Toback from office.

Activist shareholders are making similar efforts at a number of other companies. In the last proxy season, for example, shareholders at over 60 companies offered bylaw amendments that would require directors to be elected by a majority of shareholder votes rather than the present plurality system. At a host of companies, shareholders have tried to amend the bylaws to prevent the corporation's board of directors from adopting a poison pill takeover defense. And so on.

Are these shareholder efforts legally valid? Probably not. Are they good public policy? Definitely not.

Let me explain:

Delaware General Corporation Law ("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."

Clear conflicts between the statute or articles and the bylaws present little difficulty. But what if the bylaw nominally complies with the letter of the law, but conflicts with its spirit?

The critical issue here is whether shareholder-adopted bylaws, such as those being pressed by the Bally investors, 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?[1]

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.

Analysis must begin with the basic principle that 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. (This is known as the nexus of contracts model of the corporation.)

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.

This model is not inconsistent with the spirit of Delaware corporate law. As the Delaware Supreme Court recently opined:

"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." Quickturn Design Systems, Inc. v. Shapiro, 721 A.2d 1281, 1291 (Del. 1998).

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. 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.

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.

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. Such is also an historical anachronism that states unthinkingly codified from old common law principles, which lack either rhyme or reason. There simply is no good reason to treat bylaws differently than articles of incorporation.

The author is a corporate law professor at UCLA.

[1] The validity of the Bally proposal is even more complicated because DGCL § 142 specifically provides that officers may be appointed as specified in the bylaws. As such, a bylaw allowing shareholders to appoint directors may not be "inconsistent with law," although the situation is even more complicated because § 142 speaks only of bylaws relating to appointment and not removal.


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