Further Implications of the Delaware Supreme Court's Mentor Graphics Decision and Oklahoma's Fleming Decisions Shareholder Proposals Seeking Mandatory Bylaw Amendments to Prohibit, Limit or Repeal Ri

It is well-settled under Delaware law that a board of directors' adoption of a rights plan is a valid exercise of its authority to manage the business and affairs of the corporation under Delaware General Corporation Law ("DGCL") -- 141(a).¹ Equally settled is the statutory right of shareholders under DGCL -- 109(a) "to adopt, amend or repeal bylaws." In the last several years, these two provisions have become central to a debate on the validity of shareholder proxy proposals seeking binding bylaw amendments repealing or compelling the redemption of poison pills, and/or preventing or limiting their future adoption.²

In particular, companies have argued that such proposed bylaws are improper and invalid as harmfully interfering with their authority and ability to manage the business and affairs of the corporation, and have pointed out that rights plans have important benefits as corporate defense mechanisms.³ Companies thus have sought to exclude such proposals from proxy materials under SEC proxy rules enacted under the Securities Exchange Act of 1934, on the grounds that they are improper matters for shareholder action and/or violate state law.⁴ The SEC, however, previously has refused to grant no-action relief on those grounds, because the appropriateness of such shareholder action was an "unsettled point of Delaware law."⁵

In Quickturn Design Systems, Inc. v. Mentor Graphics Corporation, however, the Delaware Supreme Court held that, absent a contrary provision in the company's charter, a delayed redemption provision of a poison pill rights plan was invalid, as it impermissibly circumscribed the board's statutory power to manage the corporation under DGCL -- 141(a), and the directors' ability to fulfill their concomitant fiduciary duties.⁶ It would appear to follow from Mentor Graphics that any shareholder-proposed mandatory bylaw amendment that would prohibit, limit or repeal a rights plan by a board of directors of a Delaware corporation would be violative of DGCL -- 141(a), unless consistent with an existing limitation in the company's charter. In that case, such proposals should be excludable from proxy materials as improper matters for shareholder action and because they violate state law.

Fleming I and II

Only one case has directly addressed the seeming conflict between the board's and shareholders' respective authority, albeit under the provisions of Oklahoma state law, in the context of a request to exclude from proxy materials a shareholder-proposed bylaw amendment relating to the company's rights plan. In International Brotherhood of Teamsters General Fund v. Fleming Companies, Inc.⁷ ("Fleming I"), a federal district court in Oklahoma was asked whether Fleming Companies was required to include in its proxy statement a shareholder-proposed resolution that sought to amend the company's bylaws to nullify a newly adopted poison pill and to require a shareholder vote before a new poison pill could be adopted. The company contended that the subject was not proper for shareholder action under Oklahoma law and should be excluded from its proxy materials.

In a two-page opinion, the court in Fleming I considered the alleged conflict between two provisions of the Oklahoma General Corporation Act ("OGCA"), -- 1038 ("Rights and Options Respecting Stock") and -- 1013 ("Bylaws"). While OGCA -- 1038 grants directors the exclusive power to create shareholder rights plans, such as poison pills, OGCA -- 1013 permits shareholder amendments to bylaws. The court ordered Fleming to include the shareholder resolution in its proxy materials. According to the Fleming I court, although the board was vested with the power to initiate a rights plan, such authority did not foreclose contrary shareholder action relating to such rights plan.⁸ Following the ruling, the district court also rejected the company's request for a stay pending its appeal.⁹ Fleming then terminated its pill and, at the annual meeting, Fleming's shareholders approved the proposed bylaw.

The company appealed the Fleming I decision to the Tenth Circuit, which certified questions concerning the OGCA to the Oklahoma Supreme Court. Those questions asked whether, under the OGCA, a board has exclusive authority to create and implement poison pills, or whether the board's authority may be circumscribed by shareholder action.¹⁰ Very recently, the Oklahoma Supreme Court answered the questions ("Fleming II") as follows: "We hold under Oklahoma law there is no exclusive authority granted boards of directors to create and implement shareholder rights plans, where shareholder objection is brought and passed through official channels of corporate governance."¹¹

As in Fleming I, the focus of the Oklahoma Supreme Court's decision was a straightforward comparison of OGCA ---- 1038 and 1013. Section 1038, relied upon by Fleming, provides in relevant part that: "Subject to any provision in the certificate of incorporation, every corporation may create and issue . . . rights or options [of its stock.]" According to the court, Fleming argued the corporation's right, as expressed in this section, means the right of the board of directors. Weighed against this argument was the Teamsters' reliance on OGCA -- 1013, conferring the "power to adopt, amend or repeal bylaws . . . not inconsistent with law or the certificate of incorporation" upon shareholders.

The Oklahoma Supreme Court rejected the argument that "corporation" and "board of directors" are synonymous, noting the two terms are not used interchangeably in the OGCA.¹² Instead, the court found that a rights plan is "essentially a variety of stock option plan." ¹³ The court then cited instances in which shareholders had ratified stock option plans, analogizing such action to shareholder action in the form of a bylaw proposal relating to a rights plan. ¹⁴ The court also noted that although many states have recently enacted so-called "shareholder rights plan endorsement statutes", the Oklahoma legislature had not done so. ¹⁵ While the court emphasized that the board's authority to enact a poison pill was not dependent upon such a statute, it held that such authority nevertheless "may well be subject to the general procedures of corporate governance, including the enactment of bylaws which limit the board's authority to implement shareholder rights plans." ¹⁶

Although the court noted that "Oklahoma and Delaware have substantially similar corporation acts", ¹⁷ it did not address -- 1027(A), the OGCA provision identical to DGCL -- 141(a), the key provision of the Delaware Supreme Court's Mentor Graphics decision. The language of each provides "[t]he business and affairs of every corporation . . . shall be managed by or under the direction of a board of directors, except as may be otherwise provided for in the [OGCA/DGCL] or in [the corporation's] certificate of incorporation." Instead, the court focused solely on OGCA ---- 1038 and 1013, which are identical to DGCL ---- 157 and 109. While Fleming did argue that only the certificate could limit the board's authority, according to the court it relied solely upon -- 1038 for this claim. ¹⁸ The Oklahoma Supreme Court dismissed OGCA -- 1027 in a single sentence, concluding without citation that "the authority given a board of directors under [OGCA] -- 1027 is not without shareholder oversight, [OGCA] -- 1013(B)." The court also noted that "a review of Delaware decisions revealed no comparable case from that state." ¹⁹ It is unclear whether the Oklahoma court had the benefit of Mentor Graphics during its consideration, given the close timing of the two decisions.

SEC No-Action Position

In one reported SEC no-action letter, a shareholder cited Fleming I as "powerful precedent" in opposing a company's request to exclude from proxy materials the shareholder's proposal for a rights plan-related bylaw amendment. There, PLM International, Inc. sought to exclude a shareholder proxy proposal that would require specific board actions (including pill redemption) upon the company's receipt of certain offers to acquire the company. ²⁰ In its no-action request, the company asserted, among other things, that the proposal was "an impermissible attempt to usurp the managerial powers exclusively invested in the Board of Directors by DGCL -- 141(a)," and was excludable under SEC Rule 14a-8(i)(2) as violating Delaware law. ²¹

In opposition, the PLM shareholder asserted that his proposal was a proper matter of shareholder action, even if it was "potentially inconsistent" with DGCL -- 141(a), since under Fleming I, "a statutory grant of authority to a company's board is not necessarily an exclusive grant of authority and does not preclude shareholder action in that area." ²² In reply, the company conceded that neither it nor the shareholder "c[ould] be sure of the proper interpretation of DGCL -- 141(a) until the issue is resolved by the Delaware courts." ²³ Nevertheless, the company asserted that the proposal should be excludable as an improper matter for shareholder action under SEC Rule 14a-8(i)(1), as it was of "questionable validity" under Delaware law. ²⁴

Without addressing Fleming I or previous no-action letters in which it had agreed not to take action against a company for excluding shareholder proposals that were of "questionable validity" under applicable state law, the SEC staff refused the company's request. In so ruling, the staff noted that "whether the proposal is an appropriate matter for shareholder action appears to be an unsettled point of Delaware law." ²⁵

The Mentor Graphics Decision

In Mentor Graphics, the Delaware Supreme Court considered a suitor's challenge to the target's adoption of a "slow hand" poison pill. Such pills limit the authority of newly elected directors allied with the suitor by delaying their ability to vote to redeem the pill. In rejecting this type of defense, the court emphasized the importance of the board's ability to "completely discharg[e] its fundamental management duties to the corporation and its stockholders" in this "area of fundamental importance to the shareholders -- negotiating a possible sale of the corporation." ²⁶

In addressing the issue before it, the court emphasized that a basic tenet of Delaware corporate law is that "the board of directors has the ultimate responsibility for managing the business and affairs of the corporation." ²⁷ Any limitation on the board's authority, the court stated, must be set forth in the certificate of incorporation, as required by DGCL -- 141(a). The court noted that Quickturn's certificate of incorporation did not contain any such limitations, but that the delayed redemption plan at issue did: It "prevent[ed] a newly-elected board from completely discharging its fundamental management duties to the corporation and its stockholders for six months." Thus, the court held that the delayed redemption plan was invalid under DGCL -- 141(a).

The court further noted that the board has a fiduciary duty to the corporation and its shareholders in discharging its statutory mandate, and that any contract or provision thereof that requires a board "to act or not act in such a fashion as to limit the exercise of fiduciary duties . . . is invalid and unenforceable." ²⁸ The court noted that the delayed redemption provision at issue limited "in a substantial way" the freedom newly elected directors had in making decisions on matters of management policy. ²⁹ The delayed redemption provision was therefore invalid, the court held, as it violated the duty of each director to exercise his or her own best judgment on matters coming before the board.

More Recent Developments in Delaware

This past week, the Chancery Court was confronted with a board's challenge to a shareholder-proposed mandatory bylaw provision, though not related to a rights plan. In General DataComm Industries, Inc. v. Wisconsin Investment Board, the company sought an expedited hearing of its request to have the court declare invalid a shareholder-proposed bylaw amendment requiring shareholder approval before the repricing of any outstanding stock options.³⁰ Although the court observed "that the Repricing Bylaw is obviously invalid under the teaching of [Mentor Graphics,]"³¹ the court declined the company's motion, concluding that the dispute was not ripe for adjudication before the scheduled shareholder vote. ³² In so doing, the court cited an earlier Chancery Court opinion that similarly declined to decide the validity of a shareholder proposal before the scheduled shareholder vote. ³³ The court also noted that a further issue may be presented if, as is permissible pursuant to DGCL -- 109(a), a company's charter permits the board to amend the company's bylaws, and it uses this authority to repeal the shareholder-proposed and adopted bylaw. ³⁴

Mentor Graphics Analysis Applied to Shareholder Proposals

The reasoning of the Delaware Supreme Court in Mentor Graphics, appears applicable to any remaining question that shareholder proposals seeking mandatory bylaw amendments to prohibit, limit or repeal rights plans in a manner inconsistent with the company's certificate of incorporation are contrary to Delaware law, and implicitly rejects the contrary conclusions of Fleming I and II. Accordingly, any such proposal made with respect to a Delaware corporation (or a corporation of a state with similar corporate law) would appear to be an improper subject for inclusion in the company's proxy materials and would come within the exclusionary provisions of SEC Rule 14a-8(i)(1) and (2).

Endnotes

1. See Moran v. Household Int'l, Inc., 500 A.2d 1346, 1353 (Del. 1985); see also Dennis J. Block, Nancy E. Barton & Stephen A. Radin, THE BUSINESS JUDGMENT RULE, Vol. I at 1085 et seq. (5th Ed. 1998).
2. See Dennis J. Block, Jonathan M. Hoff and William P. Mills, "Defensive Measures in Anticipation of, and in Response to, Unsolicited Takeover Proposals," New Strategies for Corporate Control 113, 172-73 (P.L.I. 1999).
3. See Lawrence A. Hamermesh, Corporate Democracy and Stockholder-Adopted By-Laws: Taking Back the Street?, 73 Tul. L. Rev. 409 (1998) (hereinafter "Corporate Democracy"); Paul M. Sherer and Amy Barrett, With a Stealthy Takeover of Gucci Looming, That Failed Poison Pill Now Looks Less Bitter, W.S.J. Jan. 29, 1999, at C2.
4. 17 C.F.R. 240.14a-8 ("SEC Rule 14a-8"). Specifically, companies have sought to exclude such proposals under SEC Rule 14-8(i)(1), which permits the board of directors to "omit a [shareholder] proposal and any statement in support thereof from its proxy statement and form of proxy . . . [i]f the proposal is, under the laws of the corporation's domicile, not a proper subject for action[;]"and under SEC Rule 14a-8(i)(2), which permits exclusion "[i]f the proposal, if implemented, would require the [corporation] to violate any state law[.]"
5. See PLM Int'l, Inc., SEC No-Action Letter, 1997 SEC No-Act. LEXIS 575 (available Apr. 28, 1997).
6. Quickturn Design Sys., Inc. v. Mentor Graphics Corp., C.A. Nos. 511, 512, 1998 Del. Ch. LEXIS 496 at *36 (Del. Ch. Dec. 31, 1998). See Dennis J. Block and Jonathan M. Hoff, "Dead Hand Poison Pills and Recent Variations," Cadwalader Counselor Vol. 1, Issue 2, at 1 (Jan. 1999) for a detailed discussion of Mentor Graphics.
7. No. Civ-96-1650-A, 1997 U.S. Dist. LEXIS 2980 (W.D. Okla. Jan. 24, 1997).
8. Id.
9. International B'hood of Teamsters Gen. Fund v. Fleming Cos., No. Civ-96-1650-A, 1997 U.S. Dist. LEXIS 2979 (W.D. Okla. Feb. 19, 1997).
10. International B'hood of Teamsters Gen. Fund v. Fleming Cos., No. 90,185, slip op. at " 1 (Okla. Supr. Ct. Jan. 29, 1999).
11. Id. at " 2.
12. Id. at " 16.
13. Id. at " 18.
14. Id. at "" 18-19.
15. Id. at "" 23-24 (quoting such statutes from Idaho, Illinois, Indiana, Kentucky and Nevada).
16. Id. at " 25.
17. Id. at " 13.
18. Id. at " 22.
19. Id.
20. PLM Int'l, Inc., SEC No-Action Letter, 1997 SEC No-Act. LEXIS 575 at *28 (available Apr. 28, 1997).
21. Id. at *31.
22. Id. at *14.
23. Id. at *15.
24. Id.
25. Id. at *2.
26. Mentor Graphics, 1998 Del. Ch. LEXIS 496, at *33-34.
27. Id. at *33.
28. Id. at *36 (emphasis omitted).
29. Id. (internal quotation omitted).
30. C.A. No. 16923, slip op. (Del. Ch. Feb. 1, 1999).
31. Id., slip op. at 9.
32. Id., slip op. at 2-3.
33. Id., slip op. at 6 (citing Diceon Elec., Inc. v. Calvary Partners, L.P., C.A. No. 11862, 1990 WL 237089 (Del. Ch. Dec. 27, 1990)).
34. Id., slip op. at n.1, 2. See Corporate Democracy, supra, at 467-89 for fuller discussion of this issue.