Article by Lawrence A. Hamermesh
Scholars and practitioners alike have long and persistently debated the appropriate allocation of decisionmaking authority between corporate shareholders and managers. Over time, this debate has taken on a certain repetitive quality: despair over the diminution of shareholder voice co-exists with great hope for institutional investor activism, which in turn meets qualified skepticism. At the same time, some praise the efficiency of the separation of share ownership and corporate control. Through this debate, legal scholars have come to appreciate that the mechanisms by which shareholders influence corporate management are remarkably diverse and nuanced. These mechanisms include: the formal and the informal, the legal and the economic. Mechanisms of stockholder influence range from the blunt and powerful to the subtle. All of these mechanisms have their strengths and weaknesses, and most of them have been studied at length. One mechanism for stockholder influence over corporate management, however, has been only lightly examined or used, at least until very recently: namely, the ability of shareholders to initiate and approve amendments to the by-laws of the corporation. This is a mechanism of theoretically profound significance: because corporate statutes broadly permit by-laws “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,” these statutes potentially confer enormous power on the stockholders, who have the ability to adopt and amend by-laws without the approval of the board of directors.
With institutional investors in the forefront, stockholders have recently attempted to use this power to reclaim governance power from directors, particularly in relation to takeover policy. The most prominent such effort has involved proposals to adopt by-laws purporting to preclude the board of directors from adopting or maintaining takeover defenses such as “poison pills.” If effective, these shareholder by-law initiatives would dramatically alter the dynamics of corporate takeovers, because shareholder rights plans, or “poison pills,” are the principal impediments to completion of an unsolicited tender offer. To the extent that a stockholder-adopted by-law were to require the board of directors to eliminate that impediment, the unsolicited bidder's position would be dramatically enhanced.
Just as this nascent effort to shift the balance of corporate power from directors to stockholders through the use of stockholder-adopted by-law provisions is gaining momentum, however, it has exposed a critical dearth of precedent. For while stockholders have unquestioned power to adopt by-laws 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 by-laws 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 by-law provision that constrains director managerial authority is legally effective.
Related to this gap in legal authority is a less substantive but nearly as important area of legal uncertainty. Even if the stockholders could validly initiate and adopt a by-law limiting the authority of the directors, such a by-law amendment would accomplish little or nothing if the board of directors could simply repeal it after the stockholders adopted it. In some jurisdictions, of course, there is no question that such repeal can be prevented. Under many statutory schemes, the board of directors may not repeal a stockholder-adopted by-law if that by-law expressly prohibits such repeal. In other jurisdictions, however, notably Delaware and New York, the corporation statutes allow the board of directors to amend the by-laws if the certificate or articles of incorporation so provide and place no express limits on the application of such director amendment authority to stockholder-adopted by-laws. The second significant legal uncertainty, therefore, is whether, in the absence of an explicitly controlling statute, a stockholder-adopted by-law can be made immune from repeal or modification by the board of directors.
This Article explores these doctrinal gaps, attempting to delineate the appropriate contours of stockholder-adopted by-laws that limit director authority and to assess their ability to withstand nullification by director action. Part II sets the stage by describing a dispute about by-law provisions adopted in 1997 by the stockholders of Fleming Companies and the court ruling which validated those provisions and heightened investor interest in use of the by-laws as a corporate governance tool.
Part III addresses the extent to which by-laws may limit the authority of the board of directors, particularly in relation to “poison pills” and other antitakeover measures. It approaches this issue in three distinct ways, beginning with a conventional effort to construe the governing corporate statutes that confer general authority to adopt by-laws. This effort reaches the conclusion that, despite some academic suggestions to the contrary, these statutes can most plausibly be construed to preclude the adoption of by-laws that place direct limits on the managerial power of the board of directors. This conclusion is premised in part upon review of several scholarly efforts to delineate distinctions between by-law provisions that may limit director authority in regard to takeover defenses or more generally, and those that impermissibly intrude upon board authority. These efforts have been largely unsatisfactory, in that they offer a mix of factors that do not comport with precedent or the reality of corporate practice and do not in any event afford meaningfully reliable bases to distinguish by-laws limiting director authority as valid or invalid.
Recognizing that the controlling statutory language may not by itself yield a definitive answer to the doctrinal question about the proper scope of by-laws, however, Part III examines the controlling statutes from a dynamic perspective, one that attempts to assess the meaning of these broadly worded statutes in light of the ways in which related legal rules and commercial practices have evolved since the statutes were first adopted a century or so ago. Especially in light of what might otherwise appear to be nonsubstantive word changes in the governing statutes, a consideration of these evolutionary changes, including the diminished importance of by-laws as a tool of private ordering, the increased emphasis on central management, the decline of stockholder “voice,” and the statutory grant to the board of directors of concurrent power to adopt and amend by-laws, all point to the same conclusion reached through more conventional statutory construction. The statutes creating general authority to adopt by-laws may not be construed to permit stockholders to adopt by-laws directly limiting the managerial power of the board of directors.
Part III then proceeds with a third mode of analysis, one which puts aside controlling statutes and asks whether simply allowing stockholders to adopt by-laws limiting director managerial power would be beneficial. Expansive interpretation of the statutes to permit stockholders to adopt by-laws regulating director conduct might bring about several consequences adversely affecting the cost and quality of corporate decisionmaking, consequences noted by Professor Jeffrey Gordon in a path-breaking article examining stockholder policy initiatives. Such an interpretation could force undesired costs of “voice” upon investors who might prefer not to expend time and money reviewing firm-specific policy questions. Multiple policy alternatives may generate deadweight costs of “cycling” competing proposals. Alternatively, a broad role for stockholder-adopted by-laws in corporate governance could result in domination of the field by small but committed stockholder factions, creating the potential for private rent-seeking by stockholders with personal goals distinct from those of the corporation and its stockholders as a whole.
These and other concerns also emerge from exploration of the strong, although not perfect, parallel between stockholder power to adopt corporate policy through by-law amendments and the power of voters in many states to adopt legislation directly by initiative. Voter initiative to adopt legislation has aroused increasing concern of late over poor drafting, voter confusion over the content and significance of initiative proposals, bundling of unrelated initiatives and abdication of responsibility by elected representatives. Although it is suggested that such pathologies may be overstated in the political arena, and that corporate voting in any event is less likely to give rise to them, the potential for such impairments of the corporate governance process counsels against uncritical acceptance of a wider role for stockholder-adopted by-laws.
Part IV presupposes stockholder power to adopt by-laws, but examines the authority of the board of directors to amend or repeal such by-laws and whether such authority can be eliminated in a stockholder-adopted by-law. In a conclusion limited to Delaware and states whose statutes track the Delaware General Corporation Law, Part IV concludes that a stockholder-adopted by-law may not deprive the board of directors of its authority, where conferred by the certificate of incorporation, to amend even a stockholder-adopted by-law. Again, this conclusion flows from corporate law doctrinal analysis, but is buttressed by analysis of judicial treatment of efforts by legislatures to repeal or modify ballot initiative legislation.
Finally, in Part V, this Article acknowledges that the negative conclusions reached in Parts III and IV, even if ultimately and unequivocally adopted by the courts, would not eliminate the stockholder-adopted by-law as a tool for stockholder influence over corporate governance. The corporate statutes explicitly authorize by-laws that regulate a wide range of significant matters in ways that would indirectly limit the directors' conduct, with regard to takeover defenses or otherwise. Part V therefore concludes that if used properly, and notwithstanding (or perhaps precisely because of) the uncertainty necessarily surrounding their legal effectiveness, the stockholder-adopted by-law can become a moderately significant tool for investors seeking to retake ground previously lost to directors in influencing critical corporate decisions such as responses to unsolicited takeover bids. Precisely because of this potential, this Article concludes in Part VI that both corporate management and state legislatures are likely to turn their attention to responses to shareholder by-law activism that would limit the use of stockholder-adopted by-laws as a corporate governance tool.
About the Author
Lawrence A. Hamermesh. Associate Professor of Law, Widener University School of Law. B.A. 1973, Haverford College; J.D. 1976, Yale Law School.
Citation
73 Tul. L. Rev. 409 (1998)