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Albert H. Choi is Professor and Albert C. BeVier Research Professor of Law at University of Virginia Law School; Geeyoung Min is Adjunct Assistant Professor and Postdoctoral Fellow in Corporate Law and Governance at Columbia Law School. This post is based on their recent paper, and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes The Case for Increasing Shareholder Power and Letting Shareholders Set the Rules, both by Lucian Bebchuk; and Frozen Charters by Scott Hirst (discussed on the Forum here).
Over the past decade or so, courts have been willing to apply the “contractarian” theory to the organizational documents of corporations: charters (certificates or articles of incorporation) and bylaws. The notion that the charters and bylaws can be thought of as “contracts”—between a corporation and its shareholders and among the shareholders—dates back to the seminal work by Jensen and Meckling and the idea that the corporate organization can be viewed as a “nexus of contracts.” What is new and controversial, however, is the fact that the courts have been willing to apply these ideas to cases where the directors unilaterally have amended bylaws without shareholders’ express ex post approval. With respect to corporate charters, state statutes require an express shareholder approval and do not allow either the directors or the shareholders to unilaterally modify the charter. For bylaws, however, while preserving the right of unilateral modification for the shareholders, corporate statutes allow directors to unilaterally amend the bylaws, either as a matter of default or when the shareholders grant such power through a provision in the charter. While the precise scope of this authority remains somewhat uncertain, recent cases have meaningfully expanded the directors’ freedom.
The recent focus on and controversy over unilaterally amended bylaws is not surprising in light of the rise of shareholder activism and concerns over deal-related shareholder litigation perceived as being “out of control.” For instance, if the directors want to counteract an activist hedge fund or deal with imminent shareholder litigation, doing so through charter amendment would be undesirable due to uncertainty, cost, and delay. In contrast, unilaterally amending the bylaws can be done fast, at low cost, and with certainty. For example, by requiring all shareholder lawsuits to be filed in Delaware through an exclusive forum bylaw, the directors can better “manage” out-of-control shareholder litigation. Similarly, incumbent directors can better prepare for a potentially costly proxy fight by adopting an advance notice bylaw that requires any insurgent shareholder to provide detailed information about their director-nominees. Furthermore, because directors can dictate the contents of bylaws, even when they adopt a bylaw putatively in response to shareholders’ demands, they can devise a system that is potentially more favorable to them, while still showing “fidelity” to the wishes of the shareholders.
When shareholders challenged bylaw amendments, courts have upheld the amendments by applying the contractarian principle. The Delaware Supreme Court’s opinion in ATP Tour, Inc. v. Deutscher Tennis Bund [1] is exemplary. Upholding a fee-shifting bylaw unilaterally adopted by the directors of ATP Tour, Inc., the court stated that charters and bylaws constitute a “contract” between a corporation and its shareholders, and directors can amend the bylaws by adopting a fee-shifting provision because that right is granted to them in ATP’s charter. The Delaware Chancery Court applied similar reasoning when validating an exclusive forum bylaw in Boilermakers Local 154 Retirement Fund v. Chevron Corp. [2] The court stated that “the bylaws constitute a binding part of the contract between a Delaware corporation and its stockholders,” and when the right to amend bylaws has been granted to the directors, according to the court, the shareholders “will be bound by bylaws adopted unilaterally by their boards.” The Boilermakers court also emphasized the fact that, if the shareholders are displeased with the amended bylaw, they can repeal the bylaw, adopt their own bylaw, or even remove directors from the board.
The purpose of our paper, Amending Corporate Charters and Bylaws, is to examine the contractarian principle as applied to charter and bylaw amendments. The paper foremost draws on how contract law deals with contract modifications and the problems that arise when one party grants the other the right of unilateral modification. Under the existing law, amending a contract is subject to various statutory and judicial restrictions. Probably the most relevant doctrine is the duty of good faith and fair dealing. Even when exercising a contractually granted right to unilaterally modify the contract, the party with the right must exercise it in good faith and deal fairly with the counterparty. While different courts have constituted this duty with different elements, with respect to unilateral modifications, the most common requirements include the obligation to (1) disclose the proposed modification to the counterparty; (2) grant the right to opt out of the proposed modification (usually through termination of the contract); and (3) not retroactively apply the modified provision.
The paper also compares the rights of the contracting parties with those of the shareholders and uncovers several important factors that would make shareholders—minority shareholders, in particular—more vulnerable. One important difference the paper highlights is the fact that the shareholders do not have the right to truly “terminate” their relationship with the corporation. They can always sell their stock but the shareholder-corporation relationship remains preserved through the sale, and the corporation is not harmed—at least not directly or immediately—by the sale. By contrast, parties to a contract can either terminate the relationship or opt out of the proposed modification. By terminating the contractual relationship, for instance, the terminating party can deny the counter-party the expected contractual surplus. We also note other issues, such as the problems of collective action and rational apathy; and the fact that shareholder-director relationship is more vertical rather than horizontal.
Building on these differences, with the lessons learned from contract law, the paper argues that there is a policy-based justification to be more vigilant against charter and bylaw amendments and, in particular, against unilateral bylaw amendments. The policy goal should be to preserve flexibility in amending bylaws and charters while policing opportunism by directors and shareholders. The paper considers various policy instruments, including optional redemption, robust disclosure obligation, more reliance on shareholder voting and approval, and more judicial oversight. After considering the costs and benefits, we suggest that the courts more vigorously apply the “proper” and “equitable” purpose or effect test under corporate law and, borrowing from contract law, apply the good faith and fair dealing obligations. With stronger judicial oversight, we argue, the benefits of flexibility can be preserved while value-destroying opportunism (by directors’ or the controlling shareholder’s exercise of discretion in “bad faith”) can be better deterred.
The complete paper is available for download here.
1 91 A.3d 554 (Del. 2014).(go back)
2 73 A.3d 934 (Del. Ch. 2013).(go back)
