Shareholder franchise - no compromise: why the Delaware courts must proscribe all managerial interference with corporate voting.

• Author: Neuwirth, Morgan N.

INTRODUCTION

After years of rationally apathetic slumber, the shareholder has reemerged, bulked up and ready to challenge management for control of America's corporations.(1) The managers, fresh off their victory in the "hostile takeover" wars, are ready for the challenge.(2) The shareholder's weapon? -- the lowly proxy. While shareholder voting was once considered a mere formality, institutional investors with tremendous stock holdings have given the corporate election process a new vitality.(3) These institutions, which own over half of the equity in U.S. corporations,(4) have been using the proxy voting system to limit management excesses and to replace the leadership of underperforming companies. They have demanded that corporations be governed for the benefit of the owners of the firm, the shareholders.(5)

Management has responded to this new shareholder activism by constructing barriers to the voting process.(6) Managers have moved election dates, manipulated the size of the boa0rd, enforced ownership limits and placed stock into friendly hands -- all to reduce or eliminate the possibility of shareholder success in a corporate election.(7)

The judicial response to this intrusion on the shareholder franchise has been mixed. While the courts have described the shareholder franchise as deserving of judicial protection,(8) there is a marked unwillingness among judges to interfere with managerial decisionmaking.(9) In many cases, the courts have acknowledged that even though a corporate maneuver will interfere with a proxy fight, they will not invalidate the measure because the impediment was not the primary purpose behind the action.(10) In other cases, the courts blessed actions that seriously interfered with an election but did not totally preclude the shareholder's chances.(11) In still other cases, the courts argued that they needed to apply a balancing test to determine whether the degree of interference with an election was proportionate to a reasonably perceived threat to the company.(12)

This Comment proposes that the courts need to take a stronger stand against managerial interference with shareholder voting. The various tests the courts are applying -- the primary purpose, total preclusion and balancing tests -- are too deferential to management. The vote is the shareholder's only tool to oversee and discipline corporate management. With the elimination of the unsolicited tender offer, shareholders must vote management out of office if they are to recognize the gains from a change in control.(13) The shareholder vote is at the heart of the economic principles that drive corporate efficiency,(14) as well as the fiduciary principles that legitimate managerial exercise of power over the vast amount of assets that management does not own.(15)

Specifically, this Comment will argue that courts must not allow managers to purposefully interfere with the shareholder franchise. Additionally, the courts must carefully scrutinize defensive transactions that, although not primarily intended to interfere with the ability of shareholders to vote, have the effect of constraining the ability of shareholders to oust incumbent management. Presently, courts do not carefully examine the effect of defensive measures on the shareholder franchise.(16) Because the shareholder franchise is so vital to the efficient operation of the modern corporation, the court must apply the strictest level of review to actions that impede the electoral process. Additionally, courts must be willing to take positive steps to remedy impositions on the franchise by ordering the reimbursement of expenses, requiring the elimination of antiproxy measures or demanding the adjustment of corporate defenses.

After years of despairing over the inability of the shareholder to monitor management, there is finally an opportunity for efficient oversight.(17) As shareholders have begun to utilize the vote to influence, pressure and ultimately oust management, companies have attempted to raise barriers to the voting process.(18) Unless courts step in to limit managerial impositions, it is conceivable that the shareholder franchise will go the way of the unsolicited tender offer. This Comment will present a critique of the shareholder franchise case law and recommend a new direction for the courts to take.

Part I of this Comment discusses the reasons why the shareholder franchise is currently emerging as a potent weapon in the battle for corporate control. The rise of the institutional investors is discussed, as well as the changes in the legal environment that have facilitated the use of the shareholder proxy. Part Il enumerates the various defensive measures that corporations are using to prevent proxy fights. Part III reviews the relevant case law, beginning with the unsolicited hostile offer cases that provide a background for understanding the courts' analysis in the franchise cases. Part IV presents the arguments for why the shareholder franchise must be protected. Part V discusses the problems with the current doctrine and presents alternative solutions.

1. The Emerging Power of the Shareholder Franchise

   1. The Proxy Contest: A History of Irrelevance

      For many years, shareholder voting was considered a meaningless ritual.(19) In a famous early work on the market for corporate control, a scholar referred to the proxy as "the most expensive, the most uncertain, and the least used of the various techniques" for acquiring control of a corporation.(20) Others were less kind, calling the proxy an "anti-democratic device," totally dominated by management.(21) In response to claims that shareholders were not participating in corporate government because they were not given enough information about the firm, the federal government enacted laws to regulate corporate disclosure and overhaul the proxy machinery.(22)

      Despite these rules, shareholders still did not take an active role in corporate management.(23) Only rarely did a proxy fight result in a change in corporate control.(24) For the most part, the proxy was a tool of activists and gadflies who were more interested in gaining publicity than actually electing candidates to the board.(25) There is a cogent explanation for the passivity of the owners of the firm: because each shareholder owns such a small share of the firm, the costs of participating in the corporate democracy -- reading the proxy material, becoming informed, voting -- exceeds any potential benefit the shareholder could receive.(26) Thus, shareholder apathy did not result from a lack of salient information, but was rather a rational response on the part of the numerous shareholders, each owning an insignificant amount of a firm.(27) This collective action problem also explained the dearth of proxy contests. Shareholders who wished to challenge management had to expend their own resources to mount a proxy contest.(28) If they lost, they were not reimbursed.(29) If they won, they only received their proportionate share of the gain. Furthermore, management has a large advantage in a proxy contest because shareholders are more likely to vote for management than incur the expense of becoming informed about the opponent. Historically, the "Wall Street Rule" governed -- if you did not like the way the firm was being managed, sell.(30)

      An additional reason existed for the relative unimportance of proxy contests -- the availability of the tender offer.(31) As directors mismanaged the firm and shareholders sold their stock, the price of a company's shares fell. A "takeover specialist," seeing an opportunity to make a large profit, purchased the depressed shares of the firm, replaced the inefficient management and brought the company back to health (or chopped it into pieces). The tender offer eliminated many of the drawbacks of the proxy fight. Because shareholders realized immediate gains through a tender offer, the problem of rational apathy diminished. A large reservoir of financing developed, so that hostile bidders could pursue even the largest corporations.(32) The hostile tender offer became the preferred method of effectuating a change in corporate control.(33) The threat of a hostile takeover also helped discipline corporate management. A firm whose stock price had become depressed through mismanagement was a more attractive takeover target.(34) Thus, management found it in its self-interest to ensure that the price of the firm's stock was high and that the shareholders were satisfied. By the 1980s, the tender offer had assumed the intended role of the proxy in monitoring management and effectuating corporate change.

   2. The End of the Hostile Takeover Era and

      the Emergence of the Proxy Contest

      1. Corporate Management, with Friends in High Places,

         Beats Back the Hostile Raiders

         Management responded to the growing number of hostile offers by putting up defenses. Poison pills (also known as shareholder rights plans), shark repellants, white knights and other colorfully named techniques were developed in an attempt to protect corporations, and their management, from the possibility of being acquired (and fired).(35) The legitimacy of these defenses was contested in the Delaware Chancery Court and the Delaware Supreme Court. Although in a few cases the corporate defenses were found to be invalid, for the most part management was allowed to reject hostile bids, even if the shareholders were overwhelmingly in favor of the deal.(36) Today, most large firms have poison pills in place, making hostile takeovers prohibitively expensive, if not impossible.(37) Delaware courts have recognized the impact of their decisions.(18)

         In addition to the corporate takeover defenses, state legislatures have passed laws to help companies repulse unwanted bids. These antitakeover laws were passed in response to calls from local corporations and labor interests.(39) These statutes restrict takeovers through a number of mechanisms. The "control share"...