Contractarian Theory and Unilateral Bylaw Amendments

• Author: Albert H. Choi & Geeyoung Min
• Position: Professor and Albert C. BeVier Research Professor of Law, University of Virginia Law School/Adjunct Assistant Professor and Postdoctoral Fellow in Corporate Law and Governance, Columbia Law School
• Pages: 1-44

1

Contractarian Theory and Unilateral

Bylaw Amendments

Albert H. Choi & Geeyoung Min *

ABSTRACT: Corporate directors have bee n utilizing a potent mechanism i n

dealing with shareholder activism and shareholder litigation: the right to

unilaterally amend corporate by laws. Directors have exercised th is right, for

instance, to impose various requirements on wh o can nominate a director or

call a special shareholder meeting, or to desig nate an exclusive forum where

the shareholders can bring suit. Ba sed on the theory that corporate charter s

and bylaws constitute a “contract” b etween the shareholders and th e

corporation, courts have blessed many of the bylaws that directors have

unilaterally adopted. This Articl e examines the contractarian th eory by

drawing a parallel between amendi ng charters and bylaws on the one ha nd

and amending contracts on the other; and by comparing the right to

unilaterally amend corporate by laws with the right to unilaterally modify

contracts. The Article shows how cont ract law imposes various limitations on

the modifying party’s discretion. The Article a lso compares the standard

contractual relationship with that of the sh areholders and the corporation

more generally and uncovers several important differences that could m ake

shareholders (particularly, minority shareholders) more vulnerable to

counterparty (directors’ and controll ing shareholder’s) opportunism. For

example, unlike contracting parties who h ave the right to terminate the

contractual relationship or opt out of undesirabl e modifications, shareholders

lack the right of termination or opt-out. As a possible so lution, the Article

considers various mechanisms, inc luding giving the shareholde rs the right of

* Professor and Albert C. Be Vier Research Professor of L aw, University of Virginia Law

School; and Adjunct Assistant Professor and Postdoctoral Fellow in Corporate Law and

Governance, Columbia Law School, respectively. We would like to thank Rick Brooks, Quinn

Curtis, Elisabeth de Fontenay, Zohar Goshen, Larry Hamermesh, Clara Hochleitner, Mike

Klausner, Vice Chancellor Travis Laster, Alex Lee, Ann Lipton, Joshua Mitts, Peter Mol k, Roberta

Romano, Sarath Sanga, Matt Shapiro, David Skeel, Emily Stolzenberg, George Triantis, Fred

Tung, workshop participants at the University of Virginia Law School, and conference

participants at 2018 Corporate and Securities Law Conference at Tulane Law School for many

helpful comments and suggestions. We would also like to thank MacLane Taggart (University of

Virginia Law School, J.D. Class of 2019) and Wenxi Zhang (University of Pennsylvania Law

School, J.D. Class of 2019) for excellent research assistance. Comments are welcome to

achoi@law.virginia.edu and geeyoung.min@gmail.com.

2 IOWA LAW REVIEW [Vol. 104:1

optional redemption, more robust disclosur e, the right to vote (including the

right to elect or replace directors), and subjec ting bylaw amendments to more

active judicial oversight. The Articl e suggests that active judicial o versight,

through the vigorous application of th e proper and equitable purpose test or

imposition of good faith and fair deal ing obligations, would be better in

retaining the desired flexibility and pol icing directors’ and controlling

shareholder’s opportunism.

I. INTRODUCTION ............................................................................... 3

II. CORPORATE CONTRACT AND ITS AMENDMENT .............................. 11

A. CHARTER AND BYLAW AMENDMENT UNDER CORPORATE

STATUTES ............................................................................... 13

B. RECENT DEVELOPMENTS IN CORPORATE BYLAWS ....................... 15

1. Boilermakers and ATP Tour .............................................. 16

2. Subsequent Developments ............................................ 19

III. AGENCY AND CONTRACT LAW IMPLICATIONS ON

CORPORATE CONTRACT ................................................................ 21

A. AGENCY LAW’S TREATMENT OF PRINCIPAL-AGENT

CONTRACT .............................................................................. 22

B. HOW CONTRACT LAW DEALS WITH (UNILATERAL)

MODIFICATION ........................................................................ 23

1. Illusory Promise and Indefiniteness .............................. 24

2. Unconscionability .......................................................... 26

3. Interpretation ................................................................ 27

4. Implied Covenant of Good Faith and Fair

Dealing ........................................................................... 28

IV. CHANGE-OF-TERMS CLAUSE VS. RIGHT TO UNILATERALLY

AMEND BYLAWS ............................................................................. 29

V. POLICY IMPLICATIONS ................................................................... 32

A. OPTIONAL REDEMPTION .......................................................... 33

B. MANDATORY PRE-AMENDMENT DISCLOSURE ............................. 35

C. SHAREHOLDER VOTING AND APPROVAL ..................................... 35

D. STRONGER JUDICIAL OVERSIGHT ............................................... 38

1. Proper and Equitable Purpose Test .............................. 39

2. Borrowing from Contract Law Principles ..................... 39

3. Benefits of Stronger Judicial Oversight ........................ 41

VI. CONCLUSION ................................................................................ 44

2018] UNILATERAL BYLAW AMENDMENTS 3

I. INTRODUCTION

Over roughly the past decade, corporate direct ors have been utilizing

one of the most potent mechanisms in dealing with shareholder activism and

shareholder litigation: the right to unilaterally amend corporate bylaws.1

While corporate governance arrangements can be tailored using either the

charter or the bylaws,2 modifying the charter requires shareholder approval,3

which can be time-consuming, costly, and uncertain.4 On the other hand,

directors can unilaterally amend the bylaws quickly, at a low cost, and with

certainty: They can simply convene a board meeting and adopt a necessary

1. See generally Albert H. Choi, Fee-Shifting and Shareholder Litigation, 104 VA. L. REV. 59 (2018)

(providing a brief overview about the concerns over deal-related shareholder litigation, perc eived

to be “out of control,” and how that led corporations to adopt fee-shifting and exclusive forum

bylaws); Lawrence A. Hamermesh, Director Nominations, 39 DEL. J. CORP. L. 117 (2014) (discussing

examples of directors’ adopting advance notice bylaws in response to shareholder activism

regarding director elections).

2. There are exceptions, however. For instance, whether to have a super-majority voting,

to allow the directors to issue certain stock without shareholder approval (“blank check preferred

provision”), to exempt directors fr om personal liability for breach of d uty of care, or to have

cumulative voting must be conta ined in the charter. See DEL. CODE ANN. tit. 8, §§ 102(a)(4 ),

102(b)(4), 102(b)(7), 214 (2018) . A staggered (or classified) board pro vision, though it can be

in the bylaws, requires a shareholder approval. See id. tit. 8, § 141(d) .

3. See id. tit. 8, § 242; MODEL BUS. CORP. ACT § 10.03 (AM. BAR ASS’N, revised 2016).

Charter amendment is considered to be a “fundamental” change to the corporation, thereby

triggering shareholder approval requirement. When a proposed charter amendment “adversely

affects” a certain class of shareholders, that class will get to vote on the proposal as a separate

class. See DEL. CODE ANN. tit. 8, § 242(b)(2); MODEL BUS. CORP. ACT § 10.03. For a more detailed

analysis of charter amendments, including the requirements and procedures under the federal

securities laws, see generally Geeyoung Min, Shareholder Voice in Corporate Charter Amendments,

43 J. CORP. L. 289 (2018). For Delaware corporations, there is a small number of exceptions to

the rule. Unless expressly prohibited by the charter, the directors can unilaterally change the

name of the corporation, delete the names of the incorporators, or delete the provisions that

were necessary to effect stock exchange, reclassification, etc., when such changes have become

effective. See DEL. CODE ANN. tit. 8, § 241(b )(1); MODEL BUS. CORP. ACT § 10.05.

4. For a publicly traded company, the company will have to abide by the federal proxy

regulation in securing shareholder approval. See Securities and Exchange Act of 1934, 15 U.S.C.

§ 78(a) (2012); Securities Regulation Section 14A, 17 C.F.R. § 240.14a-8 (2011). Also , influential

proxy advisory firms, such as Institutional Shareholder Services and Glass Lewis, have the policy

of giving negative recommendations at the nex t director election when a firm adopts a charter

provision (materially) adverse to the interests of shareholders, such as staggering the board.

See generally Min, supra note 3 (providing a more detailed analysis). Notwithstanding this, there

are instances where a charter amendment would be more advantageous, especially if the directors

expect little or no shareholder resistance. Because they have the sole power to make an

amendment proposal, they get to d ictate the content and once the amendment has been

adopted, shareholders will be unable to change it unilaterally. DEL. CODE ANN. tit. 8, § 242.