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

Contractarian Theory and Unilateral Bylaw Amendments Albert H. Choi & Geeyoung Min * ABSTRACT: Corporate directors have been utilizing a potent mechanism in dealing with shareholder activism and shareholder litigation: the right to unilaterally amend corporate bylaws. Directors have exercised this right, for instance, to impose various requirements on who can nominate a director or call a special shareholder meeting, or to designate an exclusive forum where the shareholders can bring suit. Based on the theory that corporate charters and bylaws constitute a “contract” between the shareholders and the corporation, courts have blessed many of the bylaws that directors have unilaterally adopted. This Article examines the contractarian theory by drawing a parallel between amending charters and bylaws on the one hand and amending contracts on the other; and by comparing the right to unilaterally amend corporate bylaws with the right to unilaterally modify contracts. The Article shows how contract law imposes various limitations on the modifying party’s discretion. The Article also compares the standard contractual relationship with that of the shareholders and the corporation more generally and uncovers several important differences that could make shareholders (particularly, minority shareholders) more vulnerable to counterparty (directors’ and controlling shareholder’s) opportunism. For example, unlike contracting parties who have the right to terminate the contractual relationship or opt out of undesirable modifications, shareholders lack the right of termination or opt-out. As a possible solution, the Article considers various mechanisms, including giving the shareholders the right of * Professor and Albert C. BeVier Research Professor of Law, 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 Molk, 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 disclosure, the right to vote (including the right to elect or replace directors), and subjecting bylaw amendments to more active judicial oversight. The Article suggests that active judicial oversight, through the vigorous application of the proper and equitable purpose test or imposition of good faith and fair dealing obligations, would be better in retaining the desired flexibility and policing directors’ and controlling shareholder’s opportunism. I. INTRODUCTION ............................................................................... 3 II. CORPORATE CONTRACT AND ITS AMENDMENT .............................. 11 A. C HARTER AND B YLAW A MENDMENT UNDER C ORPORATE S TATUTES ............................................................................... 13 B. R ECENT D EVELOPMENTS IN C ORPORATE B YLAWS ....................... 15 1. Boilermakers and ATP Tour .............................................. 16 2. Subsequent Developments ............................................ 19 III. AGENCY AND CONTRACT LAW IMPLICATIONS ON CORPORATE CONTRACT ................................................................ 21 A. A GENCY L AW ’ S T REATMENT OF P RINCIPAL -A GENT C ONTRACT .............................................................................. 22 B. H OW C ONTRACT L AW D EALS WITH (U NILATERAL ) M ODIFICATION ........................................................................ 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. O PTIONAL R EDEMPTION .......................................................... 33 B. M ANDATORY P RE -A MENDMENT D ISCLOSURE ............................. 35 C. S HAREHOLDER V OTING AND A PPROVAL ..................................... 35 D. S TRONGER J UDICIAL O VERSIGHT ............................................... 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 directors 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, perceived 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 from personal liability for breach of duty of care, or to have cumulative voting must be contained 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 provision, 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 next 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 dictate the content and once the amendment has been adopted, shareholders will be unable to change it unilaterally. DEL. CODE ANN. tit. 8, § 242. 4 IOWA LAW REVIEW [Vol. 104:1 resolution 5 and bypass a shareholder vote. 6 Directors have deployed this power on numerous occasions. For example, many have attempted to better manage out-of-control shareholder litigation by requiring all shareholder lawsuits to be filed only in Delaware (“exclusive forum bylaw”). 7 Similarly, some have adopted a bylaw that requires an activist shareholder to provide detailed information about itself and its director-nominees (“advance notice bylaw”) to better prepare for a potentially costly proxy fight. 8 Other directors have shifted the corporation’s litigation expenses onto unsuccessful (or not fully successful)...