Corporate law and the limits of private ordering.

Author:Cox, James D.
Position::New Directions for Corporate and Securities Litigation

Solomon-like, the Delaware legislature in 2015 split the baby by amending the Delaware General Corporation Law to authorize forumselection bylaws and to prohibit charter or bylaw provisions that would shift to the plaintiff defense costs incurred in connection with shareholder suits that were not successfully concluded. (1) In so acting, the legislature gave managers something they wanted, a way to deal with the scourge of multi-forum litigation, (2) while pacifying the local bar that feared lucrative shareholder suits would disappear because of the chilling effect of a loser-pays rule for shareholder suits. The legislature acted after the Delaware Court of Chancery held in Boilermakers Local 154 Retirement Fund v. Chevron Corp, (3) that the board could, without the concurrence of the shareholders, adopt bylaw provisions that permitted the corporation to choose the forum in which a shareholder-initiated suit would be maintained. Subsequently, in ATP Tour, Inc. v. Deutscher Tennis Bund, (4) the Delaware Supreme Court, relying on the reasoning in Boilermakers, upheld a board-adopted bylaw that abandoned the long-maintained American Rule (whereby litigants bear their own litigation costs) to instead assign the suit's defendant's expenses (which in a derivative suit would include the corporation's costs) to the plaintiff if the suit proved unsuccessful. Because such private ordering in the shadow of shareholder suits is not isolated to Delaware, (5) the peace that the plaintiff's bar has now reached via the Delaware legislature may only shift their once Delaware-focused angst to other states. Moreover, the Delaware legislation is narrowly focused; it remains to be seen whether board-adopted bylaws can condition shareholder suits on a range of other actions that impede shareholder suits, such as standing criteria that mandate size and length of a plaintiffs shareholdings or even mandate arbitration of such claims.

Boilermakers and A TP Tour actually pose a more fundamental question than the substance of the board-adopted bylaws. In their wake there lurks the much larger question: are there limits on the power of the board of directors to act through the bylaws to alter the rights shareholders customarily enjoy? Stated differently, can the board of directors' authority to amend the bylaws extend to changing both the procedural and substantive relationship that shareholders have with the corporation and the board of directors? This is the focus of this Article.

Boilermakers and ATP Tour each reasoned from the perspective that the shareholders' relationship with the corporation, and in turn their relationship with the board of directors, are contractual so that much of the shareholders' rights can be understood to flow from certain organic documents, and most significantly and pervasively from the company's bylaws. (6) For Delaware corporations, the board enjoys the power to amend the bylaws only if granted that authority in the articles of incorporation. (7) With that grant of authority to the board present in both Boilermakers and

ATP Tour, it was a short step for each court to conclude that the board's action was pursuant to the contract shareholders had with their corporation, and that the power of the board to amend the bylaws carried with it the power to amend the shareholders' rights. (8) Repeatedly, the analysis used by each court referenced the contractual relationship the shareholders had through the articles of incorporation and the bylaws with their corporation; (9) hence, that contractual relationship was subject to modification through the mechanism provided by the web of the articles of incorporation's authorization for the board to amend the bylaws. This Article argues that this analysis is wrongly premised. The Article develops two broad points: (1) that the shareholder's relationship is more than just a contract, and, (2) even if the relationship were contractual, bedrock contract law does not support the results reached in Boilermakers and ATP Tour.


    The seeds for Boilermakers and ATP Tour were sewn three decades ago with the metaphorical pronouncements by many commentators that the corporation is but a "nexus of contracts." (10) The expression is impactful because it is more than just a metaphor; it has substantive bite. The expression not only sets the course for what should be the content of organization law (i.e., principles should be what the parties would have agreed upon if bargaining were costless), but more significantly provides escape from those principles by allowing the parties to "opt out" of norms that are thereby default rules. (11) Building on Coase's perspective on why firms exist (the view holds that labor, suppliers, customers, investors, and managers arrange their activities to their optimal benefit), some leading scholars embrace private ordering as the desired norm within corporate law. In a world of private ordering, the state corporate statute is understood to have the limited role of providing default rules in those instances where the parties have not otherwise specified how their affairs or activities are to occur. (12) Corporate participants may well not specify all aspects of their relationship and accompanying rights and duties; they would avoid setting forth such matters when the costs of contracting reduce the benefits of the privately negotiated rules such that overall the ex ante benefits of the default rule dwarf the ex ante burdens of the customized rule. (13) In any case, the default rule is tailored toward what the legislature believes most, but not all, of an organization's stakeholders would agree to if contracting were efficient. (14)

    To nexus-of-contracts adherents, corporate rules are not mandatory but default rules; the parties are free to tailor the relationship to their own particular needs. (15) Thus, within the nexus-of-contracts metaphor, forum selection, fee shifting, and mandated arbitration are just some areas, among many others, where parties can best tailor their needs through their negotiations and agreement. Broadly stated, to the nexus-of-contracts crowd, corporate law as provided by the state is merely facilitative of private bargaining. Pursuant to this view, corporate law is not public, but private law. (16) In such a realm, the only issue in doubt is what constitutes consent among the affected parties; after all, it is bargaining that then results in the consent that Coase and contract theory so heavily depend upon as the basis for the efficiency that lies at its end. Consent is inextricably linked to another central assumption of such private ordering: the belief that the terms of the resulting contract will be fully priced into the shares. (17) Even here, the champions of the nexus-of-contracts approach salve any unease about there being meaningful consent by their obeisance to the efficient pricing of the "contracts" outcomes being reflected in the price of a firm's securities. (18) That is, owners and others--for example, creditors--who believe the "bargain" may be tilted against them can overcome any anticipated disadvantage by discounting charges based on the expected costs of any resulting unfairness or harmful contractual provision. Thus, any expected advantage gained by one party in bargaining can be expected to give rise to counterparty discounting (e.g., paying less for the shares or charging more for the money, goods, or services exchanged).

    Such pricing seems unlikely for multiple reasons. First, accurate pricing of an ownership interest in a corporation can be expected to occur only for corporate shares traded in a market that is not only informationally efficient but fundamentally efficient. This requires that there be evidence that a security's price reflects the intrinsic value of the bundle of rights represented by share ownership. This level of efficiency is not even believed to exist among the most ardent supporters of the efficient market hypothesis. (19) And, even if this condition were to exist in well-developed markets, vast numbers of corporations do not trade in such a market, if they trade at all. Second, any such pricing occurs only for those who acquire their shares after the amendment has been adopted; for earlier holders, the element of surprise necessarily accompanies unilaterally adopted bylaws. To be sure, there are a range of negative value actions that boards may embrace through the bylaws, so that the average estimated cost of such future action may be within the pricing process of any company's shares. However, when a particular company held by a shareholder does embrace a negative-value bylaw amendment, there is no overall wealth impact on the individual shareholder if that shareholder holds an efficient portfolio. The realized negative-value bylaw's impact for one company in that portfolio is offset by another equally weighted portfolio company. However, to the extent that many companies ultimately follow course in adopting the negative-value bylaw amendment, the earlier estimate will prove wrong, so that the shareholder did not discount enough when acquiring the shares. Thus, pricing will not provide ex ante means for shareholders to address this risk of share ownership. Third, a bylaw amendment that deals with shareholder litigation does not necessarily lead to negative value outcomes. For example, fee-shifting bylaws may well insulate corporations from the burdens of abusive shareholder litigation. On the other hand, the provision may insulate managers from being accountable. Neither of these outcomes can be predicted when the shareholder acquires shares with only the awareness that the board of directors can unilaterally amend the bylaws to accomplish a constellation of objectives. Even the most efficient market cannot be prescient; thus, serious information deficiencies eviscerate the likelihood of pricing the impact of...

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