In a decision with potentially far-reaching consequences, the Delaware Supreme Court ruled yesterday that a bylaw proposal submitted by AFSCME to CA, Inc. requiring reimbursement of dissident proxy solicitation expenses would violate Delaware law. Significantly, however, the Court also indicated that such a bylaw could be valid if it explicitly reserved the right of the board to deny reimbursement in exercise of its fiduciary duties. CA, Inc. v. AFSCME Employees Pension Plan (Del. July 17, 2008).

AFSCME’s Proxy Reimbursement Bylaw Proposal

In March of this year, AFSCME submitted a binding Rule 14a-8 proposal to CA to amend its bylaws to require reimbursement of reasonable expenses of running a short slate of dissident nominees for election as directors if at least one dissident nominee were elected. CA sought a no-action letter from the SEC staff permitting exclusion of the proposal on the grounds that it: (1) was not a proper subject for stockholder action under Delaware law; (2) would, if adopted, violate Delaware law; (3) conflicted with SEC proxy rules (i.e., Rule 14a-7); and (4) related to a procedure for election of directors.

On June 27, the SEC staff responded to CA, disagreeing with CA’s third and fourth grounds for exclusion and noting that it was certifying the Delaware corporate law issues in the first two grounds to the Delaware Supreme Court for resolution. CA and AFSCME had submitted directly opposite opinions on those points from two prominent Delaware law firms. This was the first such certification of questions by the SEC staff under a 2007 amendment to the Delaware Constitution explicitly permitting such certification.

Proper Subject for Stockholder Action under DGCL

On the first of the Delaware law grounds for exclusion, Justice Jack Jacobs (writing for the Court sitting en banc) indicated that the power of stockholders unilaterally to approve bylaw amendments under DGCL §109 was limited by the broad mandate in DGCL §141(a) that the business and affairs of the corporation “shall be managed by” the board “except as may be otherwise provided in [the DGCL] or in its certificate of incorporation.”

Justice Jacobs noted that it is impossible to draw a bright line between those bylaws that stockholders may unilaterally adopt under §109 and those which they may not under §141(a). He found, however, that the underlying, primary purpose of AFSCME’s bylaw related to the process of electing directors and brought the proposal in line with stockholder-adopted bylaws imposing procedural and process-related restrictions on directors which Delaware courts have permitted under §109. Specifically, the Court found that, “The purpose of the Bylaw is to promote the integrity of [the] election process by facilitating the nomination of director candidates by stockholders or groups of stockholders.”

The Court also found that merely requiring the board to expend corporate funds in some cases did not render the bylaw a substantive restriction on board authority of the type Delaware courts have found impermissible except in the certificate of incorporation under §141(a).

Consequently, Justice Jacobs held that the subject of the AFSCME bylaw proposal was proper for stockholder action under Delaware law. In fact, he suggested, in footnote 20, how the proposal might be “phrased more benignly” to emphasize its procedural, rather than substantive, nature.

Violates DGCL as Drafted

On the second certified issue, however, Justice Jacobs held that AFSCME’s bylaw proposal would, if adopted, violate the DGCL due to the mandatory nature of the proposal’s language (i.e., “the board of directors shall ”). Therefore, under some “possible circumstances,” it could require the board to reimburse expenses meeting the bylaw’s conditions without reserving to directors “their full power to exercise their fiduciary duty to decide whether or not it would be appropriate, in a specific case, to award reimbursement at all.”

Justice Jacobs suggested, in footnote 20, that a proxy reimbursement bylaw which “reserves the directors’ full power to discharge their fiduciary duties” could be valid under the DGCL. The exact nature of the reservation required is not clear from the text of the opinion. The Court seems to suggest, however, that a bylaw could be valid if it required reimbursement of reasonable expenses unless the board concluded that reimbursement, under the particular facts and circumstances, would constitute a breach of its fiduciary duties – an exclusion somewhat akin to a “fiduciary out” in a merger agreement “no-shop” provision.

Impact on Contested Elections and Corporate Governance

The CA v. AFSCME opinion provides the SEC staff with grounds for permitting CA to exclude AFSCME’s current bylaw proposal. But, it will also likely provide AFSCME and other activist stockholders with a roadmap for drafting proxy reimbursement bylaws that will not violate Delaware law because they contain adequate fiduciary-duty exclusions.

For most large public companies, it should be a relatively rare occasion when reimbursement of dissident proxy expenses constitutes a breach of director fiduciary duties. Consequently, CA v. AFSCME, in all likelihood, signals the coming of a new era in contested director elections and an important shift in U.S. corporate governance. In the past, the expense of a separate proxy solicitation has seriously dampened interest in dissident short slates and has focused activist attention on forcing dissident nominees into management’s proxy materials through the various initiatives of the stockholder-access movement.

Assuming activist stockholders are able to create reimbursement bylaws that satisfy CA v. AFSCME and cause those bylaws to be adopted at major public companies, the stockholder-access movement may be expected to decline in importance. In its place will be a brave new world in which short-slate, contested elections are far more common than they have been in the past.