Establishing and Enforcing Qualifications for Directors of Delaware Corporations

Transcription

1 Establishing and Enforcing Qualifications for Directors of Delaware Corporations by Mark Gerstein, Steven Stokdyk and Anthony Bruno, Latham & Watkins LLP With the advent of proxy access, either by SEC rule or private ordering through bylaw amendment [1], companies are increasingly focusing on the qualifications of directors nominated to serve on the board of a public company. This article summarizes the considerations for companies as they review and update their director qualifications. It will first outline the relevant Delaware law and discuss some of the more common qualifications that companies traditionally employ. Within this discussion, it will touch upon questions concerning the use of director qualifications under the new proxy access regime envisioned by the SEC. This article will also tackle the interesting question of what happens if a director, who was qualified at the time he was seated, subsequently loses his qualification. Companies armed with this knowledge will hopefully be better equipped to operate in a proxy access universe, as well as address governance issues presented by insurgent nominees supported by traditional solicitations. The Delaware law permits companies to prescribe qualifications for their directors via charter amendment or bylaw [2]. The law also imposes some basic limitations upon a company s exercise of this prerogative: it requires that each director be a natural person and it prohibits the enactment of any qualification that is inconsistent with the law or corporate charter [3]. Case law further mandates that all qualifications be reasonable and equitable such that they are related to the objectives and purposes of the corporation, and it proscribes qualifications that are unreasonably vague. [4] In assessing whether a director qualification comports with these standards, courts will typically uphold the qualification so long as it is susceptible to a reasonable interpretation and is enforced in a reasonable manner. In other words, Delaware courts will generally not strike a qualification simply because it has the potential to disenfranchise shareholders; rather, qualifications will typically fail only where there is some evidence that the board intended to disenfranchise shareholders in adopting or in enforcing the qualification. [5] Qualifications that are ratified by shareholder vote whether via amendment to the corporate charter or a shareholder approved bylaw are afforded a greater presumption of legitimacy. [6] Given the Delaware courts focus on the application (as opposed to the implementation) of qualification standards, companies have wide latitude to adopt qualifications which may contain subjective components. Indeed, some of the most common qualifications, such as those establishing

2 independence standards, require incumbent directors to render subjective assessments as to whether their potential successors are qualified. This certainly poses a risk to the exercise of the shareholder franchise, but as explained, the mere threat of misuse is ordinarily no reason to strike a qualification. The series of disputes involving Milliken Enterprises provides a good example of highly subjective, yet permissible qualifications. There, the company amended the corporate charter to require that certain directors possess substantial experience in line (as distinct from staff) positions in the management of substantial business enterprises or substantial private institutions.... [7] A shareholder facially attacked the qualification, arguing that it was unreasonably vague and thus provided the board too much discretion to interfere with the exercise of the shareholder franchise. The Delaware courts twice rebuffed the challenge. In the initial litigation, the Court of Chancery concluded that the line/staff demarcation was not impermissibly vague because the distinction between line and staff positions is generally recognized in the most elementary of businesses. [8] In the follow-on case, the Delaware Supreme Court similarly affirmed the use of the word substantial. The court determined that the term was commonly used as a qualifier in a broad range of rules and statutes. [9] Hence, the qualification was not facially invalid and the board was entitled to an opportunity to apply the qualification in a reasonable manner. As for examples of qualifications that have failed to pass legal muster in the Delaware courts, the case law here is unfortunately quite sparse. To find illustrations of impermissible qualifications, it may be helpful to consider the SEC s recent interpretation of Delaware law in this area. [10] In a 2008 no-action letter, the SEC determined that a shareholder-proposed qualification which would have required all directors of a global agricultural company to take an oath to support the U.S. Constitution appeared to be unreasonable under Delaware law. [11] The SEC endorsed the view that the proposal could, among other things, unreasonably disqualify competent foreign nationals from the directorships of an international company that relied on foreign markets for 43% of its sales. [12] In another example, a shareholder proposed a bylaw which would have rendered ineligible for election any current or former director who had previously opposed an amendment to remove the company s supermajority voting provisions. [13] The SEC determined that the proposal was likely inconsistent with Delaware law because it would unreasonably interfere with a director s exercise of business judgment and would place impermissible restrictions on a director s authority. [14] The proposals above, while atypical, help define the legal boundaries for director qualifications and should be taken into account as companies update their qualifications. Due to proxy access and the corresponding possibility that a greater number of shareholder-proposed directors will be nominated or elected, companies may now want to go beyond the more traditional qualifications based on age, term limits, stock ownership and independence. To adequately screen nominees, companies may now want to establish qualifications that relate to: compliance with SEC and stock exchange rules; regulatory requirements concerning the background or status of a director; compliance with company policies; criminal history and integrity; business understanding and achievement; providing required information to the company; not serving on more than a specified number of boards; and citizenship for regulated entities.

3 Should a company adopt some of these recommendations, the next question is determining at what stage in the nomination and election process the company may enforce the relevant standard. Delaware law has traditionally recognized a bifurcated process for seating directors: the nominee is entitled to his seat only after he is elected and qualified. [15] The law further provides that the nominee need not satisfy the qualifications for director at the time he stands for election; he must merely qualify within a reasonable time subsequent to election to take his seat. [16] That said, nothing in the Delaware law prohibits a company from qualifying potential directors prior to the election so that the relevant qualification serves as a condition precedent to the right to be nominated. In fact, the Delaware Supreme Court has expressly permitted corporate boards to disregard the nominations of unqualified individuals. [17] Nomination qualifications may also serve as an effective tool to provide standards for shareholder nominees in a new proxy access regime. However, assuming that the SEC s proxy access rule (Rule 14a-11) becomes effective, an interesting question will arise concerning the compatibility of nomination qualifications with the rule. [18] It is technically possible for corporations to comply with the proxy-access requirements and still enforce nomination qualifications. Rule 14a-11 requires companies to provide insurgent nominees access to the company s proxy; it does not explicitly require access to the ballot. [19] Consequently, it appears that a company remains free to exclude unqualified nominees from the ballot, notwithstanding that the same nominees must appear on the proxy. [20] Then, at the election, the proxies in favor of the unqualified nominees would dropout and votes would simply be cast for the remaining nominees. [21] Up to this point, this article has addressed questions concerning the establishment of qualifications as a condition precedent to allowing an individual to be nominated or seated on the board of directors. However, what recourse is available when a sitting director who was qualified at the he took his seat subsequently loses his qualifications? Delaware law specifies only three procedural means by which the term of a sitting director can be brought to a close: (1) upon the election and qualification of the sitting director s successor; (2) by resignation; or (3) by removal via shareholder vote. [22] The law does not contemplate the removal of a sitting director for failing to maintain certain qualifications. An alternate private-ordered path may be available though: in Stroud v. Milliken Enterprises, the Court of Chancery determined that a company could amend the corporate charter to provide for the automatic removal of directors whose qualifications lapse. [23] Because the contemplated removal mechanism would provide for termination upon the occurrence of a predetermined event, the court reasoned that a sitting director s failure to maintain the qualification was akin to a resignation. [24] However, in so holding, the court also indicated that a disqualification mechanism that would provide the incumbent board discretion to remove its own members would likely encounter a different legal fate; under Delaware law, it is well established that directors may not remove their peers. [25] This prohibition on directors possessing the power to remove their counterparts also limits the method by which a company may implement a mid-term disqualification rule. Although a charter provision to this effect is permissible, it requires shareholder approval and this may be difficult to obtain. [26] Unfortunately, charter amendment may be the only option because it is unlikely that private ordering through the bylaws is a viable alternative. In Kurz v. Holbrook, another judge of the Court of Chancery discussed, in dicta, the validity of hypothetical bylaws as opposed to charter provisions which would terminate the service of sitting directors who fail to maintain their qualifications. [27] The court suggested that directors may not adopt bylaws of this sort because such an exercise of power would enable directors to shape the board and frustrate the shareholder franchise. [28] Unresolved, however, is whether a bylaw that is ratified by a shareholder vote could be used to impose a disqualification provision? Holbrook implies that the answer is no; the court indicated that any bylaw

4 establishing mid-term removal is impermissible. [29] But the court s reasoning here is unclear: if shareholders are empowered to establish automatic termination provisions within the corporate charter, why should they be barred from taking similar action via bylaw? The courts will have to reconcile this inconsistency. Another unresolved question concerns the timing of the imposition of removal provisions. Holbrook suggests that charter amendments establishing qualification-based removal mechanisms will only be valid if they are in place before the director is seated; they cannot be added after the fact. [30] This seems a logical corollary to the Milliken Enterprises analogy which equates an automatic termination with a resignation. So long as the director knows before he is seated that he must maintain his qualifications in order to retain the board seat, the director has full notice of all expectations. It also seems that a company can comply with this front-end notice requirement through a private ordering mechanism whereby directors are required to tender their irrevocable resignation upon being seated, effective only upon disqualification under the company s qualification standards [31], as is permitted by the DGCL. Assuming that the applicable qualifications are in place prior to delivery of the letter, this procedure should be effective, but it could lead to disputes in practice. For example, if the resignation is subject to acceptance by the board, this runs the risk of subjective application with attendant litigation; or if the resignation is unconditional, this could result in the inadvertent loss of key directors who accidentally trip a qualification issue. Given this potential for legal challenges, boards choosing to adopt similar mid-term removal schemes would be wise to seek stockholder ratification of the qualification requirements, as this would only strengthen the company s hand. In conclusion, one can expect that many boards will consider amending their director qualification provisions to address shareholder nominees that do not go through the normal board screening process. Whether in the context of proxy access or broader governance considerations, these provisions, if properly structured, adopted and applied, may benefit both the quality and propriety of a company s directors. [1] The Dodd-Frank Act confers upon the SEC the authority to enact rules permitting the use by a shareholder of proxy solicitation materials supplied by an issuer of securities for the purpose of nominating individuals to membership on the board of directors.... Dodd-Frank Act 971(b). Acting pursuant to this authority, the SEC adopted Rule 14a-11 which requires companies to include in its proxy statement information about, and the ability to vote for, a shareholder s or a group of shareholders nominees for directorships. 17 C.F.R a-11; see also Facilitating Shareholder Director Nominations, Securities Act Release No. 9136, Exchange Act Release No. 62,764, Investment Company Act Release No. 29,384 (Aug. 25, 2010) [hereinafter Rule 14a-11 Adopting Release]. This rule was to become effective on November 15, 2010, but the SEC stayed its implementation pending the resolution of a legal challenge. See In re Motion of Business Roundtable, Securities Act Release No. 9149, Exchange Act Release No. 63,031, Investment Company Release No. 29,456 (October 4, 2010) (order granting stay). [2] DEL. GENERAL CORP. LAW 141(b) (West 2010) [hereinafter DGCL]. [3] Id. 109(b). [4] See, e.g., Stroud v. Grace, 606 A.2d 75 (Del. 1992) (indicating a qualification cannot be unreasonably vague); Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971) (corporate machinery cannot be manipulated for inequitable purposes); Stroud v. Milliken Enters. Inc., 585 A.2d 1306, 1308 (Del. Ch. 1998), appeal dismissed on other grounds, 552 A.2d 476 (Del. 1989) (noting that a corporation can provide for reasonable director qualifications). [5] This principle is illustrated in Stroud v. Grace. (This case is also discussed within the text above to illustrate a different point). There, the board adopted a bylaw requiring that all shareholders submit their nominees for directorships no earlier than 50 days, and no later than 14 days, before the scheduled election. 606 A.2d. at The bylaw also provided the board the authority to bar nominees from standing for election if they did not possess the requisite qualifications. Id. at A shareholder argued that this bylaw was inequitable because the board could disqualify a shareholder s nominees within 14 days of the election, leaving that shareholder with no opportunity to propose an alternate. See id. at 95. The Delaware Supreme Court rejected the challenge, stating that there is no basis to invalidate [the bylaw] upon some hypothetical abuse since every valid bylaw is always susceptible to potential misuse. Id. at [6] See id. at [7] Id. at 92. [8] Milliken Enters., 585 A.2d at 1308.

5 [9] Grace, 606 A.2d. at 94. [10] The examples contained within the text derive from SEC No-Action Letters in which the SEC addressed whether companies could exclude certain shareholder proposals from the company s proxy materials on the grounds that the proposals were improper under state law. See 17 C.F.R (i)(1). [11] Monsanto Co., SEC No-Action Letter, 2008 WL (Nov. 7, 2008) (endorsing the company s Delaware counsel s position that the qualification appears to be unreasonable under state law). [12] See id. at *1, 11. In its assessment of Delaware law, the company s counsel indicated that a similar qualification imposed by a company doing business in a regulated industry may be permissible. [13] Brocade Commc n Sys., Inc., SEC No-Action Letter, 2007 WL (Jan. 31, 2007). [14] Id. at *4 (outlining the company s view which the SEC implicitly endorsed as to why the qualification will conflict with state law). [15] See DGCL 141(b). [16] Triplex Shoe Co. v. Rice & Hutchins, Inc., 152 A. 342, 375 (Del. 1930). [17] Specifically, the court has upheld a bylaw providing that: The Board of Directors, or if not feasible, the officer of the Corporation or other person presiding at the meeting of stockholders shall determine any questions concerning whether nominations have been made in accordance with the provisions of this By-law 3 and whether such person has met the qualification requirements, if any, set forth in the Corporation's Certificate of Incorporation. If such a determination is so made, the officer of the Corporation or other person presiding at the meeting of stockholders shall so declare to the meeting and shall declare that any such nomination shall be disregarded. Grace, 606 A.2d at [18] 17 C.F.R a-11. [19] The Rule 14a-11 Adopting Release does not expressly mandate the inclusion of shareholder nominees on the company s ballot. At the same time, the Release repeatedly states that the new rules will require... a company s proxy materials to provide shareholders... the ability to vote for, a shareholder s, or group of shareholders, nominees for directors. See, e.g., Rule 14a-11 Adopting Release at 1 (emphasis added). This implies that the SEC has an expectation that shareholder nominees appearing on the proxy will also be listed on the ballot. [20] See Adopting Release at (explaining the proxy access requirements for nominees that may fail to meet the company s qualifications). [21] For more insight regarding the interplay between private ordering and the SEC s proxy access rule, including additional information concerning the use of nomination qualifications, please see Charles Nathan, et.al., Private Ordering in the Brave New World of Proxy Access, LATHAM & WATKINS CORPORATE GOVERNANCE COMMENTARY, Nov. 2010, available at pubcontent/_pdf/pub3801_1.pdf. [22] DGCL 141(b); Crown EMAK Partners v. Kurz, 992 A.2d 377, 400 (Del. 1992). [23] Milliken Enters., 585 A.2d at The court-approved charter amendment specified that [a]ny director who, at any time during his term of office, fails to remain qualified under the Category under which he qualified at the time of his last election shall automatically cease to be a director of the corporation. Id. [24] Id. [25] Id. [26] Companies considering an initial public offering or otherwise restructuring in a context that allows them to independently revise their articles might exploit that opportunity to implement such provisions. [27] Kurz v. Holbrook, 989 A.2d 140, (Del. Ch. 2010), aff d in part and rev d in part, Crown EMAK Partners v. Kurz, 992 A.2d 377 (Del. 1992). In Holbrook, the court passed judgment upon a bylaw designed to shrink the size of the incumbent board, which would have the effect of removing incumbent directors before their terms had expired. In assessing the validity of this board-shrinkage bylaw, the court analogized to a hypothetical bylaw which would remove sitting directors who had lost their qualifications, and determined that neither is valid under the DGCL. Id. [28] See Holbrook, 989 A.2d at 157. [29] In Holbrook, even though the proponent of board-shrinkage bylaw had obtained shareholder consent to adopt the provision, the court nonetheless struck the provision because, inter alia, it would conflict with Delaware law s mandate that [e]ach director shall hold office until such director s successor is elected and qualified or until such director s earlier resignation or removal. See id. at (citing DGCL 141(b)); Crown EMAK Partners, 992 A.2d (reciting the holding of Holbrook). This reasoning suggests that a bylaw providing for the disqualification of incumbent directors, even if ratified by shareholder vote, would also be void. [30] In light of the three procedural means for ending a director s term in Section 141(b), I do not believe a bylaw can impose a requirement that would disqualify a director and terminate his service. [citations omitted] Section 141(b) s recognition of the bylaws as a locus for director qualifications instead contemplates reasonable qualifications to be applied at the front end, before a director s term commences, when the director is elected and qualified. Holbrook, 989 A.2d at 157 (emphasis added). [31] DGCL 141(b) provides that directors may tender their resignation effective upon the occurrence of a specified event.