Rule 14a-8(i)(1) — former Rule 14a-8(c)(1)

Question 9(1): Improper under state law: If the proposal is not a proper subject for action by shareholders under the laws of the jurisdiction of the company's organization.

Note to paragraph (i)(1): Depending on the subject matter, some proposals are not considered proper under state law if they would be binding on the company if approved by shareholders. In our experience, most proposals that are cast as recommendations or requests that the board of directors take specified action are proper under state law. Accordingly, we will assume that a proposal drafted as a recommendation or suggestion is proper unless the company demonstrates otherwise.

§ 14.01 Background of the Exclusion

This exclusion allows a company to exclude a proposal whose subject is not a proper one for shareholder action. The law of the company's jurisdiction of organization governs the availability of this basis for exclusion.

§ 14.01[A] History of the Exclusion

In 1942, the SEC adopted this exclusion as the sole substantive basis for exclusion under the rule. The SEC staff decides what is a proper subject for action by shareholders under the applicable state law.[fn1] The staff's quasi-judicial role quickly became — and still is — controversial.

In 1945, the SEC issued an interpretive release in which the Division of Corporation Finance defined "proper subjects" for exclusion. The SEC stated that "proper subjects" were "matters relating to the affairs of the company concerned as are proper subjects for stockholders' action under the law of the state under which it is organized" and that proper subjects did not include "matters which are of a general political, social, or economic nature."[fn2]

In 1954, the SEC formalized the practice of placing the burden of proof on companies to show that a proposal could be excluded.

As part of this burden, if a company requested exclusion under the "proper subject" provision, the SEC required the company to obtain a legal opinion and cite relevant case law or statutory precedent. The SEC also codified its interpretive position that state law dictated which "proper subjects" were appropriate and that this analysis was governed by the laws of state of the company's domicile, which had been the principal debate in the Transamerica case.[fn3] In 1976, the SEC added a Note to the exclusion. At that time, the SEC indicated that "most states do not, for the most part, explicitly indicate those matters which are proper for security holders to act upon, but instead provide only that `the business and affairs of every corporation organized under this law shall be managed by its board of directors,' or words to that effect. Under such a statute, the board may be considered to have exclusive discretion in corporate matters absent a specific provision to the contrary in the statute itself or the corporation's charter or by-laws."[fn4] In 1983, the SEC decided to keep the Note to Rule 14a-8(c)(1) despite some commentator criticism. In so doing, the SEC stated that the Note "continues to reflect general state corporate law" but also noted that the format of a proposal, whether mandatory or precatory, is not dispositive. It stated that the staff would not, under any circumstances, elevate form over the substance of a proposal.[fn5] In 1998, the SEC renumbered the exclusion as Rule 14a-8(i)(1) and made minor stylistic changes, such as changing the reference to "the state of the company's incorporation" to "the laws of the jurisdiction of the company's organization."[fn6]

[fn1] Exchange Act Release No. 3347, 1942 SEC LEXIS 44 (Dec. 18, 1942).

[fn2] Exchange Act Release No. 3638, 1945 SEC LEXIS 233 (Jan. 3, 1945).

[fn3] For additional discussion of the Transamerica case, see infra Appendix E.

[fn4] Exchange Act Release No. 12,598, 9 SEC Dock. 1030, 1033 (1976) (proposing release); Exchange Act Release No. 12,999, 10 SEC Dock. 1006, 1010 (1976) (adopting release).

[fn5] Exchange Act Release No. 20,091, 28 SEC Dock. 798, 801-02 (1983).

[fn6] Exchange Act Release No. 40,018, 1998 SEC LEXIS 1001 (May 21, 1998).

§ 14.01[B] Purpose of the Exclusion

The purpose of this exclusion is to prevent shareholders from proposing shareholder action on matters that are not proper subjects for a shareholder vote. According to the SEC, "proposals by security holders that mandate or direct the board to take certain action may constitute an unlawful intrusion on the board's discretionary authority under the typical statute. On the other hand, however, proposals that merely recommend or request that the board take certain action would not appear to be contrary to the typical state statute, since such proposals are merely advisory in nature and would not be binding on the board even if adopted by a majority of the security holders."[fn7] This exclusion is intended to allow the omission of proposals that under the corporate law of the company's state of incorporation:

may be initiated only by the board of directors,
are committed to board discretion, or
otherwise ignore the statutory role of directors by proposing direct adoption of an action.

[fn7] Exchange Act Release No. 12,999, 1976 SEC LEXIS 326 (Nov. 22, 1976).

§ 14.01[C] Overlap with Other Exclusions For most of its history, this exclusion has overlapped with each of the other substantive bases, as companies often first consider whether a proposal is cast in mandatory or precatory form. Now, proponents tend to be more experienced and are likely to draft proposals in precatory form. Companies usually briefly raise this issue but focus their efforts on other bases for omission. If a company raises this issue, the staff normally allows proponents an opportunity to recast their mandatory proposals as precatory to avoid omission under this exclusion.

Once the more obvious issue regarding the form of the proposal has been addressed, some of the more specific overlaps may involve:

Rule 14a-8(i)(2), since a proposal that is not a proper subject for shareholder action would violate state law. However, the improper subject exclusion is narrower than (i)(2) because (i)(2) encompasses violations of federal and foreign laws in addition to state laws;
Rule 14a-8(i)(6), since a company does not have the power to effectuate a proposal if it is not a proper subject for shareholder action; and
Rule 14a-8(i)(7), because if a proposal is not a proper subject for shareholder action, it may involve the company's ordinary business operations.

§ 14.02 Application Of The Exclusion

§ 14.02[A] Identifying the Key Issues

The key issue under this exclusion is the evaluation of the appropriate division of corporate powers between management and shareholders under the corporate law in the company's jurisdiction of organization.

In determining the precise division of authority between shareholders and management under the applicable law, the SEC staff has wide latitude to apply state law. This is consistent with general principles of

federalism. This wide latitude may lead to controversy because the staff effectively is playing the role of the state courts regarding matters that inevitably involve state law.

§ 14.02[B] Lack of State Law Guidance for Staff

At times, there is little state law precedent for the SEC staff to draw on when determining whether a proposal topic is a proper one for shareholder action. In the words of the SEC, "It is the Commission's understanding that the laws of most states do not, for the most part, explicitly indicate those matters which are proper for security holders to act upon, but instead provide only that `the business and affairs of every corporation organized under this law shall be managed by its board of directors,' or words to that effect."[fn8]

[fn8] Exchange Act Release No. 12,598, 9 SEC Dock. 1030, 1033 (1976) (proposing release); Exchange Act Release No. 12,999, 10 SEC Dock. 1006, 1010 (1976) (adopting release).

§ 14.02[C] Judicial Interpretation of the Interplay Between State and Federal Law

Only a handful of cases have considered the interplay of state law and the shareholder proposal process.

EXAMPLE:

In Auer v. Dressel,[fn9] a proponent submitted a proposal asking the company to call a special meeting so that it could demand the reinstatement of an ousted president. The new president refused to call the meeting, and the shareholders brought an action to compel the company to hold the meeting. The trial court ordered the meeting to be held and the court of appeals affirmed. Although the court found that under state law, the shareholders could not force the board to reinstate the president, the court held that shareholders should be permitted to ask the company to hold a meeting.

Recently, this issue has been considered more frequently in the mandatory bylaw proposal context. Cases involving mandatory bylaw proposals are discussed in Section 14.03[C] below.

[fn9] 306 N.Y. 427, 118 N.E.2d 590 (N.Y.Sup.Ct. 1954).

§ 14.02[D] Exclusion Causes Tension Between State and Federal Law

This exclusion illustrates the jurisdictional dichotomy between state law, which dictates what matters shareholders or other persons may present for a vote at a shareholder meeting, and the federal securities laws, which prescribe the procedural mechanisms for such presentation and the related disclosures necessary to ensure informed voting decisions once proxies are solicited. The SEC staff is in the same position as federal courts frequently are of having to guess how a state court judge would interpret state law.

§ 14.02[E] Legal Opinion Requirement

Under Rule 14a-8(j)(2)(iii), a company must provide a supporting opinion of counsel to rely on the improper subject basis for exclusion.

§ 14.02[E][1] Form of Opinion

The required legal opinion can be rendered either by in-house counsel or outside counsel. The opinion may be included in the text of the no-action request or attached as a stand-alone document. Either way, it must be clear that it is a legal opinion. Most companies make it part of the incoming request. It is important to note that these opinions become publicly available when filed.

§ 14.02[E][2] Opinion Content

The legal opinion submitted to the SEC staff must contain three essential elements. First, the legal opinion must clearly be an opinion and must contain language to that effect (e.g., "opines" or similar language). Second, the opinion must fully address the law that the proposal allegedly violates. Third, the opinion cannot contain excessive cautionary language that limits its scope or effect.

§ 14.02[E][3] Bar of Lawyer Rendering Opinion

The lawyer providing the legal opinion need not be barred in the company's jurisdiction of organization. Accordingly, a company's in-house counsel can provide the legal opinion even if she is a not a member of the bar in that jurisdiction. In-house counsel often renders opinions since there normally is ample precedent to support this type of opinion, particularly in Delaware. However, if the law is unsettled, it is not uncommon for a company to submit an opinion from local outside counsel who is barred in the company's state of incorporation. In fact, the SEC staff recently stated that, in determining how much weight to afford a legal opinion, one factor that the staff considers is whether counsel is licensed to practice law in the jurisdiction where the law is at issue.[fn10]

EXAMPLE:

Nonbarred lawyer relying on Delaware counsel

In Ford Motor Company,[fn11] the lawyer who provided the legal opinion stated that "in connection with my opinions on Delaware law, I wish to point out that I am a member of the Bar of the State of Michigan and do not hold myself out as expert in the laws of other states or jurisdictions. However, I have made, or caused to be made, such investigation as I have deemed appropriate with respect to the laws of other states in connection with such opinions, including the General Corporation Law of the State of Delaware, and nothing has come to my attention in the course of such investigation which would lead me to question the correctness of such opinions. Moreover, attached hereto as Exhibit 2 is a letter from Morris Nichols Arsht & Tunnell, Ford's Delaware counsel, concurring in my opinions."

[fn10] See Division of Corporation Finance, Staff Legal Bulletin No. 14B (September 15, 2004), Division of Corporation Finance, Staff Legal Bulletin No. 14 (July 13, 2001) and Item G1 (available at www.sec.gov/interps/legal/cfslb14.htm).

[fn11] 2000 SEC No-Act. LEXIS 512 (Mar. 29, 2000).

§ 14.02[E][3][a] No Requirement for Proponent to Submit Legal Opinion

Even though a proponent may argue that a law should be interpreted differently than the company, it does not have to provide a legal opinion to that effect because the company bears the burden of proof. Rule 14a-8(j)(2)(iii) requires legal opinions only as part of the procedures that companies must follow; there is no counterpart legal opinion requirement for proponents. However, a proponent sometimes submits a legal opinion because it strengthens its case before the SEC staff.

§ 14.02[E][3][b] Dueling Opinions

Sometimes the staff receives "competing" opinions from the company and the proponent. In essence, the proponent provides an opinion that "rebuts" the interpretation of a law contained in the opinion submitted by the company. These are the most difficult situations for the staff because it becomes the arbiter of state law.

In these cases, the staff may determine that one party has provided a better reasoned opinion and decide in its favor. If neither opinion is persuasive, the staff may decide in favor of the proponent because the company has failed to meet its burden of proof. In some cases, the staff may decide to not take a position because the state courts have not decided the matter and it is inappropriate for the staff to take a position in light of the competing opinions. The staff rarely takes a "no view" position and only does so if the interpretation of the law clearly appears to be undecided.

§ 14.03 Interpretive Approaches

The staff has taken three primary interpretive approaches under the improper subject exclusion. The first is the traditional treatment of mandatory proposals. Second is the exclusion of a proposal that may be inconsistent with state law, even in precatory form. The third involves the more recent dispute over mandatory bylaw provisions.

§ 14.03[A] "Mandatory" Versus "Precatory" Proposals

As described in the Note to the exclusion, the SEC views precatory proposals that do not seek to bind the board as consistent with the board's authority to manage the company. "Precatory" proposals are non-binding resolutions that ask a board to take certain action.

In most cases, a proposal that mandates a particular act will not be proper under applicable state law. However, in almost all instances, a proposal recommending the same action likely will be considered proper. As a result, it is customary for proponents to frame their proposals as non-binding, and the SEC staff generally allows proponents to recast binding proposals as precatory to avoid exclusion.

§ 14.03[A][1] Rebuttable Presumption that Precatory Proposals Includable

In a sense, the effect of the Note to Rule 14a-8(i)(1) regarding precatory proposals is to raise a rebuttable presumption that a proposal phrased as a recommendation rather than a mandate is proper under state law. However, the full analysis of whether a proposal can be omitted under the exclusion is a question of state law and does not completely depend on how the proposal is phrased. In other words, a company still has to point to a particular state law when raising the exclusion; it cannot merely note that the proposal is a mandate.

§ 14.03[A][2] Precatory Presumed Unless Binding Nature Evident

The SEC staff presumes a proposal is precatory unless the company demonstrates otherwise. This is consistent with the general rule that the company has the burden of proof to show that an exclusion applies.

EXAMPLES:

In PG&E Corporation,[fn12] the company successfully excluded a proposal that provided that the board "should" automatically approve any shareholder proposal that has been approved by a majority of shareholders. The company argued that the SEC had long recognized that a proposal, if stated as a mandatory proposal, is not a proper subject for shareholder action under state law, although such proposal may be a proper subject for shareholder action if the proposal is precatory. The company pointed to Note to Rule 14a-8(i)(1) which codified this position. The company noted that because the word "should" has many meanings, shareholders may believe that the proposal, if approved, would require the board to approve all shareholder proposals that receive a majority vote. The proponent did not submit a rebuttal.
In Alaska Air Group, Inc.,[fn13] the proposal required the reinstatement of simple majority voting on all matters submitted to a shareholder vote. The company argued that "one must stretch to conclude that the proposal is intended to be a recommendation (rather than a mandate) from the use of the word `a recommendation' at the end of the next sentence: `Reinstate simple majority vote on all issues that are submitted to shareholder vote (a recommendation)'." The company argued that the staff should not afford the proponent further opportunities to cure this deficiency, in view of his familiarity with this issue, his prior experience with the staff in dealing with it, and his unwillingness to properly correct the proposal as demonstrated by his rebuttal. The proponent argued that his proposal was not binding. To avoid exclusion, the staff instructed the proponent to recast the entire portion of the proposal under "Resolved" so that it was clearly precatory.

[fn12] 2001 SEC No-Act. LEXIS 93 (Jan. 18, 2001).

[fn13] 2000 SEC No-Act. LEXIS 479 (Mar. 26, 2000).

§ 14.03[A][3] Which State Law Applies

As with any governance issue, the law of the company's state of incorporation governs the availability of the exclusion.

§ 14.03[A][4] Opportunity to Cure

Before 1976, the staff routinely gave proponents a chance to recast their proposals as precatory to avoid omission under this exclusion. Since the SEC added a Note to the provision in 1976 to make clear that proposals must be precatory, the staff could have become more selective in providing this opportunity. However, the staff normally allows an opportunity to cure unless it is clear that the applicable state law renders the problem uncurable.

§ 14.03[A][5] Laws that Provide Specific Power to the Board

Companies most commonly argue that proposals are excludable on this basis because state law gives control over the management of a company to the board, absent a contrary provision in a company's corporate governance documents. Each state has corporate law provisions that state that the board has day-to-day management authority and that shareholders cannot mandate that the board take specific action unless another state law gives such power to shareholders and overrides the grant of authority to the board.

The typical state corporation law that authorizes boards to manage companies provides something akin to Section 141(a) of the Delaware General Corporation Law, which states that "the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation."[fn14] Based on these laws, the staff almost uniformly finds that proposals cast in precatory form are not inconsistent with state laws delegating power over the company's management to the board.The following examples illustrate how this process works in connection with companies incorporated in a variety of states.

EXAMPLES:

Delaware

In Ford Motor Company,[fn15] the company was required to include a proposal requesting that shareholder approval be obtained before any stock repurchase program is implemented. The company argued that by requiring the company to obtain stockholder approval before implementing a stock repurchase program, the proposal would deprive the board of its ability to manage the company's overall capital structure and financing activity, which are fundamental aspects of the business and affairs of a corporation to be managed by the board. The company argued that the proposal violated Section 141(a) of the Delaware General Corporation Law, which provides that "the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation." The company noted that neither Delaware law nor the company's certificate of incorporation limited the general authority of the board to manage the company's business. The company also argued that the proposal was not a proper subject for action by stockholders because it lacked sufficient specificity for stockholders to know the consequences of a vote for the proposal or for the board to implement the proposal since Section 160 of the Delaware General Corporation Law provided broad authority for a corporation to "purchase, redeem, receive, take or otherwise acquire . . . its own shares." The company noted that this broad power is subject only to the limitations set forth in Section 160 and that the Delaware General Corporation Law did not include any provision requiring stockholder approval of a stock repurchase program.

In Associates First Capital Corporation,[fn16] the proposal mandated that all bonuses be voted on by shareholders and be limited to 10% of the salaries of executive officers filling identified positions. The SEC staff required the proponent to recast the proposal as precatory to avoid exclusion. The company argued that compensation paid to employees clearly fell within the realm of the "business and affairs" of the corporation and that no provision of Delaware law granted to shareholders the authority to set company policy in such matters, over which the board had exclusive discretion.

North Carolina

In Duke Energy Corporation,[fn17] the SEC staff required the company to include a proposal recommending that the board limit future board nominations to persons serving on no more than four boards of other companies, organizations, or entities. The company argued that the proposal violated North Carolina law (specifically, North Carolina General Statutes Section 55-7-31(b)), which provided that all corporate power shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, the board of directors, except as provided in the articles of incorporation or in an agreement. The company noted that neither the North Carolina law nor did its articles of incorporation limit in any way the general authority of the board to manage the business of the company, including the selection of nominees for election as directors. The proponent's rebuttal did not specifically address this exclusion.

California

In PG&E Corporation,[fn18] the SEC staff required the proponent to revise the proposal, which mandated that the company not count abstentions as votes cast on a proposal, to make it precatory. The company noted that the proposal would impose new voting tabulation procedures and that the board's authority to make decisions regarding such matters was not limited by Section 300(a) of the California General Corporation Law or by the company's articles of incorporation or bylaws.

Maryland

In Washington Real Estate Investment Trust,[fn19] the proposal required the company to limit bonuses to all company personnel to a maximum of 10% of annual salary. To avoid exclusion, the SEC staff required the proponent to recast the proposal so that it was precatory. The company contended that the proposal would cause it to violate Section 8-301 of the Maryland Corporations and Associations Code because the proposal would remove its ability to determine compensation for employees.

Washington

In Washington Mutual, Inc.,[fn20] the proposal mandated that the company hire a proxy advisory firm, to be chosen by shareholder vote, to make shareholder voting recommendations. The proponent argued that the proposal was intended to be precatory and to clarify this, he offered to change the wording to maintain consistently precatory language. The company believed that the proposal dealt with an improper subject for action by shareholders under several subsections within the Revised Code of Washington Section 23B (RCW 23B) because shareholders cannot require the company to hire external consultants or entirely eliminate the company's management from the process of selecting such consultants. The SEC staff required inclusion on the condition the proponent modify the proposal to make it clearly non-binding.

Virginia

In Philip Morris Companies Inc.,[fn21] the proponent defeated a no-action challenge to a proposal requesting that management develop a report for shareholders describing how the company intends to address the "sicknesses" caused by its products and correct the defects in its products. The company did not cite the specific law that rendered the proposal improper under this exclusion.

Ohio

In Kroger Co.,[fn22] the SEC staff required the company to include a proposal asking that the board adopt a policy of removing genetically engineered crops from all products sold. The company argued that Section 1701.59(A) of the Ohio Revised Code gave the board exclusive authority and discretion to manage the company's business and affairs, including the authority to select suppliers and products and make decisions regarding the development and production of private label products.

Maine

In Bangor Hydro-Electric Company,[fn23] the proposal mandated that the company prepare a report discussing political contributions by the company, its directors, and certain of its employees. The proponent had to recast the proposal so that it was precatory for it to be included. The company argued that the proposal was not proper under Maine Revised Statutes Annotated Title 13-A, Section 701. This statute requires that the business and affairs of a corporation be managed by the board.

[fn14] 8 Del. C. § 141(a) (2001).

[fn15] 2000 SEC No-Act. LEXIS 512 (Mar. 29, 2000).

[fn16] 2000 SEC No-Act. LEXIS 287 (Mar. 2, 2000).

[fn17] 2000 SEC No-Act. LEXIS 294 (Feb. 24, 2000).

[fn18] 2000 SEC No-Act. LEXIS 173 (Feb. 22, 2000).

[fn19] 2000 SEC No-Act. LEXIS 947 (Dec. 13, 1999).

[fn20] 2000 SEC No-Act. LEXIS 222 (Feb. 22, 2000).

[fn21] 2000 SEC No-Act. LEXIS 202 (Feb. 14, 2000).

[fn22] 2000 SEC No-Act. LEXIS 547 (Apr. 12, 2000).

[fn23] 2000 SEC No-Act. LEXIS 418 (Mar. 13, 2000).

§ 14.03[B] Precatory Characterization Not a Cure

In most cases, the format of the proposal dictates whether a proposal is excludable under this exclusion. In rare circumstances, even if a proponent recasts a proposal as precatory, it is not enough to prevent omission of a proposal. Below are several examples in which companies raised this argument.

§ 14.03[B][1] Exxon Corporation

In Exxon Corporation,[fn24] the company was required to include a proposal mandating a bylaw amendment to create a shareholder advisory committee to review and evaluate the performance of the board, both in managing the company and representing shareholder interests. In addition, the proposal would have required the company to provide a committee report in its proxy statement and nominate committee members in the same manner as directors. Under the proposal, the company would pay fees to any consultants that the advisory committee hired in an amount up to $.01 times the number of outstanding shares as well as indemnify advisory committee members. The company, a New Jersey corporation, argued that New Jersey law barred shareholders from interfering with the board's authority to manage the company through a self-executing bylaw amendment. The company submitted an opinion from New Jersey counsel that New Jersey law requires a corporation to be managed by the board and that a shareholder advisory committee would impinge upon its oversight authority and violate the state law requirement. However, the opinion acknowledged the lack of precedent on point. The proponent replied that the committee would not impermissibly intrude on the board's authority to run the company. In its response, the staff stated that it was unable to conclude, based on the company's opinion, that the applicable state law prohibited such a bylaw provision.

[fn24] 1992 SEC No-Act. LEXIS 281 (Feb. 28, 1992).

§ 14.03[B][2] Pennzoil Corporation

In Pennzoil Corporation,[fn25] the California Public Employees' Retirement System (CalPERS) did not succeed in including almost exactly the same bylaw amendment that had been deemed includable at Exxon during the prior year. The company, a Delaware corporation, argued that a committee charged with offering advice to the board and able to incur expenses without oversight was contrary to Delaware law, which requires that the board manage companies. The company also contended that indemnification of the shareholder advisory committee was inconsistent with Delaware law. In its response, the staff focused on how the shareholder advisory committee was funded. It noted that Delaware law did not permit shareholders to authorize the expenditure of corporate funds without "some concurring action" by the board.

After the staff's decision, CalPERS asked for reconsideration so that it could amend its proposal to make it precatory and avoid exclusion. The company objected and argued that, once adopted, the precatory bylaw amendment could only be amended by a supermajority vote of the shareholders, thus rendering it invalid under Delaware law. The company believed that its board could not voluntarily relinquish its power to amend the bylaw because this would harm future boards from wielding it full power. The proponent replied that its modified proposal was includable because it only requested the board to consider the advisability of establishing a shareholder advisory committee as contemplated by the Note to this exclusion basis. The staff agreed with the company and did not allow CalPERS to amend its proposal.

EXAMPLE:

In Badger Paper Mills, Inc.,[fn26] the company successfully excluded a proposal that requested that the voting power of the shares held by a specific shareholder be restored to full voting power pursuant to Section 180.1150 of the Wisconsin Business Corporate Law. The company, which was a Wisconsin corporation, argued that the proposal was really submitted to restore voting rights to shares of company common stock owned by another shareholder. The company argued that this Section provided that such a proposal could be submitted only by the holder of the shares whose full voting power was proposed to be restored. The proponent did not submit a rebuttal.

[fn25] 1993 SEC No-Act. LEXIS 304 (Mar. 22, 1993).

[fn26] 2000 SEC No-Act. LEXIS 450 (Mar. 15, 2000).

§ 14.03[C] Mandatory Bylaw Proposals

The SEC staff generally has required companies to include bylaw amendments that are precatory and does not view them as intruding upon the statutory authority granted to the board to conduct a company's affairs. However, a number of proponents have submitted proposals mandating the adoption of bylaws that would require management to take certain action. Proponents argue that such bylaw amendments are proper because applicable state corporate law and a company's charter and bylaws permit shareholders to initiate bylaw amendments on the subject of the proposal.

It often is not clear whether a particular state corporate law allows shareholders to submit mandatory bylaw amendments. As a result, the question of whether this type of proposal is valid under state law remains hotly debated. This approach to activism has led to contentious battles between companies and proponents and eventually resulted in several court cases.

Some seemingly inconsistent staff decisions and costly court battles have frustrated proponents who have submitted shareholder proposals with mandatory bylaw amendments. Increasingly, these proponents have not relied on Rule 14a-8 to achieve their goal but instead have conducted their own independent solicitations. These proponents file proxy solicitation materials with the SEC that cover the proposed bylaw amendment and then conduct a limited solicitation of only the largest shareholders, enabling them to limit expenses.[fn27]

One interesting tactic is being employed by Herbert Denton, President of Providence Capital. Mr. Denton has initiated and has indicated that he will continue an anti-poison-pill campaign by submitting binding bylaw resolutions to a number of companies. Until Mr. Denton's campaign, the submission of binding bylaw amendments had faded over the past few years due to concerns over the legality of prohibiting directors from adopting pills under Delaware law.

In the hope of avoiding the legal uncertainties mentioned above, Mr. Denton has submitted a new type of binding proposal that focuses on director qualification: following majority shareholder approval of a proposal dealing with poison pills, a board must respond within 180 days by redeeming the plan or calling a meeting of shareholders to hold a referendum on the pill's continuation. Any director who fails to support one of these actions would no longer be qualified to be re-nominated for a new board term.[fn27.1] As of this writing, the validity of this proposal has not been litigated.

[fn27] One result of this tactic may be to deny management the ability to exercise the discretionary voting authority conferred on it by earlier obtained proxies with regard to this issue, because it now knows there will be a contested vote at the annual meeting. Rule 14a-4(c)(1) generally denies management the ability to use the discretionary voting authority granted it by the standard proxy with respect to shareholder proposals as to which it has received adequate notice a reasonable time before the shareholders' meeting.

[fn27.1] See Michael Hanrahan, "The Next Poison Pill Antidote — Director Nomination By-Law Amendments," Corporate Governance Advisor (Jan./Feb. 2002).

§ 14.03[C][1] Laws that Allow Shareholders to Mandate Bylaw Amendments

Mandatory bylaw proposals create legal tension because the relevant and potentially applicable statutory provisions can be read to conflict, making it unclear whether such proposals are permissible under state law. The majority of states permit shareholders to initiate and approve by law amendments directly without board approval.

For example, Delaware law clearly contemplates shareholders taking action to propose bylaw amendments. Section 109(a) of the Delaware General Corporation Law ("DGCL") provides: "The original or other bylaws of a corporation may be adopted, amended or repealed by the incorporators, by the initial directors if they were named in the certificate of incorporation, or, before a corporation has received any payment for any of its stock, by its board of directors. After a corporation has received any payment for any of its stock, the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote, or, in the case of a nonstock corporation, in its members entitled to vote; provided, however, any corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors or, in the case of a nonstock corporation, upon its governing body by whatever name designated. The fact that such power has been so conferred upon the directors or governing body, as the case may be, shall not divest the stockholders or members of the power, nor limit their power to adopt, amend or repeal bylaws."[fn28]

On the other hand, Section 141(a) of the DGCL contains an equally broad and unqualified statement supporting the board's authority: "The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation."[fn29] As Professor John Coffee has noted, "not only does this provision seemingly make the board the ultimate repository of all corporate power and authority, but it can also be read to require that any deviation from this fundamental rule be expressed in the certificate of incorporation. Alternatively, one can read the phrase "except as otherwise provided in this chapter" as a cross-reference to Section 109 and its broad recognition of shareholder authority to adopt and amend bylaws."[fn30]

[fn28] 8 Del. C. § 109(a) (2001).

[fn29] Id. § 141(a).

[fn30] John C. Coffee, Jr., "Mergers and Acquisitions Symposium: The Bylaw Battlefield: Can Institutions Change the Outcome of Corporate Control Contests?" 51U. Miami L. Rev. 605 (1997).

§ 14.03[C][2] Staff Analysis of Bylaw Amendment Proposals

The SEC staff normally allows proponents to include mandatory bylaw proposals that are not inconsistent with the law or with the company's corporate governance documents. However, in many cases, while there may not be a direct conflict between a bylaw and state law, there still is an issue regarding whether the proposal's purpose conflicts with the purpose of the law or with a company's corporate governance documents. Since there are a limited number of state court decisions to provide guidance, the staff must make its own evaluation.

To satisfy its burden, a company has to argue that the proposed bylaw is invalid under the applicable state law and submit a legal opinion to support its position. Since the staff generally is reluctant to interfere with shareholders' rights to initiate bylaw amendments based on arguments that are not supported by case precedent, if a proposal's bylaw is not inconsistent with a specific provision of the state law or the company's charter, exclusion may not be permitted.

§ 14.03[C][3] SEC Staff May Have "No View"

In some recent no-action letters, the SEC staff has expressed "no view" as to whether the proposal may be excluded. In most of these letters, both the company and the proponent have offered legal opinions supporting contrary interpretations of the law. To avoid "playing judge" in these close calls, the staff declines to make a decision and leaves the ultimate decision to the parties. Since companies and proponents have gone to the time and expense of complying with the Rule 14a-8 process, the staff rarely resorts to not taking a position and only does so if the interpretation of a law clearly appears to be undecided.

Absent a negotiated settlement, the only recourse for a proponent is to take the issue before the courts. Companies and proponents rarely file lawsuits regarding shareholder proposals, but the level of litigation over proposals gradually has increased over the last decade, primarily due to mandatory bylaw proposals.[fn31]

EXAMPLES:

In Community Bancshares, Inc.,[fn32] the staff decided, because of the lack of any legal authority, not to express a view on the proposals in question. The first proposal sought to amend the bylaws to require that the same person not hold the positions of chairman of the board and president simultaneously. The second proposal sought to amend the bylaws to require that the board consist of directors who were independent, except for the president. The company argued that the implementation of the proposals would require them to violate Sections 109, 141, and 142 of the Delaware General Corporation Law (DGCL). The company detailed the specific violations that the proposals would create, stating that the proposals mandated action and thereby usurped the authority of the board under Delaware law in violation of Section 141 of the DGCL; that the proposals would result in an impermissible delegation of board authority in violation of Section 142 of the DGCL; and that the proposals would put in place a bylaw that could not be altered by any board in violation of Section 109 of the DGCL.
In Union Carbide Corp.,[fn33] the staff decided that because of the lack of any legal authority, it would not express a view on the proposal. The proposal would have amended the company's bylaws to prohibit the board from changing the expiration date of its shareholder rights plan or adopting any new shareholder rights plan, without shareholder approval. The company argued that the proposal would violate Sections 505, 510, 601, 701 and 717 of the New York Business Corporation Law.

[fn31] See supra Chapter 5.

[fn32] 1999 SEC No-Act. LEXIS 426 (Mar. 15, 1999).

[fn33] 1999 SEC No-Act. LEXIS 145 (Feb. 5, 1999).

§ 14.03[C][4] Battles Over Mandatory Bylaw Amendments

In the early 1990s, several no-action letters signaled that proponents were becoming increasingly interested in the use of mandatory bylaw amendments as a way to force companies to take action regarding particular matters, particularly poison pill redemptions.

The courts, however, have delivered mixed results. Most important, no court has yet addressed the validity of mandatory bylaw amendments under Delaware law.

The uncertainty about mandatory bylaw amendments and the expense associated with submitting and defending them before the SEC staff and in court appears to have chilled proponents' interest in them. Different tactics, such as "just vote no" campaigns and nomination of short slates, are now being explored. The following highly publicized battles chart the course of the debate over mandatory bylaw amendments.

§ 14.03[C][4][a] Fleming Companies

In 1995, Fleming Companies included a precatory proposal from the International Brotherhood of Teamsters in its proxy materials asking the board to eliminate the company's poison pill unless it was approved by a majority of the outstanding shares. At the annual shareholders' meeting, the proposal received the support of nearly two-thirds of the shares voted. In the face of this vote, the company's board approved the adoption of a new poison pill to replace the one that was due to expire. This disappointed the proponents. In 1996, the International Brotherhood of Teamsters submitted a new proposal that mandated the adoption of a bylaw that would have prohibited the company from adopting or maintaining a poison pill without shareholder approval. After receiving the proposal, the company, an Oklahoma corporation, decided not to wait for the SEC's no-action decision and went directly to court to obtain a declaratory judgment that the bylaw proposal was not a proper subject for shareholder action. The SEC staff decided not to take a position on the proposal pending the court's decision. In International Brotherhood of Teamsters v. Fleming Cos., Inc.,[fn34] the district court held that the bylaw was proper under Oklahoma corporate law. The company included the proposal and shareholders overwhelmingly supported it.

The company diminished the importance of the vote by eliminating its poison pill just before the meeting. In addition, the company appealed the district court's decision. The Court of Appeals decided not to pass on the issue and certified the question to the Oklahoma Supreme Court.

In the Supreme Court, the company argued that the bylaw amendment violated Oklahoma's General Corporation Law, which "empowers the board of directors to create and issue stock rights." In International Brotherhood of Teamsters v. Fleming Companies,[fn35] the Oklahoma Supreme Court held that a board does not have exclusive authority to create and implement shareholder rights plans.

The court noted that there was no authority under Oklahoma law that precluded shareholders from proposing resolutions or bylaw amendments regarding such plans and that "shareholders may, through the proper channels of corporate governance, restrict the board of directors [sic] authority to implement shareholder rights plans." The Fleming decision was the first time that a company was compelled to include in its proxy statement a mandatory bylaw amendment to repeal a shareholder rights plan. The court's decision was a surprise to many practitioners. Some commentators believe that this case is significant even though few companies are incorporated in Oklahoma because the relevant provisions of Oklahoma law are virtually identical to its Delaware counterparts.[fn36] However, the case's true significance is uncertain until Delaware courts address the issue.

[fn34] 1997 U.S. Dist. LEXIS 2980 (W.D.Okla. Jan. 24, 1997).

[fn35] 975 P.2d 907 (Okla. Sup. Ct. 1999).

[fn36] Compare 18 Okla. Stat. Ann. § 1027(A) (West Supp. 1999) with 8 Del. C. § 141(a) (1991 & Supp. 1998) (statutes in effect at the time of the Fleming case); see also IRRC Corporate Governance Bulletin, at 4 (Nov.-Dec. 1998); "OK Court Says Shareholders Can Undo Defenses through Bylaw Changes," Delaware Corporate Litigation Reporter, at 11 (Feb. 16, 1999).

§ 14.03[C][4][b] Quickturn Design Systems, Inc.

In Quickturn Design Systems, Inc. v. Mentor Graphics,[fn37] the Delaware Supreme Court held that a defensive measure barring a newly elected board from redeeming the company's shareholder rights plan was inconsistent with Section 141(a) of the Delaware General Corporation Law. The "interested person" in this case would have been the defendant, Mentor Graphics, which had made the hostile takeover bid for Quickturn. In finding that so-called "dead-hand" provisions are invalid under Section 141(a) of the Delaware General Corporation Law, the court noted that "one of the most basic tenants of Delaware corporate law is that the board of directors has the ultimate responsibility for managing the business and affairs of a corporation. Section 141(a) requires that any limitation on the board's authority be set out in the certificate of incorporation." According to some commentators, the court's reasoning could be followed to oppose mandatory bylaw amendments that restrict a board's power and prevent it from fulfilling its fiduciary duty to manage the business and affairs of a company since the case provides an indication of how the Delaware court feels about the board's authority to manage a company.[fn38]

[fn37] 721 A.2d 1281 (Del.Sup.Ct. 1998).

[fn38] Charles F. Richards & Robert J. Stearn, Jr., "Shareholder By-laws Requiring Boards of Directors to Dismantle Rights Plans Are Unlikely to Survive Under Delaware Law," 54 Bus. Law. 607 (1999); Lawrence A. Hamermesh, "The Shareholder Rights By-Law: Doubts from Delaware," Corp. Gov. Advisor (Jan./Feb. 1997).

§ 14.03[C][4][c] Shiva Corporation

In the spring of 1998, the SEC staff, in an apparent reversal of previous policy, allowed a company to rely on the ordinary business exclusion to omit a proposal to amend the company's bylaws to prohibit the repricing of stock options. Since the early 1990s, the staff's position when assessing the application of the ordinary business exclusion to bylaw proposals was that action in bylaws was not ordinary business. In taking that approach, the staff did not look through the bylaw proposal to determine the nature of the underlying corporate activity addressed by the proposed bylaw. In Shiva Corporation,[fn39] the staff made clear that it now took the position that a bylaw regarding compensation would be treated just like any other proposal subject to all of the substantive exclusions, including the ordinary business exclusion.

In this case, the State of Wisconsin Investment Board (SWIB) submitted a bylaw amendment that would have prohibited the company from repricing options without shareholder approval. The company in its submission to the staff argued that the proposal should be excluded as involving compensation of the general workforce, a subject matter traditionally viewed as ordinary business. The company did not address the bylaw amendment issue, nor did the staff in its response. SWIB appealed the staff's no-action position to the Commission, which upheld the staff's decision. SWIB unsuccessfully sued the company to compel inclusion; the court did not specifically address the issue of bylaw amendments under Rule 14a-8.

[fn39] 1998 SEC No-Act. LEXIS 394 (Mar. 10, 1998).

§ 14.03[C][4][d] General DataComm

In General DataComm Industries, Inc.,[fn40] the proposal mandated a bylaw amendment on the repricing of stock options. The staff decided that because of the absence of any legal authority not to express any view on the exclusion of the proposal under Rule 14a-8(i)(1). The company cited Sections 109, 122(15), 141, 152, 153, 157, and 161 of the Delaware General Corporation Law as supporting exclusion. The proponent argued that there was no precedent on the exclusion of the proposal under the improper subject exclusion and contended that the company had thus not met its burden of proof.

In General DataComm v. State of Wisconsin Investment Board,[fn41] the Delaware Chancery Court had the mandatory bylaw amendment issue before it, but ultimately did not decide the case on the merits. The company sought declaratory and injunctive relief regarding the validity of the bylaw amendment that would have restricted the ability of the company to reprice its stock options without shareholder approval. The court found that the bylaw amendment was not ripe for consideration until it had been approved by shareholders. However, in dicta, the court noted its "reticence to issue a ruling" was "influenced by [a] reluctance to encourage corporations to seek advisory opinions about important issues of Delaware corporation law as a method of shaping their annual meeting proxy materials." The court went on to say that "if this option were routinely available, this court could find itself playing a parallel role to the SEC, which is regularly involved, pursuant to its statutory and regulatory authority, in the proxy preparation process."

[fn40] 1998 SEC No-Act. LEXIS 1037 (Dec. 9, 1998).

[fn41] 731 A.2d 818 (Del.Ch. 1999).

§ 14.03[C][5] Debate Over Mandatory Bylaw Amendments

The debate over the extent to which companies can erect barriers to the ability of proponents to mandate bylaw amendments under Rule 14a-8 has been elaborated by the arguments on both sides of this battle.

§ 14.03[C][5][a] Reasons for Allowing Mandatory Bylaw Amendments

Boards are free to ignore precatory requests even if a majority of the votes cast support a proposal.

A board's authority under state law to exclude proposals cannot be used to diminish general shareholder rights under Rule 14a-8. Since state law generally has not limited the substance of bylaws or shareholder-initiated amendments to the bylaws, shareholders can address through bylaw amendments any aspect of the business or affairs of a company unless barred explicitly by state law or a company's certificate of incorporation.

§ 14.03[C][5][b] Reasons for Not Allowing Mandatory Bylaw Amendments

Supreme board authority over management is illustrated by its ability to erect hurdles by adding charter limitations on bylaw amendments under the state law, if permissible, or by amending the bylaws.

The right of a board of directors under state law to issue equity is within its own business judgment.

§ 14.04 Practice Pointers

Company Practice Pointers

Do not rely solely on this exclusion. Although the laws of most states provide that the business and affairs of a company are to be managed by the board of directors, there does not appear to be much state case law to provide further clarification. Accordingly, a company's burden normally is not easy to satisfy and other bases for exclusion should be raised if possible.

Approach to mandatory bylaws. The key to dealing with resolutions framed as mandatory bylaw amendments under this exclusion is the ability of the company to demonstrate that under the applicable state corporate law either:

shareholders do not have the power to initiate bylaw amendments either because of applicable provisions of law or the company's charter; or
the provisions of the bylaw provision are in conflict with specific provisions of the law or the company's charter.

Proponent Practice Pointers

Change mandatory bylaw proposal to non-binding. Since shareholders have broad powers to amend the bylaws, the SEC staff generally will afford a shareholder whose proposal is improperly couched in mandatory language the opportunity to avoid exclusion by recasting the proposal in precatory or nonbinding terms. Precatory proposals request the board merely to consider action and are not legally binding on the board.

Obtain a legal opinion. Proponents who are determined to present a binding proposal should try to obtain a legal opinion attesting to its validity under state law.

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