Greetings from Delaware

Residents of Delaware proudly proclaim it to be the First State, an official motto backed up by some very notable firsts: Delaware was the first state in the union and the first to ratify the Constitution. Apart from these important historical facts, Delaware is also foremost when it comes to corporate registration and regulation.

While Delaware might be the country’s second smallest state and the fifth smallest by population, it is also the officially registered home of more listed companies than any other state in the US. At last count 60 percent of the Fortune 500 call it home and almost 51 percent of all NYSE-listed companies are registered there. It is no wonder that changes to the regulatory framework will receive intense US-wide scrutiny. So while much attention is focused on debate taking place at the federal level that could soon see the enactment of new corporate regulation, the real and possibly more important change is in Delaware and concerns its General Corporation Law (DGCL).

But what would motivate a state, which has long been regarded as the most corporate friendly, and by extension the least shareholder friendly, in the nation to change the very rules that helped it attract such a high level of corporate registration? According to John Grossbauer, partner at Potter Anderson & Corroon, ‘Delaware is eager to remain at the cutting edge of corporate law and to get out in front of some of the changes that are taking place in corporate governance. The Delaware Bar [which submits amendment proposals to the state] saw a need to move quickly to make sure that Delaware still has a voice out there and is able to participate in a meaningful way.’

Specifically, the state needs to ensure its legal structure keeps pace with changing trends in shareholders’ rights and corporate governance best practices. Shareholders have been successful in advancing their agenda for greater influence over corporate boards but they are pushing for even stronger rights. The most contentious issue at the moment is proxy access. While significant advancements have been made in the areas of board declassification and majority voting for the election of directors, formal proxy access has, to this point, garnered little support from federal regulators. But the pending changes in Delaware may help to advance the concept.

Four points of interest
Many sections of the DGCL are being overhauled but four, including new sections 112 and 113 and sections being amended 213(a) and 145(f), are of most interest to public companies and investors. The proposed changes have been approved by the legislature and will pass into law pending ratification by the governor.

In brief, 112 authorizes Delaware corporations to adopt bylaws granting shareholders the right to include their nominees on the company’s proxy material and 113 allows for the reimbursement of proxy campaign expenses. 213(a) permits the board to fix separate record dates for voting and notice of shareholder meetings, while 145(f) formalizes indemnification and advancement of expenses rights for directors.

The proposed changes, which according to Grossbauer are almost certain to be ratified without modification, have been positively received by the shareholder and governance community. Charles Elson, director of the Weinberg Center of Corporate Governance at the University of Delaware, feels that overall, the changes will be positive for Delaware and will help to keep the state at the forefront of corporate governance. ‘These changes are very timely and I believe they show a pro-shareholder attitude and will result in shareholders being given more power and influence. This will lead to more accountability on the part of corporate directors,’ he says.

All access
Marc Weingarten, partner in Schulte Roth & Zabel’s New York office, says 112 and 113 are significant for activist investors in that they will greatly increase access to a corporation’s proxy statement and codify the right to reimbursement for nominating directors.

It is worth pointing out that the DGCL did not previously exclude the possibility for companies to include bylaws similar to those allowable under 112 and 113. Some observers have pointed to this asking: ‘If companies were not prevented from doing so before, why write a rule that expressly says they can?’ Grossbauer explains that, in the past, some companies had successfully challenged access proposals by arguing to the SEC that such a proposal would not be in line with the full intent of state law. ‘The new section 112 will permanently remove this argument.’

While the rules are generally positive for shareholders, investors should view them cautiously. Dean Hanley, partner, Foley Hoag, points out that ‘Under 112, companies can, with some careful application of language, apply significant hurdles to proxy access that will be very difficult to circumvent.’ He explains that 112 allows the company to ‘define the conditions under which proxy access will be permitted. Should they choose, the company could set those conditions very high and very rigidly.’ This is not to say that a company will take this path, just that the potential is there. Chris Edwards and Andrew Ledbetter, partners at DLA Piper, agree, stating in a recent client briefing: ‘The proposed amendments would make clear that a company has the authority to provide stockholders access to its proxy materials through a bylaw provision, offering certainty to companies and stockholders that choose to provide access to the company’s proxy. The amendments also attempt to strike a reasonable balance as to when a company may determine that it is not appropriate to provide access to its proxy.’

Weingarten further explains that while this could result in economic savings for activists, a corporation adopting such provisions in its bylaws has significant discretion in controlling the grant of proxy access and reimbursement by imposing various conditions. Shareholders themselves could propose such bylaws for adoption, without conditions, but it would no doubt require a proxy contest to get these provisions adopted.

The introduction of reimbursement expenses under 113 is, as Grossbauer attests, an attempt to codify the Delaware Supreme Court’s ruling in CA v AFSCME. ‘That case validated the concept of ‘short slate reimbursement’ bylaw provisions.’ It provides a statutory framework for the development of bylaw provisions, which mandate reimbursement of reasonable expenses incurred by stockholders who achieve a defined level of success in a proxy contest. But again, there is some ambiguity here, as Edwards and Ledbetter observe in a briefing: ‘Some companies may utilize the flexibility in the proposed amendment to condition reimbursement to circumstances that are consistent with the directors’ performance of their fiduciaries duties. It remains to be seen whether the Delaware courts will follow the suggestion in the AFSCME decision and read a fiduciary-out standard into the proposed new Section 113.’

In another response to recent court rulings, the amendments to 145(f) attempt to clarify (and partially reverse) the ruling in Schoon v Troy, which denied advancement of litigation expenses to a former director of the company because the company had, after the departure of the director, amended a bylaw allowing it to withhold indemnification for former board members. This was despite the fact that at the time the alleged wrongdoing occurred the bylaw required advancement of expenses. 145(f) effectively states that a company may not retrospectively withhold litigation expenses under such circumstances, with some exceptions.

Running on empty
The amendments also attempt to address the problem of empty voting, which occurs when individuals or institutions acquire voting rights disproportionate to their economic holding in the company. This is typically achieved through short selling or share lending between the date of record for voting rights and the date of notice of annual meeting. As Hanley explains, under the old statute, the record date for notice of a shareholder meeting and entitlement to vote at that meeting are one and the same, and must be no more than 60 days and no fewer than 10 days before the shareholder meeting. ‘By divorcing voting power from economic interest, empty voting potentially disrupts the presumed tendency of stockholders to vote in a manner that maximizes their ownership interests in the company,’ suggests Grossbauer.

The rewritten 213(a) allows the board to fix separate voting and notice record dates. ‘Setting the record date for voting much closer to the meeting increases the likelihood that the shareholder of record actually owns the stock and therefore has an economic interest in the corporation,’ notes Hanley.

With shareholder activism on the rise and federal regulators, including the SEC, taking a more aggressive stance on corporate governance, these changes to Delaware law could significantly impact the relationship between listed corporations and their shareholders, even those not registered in Delaware. Although the changes are broadly shareholder positive, both companies and investors should familiarize themselves with the details to ensure they can achieve an optimal balance between shareholder rights and the ability for company management and boards to effectively run their companies and navigate through these challenging times without excessive interference.