The Delaware Supreme Court in Kellner v. Aim Immunotech1recently ruled on the enforceability of a "modern" set of advance notice bylaws. Advance notice bylaws are the key tool corporations have to regulate the director nomination process and ensure full and fair disclosure to stockholders in a proxy fight. Critically, advance notice bylaws also allow the board to gather information necessary to guide its recommendation for or against a nominated candidate. While the headline may be that the court found all the challenged bylaws to be unenforceable, looking at each bylaw individually reveals a much less discouraging picture for corporations.2
First, a few overall lessons.
- Draft Clearly. The obfuscatory manner in which many advance notice bylaws are written will impair enforceability. In Kellner, one of the bylaws in question was found to be "indecipherable," leading the Delaware Supreme Court to remind us that "[an unintelligible bylaw is invalid under 'any circumstances.'"3
- Maintain Proper Focus. Bylaws that intentionally throw up roadblocks to a nomination or that otherwise are meant to impair the stockholder franchise will not survive judicial scrutiny. Preventing an activist from nominating directors is not a proper purpose – even if the board views the activist as obnoxious, its nominees as foolish and its agenda as destructive. On the other hand, requiring the activist to fully disclose in a timely manner its intentions and conflicts will enhance the ability of stockholders to vote wisely. This is both a proper purpose and necessary to allow boards to discharge their duty of care.
- Act on a Clear Day. If advance notice bylaws are adopted or amended only in the teeth of an upcoming proxy fight, the adoption or amendment of the bylaws will be tested under Unocal/Coster – meaning that the corporation will need to show that a potential proxy fight constitutes a threat to an important corporate interest, and that the adoption or amendment of the bylaws is a reasonable reaction to that threat. However, if the advance notice bylaws are adopted on a clear day, the court will presume in the first instance that the bylaws were adopted to regulate the orderly running of a proxy contest and to provide transparency to voting stockholders. In this latter case, Unocal/Coster will be used only to test the board's discretionary application of the bylaws in rejecting of a nomination. Avoiding an extra layer of scrutiny while in the midst of a proxy fight will allow the board to focus on the process of properly responding to a nomination, rather than designing bylaws to counter an ongoing activist threat.
With that background, let's look at the bylaws at issue in Kellner and at alternative or supplemental approaches we would recommend.
- Arrangements, Agreements and Understandings Bylaw and
Known Supporter Bylaw. Both of these familiar bylaws
sought information about just who was supporting the director
nomination and in what capacity – a wholly non-controversial
goal. Arrangements, agreements and understandings with respect to
target's stock have long been required by law to be disclosed
– both in any proxy statement and, if applicable, pursuant to
Schedule 13D.4 Information regarding the identity of
persons supporting the nomination has been recognized by the
Chancery Court as "vitally important
information"5 and is captured to a limited extent
in the Schedule 14A definition of exactly who is a
"participant" in a proxy solicitation6.
Unfortunately, the particular bylaws at issue in Kellner swept too
broadly – requiring disclosure: (i) not just of persons
supporting the nomination known to the nominating stockholder, but
of any such persons known to any "Stockholder Associated
Person" (or SAP) and (ii) not just of agreements and
understandings between the nominating stockholder and third
parties, but between any SAP and any third party.
The SAP definition turned out to be the Achilles heel of these bylaws. The definition included any persons acting in concert with, or affiliated or associated with, or in the immediate family of "each beneficial holder on whose behalf the nomination is made." Note that every person acting in concert with the nominating stockholder could likely be deemed a "beneficial holder on whose behalf the nomination is made," creating an "ill-defined daisy chain of persons."7 This daisy chain in turn led to "an ill-defined web of disclosure requirements,"8 rendering the bylaws "overbroad, unworkable, and ripe for subjective interpretation by the Board."9 The basic lesson: ask for information that is reasonably available to the nominating stockholder and that will be material to stockholders in voting and to the board in deciding whether to recommend for or against the nominations.
A general weakness of this style of bylaw – not discussed in Kellner – is that its disclosure requirements turn on certain key terms, such as "understandings" and "group," that are subject to dispute even in the context of long-standing statutory disclosure regimes under Rule 13d, Section 16, and Regulation 14A. Determining whether a nominating stockholder is "acting in concert with" other holders, or has an "understanding" with others, will reveal to voting stockholders who is supporting the nomination, but only after the courts have sorted out what those terms mean.
A preferable approach, or supplement to the traditional approach, would focus on the disclosure of easily ascertainable facts regarding the outreach to potential supporters – whether current stockholders or potential investors in the corporation. Certainly, a nominating stockholder knows who it has approached and described its investment thesis to. The activist knows what materials it has presented to third parties and knows whether a particular third party has expressed interest in supporting or partnering with the activist. The activist knows whether the third party has indicated that it will vote shares it already owns in favor of the activist's nominees, or whether the third party has indicated it will buy up shares on the market. All of this information will be of direct interest to stockholders wishing to understand how the nominating stockholder built its constituency, whether the initial pitch was made to hedge fund investors or long-term stockholders, and whether the pitch made to pre-announcement investors is fully consistent with post-announcement messaging to voting stockholders.
- Consulting/Nomination Bylaw. This bylaw sought
information that would shed light on the independence of the
nominees from the nominating stockholder. Here again, incorporation
of the SAP definition meant that the bylaw swept too broadly,
requiring information about any arrangement between each nominee
and any SAP in the prior 10 years. The Delaware Supreme Court found
that this imposed "ambiguous requirements . . . across a
lengthy term" all in a search of "only marginally useful
information"10 – which resulted in the bylaw
being struck down.
While the strength of the allegiance of each nominee to the nominating stockholder will clearly be of importance to voting stockholders, seeking "marginally useful information" may well be viewed as intentionally setting up obstacles to a nomination. Certainly, requesting information regarding financial, professional and social ties will be of importance, but limiting disclosure of ties to an identifiable scope of persons should be sufficient.
Note that the "independence" of the nominee should be measured not as independence from existing management under stock exchange rules (which is the concern with nominees put forward by the board) but rather as independence of the nominee from the nominating stockholder under by the standards of Delaware law used in testing independence from a controlling stockholder. While the nominating stockholder will rarely be a controlling stockholder, voting stockholders should be able to understand the full scope of the relationship between the nominee and the nominating stockholder (who will gain a degree of control if its nominees are elected), as well as the strength of the nominee's attachment to the nominating stockholder's agenda.
In this regard, it will be important for stockholders to learn whether the nominating stockholder and the nominee have had substantive conversations regarding e.g., their views on the quality of management, investment or dividend policies, material acquisitions or divestitures or other transformational transactions, among other matters. The content of these alignment conversations will be just as important to voting stockholders as they were to the nominating stockholder and should be fully disclosed. Together with information regarding the financial, professional and social relationships with the nominating stockholder, this will help voting stockholders understand whether the nominee was selected to implement a particular agenda or to act as a truly open-minded independent director.
Finally, to allow the board and voting stockholders to judge the ongoing influence of the nominating stockholder, it will be of critical importance for stockholders to know whether the nominee intends to take advantage of a common law exception to the directors' duty of confidentiality. This exception is only available "when it is understood that the director acts as the stockholder's representative"11 and allows ongoing discussion of confidential board matters between the nominee and the nominating stockholder. Voting stockholders will want to understand whether the nominating stockholder will weigh in with the nominee outside of board meetings advocating for its preferred positions on topics of importance to all stockholders, and whether the nominee will be expected to push the nominating stockholder's positions in board discussions.
- Ownership Bylaws. The Delaware Supreme Court
described this bylaw as follows: "a 1,099-word run-on sentence
of 13 subsections, requiring, among other things, disclosures
relating to the ownership of any equity interest in AIM and any
'principal competitor' of AIM, by a broadly defined group
of people including SAPs."12 The Chancery Court
found the resulting by law "'indecipherable' and
seemingly designed to preclude a proxy contest."13
The overreach here again came in part through the unrestrained use of the SAP definition – broadening the scope of disclosure to persons unlikely to be under the control of (or part of a group with) the nominating stockholder or its affiliates. But the overreach also came through an approach to derivatives disclosure that represented a seriously overcomplicated presentation of a basic question: What are your economic interests – direct or indirect – in the target company?
Derivative ownership disclosure, rather than simply requiring a recitation of the types of derivatives and dates purchased, would be better focused on the purpose for which the derivatives were purchased, pricing terms, and opportunities for and consequences of exercise. For example, were the derivatives purchased to protect against a falling price, or to supercharge returns if the price rises? When and at what price do the derivatives become exercisable, and when do they expire or reset? How big is the potential hedge? Has the nominating stockholder taken stock loans to bolster its voting power?14 In other words, how aligned are the economic interests of the nominating stockholder with the economic interests of a long-term holder? While Rule 13d and Schedule 14A both require disclosure of certain derivatives, the sophistication of the derivatives markets long ago moved past the framework established in those regulations. Advance notice bylaws should cover the gaps left by those regulations to provide a clearer answer to the questions of why the nominating stockholder owns derivatives, what pricing assumptions and time horizons are reflected in the derivatives, and whether the nominating stockholder is economically aligned with other stockholders.
- A Basic Question: Plans and Proposals. While
it may seem curious, there was no bylaw in Kellner
requiring disclosure of the plans and proposals of the nominating
stockholder. Even more curious is that Schedule 14A also does not
require this disclosure. One could presume that the nominating
stockholder, in order to make its case for change, will disclose in
significant detail its plans and proposals, but that is not always
the case, and leaving this disclosure solely to the discretion of
the nominating stockholder would be akin to the SEC declaring that
management can unilaterally decide what it wants to tell
stockholders in the Management Discussion and Analysis section of
the company's 10K. Leaving the content of this disclosure (and
even the choice as to whether make fulsome disclosure) to the
unfettered discretion of the nominating stockholder is an open
invitation to tailor a message that is consistent only with the
self-interest of the disclosing party – which interest is, in
this case, to get voting stockholders to support the activist's
nominees. Often, the voting stockholders will be long-term holders,
with interests that can conflict sharply with those of a short-term
holder. Accordingly, disclosure by activists of plans and proposals
may, intentionally or not, to take on a certain slant. One only
need to look to the dueling background sections in company and the
activist proxy statements to realize that there is at times a
significant gap between what the activist seems to have demanded
from the company in the lead-up to the nomination and what the
activist has stated as its objectives in the proxy. A clear
statement of why the activist is seeking board seats – what
problems it sees and what remedies it proposes – is perhaps
the most critical piece of information needed by the board in
formulating its recommendation and by stockholders in exercising
their franchise. If the activist favors a new management team to
improve operational performance, it should say so. If the activist
favors a new management team because the current team opposes
incurring debt to fund a dividend, it should let the board and
other stockholders know. Hiding the ball on plans and proposals
seriously impairs the stockholder franchise. As a matter of
Delaware law, it is incumbent on boards to take prudent steps to
ensure that proper and complete disclosure of the nominating
stockholder's plans and proposals be presented in nomination
notices and in the nominating stockholder's proxy statement.As
part of this inquiry, it will be important not to be trapped into a
lengthy and indeterminate debate about exactly what constitutes a
"plan or proposal" (as often happens in the context of
Schedule 13D disclosure). For example, assume the nominating
stockholder has done an extensive analysis of its investment
returns over selected timeframes under a variety of different
liquidity alternatives – from a buyback funded by a reduction
of R&D expenses, to a leveraged recapitalization, to a PIPE
investment, to a sale of the company. The analysis shows that the
nominating stockholder's returns will be far greater if the
nominating stockholder funds a PIPE investment into the company and
then seeks a sale. Even if this PIPE investment or sale is arguably
not yet a "plan or proposal," unless it has not been
completely discarded as a possibility, stockholders will want to
know, before voting, that a conflict transaction has been analyzed
and will be strongly in the nominating stockholder's
interests.Accordingly, the advance notice bylaw should be drafted
such that disclosure does not turn on definitional game-playing,
but rather so that it captures information that presents "a
substantial likelihood" of being important to "a
reasonable shareholder . . . in deciding how to
vote."15 This would include disclosure of analyses
performed by or for the nominating stockholder that show the
nominating stockholder likely has a strong point of view on the
best outcome of a strategic alternatives review, or material
economic reasons to press for one outcome over others.
- Deceptive Conduct. Finally, note that the Delaware Supreme Court, while declaring the AIM Immunotech bylaws unenforceable, agreed with the Chancery Court's decision to deny relief to plaintiffs, given plaintiffs' "deceptive conduct."16 We would recommend that this element of Kellner also be worked into advance notice bylaws. In short, if there has been a material breach of those proxy rules designed to protect the stockholder franchise, the board should be authorized or required to disqualify the nominees. This would include any material violation of 14a-12 (designed to put all stockholders on an equal informational footing) and any material violation of Rule 14a-9 (designed to eliminate false or misleading statements in the context of a proxy fight). While the board would of course need to be circumspect in exercising this power, there is no reason that nominating stockholders should be allowed to proceed with a nomination in violation of the proxy rules.
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It will not be unusual for companies, while reviewing their advance notice bylaws, to find that these bylaws may not be clearly drafted or properly targeted at obtaining useful information and establishing guidelines for presenting director candidates at a stockholder meeting. Some may appear to be a confusing accretion of ideas and worries that have presented themselves over the years. We recommend that, if that is the case, such companies start afresh with clearly drafted advance notice bylaws that allow boards and stockholders to fully understand the qualifications and conflicts of the nominees, and the interests and intentions of the nominating stockholder.
Footnotes
1. Kellner v. AIM Immunotech Inc., — A.3d —, 2024 WL 3370273 (Del. July 11, 2024).
2. Of course, the other headline was that the Delaware Supreme Court agreed with the Chancery Court's decision to deny relief to plaintiffs, given plaintiffs' "deceptive conduct". Id. at 51.
3. Id. at 42.
4. C.F.R. Section 240.14a-101, Item 4; C.F.R. Section 240.13d-101, Item 6.
5. Rosenbaum v. CytoDyn, 2021 WL 4775140, at 49.
6. C.F.R. Section 240.14a-101, Item 4, Instruction 3.
7. Kellner at *50.
8. Id. at *46.
9. Kellner v. AIM ImmunoTech Inc., 307 A.3d 998 (Del.Ch.2023) at *1030.
10. Id. at *47 (internal quotations omitted).
11. Kalisman v Friedman, et. Al, 2013 WL 1668205, at *9.
12. Kellner at *23.
13. Id. at*25.
14. Companies should also consider prohibiting nominating stockholders and their affiliates from voting borrowed shares. Empty voting in a proxy contest is certainly not designed to promote long-term stockholder interests.
15. TSC Indus. Inv. V. Northway, Inc. 426 U.S. 438, 445 (1976).
16. Kellner at*51.
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