Delaware Court Invalidates Supermajority Bylaw to Remove Directors Without Cause

20 March 2017 Westlaw Journal Corporate Officers & Directors Liability Publication
Authors: Gardner F. Davis Neda A. Sharifi

The Delaware Chancery Court recently ruled that a corporate bylaw provision providing that stockholders may remove directors only upon a supermajority vote is invalid. The court found that the provision runs afoul of 8 Del. C. § 141(k), which allows directors to be removed by a simple majority vote.

Public Delaware corporations with similar supermajority requirements in their bylaws for removal of directors should repeal them to avoid shareholder suits.

In Frechter v. Zier, No. 12038-VCG, 2017 WL 345142 (Del. Ch. Jan. 24, 2017), Vice Chancellor Sam Glasscock III addressed a shareholder derivative suit against Nutrisystem Inc. and members of its board of directors.

The suit alleged that the board breached its fiduciary duty by adopting a bylaw requiring a two-thirds stockholder vote to remove directors and that the removal bylaw violated Section 141(k) of the Delaware General Corporation Law.

A Bylaw Too Far?

Nutrisystem’s charter provides the board with the power to “make and to alter or amend the bylaws of the corporation.” Pursuant to this authority, in 2009 the Nutrisystem board adopted bylaws permitting stockholders to remove directors only if the removal was both for cause and approved by a vote of two-thirds of all stockholders.

In response to the Delaware Chancery Court’s 2015 ruling in In re VAALCO Energy, Inc. Stockholder Litigation, C.A. No. 11775-VCL (Del. Ch. Dec. 21, 2015) (transcript), that bylaws prohibiting the removal of directors of unclassified boards without cause are invalid under 8 Del. C. § 141(k), the Nutrisystem board removed the cause requirement for the removal of directors from the bylaws.

However, the amendment did not alter the bylaw provision requiring the two-thirds vote of the stockholders to remove a director.

The Frechter plaintiffs alleged that the consequence to stockholders of not permitting removal of incumbent directors by a simple majority vote is so significant that the stockholder franchise is undermined. They said the supermajority removal provision had the effect and purpose of deterring proxy contests. The plaintiffs further contended that the board put the removal provision in place to entrench themselves in office.


Noticeably absent from the complaint, however, was any allegation that the Nutrisystem board ever faced a threat to corporate control, such as a proxy contest or hostile takeover attempt, or that the plaintiff desired to remove any of the directors.

Fee for the Phantom Menace?

Indeed, Nutrisystem’s Securities and Exchange Commission filings from 2000 through 2016 contain no indication of any contested elections or other struggle for control.

Frechter appears to be another stockholder lawsuit brought by plaintiffs’ lawyers seeking to earn a fee for remedying an abstract, theoretical legal violation as opposed to providing meaningful relief for a direct and substantive injury.

It is hard to believe the Nutrisystem shareholders received their money’s worth for the fees paid to plaintiffs’ counsel with company funds.

The Frechter plaintiffs alleged that the Nutrisystem directors breached their fiduciary duties by adding the supermajority vote removal provision to the bylaws.

Interestingly, only two of the eight defendant directors were on the board when the bylaw provision was adopted.

The plaintiffs also sought a declaration that the two-thirds vote requirement for the removal of directors plainly contradicted Section 141(k) of the Delaware corporate statute, which grants stockholders the power to remove directors by “a majority of the shares then entitled to vote.” As such, they alleged the removal provision was “inconsistent with law” and therefore void.

The defendants countered plaintiff’s contentions by arguing that Section 141(k) is a default provision that applies only if the process is not outlined elsewhere in the bylaws.

In other words, they argued that Section 141(k) is merely permissive and provides only that a majority of stockholders may remove directors, thereby leaving the bylaws free to require a minority, a supermajority, or even unanimity as a requisite for director removal.

The defendants argued that had the intent of the general assembly been to provide that a simple majority of stock is sufficient to remove directors, it could have expressed that intent by mandatory language.

Shall or Must?

The defendants pointed to seven different sections of the Delaware corporate statute —including six that use the word “shall” and one that uses the word “must” — to argue that when the Legislature intends to establish a vote required for a certain action, it does so by using mandatory language.

Thus, argued the defendants, nothing in Section 141(k) prevents exercise of the power of the board, under Section 216, to set a supermajority bylaw requirement for the removal of directors.

Vice Chancellor Glasscock addressed the issue as a question of law at the summary judgment stage. He noted that the Delaware corporate statute is, broadly, an enabling statute.

Section 109(b) of the Delaware corporate statute states, in relevant part, that “the bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights and powers or the rights or powers of its stockholders.”

This section regarding the bylaws stands in contrast to Section 102(b)(4), which provides that a certificate of incorporation may require “for any corporate action ... a larger portion of the stock ... than is required by this chapter.”

An Unnatural Reading

Vice Chancellor Glasscock rejected the defendants’ argument as an unnatural reading of Section 141(k).

The section provides the holders of a majority of stock may — not must — remove directors. That is, if they so choose, the section confers that power.

According to the vice chancellor, the shareholders need not exercise the power at any given time; instead, they “may” do so. In contrast, the Nutrisystem removal provision prevents a simple majority of stockholders from exercising such power.

Therefore, the vice chancellor found the Nutrisystem bylaw was unambiguously inconsistent with the Delaware statutory provision that says a majority may remove directors.

Vice Chancellor Glasscock noted that the defendants’ reading of Section 141(k) was inconsistent with the ruling in VAALCO Energy, which said Section 141(k)’s statement that directors “may” be removed with or without cause prohibits bylaws requiring cause for that purpose.

Likewise, Section 141(k) mandates that a majority of stockholders may remove directors.

As the vice chancellor in VAALCO Energy stated: “Section 141(k) states affirmatively ‘any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at the election of directors.’ That is the rule.”

Takeaways

Accordingly, Vice Chancellor Glasscock granted summary judgment in favor of the plaintiffs and struck down the supermajority director removal provision in the Nutrisystem bylaws as contrary to Delaware corporate law.

The takeaway is that publicly held Delaware corporations should remove similar provisions from their bylaws to avoid shareholder suits brought by plaintiffs’ lawyers who seek to earn a fee for remedying abstract legal transgressions.


Gardner Davis is a partner and corporate lawyer with Foley & Lardner, based in Jacksonville, Florida. He advises boards of directors and special committees in regard to fiduciary duty issues in various contexts. Davis can be reached at 904-359-8726 or gdavis@foley.com. Neda Sharifi, Ph.D., is an associate at the firm, and she focuses her practice on corporate and securities law matters, including mergers and acquisitions and securities law compliance counseling. Sharifi can be reached at 904-359-8719 or NSharifi@foley.com .