Companies Must Pay for Some Shareholder Challenges

Charles M. Elson is the Edgar S. Woolard, Jr., Chair in Corporate Governance and the Director of the John L. Weinberg Center for Corporate Governance at the University of Delaware. He is also “Of Counsel” to the law firm of Holland & Knight. His fields of expertise include corporations, securities regulation and corporate governance.

By Charles Elson

Central to the philosophy of the modern Delaware corporate law has been the concept of judicial restraint in the review of director decision-making. Wide discretion is granted to boards through the operation of the Business Judgment Rule.

The theory is that shareholders, through exercise of the electoral franchise, provide the best mechanism for ensuring appropriate director discretion than the review by a third-party judicial body. Of course the lynchpin to this approach is the availability of an open and fair election to provide the necessary outlet for shareholder will.

Unfortunately, for a variety of reasons, in most public companies the shareholder election process functions as a mere formality to ratify the actions of a generally self-perpetuating board and management. For the election to serve as the appropriate accountability vehicle intended by the Delaware scheme, it is important that from time to time there is the real potential that it function as a true contest over corporate policy and direction.

To accomplish this, we need to level the playing field a bit between the incumbent board and the shareholders in the electoral process.

Traditionally in a proxy contest, the expenses of the challenging party are solely borne by that party, while the board uses the corporate treasury to finance the presentation of its position.

This has been an obvious impediment to fostering vibrant elections as all shareholders effectively subsidize the board’s candidacy while the challenger is forced to personally bear the cost of a campaign. If the challenge involves a legitimate debate on corporate direction and policy, there is no good reason why the shareholders of the corporation should fund the cost of the promoting one viewpoint and not the other. This asymmetry is certainly problematic in that it acts to stifle thoughtful discussion and re-examination of corporate policy which ultimately leads to lessened accountability by the incumbent board and management to shareholders. That is why reform is necessary.

The simplest solution to this problem is to provide some sort of reimbursement of reasonable expenses to challengers in non-control directorial election challenges. If one is successful in proposing and electing a director, then that one’s expenses should be reimbursed by the corporation.

If an individual is unsuccessful, but loses only by a small percentage, then it is clear that the effort was over a legitimate issue. Therefore, some portion of that individual’s expenses should be reimbursed. Should the challenging candidate or candidates lose by a significant vote, then no corporate funds should be expended for the support of the effort.

Such a scheme would be initiated with shareholder consent and the Delaware code should be amended to explicitly provide for the mandatory establishment of such a regime upon an appropriate shareholder vote. By removing an important financial impediment to more vibrant corporate elections, the election process would no longer be a simple formality but a real forum for informed debate and ultimate expression of shareholder will.

This would accomplish two important goals.

First, it would assure the necessary vibrancy of the electoral process vital to the appropriate functioning of the corporate regime as contemplated under the traditional Delaware corporate law.

Second, the election itself, or merely the threat of a contested election, would encourage better directorial and management accountability to shareholders and ultimately more effective corporate performance.

The Delaware corporate law has proven to be an incredibly effective vehicle for the regulation of public corporations. This proposed measured change is necessary to ensure its continued utility and effectiveness.

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