Let bylaws be bylaws

More than 2,400 years ago, in his fable "The Wolf in Sheep's Clothing," Aesop warned that appearances can be deceiving. He may have been channeling activist investors.

A recent decision by the Delaware Court of Chancery, TravelCenters of America LLC v. Brog et al., and amendments to the Delaware General Corporation Law, set to take effect on Aug. 1, both appear to be legal wins for activist investors. However, a closer examination reveals that these developments in Delaware law may open the door for companies to raise the stakes when activist investors attempt to nominate members of a company's board of directors.

In TravelCenters, a publicly held limited liability company sued a group of investors to recover the cost of opposing procedurally invalid director nominations. TravelCenters of America LLC based its action on its LLC agreement, which provided that each shareholder would indemnify the company against all costs and expenses arising from a shareholder's breach of the agreement's provisions. The company argued that an invalid director nomination notice breached the LLC agreement. Therefore, TravelCenters was entitled
to indemnification.

The court disagreed, citing the distinction between covenants and conditions. Covenants create a duty to perform, the court opined, while conditions are events that must occur before performance. The language of the LLC agreement made proper notice a condition to nominating a director, the court said, not a covenant. The court found no evidence in the language that shareholders had agreed to indemnify the company for costs incurred in defending against an invalid director nomination. Thus, on its face, TravelCenters was an
investor victory.

The court's decision, however, hinged on the principle that limited liability companies are creatures of contract. TravelCenters and its investors could have included a provision stating that any shareholder who submitted a defective director nomination notice would be liable to the company for costs incurred in opposing the nomination. The court's reasoning suggests that it would have enforced such a provision. Were a limited liability company to take this approach, the company could raise the ante for activist investors seeking to nominate candidates for election to the board.

Recently enacted DGCL amendments also appear to promote activist stockholder rights by providing that a corporation's bylaws may require proxy solicitation materials to include stockholder-nominated candidates for director elections, as well as provisions for the reimbursement by the corporation of a stockholder's expenses incurred in soliciting proxies to elect a director. However, the new DGCL amendments also provide that a corporation's bylaws can include lawful conditions to proxy statement access and expense reimbursement.

This creates an interesting possibility. Corporations might adopt bylaws that require stockholders, as a condition to nominating a candidate, to agree to indemnify the corporation for costs incurred in opposing the nomination if it is procedurally defective. To borrow a phrase from the TravelCenters opinion, this might mean that failing to comply with "hyper-technical" requirements could cost a stockholder millions. To be enforceable, such a condition would need to be "lawful" under existing Delaware case law, which stringently safeguards stockholders' voting rights.

A corporation considering a bylaw provision that seeks to penalize stockholder efforts to participate in director elections must consider Blasius Industries Inc. v. Atlas Corp., in which the Delaware Court of Chancery held that directors must demonstrate a "compelling justification" if they take action with "the primary purpose of impeding the exercise of stockholder voting power." If Blasius applied -- it is unclear whether it would -- the board would either have to show a purpose for the bylaw provision independent of impeding the exercise of stockholder voting power or demonstrate a "compelling justification" for the provision.

These recent developments in Delaware provide an opportunity for companies advised by creative counsel to consider advance notice bylaw provisions with real teeth to deter vexatious interference with board elections. At the same time, activist investors should conduct careful due diligence on the governance documents of any potential target investment to be on the lookout for provisions that explicitly or implicitly threaten financial penalties for efforts to participate meaningfully in director elections.

Joseph F. Bernardi Jr. is an associate, Joseph J. Basile is a partner and Arthur Kimball-Stanley is a summer associate in the corporate department of Weil, Gotshal & Manges LLP.