Section 141(k) Mandatory Prohibition of For-Cause Removal of a Declassified Board

Kendra Rodwell

On December 21, 2015, in In re Vaalco Energy Shareholder Litigation, the Delaware Court of Chancery granted the plaintiffs’ motion for summary judgment, invalidating a provision included in Vaalco Energy’s bylaws and charter that purported to make directors of a non-classified board removable only for cause.  The Court ruled that this provision directly conflicted with the default rule of § 141(k) of the Delaware General Corporation Law (“DGCL”) and was therefore invalid.

This case highlights the rigid interpretation and lack of interplay of § 141(k) and § 141(d). Section 141(d) provides the statutory basis for stockholders to adopt a classified or “staggered” board. Under this provision, the directors are elected to serve two or three-year terms for each class, with only one class facing election each year.  Accordingly, members of classified boards may not be removed without cause unless the certificate of incorporation contains a provision permitting such removal.  Implicit in § 141(k), in contrast, is a requirement that directors be removable without cause in the case of a declassified board (where the director is elected on an annual basis), either at a meeting of stockholders, or without a meeting through written consent (§ 228(a)), unless the certificate of incorporation includes a provision eliminating stockholder action by written consent. 

Vaalco argued, inter alia, that a technical application of § 141(d) permits a director, serving a one-year term, to be removed only for cause, as members of a board “divided into 1” class, per the language of § 141(d).  In support of their argument, Vaalco’s counsel offered that there is no policy reason that would prohibit such a phenomenon, even though Vice Chancellor Laster described it as an “oxymoronic concept.”

While the Court gave Vaalco some credit for the novelty of that argument, Vice Chancellor Laster, nonetheless, rejected it based on three independent grounds.  The Vice Chancellor used the historic interpretation of § 141(k) to conclude that Vaalco’s “new discovery” “would cut against what [Vice Chancellor Laster] thinks has been the standard analysis of 141(k).”  To further support this conclusion, Vice Chancellor Laster used the comments to the 1974 Amendments to the Delaware Corporation Law to show that the language of § 141(d), “divided into 1, 2, or 3 classes,” was included to clarify in the instances where the certificate of incorporation elected special directors for the purpose of being holders of any class or series of stock, that they were not to be considered an additional class of directors for the purposes of creating a staggered board.  And lastly, the Vice Chancellor stated that if this were a case where the directors called a meeting with its stockholders announcing the declassification from three classes into one class, the issue of the appropriate interpretation of what “1, 2, or 3 classes” means would be proper in the case.  But because Vaalco had a declassified straight board, Vice Chancellor Laster was not inclined to let the defendants use the provisional language under § 141(d) to justify the invalid provision that was at issue.

The transcript was riddled with the assertions that § 141 allows corporations to contract around the default rules by including alternative rules in the corporation’s charter.  It is true.  The certificate of incorporation may take away the shareholder right to remove directors from the board by written consent.  It is also well established in Delaware that the certificate of incorporation may provide that only the board can call for special meetings of stockholders.  Based on that, it can be inferred that stockholders could only remove directors at annual meetings, which requires fewer votes than the majority required for removal under § 141(k).

There are no stockholders’ governance rights that need protection given the ability to eliminate action by written consent and the right to call special meetings of stockholders corporate action.  Ordinarily, when a shareholder is not pleased with management, they have three possible resolutions: 1) sell their shares; 2) campaign to vote for new directors; or 3) sue its directors through a derivative action, hold directors personally liable for damages, or seek a preliminary injunction to prevent a transaction from being consummated.  The DGCL provides for the certificate of incorporation to opt-out of written consent and the right to call special meetings of stockholders for corporate action.  So long as the corporation went through the proper procedure of obtaining shareholder approval to opt-out of these rights, the shareholder franchise has not been compromised.  

Assuming that the right to remove a director from a board without cause was eliminated along with the right to written consent and calling special meetings for corporate action, shareholders stand to lose the flexibility the DGCL afforded them.  Without those rights, the shareholders lose the ability to change ownership of a majority shareholder and the directors gain guaranteed tenure afforded to them by the common law.  To remove a director for cause, the targeted director must be given adequate notice and afforded the opportunity, at the corporation’s expense, to address the accusations at a judicial proceeding.  Under these sets of circumstances, the right of removal is predicated on the director’s conduct. In addition, the burden to remove a director for cause is higher than removing a director without cause.  If there were a director who disagreed with the shareholders on corporate policy or desired to take over control of the corporation, the shareholders would be stuck with that director until he was up for election.  Taking that into consideration, directors’ awareness of their obligations to serve the interest of the stockholders might be diminished. Conflicts between the wishes of management and that of the shareholders are more likely to occur.  The certificate of incorporation should not restrict or be “so pervasive as to intrude upon” shareholders’ rights, because it diminishes the shareholders’ role in corporate governance.  It follows that a line should be drawn to ensure that directors of corporations are not using the rules of DGCL arbitrarily to limit shareholder’s rights.                  

One contention that Vaalco asserted was that a large number of corporations with similar provisions that Vaalco had will be affected if that sort of provision were invalidated.  To discredit this argument, the Court asserted that those corporations were misreading the statute.  In addition, the Court reasoned that even if this is true, only a small percentage of corporations, in the grand scheme of things, are being affected by this ruling.

Even though the Vice Chancellor disagreed with Vaalco’s arguments, he offered a solution that would help those corporations avoid being sitting ducks for shareholder litigation. The Court suggested that those corporations, Vaalco included, should go back to the drawing board.  The Vice Chancellor stated that the boards should “issue some new disclosure” statements “and do whatever it thought it had to do as a matter of Delaware disclosure law and the federal securities laws.”  One can surmise that when the Vice Chancellor said “do whatever,” that entails proposing to amend those invalid provisions and putting them out for a stockholder vote.  And, if the directors receive the required majority vote, then the corporation would need to file an amendment to the certificate of incorporation reflecting the revised provisions in accordance with Delaware law.

While the Court does not specifically address how those steps would minimize litigation cost or fee applications, it can be inferred that those steps may decrease the likelihood of shareholders exercising their fundamental right to sue the corporation when invalid provisions are used in the corporate charters and bylaws that are in direct conflict with Delaware law.  By following the steps offered by Vice Chancellor Laster, corporations have effectively limited the cost of defending these types of claims because the certificate of incorporation will be compliant with Delaware law.  Secondly, there are costs associated with amending a certificate of incorporation.  While the total cost to amend may be relatively small compared to the value of the company, the fee application coupled with the litigation cost and the time wasted defending these types of claims could be completely avoided by heeding Vice Chancellor Laster’s suggestion to amend the certificates of incorporation in accordance with the ruling of this case.

Kendra Rodwell is a fourth-year evening division student at the Delaware Law School and Staff Editor of the Delaware Journal of Corporate Law.  She is also a Member of the Delaware Law Transactional Law Honor Society.

Suggested Citation: Kendra Rodwell, Section 141(k) Mandatory Prohibition of For-Cause Removal of a Declassified Board, Del. J. Corp. L (May 3, 2016), www.djcl.org/blog. 

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