July 02, 2008
Classified Boards in Transition
Posted by Gordon Smith

Steve Davidoff and Matt Bodie are blogging about a nasty issue of statutory interpretation emanating from the takeover dispute between InBev and Anheuser-Busch. Matt describes the problem:

In most cases, the determination of whether shareholders can remove directors is straightforward: if the board is classified, they need cause; if not classified, there is no need for cause.  The A-B board, however, is in a period of transition.  In 2007, the Board and shareholders amended the A-B charter to declassify the board.  Thus, beginning with the 2007 shareholders meeting, directors would be changed over from classified three-year terms to annual elections.

As of now, eight of the thirteen directors have been changed over from classified to annually elected.  The remaining five will be elected to one-year terms at the 2009 shareholders meeting.  However, as of now they are serving out their last classified term of three years.  So -- are they still classified or not?

Obviously, this situation is unlikely to arise often, and both Steve and Matt contend that the Delaware statute does not address this situation expressly. Let's think about this ...

Consider first Section 141(k): "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 an election of directors, except ... in the case of a corporation whose board is classified as provided in subsection (d) of this section."

Note that the board is classified, not the directors.

But then look at Section 141(d):

The directors of any corporation organized under this chapter may, by the certificate of incorporation or by an initial bylaw, or by a bylaw adopted by a vote of the stockholders, be divided into 1, 2 or 3 classes; the term of office of those of the first class to expire at the first annual meeting held after such classification becomes effective; of the second class 1 year thereafter; of the third class 2 years thereafter; and at each annual election held after such classification becomes effective, directors shall be chosen for a full term, as the case may be, to succeed those whose terms expire.

Hmm. Can we reconcile these provisions? Beyond the problem of whether the board or the directors are classified, by a literal reading, these sections are nonsensical: if the board of directors is "divided" into "1 class," as allowed by Section 141(d), then the directors on that board would not be removeable, except for cause pursuant to Section 141(k). Of course, most boards of directors have only one class, and every board must have "1, 2 or 3 classes," so did the drafters of this statute intend to prohibit removal except for cause in all circumstances? Nonsense!

The only reasonable reading of the statute would hold that a "classified board" is one with at least two and no more than three classes. Using this as a starting point, A-B could argue that it's current board has two classes: directors to be elected in 2008 and directors to be elected in 2009. That's a pretty straightforward argument that all of the directors are subject to removal only for cause. But would it work? I think there is a strong argument that it would not. Two points ...

First, both Steve and Matt, apparently taking their cues from A-B, imagine an argument in which five of the A-B directors are "classified" while the remaining eight directors "have been changed over from classified to annually elected." I do not see how this is possible under the terms of the Delaware statute. Whether you are talking about a "classified board" or "classified directors," it seems clear that all of the directors have to be involved in the classification scheme. In other words, a company cannot have a mix of classified and unclassified directors.

Second, as suggested above, in this case, A-B could argue for two classes that would become one at the end of 2009. This would take care of the problem in the foregoing paragraph, but it seems to me that Section 141(d) would foreclose such an argument because the argument rests on the premise that one set of directors could be elected for multi-year terms while another set would be elected annually. Section 141(d) plainly contemplates terms of equal length for each class of directors. Thus, the A-B transition scheme seems to violate the terms of the statute.


UPDATE: The implication of my analysis is that a declassification of the board of directors would permit the immediate removal of all directors with or without cause prior to the expiration of the full terms to which directors were elected. This is why John Coates wrote in 2001: "To be effective, a staggered board must be specified in the charter, or, if in the bylaws, the shareholders must not be able to amend by the bylaws without a supermajority vote." John C. Coates IV, Explaining Variation in Takeover Defenses: Blame the Lawyers,  89 Cal. L. Rev. 1301, 1411 (2001).

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Comments (7)

1. Posted by coates on July 2, 2008 @ 12:54 | Permalink

I would have to disagree....i think the meaning from their amendment to the bylaws was clear...that the board would become declassfied following the last term of the remaining staggered board.

it wasn't effective immediately...it was effective upon the end of their term...at least that is what the amendment said that shareholders approved.

2. Posted by coates jr. on July 2, 2008 @ 13:02 | Permalink

I agree with the earlier comment. In looking at the amendment that shareholders approved to declassify the board, it says that while the board would be declassified it broke up that declassification in separate classes. So those elected in 2004 up in 2007, and those in 2005 in 2008 and those in 2006 in 2009.

If the author of this was correct, then all of the bud directors should have been up for re-election in 2008 (but instead only 9 were) since the other 5 weren't voted upon...It would not be fair to say that they weren't up in 2008 but they can be now prior to 2009.

seems the meaning which shareholders voted upon was that the other 5 won't be up until 2009.


3. Posted by Gordon Smith on July 2, 2008 @ 13:06 | Permalink

The issue discussed in my post is not whether they intended to retain a "classified board" until the last term of the exiting classified directors -- I agree with you that this seemed to be their intention -- but whether Delaware law would permit them to execute on this intention. My argument is that such a scheme would violate the terms of the statute.

4. Posted by Jeff Lipshaw on July 2, 2008 @ 14:55 | Permalink

I have to disagree with Gordon's interpretation, understanding that this is indeed an open question. My experience, by the way, is probably not relevant but we "declassified" at Great Lakes in a vote in our 2003 proxy statement, and I researched at the time how companies had done it - whether by cutting off existing terms in one fell swoop, or by playing out the declassification over three years. We opted for the latter. We did it by simply eliminating the classification language from the certificate, but providing that any director elected before 2003 would be entitled to serve out the term: "Each director of the Corporation shall hold office until his or her successor is duly elected and qualified or until his or her prior death, resignation, retirement or removal from office, provided that any director elected at or before the Corporation's annual meeting of stockholders for 2003 shall serve the length of term to which such director was originally elected."

I think, Gordon, you've made a subtle but incorrect grammatical move. Is the word "classified" an adjective describing board, or is it the past participle of the verb "to classify?" I would argue that it's the latter, because there really is no reference anywhere in the statute to something that is a "classified board," even though in practice and loose usage, we said that all the time.

Indeed, the first part of the statute refers to dividing the board into classifications, and I interpret "is classified" in the second part to be a shorthand reference to the process of having been divided into classifications. Even after we amended the certificate, therefore, we continue to divide the directors into separate classifications based upon the length of the remaining term.

What the policy here? Most elections of directors occur annually. As to one-year termed directors, it doesn't make much difference. But if you can remove a director with more than a year long term without cause, the longer term is meaningless. But there has to be an avenue for removing a director for cause when the term lasts more than a year. So the logical answer is that directors who by the charter have a two or three year term have the right to serve it out, unless there is a showing of cause.

5. Posted by Gordon Smith on July 2, 2008 @ 16:46 | Permalink

Hi Jeff,

Nice comment. Just to be clear (and I think you got this, but I am writing to an audience broader than one): I am aware that many companies transition from classified to declassified boards by allowing all of the directors to serve out their terms, as A-B apparently was intending and as you did with Great Lakes. My point is that this practice may not be consistent with the statute. And you are right that this is an open question.

Ok, now to the heart of your comment, the point about interpretation. Do cases matter here, or are you just having fun with the statute? Because lots of Delaware cases refer to "classified boards." Are you suggesting that this is just loose language?

Even if that is an inappropriate leap from the statute, it's not clear to me how your reading is different. Being "classified" is a process rather than a state? But this process requires you to exist for several years with directors having different terms of office. What makes you think that's permitted? Section 141(d) certainly doesn't authorize that, and seems to imply equal terms.

Finally, as to your policy analysis, you write: "As to one-year termed directors, it doesn't make much difference. But if you can remove a director with more than a year long term without cause, the longer term is meaningless." Two problems here.

First, you assume that a corporation can have directors with mixed terms (some one-year-term directors and some multi-year-term directors). I just don't see anyplace in the statute that authorizes that structure. You are talking about having such a structure during the transition from classified to unclassified, but the statute does not contemplate such a transition, which leads me to believe that it is not permitted. And if you could have mixed terms during the transition, could you also have them permanently?

Second, multi-year terms are not meaningless just because directors might be removed without cause. Yes, classified boards are primarily about hostile takeover defense, but in some circumstances, isn't it possible that a corporation might want to provide for a classified board for other reasons? The statute seems to contemplate just this sort of circumstance. Chancellor Allen wrote about this in Roven v. Cotter, 547 A.2d 603 (1988): "in 1974 the issue of removal was settled when the General Assembly amended ยง 141 to permit removal with or without cause. This included the specific recognition that even a classified board could be removed without cause if the certificate of incorporation so provided. Thus, it is clear that the shareholders retain the right to remove directors without cause, even if the board is classified. This leaves to shareholders the ultimate decision of how they will balance concerns for continuity and director security against those of flexibility and accountability."

Also re the policy analysis, re-read the Coates quotation in my update of the post. Directors only have a right (?) to serve out their terms when the constitutional documents of the corporation give them that right. And I am suggesting that the constitutional documents cannot give some directors the right to serve out those terms when other directors are serving one-year terms.

6. Posted by Jeff Lipshaw on July 2, 2008 @ 20:33 | Permalink

My sneaking suspicion is that the drafters of the statute simply never contemplated the de-staggering of a board. Moreover, the first sentence of Section 141(d) explicitly authorizes terms of different lengths as the classifications "ramp up" in the first three years. During that period, the board members are serving terms of different lengths. Surely the board is classified for purposes of Section 141(k)(1) during this ramp up, despite terms of different length.

We ought to be able to de-stagger, and symmetry would suggest that we can de-stagger by "ramping down" in the same way we ramped up, even if not explicit in the statute. Again, for symmetry's sake, would we say that the board is not classified for purposes of Section 141(k)(1) during the "ramp down?" I think not.

As to cases, well, I used the term adjectivally all the time - and never thought about it one way or the other - until this issue forced me to parse the syntax. I don't think mere colloquial usage counts as "law."

7. Posted by Gordon Smith on July 2, 2008 @ 21:18 | Permalink

Jeff, This is a fair point about ramping up, though ramping up is required to implement a classified board. There's no other way to get from point A to point B. It's not required to go the other direction, and I don't see any indication in 141(d) or elsewhere that mixed terms on the way down are authorized. To be fair, however, your sneaking suspicion seems pretty plausible.

I have been thinking about Allen's opinion, and I am interested in his statement that shareholders should make the ultimate decision. In this case, one could argue that the shareholders approved the ramping down of A-B's classified board and that decision should be allowed to stand. But, of course, that decision stands in the way of the present shareholder action. So I am not sure the shareholder touchstone provides much in the way of a decision rule.

Nor does your proposed policy of ensuring that classified boards function in a manner that prevents removal without cause.

Obviously, when I wrote "simple" in the original post, my tongue was firmly planted in my cheek. This is not a simple case.

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