Commercial, Professional Perspective - Lessons From Advance Notice Bylaw Litigation

By Renee Zaytsev and Nili T. Moghaddam

The article originally appeared on Bloomberg Law.

Editor's note: Renee Zaytsev was counsel in the matter of Paragon Technologies, Inc. v. Cryan prior to joining Boies Schiller Flexner.

Advance notice bylaws—provisions in a company's bylaws setting forth requirements for stockholders to nominate directors for election to the board—have been widely employed since the mid-1990s and today are ubiquitous among public corporations. Recent developments, however, have thrust these provisions into the spotlight. In the wake of the SEC's announcement of a new “universal proxy” rule, many public companies proactively amended their bylaws in anticipation of increased activist activity. At the same time, Delaware saw a wave of litigation by stockholders whose nomination notices had been rejected for alleged failure to comply with advance notice bylaws.

As discussed below, stockholder challenges to rejected nomination notices have been largely unsuccessful, with one notable exception where the Court of Chancery granted significant fees to a stockholder whose litigation led the board of Masimo Corporation to voluntarily withdraw a particularly extreme bylaw.

Most recently, on July 11, 2024, the Delaware Supreme Court issued a closely watched decision in Kellner v. AIM Immunotech Inc., finding that bylaws adopted for the purpose of thwarting a proxy contest were unenforceable. Despite this ruling, the Court denied the stockholder any tangible relief, underscoring the hurdles stockholders still face in successfully getting on the ballot. The Court's mixed ruling provides important lessons for boards and stockholders alike.

Enhanced Scrutiny Review

Stockholders who fail to comply with advance notice requirements run the risk that their nominations will be rejected by the board. At the same time, directors must act in accordance with their fiduciary duties when enacting and applying advance notice requirements.

Clear and unambiguous bylaws that are adopted on a “clear day,” i.e., when the board is not facing an imminent threat to corporate control, will generally be enforced. However, recognizing that advance notice bylaws can be misused to entrench incumbent directors, Delaware courts require a board that adopts, amends, or enforces advance notice bylaws during a proxy contest to demonstrate (i) that it acted in response to a legitimate threat to the corporation and not for the primary purpose of precluding a challenge to its control, and (ii) that its response was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder franchise. This standard of review is a form of enhanced scrutiny, Delaware's intermediate standard of review.

An Uphill Battle for Activists Challenging Clear and Unambiguous Requirements Adopted on a Clear Day

Delaware courts have not shown leniency to stockholders who fail to strictly comply with clear and unambiguous advance notice requirements that were adopted on a clear day:

• In BlackRock Credit Allocation Income Tr. v. Saba Capital Master Fund, Ltd., 224 A.3d 964 (Del. 2020), the Delaware Supreme Court ruled against a stockholder who inadvertently missed the deadline to return a questionnaire required to complete its nomination.
• In Strategic Inv. Opportunities LLC v. Lee Enterprises, Inc., 2022 BL 50143 (Del. Ch. Feb. 14, 2022), the Court of Chancery ruled against a stockholder who attempted to comply with a recordholder requirement in the corporation's bylaws but failed to complete the transfer of shares into record name prior to the nomination deadline. As the court noted, the stockholder's decision to wait until “the last minute” “left no room for error” and “eliminated any window time for [the stockholder] to cure deficiencies.”
• In Rosenbaum v. CytoDyn Inc., 2021 BL 391339 (Del. Ch. Oct. 13, 2021), the Court of Chancery held that the board properly rejected a nomination notice due to disclosure deficiencies and again admonished the stockholder for submitting its notice on the “eve of the deadline,” thus “leaving no time to fix the deficient disclosures.”
• In Jorgl v. AIM ImmunoTech Inc, 2022 BL 388149 (Del. Ch. Oct. 28, 2022), the Court of Chancery ruled in favor of a board that rejected a nomination notice based on its suspicion that the submitting stockholder had not disclosed his association with another individual with whom the company had been engaged in litigation. The court found that factual issues precluded it from entering a preliminary injunction requiring the board to accept the stockholder's notice. As a result, the annual meeting went forward without the stockholder's nominees on the ballot.

Losing the War in Stockholder Challenges to Defensive Bylaws

The above cases each involved advance notice bylaws that were adopted on a clear day, with scant or inconclusive evidence to show that the board acted inequitably in applying the advance notice requirements. In two subsequent cases, the Court of Chancery confronted bylaws adopted on the proverbial “cloudy day” and with substantial evidence of fiduciary misconduct. In both cases, the court expressed skepticism of or even invalidated certain of the board's decisions, but ultimately allowed the stockholder's nominees to be excluded from the ballot:

• In Paragon Technologies, Inc. v. Cryan, 2023 BL 435982 (Del. Ch. Nov. 30, 2023), the Court of Chancery again held that factual issues prevented it from granting a preliminary injunction. However, the court noted that it reached this ruling with “trepidation” given evidence that the board “amended its bylaws and adopted the rights plan after [the stockholder] emerged on the scene,” sat on the notice for “three weeks” and then rejected it at “the end of the nomination window,” based its rejection on “nitpicky” and “suspect” issues, and “then raised more deficiencies in this litigation.”
• In Kellner v. AIM ImmunoTech Inc., 307 A.3d 998 (Del. Ch. 2023), the Court of Chancery held that four of the six bylaws at issue were invalid because they improperly impeded the stockholder franchise and seemed designed to thwart the plaintiff's proxy contest. However, the court held that the board nevertheless properly rejected the stockholder's nomination notice for failure to comply with the remaining, valid bylaws. This decision and its appeal are discussed in more detail below.

The Delaware Supreme Court Weighs In: Kellner v. AIM ImmunoTech

In Kellner v. AIM ImmunoTech Inc., 2024 BL 236471 (Del. July 11, 2024)—an appeal from the Court of Chancery decision discussed above—the Delaware Supreme Court held that the bylaws adopted by the AIM board were invalid due to the board's improper purpose in adopting them. However, as discussed below, the Court nevertheless denied the stockholder relief at the ballot box.

Kellner involved a series of attempted proxy contests at AIM ImmunoTech. In 2021 and 2022, the AIM board rejected nomination notices due to alleged disclosure deficiencies. The second of these rejections led to the Jorgl litigation discussed above, with the board rejecting the notice based on its belief that the nominating stockholder was acting as a front for an individual who had pled guilty to securities fraud and was enjoined from engaging in certain activities related to the company.

Following the events of the Jorgl litigation, the AIM board—anticipating another proxy contest—amended its bylaws and added multiple new advance notice requirements. Subsequently, a third stockholder, Ted Kellner, sought to nominate three directors for election at the 2023 annual meeting. Believing Kellner's nomination to be a continuation of the prior years’ nomination efforts, the board again deemed the notice deficient. Kellner then sued, challenging the validity of six of the amended bylaws and alleging that the board improperly applied those bylaws to reject his nomination.

As noted above, the Court of Chancery found four of the six challenged bylaws facially invalid. The Delaware Supreme Court reversed in part and affirmed in part.

First, the Court disagreed with the Court of Chancery's context-specific analysis to assess facial validity. As the Court explained, a bylaw is facially invalid only if it “cannot operate lawfully under any set of circumstances.” The Court held that this condition did not apply to five of the six bylaws in question. However, it agreed that one of the challenged bylaws—with its “vague,” “indecipherable,” and “virtually endless requirements”— was facially invalid because “[a]n unintelligible bylaw is invalid under ‘any circumstances.’”

Next, the Court held that the amended bylaws did not meet the test of equity. As the Court explained, “[i]n the middle of a proxy contest, the AIM board adopted one unintelligible bylaw and three unreasonable bylaws,” which it “then used . . . to reject Kellner's nomination notice.” These facts led the Court to conclude that the board “amended its bylaws for an improper purpose—to thwart Kellner's proxy contest and maintain control.” Thus, “[a]s the product of an improper motive and purpose,” all the challenged bylaws were “inequitable and therefore unenforceable.”

Despite these findings, the Court stopped short of allowing Kellner's nominees a second bite at the election apple. At the conclusion of its opinion, the Court noted that, because “Kellner submitted false and misleading responses to some of the requests[,] . . . no further action is warranted.” In a subsequent Order, the Court clarified that it was not remanding the case for any further relief, including attorneys’ fees, and that the case is closed. Although the Court did not elaborate on its reasoning, its conclusion appears to be based on the equitable principle requiring those who seek equity to do so with clean hands.

Another Bridge Too Far: The Case of Masimo

Another recent ruling provides an additional example of a board going too far—this time with more concrete consequences.

In Politan Capital Management LP v. Kiani, No. 2022-0948-NAC (Del. Ch.), hedge fund Politan Capital challenged advance notice bylaws adopted by the board of Masimo Corporation. The amendments, adopted after Politan publicly disclosed its investment in the company, were extreme and unprecedented: they required nominating investment funds to disclose the identities and holdings of their limited partners, as well as any plans or proposals to nominate directors at other public companies within the next 12 months.

The bylaws were met with significant public criticism, with many noting that the disclosure requirements, if upheld, could end shareholder activism altogether. For example, in an amicus brief, the Managed Funds Association warned that, because most funds have contractual agreements that prevent the disclosure of limited partner identities, the practical effect of the bylaws would be dramatically fewer nominations and increased entrenchment by incumbent boards.

Politan also challenged other preclusive features of Masimo's corporate governance, including a poison pill and a change-in-control provision that would have entitled the CEO to a special payment worth at least $450 million if as few as two new directors were elected to the board.

Ultimately, the bylaws and other preclusive measures were voluntarily rescinded or waived before the Court of Chancery could rule on their validity. However, given the substantial corporate benefits conferred by the litigation, the court awarded Politan a mootness fee of nearly $18 million.

Although the fee award took into consideration the corporate benefits as a whole, the court specifically held that the board's repeal of the advance notice bylaw “had remarkable value” and constituted “an extraordinary corporate benefit” that—in light of the potential consequences to the shareholder activism industry—could “alone justify an award of $18 million.”

Analysis

As demonstrated by the string of board-friendly decisions over the last several years, Delaware courts have been largely deferential to boards applying clear and unambiguous advance notice bylaws that were adopted on a clear day.

However, as Kellner and Masimo make clear, boards can go too far and risk significant consequences when they do. Though boards may be emboldened by the fact that the Supreme Court in Kellner denied the stockholder further relief, the decision may make it easier for activists to bring successful challenges in the future. Further, the Court's denial of further relief was expressly based on the Court of Chancery's findings that the stockholder and his nominees engaged in “deceptive conduct” with respect to their disclosures. The same result may not apply where a court does not view alleged disclosure deficiencies as being intentionally deceptive. In such cases, the stockholder may well be entitled to a new election, attorneys’ fees, or both.

Considerations for Boards and Stockholders

Whether a stockholder submitting a nomination notice or a board responding to one, the above cases provide important lessons.

Boards of directors adopting, updating, and/or applying advance notice provisions should consider the following:

• Act on a clear day. Where possible, boards should review and amend their advance notice bylaws as needed on a periodic basis, before a specific activist threat emerges. Bylaw amendments adopted after the board has notice of a potential activist threat may be deemed defensive measures and would be subject to enhanced scrutiny, with the board bearing the burden of justifying its conduct.
• Draft clear & unambiguous requirements. To avoid challenges, advance notice provisions should be drafted as clearly and unambiguously as possible. Ambiguities in advance notice bylaws will be construed in favor of stockholder election rights. Further, bylaws that are overly long and confusing could be cited as evidence of an improper purpose and, in extreme cases, may be deemed facially invalid.
• Be mindful of market practice. Advance notice provisions should be tied to legitimate information-gathering goals. Caution should be exercised before imposing atypical requirements that deviate substantially from market practice.
• Respond in a timely manner. Unless a nomination notice is submitted at the last minute, boards should endeavor to respond and identify deficiencies within the nomination window.
• Identify all known deficiencies. Boards should also endeavor to timely provide a complete list of alleged deficiencies. Deficiencies not identified within the nomination window could be considered waived or could be viewed as evidence of an improper purpose.
• Act reasonably and proportionately. Even valid advance notice requirements that are adopted on a clear day can be subject to challenge when they are applied inequitably. When responding to a nomination notice, boards should focus on deficiencies that are substantive and material, rather than on those that could be considered nitpicky.

Stockholders planning to nominate directors for election should consider the following:

• Plan in advance. Stockholders should ensure they have sufficient time to collect all information required, especially as advance notice requirements have become increasingly lengthy and complex. In addition, certain logistical steps—such as transferring shares into record name or requesting director questionnaires—may require several days of lead time.
• Submit early. Stockholders should submit nomination notices as early in the nomination window as possible to ensure that there is time to cure any deficiencies that may be identified by the board. Stockholders who wait until the end of the nomination window leave no room for error.
• Use best efforts. Stockholders should use best efforts to meet all advance notice requirements to the extent possible, even where such requirements are burdensome or differ from the disclosure requirements imposed upon the incumbent directors.
• Object in a timely manner. If a request is unclear or unreasonably difficult to comply with, stockholders should comply to the best of their ability and note the objection in a timely manner to avoid being accused of manufacturing after-the-fact excuses.

Finally, stockholders and boards alike would be well advised to seek experienced counsel to help them navigate the potential pitfalls surrounding the preparation of nomination notices and the adoption and enforcement of advance notice bylaws.

Copyright 2024 Bloomberg Industry Group, Inc. (800-372-1033) Lessons From Advance Notice Bylaw Litigation. Reproduced with permission.