A recent December ruling is causing Delaware companies to take a closer look at the director removal provisions in their organizational documents. A number of publicly traded companies have provisions that limit the removal of board members only to situations involving “cause.” The provisions are often a result of eliminating a classified board, while retaining a statement that directors may be removed only under circumstances constituting “cause.” In In re VAALCO Energy, Inc. S’holder Litig., C.A. No. 11775-VCL (Del. Ch. Dec. 21, 2015) (TRANSCRIPT), the Delaware Court of Chancery invalidated these removal provisions where directors serve on non-classified boards and are not elected by cumulative voting.

In this article, we analyze VAALCO and compare the ruling to the business corporation laws of several other states. While companies incorporated in Delaware should remove these provisions from their organizational documents, companies incorporated elsewhere are encouraged to review their organizational documents to ensure their provisions are valid under state law.

Background

In VAALCO, the Delaware Court of Chancery examined the charter and bylaw provisions of VAALCO Energy, Inc. (VAALCO) that allowed the removal of directors only for cause, despite VAALCO having a non-classified board and not having cumulative voting. The suit was brought by activist investors seeking to remove a majority of VAALCO’s directors after the company had experienced a significant decline in its stock price from May 2014 to September 2015. When VAALCO contended that its directors could only be removed for cause, the activist investors instituted proceedings against the company. The investors sought a declaratory judgment that VAALCO’s articles of incorporation and bylaws were invalid as a matter of law under Section 141(k) of the DGCL.

In a transcript ruling, the court held that the plain language of Section 141(k) of the DGCL entitles stockholders to remove a director with or without cause, limited only by two exceptions: (a) where the board is classified, in which case a director may be removed only for cause unless the certificate of incorporation provides otherwise; or (b) where directors are elected by cumulative voting. The court was guided by a plain reading of the DGCL, and was not persuaded by the argument that approximately 175 other public companies had adopted similar provisions. The parties in VAALCO later settled out of court, precluding the opportunity for an appeal and solidifying Vice Chancellor Laster’s ruling regarding director removal provisions under the DGCL.

Practical Implications

As a result of VAALCO, some Delaware corporations have been sued because of the director removal provisions in their organizational documents. Because the decision in VAALCO remains valid, the possibility exists that similar litigation may be brought against Delaware companies who have yet to conform their organizational documents to the ruling.

The Delaware ruling suggests that companies incorporated in other states that have similar provisions should review their organizational documents. This is particularly true for companies without classified boards or cumulative voting.

Below is a sampling of states and their associated business corporation laws that relate to removing directors. This analysis provides a jurisdictional overview of the pertinent provisions of director removal statutes in each state.

State Corporation Laws Similar to the DGCL

Similar to the DGCL, the business corporation laws in California and Illinois generally prohibit companies from limiting director removal without cause. The pertinent sections of each state’s business corporation law are described below.

California[1]

Section 303(a) of the California Corporations Code provides in pertinent part that: “Any or all of the directors may be removed without cause if the removal is approved by the outstanding shares . . . .” Thus, shareholders may remove a director without cause if the removal is supported by a majority of the outstanding shares entitled to vote in the election. The statute does not allow a company to alter this default rule in its organizational documents. Section 17702.01(c) provides that the articles of incorporation may not contain provisions that are inconsistent with the law.

Companies with classified boards, as addressed in Section 303(a)(3), may also remove any director without cause. The only difference for classified boards relates to calculating the requisite votes in the removal process. Companies with cumulative voting are not specifically addressed in the statute, and as such remain subject to the default rule that any director may be removed without cause.

Illinois

Section 8.35(a) of the Business Corporations Act of 1983 provides that: “One or more of the directors may be removed, with or without cause, at a meeting of shareholders by the affirmative vote of the holders of a majority of the outstanding shares . . . .” The specific reference to “with or without cause” in the statute, and lack of any language allowing a company to provide otherwise, means that removal of directors generally cannot be limited to situations involving cause. Section 2.10(b) allows the articles of incorporation to regulate the rights of shareholders so long as those provisions are not inconsistent with the law.

For those companies with classified boards, Section 8.35(a)(4) allows the articles of incorporation to stipulate that a director may be removed only for cause. Section 8.35(a)(2) sets forth a “with or without cause” standard for companies with cumulative voting, thus preventing cumulative voting companies from adopting for-cause removal provisions.

State Corporation Laws Differing from the DGCL

Unlike the DGCL, the corporation laws of New Jersey, New York, and Pennsylvania all allow companies incorporated thereunder to supersede the default statutory provisions related to removing directors. Each state allows for the adoption of specific provisions either prohibiting or allowing shareholders to remove directors for cause. The pertinent sections of each state’s business corporation law are described below.

New Jersey

Section 14A:6-6(1) of the New Jersey Business Corporation Act provides that: “One or more or all the directors of a corporation may be removed for cause or, unless otherwise provided in the certificate of incorporation, without cause by the shareholders by the affirmative vote of the majority of the votes cast . . . .” The key language of “unless otherwise provided in the certificate of incorporation” clearly allows a New Jersey company, in its corporate charter, to restrict the removal of directors only for cause.

Section 14A:6-6(2)(a)–(d) qualifies the default rule, and contains provisions addressing classified boards and cumulative voting. Importantly, prior to listing the (a)–(d) qualifications, Section 14A:6-6(2) begins by stating, “[u]nless otherwise provided in the certificate of incorporation . . . .” This prefatory language has the effect of allowing companies with classified boards or cumulative voting to adopt for-cause director removal provisions so long as they appear in the certificate of incorporation.

New York

Section 706(a) of the New York Business Corporation Law provides that: “Any or all of the directors may be removed for cause by vote of the shareholders.” Section 706(b) further states that: “If the certificate of incorporation or the by-laws so provide, any or all of the directors may be removed without cause by vote of the shareholders.” As such, the default rule in New York is that directors may only be removed for cause. A company may deviate from this rule in its certificate of incorporation or bylaws.

Section 706(c)(1) sets forth the voting requirements for removing a director from a company with cumulative voting. The voting mechanics of the statute are subject to any removal provisions found in the certificate of incorporation or bylaws. In other words, regardless of whether the company has cumulative voting, any for-cause director removal provisions in a company’s organizational documents relating to shareholders’ rights will govern. Interestingly, the statute does not specifically reference the removal of directors of companies with classified boards.

Pennsylvania

Section 1726(a)(1) of the Pennsylvania Business Corporation Law provides that: “Unless otherwise provided in a bylaw adopted by the shareholders . . . [a] director of a business corporation may be removed from office without assigning any cause . . . .” As such, the default rule for non-classified boards is that a director may be removed without cause. The rule may be superseded by a for-cause director removal provision in a bylaw adopted by the shareholders.

Section 1726(a)(1) addresses removing directors from classified boards. The default rule for classified boards is that directors may only be removed for cause. Per Section 1726(a)(1), companies may adopt removal provisions deviating from this rule in their articles of incorporation, so long as the provisions are “specific and unambiguous” in articulating that concept.

Section 1726(a)(3) addresses the votes necessary to remove a director from a company with cumulative voting, but does not specifically restrict those companies from adopting for-cause director removal provisions. As such, the Pennsylvania laws outlined above also govern cumulative voting companies.

Conclusion

As the analysis above indicates, companies incorporated in California and Illinois are strongly encouraged to reexamine their organizational documents with an eye towards any for-cause director removal provisions. Although New Jersey, New York, and Pennsylvania specifically allow for these provisions, companies incorporated there should nevertheless ensure that those provisions appear in the appropriate governing document. At the end of the day, an annual review of your company’s organizational documents has value beyond merely avoiding VAALCO-type liability, it bespeaks effective corporate governance. You just might be surprised at what you find.