The Invisible Constitution of the Corporation

Introduction

The Constitution constrains government, but corporate governance operates according to a different set of laws, rules derived from statute, contract, and regulation that allocate and defend control over a firm.

Such rules are mostly hidden in seldom-read documents such as certificates of incorporation, bylaws, and shareholder agreements. Yet these documents affect the power of shareholders to elect directors, sue, or influence corporate decisions.

For many corporations the distribution of power depends in part on rules that affect who may control a company. But rules about control are of interest to shareholders not only because they may protect some owners against takeover, but also because they may entrench incumbent management.

The Allocation of Control Rights and Voting Power

The purchase of an equity security generally entitles an investor to an ownership interest in a corporation but rarely to any direct control over the company. By statute corporate management authority is typically allocated to boards of directors subject to certain statutory or shareholder-based rights. For example, Section 141(a) of the Delaware General Corporation Law generally provides that "the business and affairs of the corporation... shall be managed...by or under the direction of a board of directors...as may be provided or permitted by this title or by the certificate of incorporation."¹

Thus while shareholders of Delaware incorporated firms have a residual entitlement to manage the business of the corporation, this power obviously cannot be exercised directly by millions of dispersed owners.

A necessary consequence of such a system is that control over large publicly held corporations typically resides with professional managers. The question then arises, how can shareholders hope to control managers?

Bylaws and Procedural Defenses of Incumbent Management

Provisions of a corporation's bylaws, which typically specify details of the conduct of shareholder meetings or nominating procedures and which may supplement or limit the powers of a board of directors, can play an important role in such disputes, subject to applicable law and the corporations' own rules.

Although such provisions may seem like mere procedural technicalities, they are often critical to disputes over challenges to management. For example, advance-notice bylaws, which provide that shareholders seeking to nominate directors must deliver information to the company before a specified deadline for inclusion in a proxy statement, may enable a company to organize a smoothly run election campaign while disclosing fully the identities and backgrounds of all nominees. However, such "demand" rules can also operate to ensure that only shareholders with significant resources can participate in the nominating process. But how did investors get placed in this position?

Problems of Allocation, Control, and Private Constraints

The issue of control is further complicated by the fact that most corporate control rules are not directly negotiated by shareholders, or even by management. Although directors and incorporators adopt many of the critical "rules of the game" within the confines of applicable corporate law, shareholders retain the power to alter them by voting. That power is often limited by the allocation of voting rights or voting blocs, and the law, at times, facilitates such entrenchment by limiting the ability of dissident shareholders to act effectively.

It becomes necessary then to consider why laws and institutions might constrain or facilitate the ability of shareholders to influence corporate decisions.

A corporation law permitting variation among permissible forms of organization, as U.S. laws typically do, leaves the selection of any particular method to private ordering: the selection by contracting parties of legal rules affecting their relationship. Yet statutory, fiduciary, or judicial constraints limit the ability of shareholders to create whatever rules they wish in order to entrench directors. In Schnell v. Chris-Craft Industries, Inc., for example, the Delaware Supreme Court rejected the claim that the inequitable is necessarily permissible, even when authorized by statute.²

Thus rules of procedure are often inseparable from the substantive purposes for which they are enacted, and analysis of the legality of a particular corporate-governance rule may require careful examination of context and effect as well as formalistic adherence to a particular statutory provision.

Why It Matters

The rules of the game concern much more than the allocation of management rights. They affect how firms are governed and how they react to shareholders, how decisions are made, and who controls vital resources. They may influence the power of particular categories of shareholders to induce changes in the composition of corporate control or in the distribution of power within large institutions that involve millions of workers and trillions of dollars of retirement assets.

Conclusion

The bylaws of publicly traded companies may not look much like the Constitution, but they perform a similar function in the organization of society's resources.

1. Del. Code Ann. tit. 8, § 141(a).

2. Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437, 439 (Del. 1971).