Altering Rules, Cumulative Voting, and Venture Capital

Until 1870, corporate elections in the United States were generally conducted under a system of straight voting. In that year, the State of Illinois adopted a new constitution requiring that cumulative voting be used to elect directors to the boards of Illinois corporations. Over the next eighty years, a number of states followed suit and adopted laws mandating the use of cumulative voting in corporate elections. As one scholar has written:

The high water mark of mandatory cumulative voting as a force in American corporate law was probably the late 1940s. At that point, twenty-two states had mandatory provisions. The Banking Act of 1933 required cumulative voting for national banks. The Securities and Exchange Commission favored cumulative voting in the reorganization cases of the 1930s and 1940s. The first Model Business Corporation Act, proposed by the American Bar Association, officially published in 1950 but drafted in the late 1940s, called for mandatory cumulative voting.[1]

Over the past seventy years, the tide in the United States has turned decisively against cumulative voting. Whereas the first version of the Model Business Corporation Act mandated the use of cumulative voting, the modern incarnation of that Act makes straight voting the default rule. In 2006, Congress repealed the provision in the Banking Act of 1933 that had required that directors of national banks be elected via cumulative voting. A number of surveys have found that the number of U.S. corporations utilizing cumulative voting has plummeted over the past thirty years.

What explains this sharp turn against cumulative voting in the latter half of the twentieth century? Jeffrey Gordon attributes this shift to opposition by incumbent managers in public companies. Because cumulative voting lowers the vote threshold for obtaining a seat on a corporation’s board, its use increases the chance that a group of insurgent shareholders will launch a proxy contest. Even if this group fails to garner enough shares to gain control of the board outright, the acquisition of some number of board seats will make it easier to launch subsequent proxy fights and, in so doing, to gain control of the corporation. After corporate raiders initiated a series of high-profile proxy contests against corporations with cumulative voting in the 1950s, corporate America—and the U.S. corporate bar—began to rethink the virtues of cumulative voting. So long as proxy fights and hostile takeover attempts were rare, there was no immediate need to take action. When the early 1980s saw a dramatic increase in hostile takeover activity, however, these managers began lobbying state legislatures to abolish mandatory cumulative voting to protect local corporations from unwanted suitors. These lobbying campaigns were generally successful. In 1980, there were nineteen states that mandated that cumulative voting be used in some or all corporate elections. By 2016, this number had shrunk to six. One of these six remaining states, however, is California.

State policy in California has long been strongly supportive of cumulative voting. Under California law, state agencies that own shares in private companies are required to vote (as shareholders) in favor of proposals to permit or authorize cumulative voting.[2] In the corporate law context, California requires that shareholders in private companies be permitted to elect their directors cumulatively.[3] While the statute permits public companies to opt out by amending their articles of incorporation to provide for straight voting, it denies this right to private companies.[4]

This legislative commitment to a system of mandatory cumulative voting is reinforced by four negative altering rules set forth in the California Corporations Code. The first such rule is Section 2115, which mandates (in effect) that even corporations incorporated in other states elect their directors via cumulative voting if the corporation has a sufficiently close connection to California. The second is Section 301, which prohibits private companies from adopting staggered boards that might dilute the efficacy of the cumulative voting right. The third is Section 212, which requires a supermajority vote of the shareholders to reduce the size of the board below five. (The smaller the board, the less effective the cumulative voting right.) The fourth and final negative altering rule is Section 303, which limits the ability of the majority shareholder to remove directors elected by cumulative voting. The purpose of each of these provisions is to prevent California-based companies from contracting around or watering down the cumulative voting rule.

The California Corporations Code also contains several “positive” altering rules that tell corporate actors how to opt out of this rule. Section 706, for example, enables shareholders to contract around virtually any provision in the California Corporations Code by entering into a separate shareholder agreement. This provision goes a long way towards explaining why cumulative voting is all but unknown in Silicon Valley. When a venture capital fund invests in a start-up, it will typically demand that all—or virtually all—of the company’s shareholders enter into a voting agreement. In this agreement, the signatories agree on how they will vote their shares in board elections. The effect of these voting agreements is to determine the composition of the board of directors purely as a matter of contract law and, in so doing, to make cumulative voting rights irrelevant.

Why has the California legislature given its blessing to this particular positive altering rule? It is most likely because shareholder agreements typically serve to further the goal of providing for minority representation on the board. Indeed, the venture capitalists investing in early-stage companies are themselves typically a minority shareholder whose representation on the board is assured by means of a shareholder agreement. If the goal of achieving minority representation is achieved, and if this is done with the consent of the minority shareholders whose interests are affected, then it is inconsequential as to whether this goal is achieved via cumulative voting or a shareholder agreement.

While the use of a shareholder agreement is the only “official” means of contracting around the cumulative voting rule, there are two other tools that are often used by private actors to achieve this same end. First, there is no California law mandating that LLCs use cumulative voting.[5] One can, therefore, contract around California’s cumulative voting rules simply by organizing a new business as an LLC rather than a corporation or by converting an existing corporate entity into an LLC. Second, the effect of the cumulative voting rule may be diluted by creating a dual-class board, per Section 301 of the California Corporations Code. Each of these avenues permit private actors to contract around the cumulative voting rule that the California legislature has gone to such great lengths to protect in other contexts. To date, that legislature has declined to act to address either of these loopholes. The effect is to render many of the negative altering rules discussed above irrelevant.

This analysis supports two general insights. The first is descriptive. Legislatures can—and sometimes do—deploy a combination of negative and positive altering rules in an attempt to give a rule precisely the right level of stickiness. In California, the legislature went to great lengths to craft a cumulative voting regime that was very sticky but not quite mandatory. It surrounded its cumulative voting rule with an array of negative altering rules that foreclosed several means of contracting around it. At the same time, the legislature enacted a positive altering rule that specifically permitted the parties to opt out of this rule by entering into a shareholder agreement. In the annals of altering rules and sticky defaults, this particular scheme represents an impressive legislative effort to calibrate the stickiness of a particular rule in pursuit of a particular legislative end.  In this, this legislative scheme should feature prominently in future scholarly debates about the nature of altering rules.

The second insight to be derived from the foregoing discussion is normative. There is virtue in simplicity when it comes to altering rules. If a particular substantive rule can only be made effective by surrounding it with a multitude of negative altering rules, then this is prima facie evidence that the substantive rule chosen by the legislature should simply be made mandatory. In the cumulative voting context, the California legislature enacted no fewer than four negative altering rules to protect its cumulative voting rule. This effort was, however, arguably inadequate. Under current California law, a majority shareholder can significantly dilute the cumulative voting rule by creating a dual-class board. It can avoid it altogether by creating an LLC. It would seem, therefore, that the legislature really should have enacted six specific negative altering rules—one additional rule barring the use of dual-class boards, plus one more relating to LLCs—to ensure that the shareholder agreement represented the exclusive means of contracting around the cumulative voting rule. The more negative altering rules that are viewed as necessary to buttress the underlying rule, in other words, the stronger the case for making the rule mandatory. In these cases, the game of altering rules may not be worth the candle.

ENDNOTES

[1] Jeffrey N. Gordon, Institutions as Relational Investors: A New Look at Cumulative Voting, 94 Colum. L. Rev. 124, 145 (1994).

[2] See Cal. Gov’t. Code § 6900.

[3] Cal. Corp. Code § 708(a). Any shareholder who wishes vote cumulatively must give notice of his or her intent to do so at the meeting prior to the voting. Cal. Corp. Code § 708(b).

[4] Cal. Corp. Code 301.5.

[5] See Cal. Corp. Code § 17704.07(r).

The preceding post comes to us from John F. Coyle, Assistant Professor of Law at the UNC School of Law.  The post is based on his recent paper, which is entitled “Altering Rules, Cumulative Voting, and Venture Capital”, forthcoming in the Utah Law Review and available here.

1 Comment

  1. Clayton Vreeland

    Very good article. I agree that California should add a cumulative voting provision to RULLCA for manager-managed LLCs, similar to the existing cumulative voting provision already on the books for corporations in Corp. Code section 708.

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