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Corporations can define shareholder voting rights by setting limits on certain classes of stock, the U.S. Court of Appeals for the Third Circuit has ruled. Although the issue had been long settled in Delaware corporate law, the appellate court’s precedential decision adopts the regulation as federal law.

Robert Freedman, a Viacom Inc. shareholder, filed a lawsuit in the U.S. District Court for the District of Delaware alleging the company’s executive compensation program was corporate waste because a portion of it was not a tax-deductible business expense. Typically, corporate taxpayers are able to deduct executive compensation over $1 million if approved by the board and a majority of shareholders.

Freedman argued that 26 U.S.C. Section 162(m) of the federal tax code requires executive compensation to be approved by all corporate shareholders. Therefore, shareholders who own nonvoting classes of stock must also approve the compensation plan before it can be implemented.

The lawsuit named all of Viacom’s board members as defendants, including Executive Chairman Sumner Redstone and New England Patriots owner Robert K. Kraft.

U.S. District Judge Sue L. Robinson of the District of Delaware rejected the plaintiff’s claims in Freedman v. Redstone, holding Congress did not intend for Section 162(m) to override Delaware corporate law permitting corporations to set limits on certain stock classes. Freedman appealed to the Third Circuit, but the appellate court affirmed Robinson’s decision.

“Freedman argues that federal tax law preempts Delaware law with respect to corporate votes but federal law does no such thing,” said Senior Judge Morton I. Greenberg in a unanimous opinion. “This presumption against preemption is heightened in areas traditionally occupied by the states, such as corporate, ‘including the authority to define the voting rights of shareholders.’”

Greenberg authored the opinion on behalf of a three-judge panel that also included Judge Julio M. Fuentes and Senior Judge Franklin S. Van Antwerpen. The panel concluded that Section 162(m) does not provide voting rights to stockholders or even address the mechanics of shareholder voting. In addition, the judges ruled that nothing in the federal statute can displace Delaware’s law permitting companies to limit shareholder activity by issuing different stock classes.

“Delaware law presents an obstacle to Freedman’s attempt to obtain a judicial result that nonvoting shares be allowed to vote,” Greenberg said. “Delaware law expressly grants corporations the right to issue stock with limitations, including limitations on voting rights.”

Freedman’s attorneys countered that Section 162(m) enfranchises all shareholders, even those holding nonvoting shares, on a corporation’s executive compensation plans. Therefore, the statute conflicts with Delaware law granting corporations permission to issue nonvoting stock.

Greenberg said Section 162(m) does not confer voting rights to nonvoting shareholders and only creates a mechanism for corporations to deduct certain portions of their executive compensation plans from their taxes.

Section 162(m) “does not provide voting rights to stockholders holding nonvoting shares, it does not override Viacom’s certificate of incorporation and it does not supersede decades of established Delaware law,” the judge said. “Accordingly, we do not conclude that Congress has preempted Delaware corporation law and we therefore hold that the district court properly dismissed Freedman’s claim.”

Freedman had also brought a derivative claim against Viacom’s directors regarding the executive compensation plan. The appellate court also dismissed the derivative action, ruling that the plaintiff failed to make a demand upon Viacom’s board as required by the Federal Rules of Civil Procedure and Delaware corporate law.

Greenberg noted that the court would excuse a plaintiff’s failure to make a demand on a corporate board if the plaintiff could prove that such an action would be futile, but Freedman failed to meet his burden. Viacom’s 10-member board is composed of five interested and five disinterested investors.

“Although Freedman may disagree with the board’s decision to award Viacom’s executives substantial short-term incentive compensation, the board, acting through the compensation committee, did not exceed its powers under Delaware law and we may not second-guess its exercise of its business judgment in this matter,” Greenberg said. “Freedman was obligated to make a presuit demand. Because he failed to do so, the district court properly dismissed his derivative claim under Rule 23.1.”

A. Arnold Gershon of Barrack, Rodos & Bacine and Brian E. Farnan of Farnan LLP represented Freedman. Gershon did not return calls seeking comment.

Viacom was represented by Jaculin Aaron and Stuart J. Baskin of Shearman & Sterling. John P. DiTomo and Jon Abramczyk of Morris, Nichols, Arsht & Tunnell also represented the company. Aaron and DiTomo referred all calls to Viacom’s corporate communications office. Viacom declined to comment on the decision.

This article first appeared in Delaware Business Court Insider, a Legal sibling publication.

Jeff Mordock can be contacted at 215-557-2485 or jmordock@alm.com. Follow him on Twitter @JeffMordockTLI.