On April 21, 2010, the Delaware Supreme Court issued an
important opinion addressing Delaware law principles regarding
improper vote buying, record ownership of stock, and the propriety
of a by-law amendment purporting to remove directors by reducing
the size of the board. The Court's opinion in Kurz v.
Holbrook, which affirms in part and reverses in part the
earlier opinion of the Delaware Court of Chancery, also discusses
whether an agreement to sell shares violated an existing agreement
restricting the sale of such shares.
The Kurz case arose out of a contest for corporate control of EMAK Worldwide, Inc. ("EMAK") in which Take Back EMAK, LLC ("TBE"), a group of insurgent stockholders, through resolutions adopted by written consent, purported to remove two directors from a board of seven directors and fill the two vacancies with TBE's nominees. Crown EMAK Partners, LLC ("Crown"), a holder of EMAK preferred stock that was contractually entitled to elect separately two of the seven directors, then launched a consent solicitation to adopt a by-law amendment purporting to reduce the size of the board to three members. If the number of directors then in office exceeded three, the by-law amendment would also require the holding of a special meeting of stockholders to elect a single director as the successor to all of the directors other than the two directors elected separately by the holders of the preferred stock. Crown did not solicit consents to remove any of the directors.
Crown obtained and delivered a sufficient number of consents to approve its proposed by-law amendment (the preferred stock was not entitled to vote generally on the election of directors but voted on an as-converted basis with respect to other matters). TBE also obtained and delivered a sufficient number of consents to remove and replace the directors, but the inspector of elections invalidated the votes of shares held in "street name" because an "omnibus proxy"1. from Cede & Co., the nominee of The Depository Trust Company ("DTC") in whose name "street name" shares are held (as is customary for U.S. public companies), was not obtained. The shares voted by TBE included shares held by a former employee of EMAK who had signed a Restricted Stock Grant Agreement with EMAK that prohibited the sale of those shares before March 2011. Immediately prior to the delivery of the consents, TBE and the former employee had entered into an agreement pursuant to which the former employee agreed to sell those shares to TBE and granted TBE a proxy to vote the shares.
At the trial court level, the Court of Chancery held that the by-law amendment violated the Delaware General Corporation Law ("DGCL") by improperly reducing the size of the board without formally removing any directors. The Chancery Court further held that the DTC participant list (the list of brokers and other nominees who have positions in the DTC-held shares) constituted part of the EMAK stock ledger for purposes of the DGCL and, therefore, that it was not necessary for the DTC participants to obtain the "omnibus proxy" from DTC to vote the shares. Finally, the Chancery Court held that the purchase agreement between TBE and the former employee did not constitute improper vote buying under Delaware law and did not violate the Restricted Stock Grant Agreement.
The Supreme Court affirmed the Vice Chancellor's opinion that TBE had not engaged in improper vote buying. The Court agreed that because the purchase agreement resulted in Crown voting the shares that determined the outcome of the consent solicitation the arrangement should be reviewed in light of Delaware's prohibition on improper vote buying. Under that scrutiny, however, the Supreme Court determined that the transaction was not illegal because it did not involve fraud and did not result in a "misalignment between the voting interest and the economic interest of shares" to which Delaware courts have historically objected. However, in a reversal of the Chancery Court decision, the Supreme Court found that that the purchase agreement breached the Restricted Stock Grant Agreement because it effected a transfer of both the economic ownership and the formal voting rights of the shares, despite the parties' efforts to comply technically with the Restricted Stock Grant Agreement by having the former employee retain legal title to the shares during the restricted period. Consequently, the Court held that TBE could not vote those shares.
Because TBE could not vote the restricted shares, TBE did not have sufficient votes to act by written consent. As a result, the Court found it unnecessary to make a formal judgment on whether the DTC participant list constituted part of the stock ledger for purposes of the DGCL. However, the Supreme Court did say that the Chancery Court's decision on this point is "obiter dictum and without precedential effect," and the rather lengthy discussion in the opinion of the depository system and the judicial precedents regarding record ownership under Delaware law implies strongly that the Court would have overturned the Chancery Court's determination that the DTC participant list should be deemed part of the stock ledger.
As noted above, the Supreme Court upheld the Chancery Court's decision that the by-law purporting to reduce the size of the board without removing directors violated the DGCL. The Court noted that giving effect to the by-law amendment would have resulted in the anomalous situation in which there would be more members of the board than board seats and would also have conflicted with the provision of the DGCL that provides the exclusive means by which a director of a Delaware corporation may be removed from office. The legally proper sequence for reducing the number of currently sitting directors in a contested election would be to remove the challenged directors, reduce the number of directorships and then fill any vacancies. In this instance, the preferred stockholders did not have the right to vote their shares to remove directors, and their attempt to achieve the same objective indirectly through a by-law amendment ran afoul of the DGCL.
1. An omnibus proxy is a proxy given by DTC to the various DTC participants (i.e. brokerage firms, banks and other entities whose customers are the beneficial owners of the shares registered in the name of Cede & Co.) to enable those entities to vote the shares.
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