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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