Originally published on Law360, Securities Law, May 26, 2010.
In a case of first impression, Kurz v. Holbrook, 2010 WL 707425 (Del. Ch., Feb. 9, 2010), the Delaware Chancery Court (Court) held that a successful consent solicitation by a major shareholder to amend a company's bylaws to reduce the size of the board from six to three directors so that its two directors would comprise a majority of the board conflicted with Delaware corporate law (DGCL) and was therefore void. This decision is significant because Delaware courts have never considered the outcome of a bylaw amendment that would shrink the number of board seats below the number of sitting directors. DGCL does not address the issue, and none of the leading treatises on Delaware law even mentions it. In fact, no one seems to have contemplated that this issue would ever arise, according to the Court.
In December 2009, three consent solicitations were underway. At stake was control of the board of directors of EMAK Worldwide, Inc. (EMAK). A dispute arose among the sponsors of the consent solicitations as to which, if any, of the proponents was successful. After one of the EMAK directors resigned on December 18, Crown EMAK Partners, LLC (Crown) delivered sufficient consents (Crown Consents) to amend EMAK's bylaws in two significant ways. First, the Crown Consents reduced the size of EMAK's board from six to three directors (Shrinkage Bylaw). Crown had the right to appoint two of the directors as the holder of Series AA Preferred Stock, which meant that it would thereafter control a majority of the board. Second, the Crown Consents added a new bylaw provision, which required the EMAK CEO to call a special meeting to elect the third director whenever the number of sitting directors exceeded three. The singular successor would then take office as a director and replace multiple predecessors.
Through the Shrinkage Bylaw amendment, Crown attempted to shrink the size of EMAK's board below the number of currently sitting directors and, as the Court put it, metaphorically pull the directors' seats out from under them. Typically, in a contested director election, the insurgent first attempts to remove the sitting directors, then reduces the number of board seats and fills the vacancies. Crown could not follow this traditional route, however, because it could not vote its Series AA Preferred Stock either to elect or to remove directors. The effect of the Shrinkage Bylaw, if valid, would be to literally shrink the size of the board to three directorships at a time when five directors were in office. The "surplus directors" would then either have their terms curtailed or continue to serve without having official board seats. The Court found that this rigged game of "musical chairs" – suspending sitting directors into a state of limbo – could not stand under the express language of Section 141 of DGCL.
Under Section 141(b) of DGCL, each director holds office until a successor is elected and qualified or until an earlier resignation or removal. Thus, the statute recognizes the following three procedural means for ending the terms of a sitting director: (1) when the director's successor is elected and qualified; (2) if the director resigns; or (3) if the director is removed. The Court noted that this statutory regime is congruent with the way the law has developed in Delaware. Under common law principles, a voluntary assumption of management responsibility by a director resulted in the director having a "vested right" to serve on the board for a full term unless removed for cause. The mechanics for removal under DGCL are included in Section 141(k), which provides that directors may be removed, with or without cause (with certain exceptions related to classified boards), by the holders of a majority of the shares entitled to vote at an election of directors.
The Court determined that the specific references to removal in DGCL, the absence of any comparable provision addressing board shrinkage and the common law tradition that a director otherwise would serve a full term absent cause for removal were persuasive reasons supporting its judgment that directorships cannot be eliminated through board shrinkage. The Court disagreed with Crown's argument that because Section 141(b) of DGCL does not list a director's tenure as being extinguished upon death, the fact that shrinkage of the board is not on the list is simply not relevant. The Court pointed out that "death remains an insurmountable barrier to board service," and that "imposing death" on a director is not a legitimate method of making a change in the board. In other words, to be a living person is simply a "minimum qualification for board service."
A procedure that establishes qualifications for directorship and provides that a director who ceases to meet them can no longer serve is, according to the Court, likewise distinguishable from displacing a sitting director through board shrinkage. Although the Court had previously upheld a limited example of this type of provision in a company's certificate of incorporation, the Court said that a bylaw that effectively would disqualify a sitting director and terminate her service would be invalid in light of the procedural means for ending a director's term in Section 141(b) of DGCL. The concept of a bylaw that would end a director's service through disqualification thus lends no support to the validity of the Shrinkage Bylaw because, according to the Court, neither is valid under Section 141(b). Moreover, the Court said that if a bylaw amendment reducing the size of the board could eliminate sitting directors, then directors would effectively have the power to remove other directors. For 89 years, Delaware law has barred directors from removing their fellow directors.
The Court next examined whether a board shrinkage bylaw could be upheld on the basis that, rather than eliminating excess directors, the directors whose seats were eliminated would continue serving without board seats until they resigned or were properly removed. The argument in support of this alternative theory – that unseated directors might be analogous to holdover directors who serve beyond their allotted time – is, at first blush, plausible. Holdover directors may remain validly in office, for example, when a corporation has not held a timely annual meeting or because no successor directors were validly elected and qualified. The Court concluded, however, that although this alternative theory holds some appeal, it actually runs counter to Crown's position because Section 211(c) of DGCL specifically authorizes holdover directors under the above circumstances. In the Court's words, "Our law does not contemplate a liminal state in which suddenly surplus directors might continue to exist, untethered from the statute or any constitutive corporate document." Although Delaware law does not require that a corporation's charter or bylaws stipulate a specific number of directors, the presence of directors whose board seats have been eliminated under the Shrinkage Bylaw would create a direct conflict between the number of directors in office and the number provided for in EMAK's bylaws.
The Court also pointed out, in striking down the Shrinkage Bylaw, that quorum requirements for board meetings would be impossible to apply if the number of directors could exceed the number of directorships. EMAK has a majority quorum requirement. If the Shrinkage Bylaw turned two of the directors into continuing but seatless directors, a quorum would be two out of three seats, even though there would be five directors in office. This would conflict with the mechanism in Section 141(b) of DGCL for determining a quorum of the board.
Although the Court agreed that the Crown Consents were sufficient to amend EMAK's bylaws, it held that the amendments were invalid and of no effect. In an age where proxy contests by disenchanted shareholders have become commonplace, easier and cheaper to conduct under DGCL and the federal securities laws, and the Securities and Exchange Commission has begun to take steps to facilitate direct shareholder participation in the nomination and election of directors, this decision by the Delaware Chancery Court is a significant reminder that there are boundaries that even the most creative insurgent shareholders cannot cross.
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