DE Courts Tackle Novel Issues Presented by Contested Director Election

Recently, in Kurz v. Holbrook (C.A. No. 5019-VCL (Del. Ch. Feb. 9, 2010), aff'd in part and rev'd in part, No. 64 (Del. 2010)), the Delaware Court of Chancery and Supreme Court confronted dueling consent solicitations over control of the board of directors of EMAK Worldwide, Inc. This contest generated three issues of first impression:

• Whether directors can be removed from office, mid-term, through a reduction in the size of the board effected via a stockholder-approved bylaw amendment;
• Whether a purchase of the “swing votes” necessary to win the contest can constitute illegal vote buying; and
• Whether an omnibus proxy is required from the Depositary Trust Company (“DTC”) in order for banks and brokers to vote “street name” shares on behalf of their customers.

Vice Chancellor Laster tackled these issues head-on in a thoughtful analysis that is likely to impact strategies and outcomes of future battles for corporate control. However, precisely because of the decision's potential precedential impact, the Delaware Supreme Court heard an appeal on an expedited basis. In a unanimous decision, the Supreme Court affirmed the Court of Chancery's decision in part and reversed it in part, thereby blunting the impact of the lower court decision in one area.

Background

EMAK, a Delaware corporation based in Los Angeles, has two classes of stock: common and Series AA preferred. The preferred stock, owned by Crown EMAK Partners, LLC, does not participate in the election of directors by the common stockholders, but entitles Crown to designate two additional directors. The preferred stock does vote, on an as-converted basis, with the common stock on all other matters, thereby entitling its holder to approximately 28% of the total voting power on such matters.

In late 2009, EMAK found itself subject to two competing consent solicitations seeking control of its board. One group, Take Back EMAK, LLC (“TBE”), included Donald Kurz, a sitting director previously elected by the common stockholders. TBE sought majority representation on the board by asking the common stockholders to remove the other two EMAK directors previously elected by the common stockholders, without cause, and to fill the resulting vacancies with TBE's nominees.

Because Crown was not entitled to vote its preferred stock to either remove directors elected by the common stockholders or elect their replacements, it pursued an alternative strategy of asking stockholders to adopt bylaw amendments to reduce the size of the board to three ' the two directors designated by Crown through its preferred stock, and one elected by the common stockholders. In this way, Crown hoped to “metaphorically pull ' their seats out from under” two of the directors elected by the common stockholders.

Dueling Solicitations

TBE and Crown followed very different strategies in soliciting consents. Because Crown's preferred stock gave it the right to designate two directors and approximately 28% of the total vote on its bylaw amendments, Crown focused on winning the support of EMAK management and one large institutional holder.

TBE, meanwhile, conducted a typical solicitation of the common stockholders. As a publicly held company, most of EMAK's common stock is held in “street name.” A product of our securities markets' depository system in which the actual stock certificates are “immobilized” in a central depositary to facilitate securities trading, the holding of shares in “street name” splits stock ownership between two groups ' beneficial owners who possess the economic interest in the shares, and record owners who, while lacking an economic stake, are the registered holders on the corporations' stock ledgers and therefore possess the right to vote under the Delaware General Corporation Law (“DGCL”). DTC, the only remaining U.S. securities depository, plays a central role by both clearing trades and serving as the record owner of nearly all “street name” shares.

The “typical” solicitation of proxies (and consents) involves a series of steps. First, because DTC is the record holder of the shares held on deposit, it has been assumed to have power to vote those shares. Thus, an omnibus proxy that transfers DTC's voting authority to the banks and brokers that deposited the shares on behalf of their clients is usually obtained. Next, the banks and brokers shift voting authority to Broadridge Financial Services, which communicates with the beneficial owners via proxy materials and voting instruction forms. Finally, after receiving voting instructions from the beneficial owners, Broadridge votes in accordance with their wishes. It should be noted that neither DTC, Broadridge nor the banks and brokers generally has the authority to vote without instructions.

Four days before the deadline, TBE found itself 116,325 votes short. To overcome this, Kurz contacted Peter Boutros, a former EMAK employee who owned 175,000 shares. After some haggling, Boutros signed a purchase agreement for: 1) the sale of 150,000 shares to Kurz, at a premium price of $1.50 per share; and 2) the grant to Kurz of an irrevocable proxy to vote those shares in his discretion. The proxy was necessary because Boutros's shares were subject to certain restrictions preventing transfer of legal title at that time.

The Parties Go to Court

Convinced that the Boutros proxy had put it over the top, TBE claimed victory. Crown also believed that it had sufficient consents to adopt its bylaw amendments and take control of the board. Not surprisingly, each group challenged the other's consents, seeking relief under DGCL Section 225, which empowers the Court of Chancery to resolve election disputes.

TBE challenged Crown's consents on the basis that the proposed bylaw amendments violated Delaware law. With regard to TBE's consent solicitation, there was no dispute that Broadridge correctly collected, recorded and totaled the beneficial owners' voting instructions. Similarly, Broadridge received proper authorization from the banks and brokers to vote the EMAK shares on their behalf. Missing, however, was an omnibus proxy transferring voting authority from DTC to the banks and brokers. With this link missing, Crown argued that legal authority to vote remained with DTC, rendering TBE's consents ineffective. Crown also argued that the arrangements with Boutros violated the transfer restrictions on his shares and, in any event, constituted illegal vote buying.

After considering arguments from both sides, Vice Chancellor Laster declared TBE the winner. On appeal, however, the Delaware Supreme Court remanded the case to the Court of Chancery for further proceedings. As a result, neither Crown nor TBE has succeeded in taking control of EMAK's board, and the status quo continues.

The Courts' Analysis

Reducing the Size of the Board

It is not an uncommon tactic for an insurgent to seek control by soliciting stockholder votes to expand the size of a company's board through a bylaw amendment and fill the vacancies with the insurgent's nominees. However, prior to Kurz, Delaware courts had not been asked to consider an attempt to gain board control via a bylaw amendment to reduce the size of the board. In the words of Vice Chancellor Laster: “Our law has not addressed what happens when a bylaw amendment would shrink the number of board seats below the number of sitting directors. The DGCL does not address it. No Delaware court has considered it. None of the leading treatises on Delaware law mention it. Indeed, no one seems to have contemplated it.”

The Vice Chancellor observed that while DGCL Section 141(b) explains the process for filling vacant board seats if a bylaw amendment expands the board, it is silent on what happens if a bylaw amendment reduces the board. Accordingly, he considered ' and rejected ' “two possible consequences for the suddenly surplus directors”: 1) the termination of the terms in office of the “surplus directors”; or 2) the “surplus directors” continuing to serve without an underlying board seat.

Early Termination of  'Surplus Directors'

The Vice Chancellor concluded that this alternative conflicts with DGCL Section 141(b)'s “mandate that '[e]ach director shall hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal.'” In support, he observed that DGCL Section 141(k) provides that directors “may be removed, with or without cause, by the holders of a majority of the shares entitled to vote at an election of directors,” and then noted that “[t]he specific references to removal in Sections 141(b) and (k), the absence of any comparable provision addressing board shrinkage, and the background common law exception that a director otherwise would serve out a full term absent cause for removal reinforce my view that eliminating directorships through board shrinkage is not permitted.”

'Surplus Directors' Continue in Office

Next, the Vice Chancellor analogized the alternative that the “surplus directors” continue to serve, without official directorships, to “holdover directors,” who are permitted to serve beyond their terms under DGCL Section 211(c) if either the company fails to timely hold an annual meeting or a successor is not elected. Because DGCL Section 141(b) “does not contemplate a board with more directors serving (albeit without official seats) than the 'number ' fixed by ' the bylaws,'” he rejected this analogy, noting that “[i]f the excess directors are not eliminated, then for a time EMAK will have a greater number of directors serving than what the Bylaws provide, which cannot occur under Section 141(b).”

Unable to find a statutory basis for removing directors mid-term through bylaw amendment, Vice Chancellor invalidated Crown's consents. The Supreme Court supported this aspect of the decision.

There are several methods available to unhappy stockholders or acquisitive raiders to seek control of a company. Experienced practitioners understand how to parse corporate charter documents, searching for faulty defenses or loopholes by which to gain an advantage. But one important lesson of Kurz v. Holbrook is that Delaware courts will strictly adhere to statutory language when adjudicating election disputes. The technique pursued by Crown and its allies to take over the EMAK board, however, simply did not pass muster.

Third-Party Vote Buying

The Vice Chancellor prefaced his analysis of this issue by explaining that the historic vote buying cases generally involved “insiders using corporate resources to 'buy' votes” or “a fiduciary [who] receives inside information about how a vote is trending and then acts on the information to swing a close vote.” Although these circumstances were absent in Kurz, in confronting this “undeveloped area of our law,” the Vice Chancellor reasoned that “the concept of vote buying” is “broad enough to encompass” the purchase of votes without using corporate assets or taking advantage of inside information. The Vice Chancellor labeled this variation on vote buying as “third-party vote buying,” and declared that where third-party vote buying proves “deleterious to stockholder voting, this Court can and should provide a remedy.”

On this basis, the Vice Chancellor analyzed the arrangements between Kurz and Boutros. Although Kurz was an EMAK director, he “used his own resources to acquire Boutros's shares” and “did not take advantage of any inside information.” Thus, traditional vote buying analysis did not apply.

However, because Kurz's arrangements with Boutros “provided TBE with the votes they needed to prevail,” the Vice Chancellor considered them “potentially disenfranchising” and therefore subjected them to “a vote buying analysis.” While acknowledging that “the full measure of principles that will govern third-party vote buying must await case-by-case development,” the Vice Chancellor articulated “several broad concepts” to guide his analysis. First, third-party vote buying will “merit review only if it is disenfranchising, in the sense of actually affecting the outcome of the vote.” This includes vote buying that “delivers the swing votes” or “alters the voting pattern in a critical way.” Second, a third-party vote buying arrangement “must not be the product of fraud.” Fraud might be indicated by informational disparities or inadequate disclosures. Third, a stockholder's underlying economic interest should accompany the sale of voting rights to avoid Delaware law's close scrutiny of those who “divorce ' property interest from voting interest ' .”

Although the first of these elements, the delivery of “swing votes,” was present, the other two were not:

The Vice Chancellor found “no evidence of fraud”: Boutros “was fully informed about the ongoing consent solicitations,” “must have been cognizant” that “his shares were the swing shares,” and “was advised by counsel,” all “hallmarks of a transaction in which Boutros understood what he was selling, the circumstances under which he was selling it, and what he was getting in return.”

The Vice Chancellor found the economic and voting interests in Boutros's shares to be properly aligned. Even though the transfer restrictions prevented Kurz from taking title to the shares, because “he now bears 100% of the economic risk” under the purchase agreement, “Delaware law presumes that he should and will exercise the right to vote.” He also noted that Kurz had no “competing economic or personal interests that might create an overall negative economic ownership in EMAK”; he was “overwhelming long EMAK's stock” with “no countervailing short interest,” and his EMAK holdings “represented a sizable portion of his personal wealth.”

Despite conceding that “Kurz primarily wanted the voting rights carried by the shares, not the shares themselves,” the Vice Chancellor could “not perceive anything illicit in that fact given the nature of the transaction as a whole.” In short, he did not believe that “Kurz has any reason to vote other than in the manner he thinks would best maximize the value of EMAK as a corporation,” and concluded that “[t]he proxy granted to Kurz under the Purchase Agreement comports with what our law expects.”

The Supreme Court agreed with this analysis, focusing primarily on the continued alignment of the voting and economic interests in the Boutros shares. However, the Supreme Court went on to conclude that the purported transfer of shares from Boutros to Kurz was prohibited by the stock transfer restrictions and, therefore, “the Purchase Agreement did not operate as a legally valid sale or transfer of Boutros' shares, and ' Kurz was not entitled to vote those shares.” In this case, the alignment issue actually worked against TBE, as the Supreme Court noted that “Boutros' immediate divestiture of all voting and economic rights in his shares frustrates the purpose of the [transfer restrictions], because bare legal title, alone and without more, does not give Boutros a stake in the corporation's future.”

Although the Supreme Court determined that Boutros was not entitled to transfer his shares and grant the accompanying proxy to Kurz, the Court of Chancery's analysis in Kurz v. Holbrook does serve to expand Delaware's traditional vote buying jurisprudence, applying it to so-called “third-party vote buying.” In light of the still-strong market in derivatives, structured products and other forms of financial risk management that seek to separate voting rights and/or legal title from economic risk, the Kurz analysis could impact strategies and outcomes of future contests for corporate control. However, as the Supreme Court noted, where the voting and economic interests on shares remain aligned, arrangements that provide the deciding votes in an election contest will not be viewed as improper vote buying.

Voting 'Street Name' Shares

Before addressing the absence of a DTC omnibus proxy, the Vice Chancellor noted that DGCL Section 228(a) requires that stockholder consents be “signed by the holders of outstanding stock.” In the Vice Chancellor's view, this means that DGCL Section 228(a) “incorporates the concept of record ownership that governs voting at a meeting of stockholders.” And because DGCL Section 219(c) limits the right to vote to stockholders of record, he likewise determined that only record holders may sign a written consent. Without further analysis, this would have automatically voided the TBE consents executed by Broadridge. In fact, Vice Chancellor Laster noted that “I will confess that when I first learned about the absence of a DTC omnibus proxy, I thought it was a clear winner” for Crown.

Vice Chancellor Laster was not satisfied with this result, however. Delving deeper, the Vice Chancellor conducted a comprehensive review of the depositary system, leading him to conclude that DTC's company-specific breakdown of shares deposited by banks and brokers on behalf of their clients ' the true beneficial owners ' should be considered part of a corporation's stock ledger under DGCL Section 219(c). In reaching this conclusion, the Vice Chancellor observed that the DTC omnibus proxy does not appear to be governed by “any federal statute or regulation, any listing standard, or any state statute or decision calling for [its issuance].” Rather, it “appears to have evolved spontaneously in the 1970s after Congress and the SEC implemented a policy of share immobilization to the depository system.” Recognizing that “some mechanism would be needed for purposes of Delaware law to ensure that the depositories' voting authority was transferred to the brokers,” the Vice Chancellor reasoned that the omnibus proxy was likely utilized as “the improvised coupling by which the federally mandated system of indirect ownership through DTC links up with Delaware's traditional system of direct ownership evidenced through the stock ledger.” However, “when the system breaks down, as it did in this case, insisting on the need for the DTC omnibus proxy disenfranchises stockholders ' contrary to Delaware public policy, which rests on a 'general policy against disenfranchisement.'”

The Vice Chancellor added that he could find no “practical or policy-based impediments” to treating the DTC breakdown as part of the stock ledger. Because DTC breakdowns are readily available to corporations, and stockholders can obtain these materials by requesting a stock list under DGCL Section 220, Vice Chancellor Laster concluded that such access “fully addresses any concerns about efficiency, certainty, and predictability of application.” The Vice Chancellor also narrowed the potential impact of his ruling by stipulating that his analysis “does not apply to any entity other than DTC in its role as a federally registered clearing agency,” and does not otherwise “alter the traditional distinction between record and beneficial ownership.”

Because its ruling invalidating the purported transfer of shares and the accompanying proxy from Boutros to Kurz deprived TBE of the votes necessary to win the election contest, the Supreme Court did not find it necessary to decide whether or not it agreed with the approach taken by Vice Chancellor Laster in dealing with TBE's failure to obtain a DTC omnibus proxy. To emphasize its view that “a gratuitous statutory interpretation resolving this difficult issue” would not be “prudent,” the Supreme Court declared the Vice Chancellor's ruling that the DTC breakdown is part of a corporation's stock ledger to be “obiter dictum and without precedential effect.” Moreover, the Supreme Court noted that “[t]he human failures that occurred in this case are easily avoidable in the future and may be a one-time anomaly that may not again occur.” And, in any event, if issues over obtaining a DTC omnibus proxy were to persist in future election contests, the Supreme Court observed that “a legislative cure is preferable ' through a coordinated amendment process.”

Conclusion

Although the Delaware Supreme Court, in effect, rejected Vice Chancellor Laster's practical approach to dealing with TBE's failure to obtain a DTC omnibus proxy, the Court of Chancery's analysis of the solicitation process in Kurz v. Holbrook offers helpful insight into the impact of street name shares on proxy/consent solicitations. It will be interesting to see if the Delaware legislature agrees with the Supreme Court that the fact pattern in Kurz was indeed anomalous or is deserving of a legislative fix. For his part, Vice Chancellor Laster does “not foresee any headaches” in applying his analysis to either DGCL Section 219(c) or any other DGCL provision that relies on the concept of record ownership to trigger rights or protections, noting that “the consequences of treating banks and brokers on the DTC breakdown as record owners [for purposes of these other sections] appear to range from neutral to beneficial.”

Robert S. Reder, a member of this Newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. The author gratefully acknowledges Alison S. Fraser, Dean W. Sattler and Brian P. Murphy, associates in the firm's Global Corporate Group, who assisted in the preparation of this article.

Recently, in Kurz v. Holbrook (C.A. No. 5019-VCL (Del. Ch. Feb. 9, 2010), aff'd in part and rev'd in part, No. 64 (Del. 2010)), the Delaware Court of Chancery and Supreme Court confronted dueling consent solicitations over control of the board of directors of EMAK Worldwide, Inc. This contest generated three issues of first impression:

• Whether directors can be removed from office, mid-term, through a reduction in the size of the board effected via a stockholder-approved bylaw amendment;
• Whether a purchase of the “swing votes” necessary to win the contest can constitute illegal vote buying; and
• Whether an omnibus proxy is required from the Depositary Trust Company (“DTC”) in order for banks and brokers to vote “street name” shares on behalf of their customers.

Vice Chancellor Laster tackled these issues head-on in a thoughtful analysis that is likely to impact strategies and outcomes of future battles for corporate control. However, precisely because of the decision's potential precedential impact, the Delaware Supreme Court heard an appeal on an expedited basis. In a unanimous decision, the Supreme Court affirmed the Court of Chancery's decision in part and reversed it in part, thereby blunting the impact of the lower court decision in one area.

Background

EMAK, a Delaware corporation based in Los Angeles, has two classes of stock: common and Series AA preferred. The preferred stock, owned by Crown EMAK Partners, LLC, does not participate in the election of directors by the common stockholders, but entitles Crown to designate two additional directors. The preferred stock does vote, on an as-converted basis, with the common stock on all other matters, thereby entitling its holder to approximately 28% of the total voting power on such matters.

In late 2009, EMAK found itself subject to two competing consent solicitations seeking control of its board. One group, Take Back EMAK, LLC (“TBE”), included Donald Kurz, a sitting director previously elected by the common stockholders. TBE sought majority representation on the board by asking the common stockholders to remove the other two EMAK directors previously elected by the common stockholders, without cause, and to fill the resulting vacancies with TBE's nominees.

Because Crown was not entitled to vote its preferred stock to either remove directors elected by the common stockholders or elect their replacements, it pursued an alternative strategy of asking stockholders to adopt bylaw amendments to reduce the size of the board to three ' the two directors designated by Crown through its preferred stock, and one elected by the common stockholders. In this way, Crown hoped to “metaphorically pull ' their seats out from under” two of the directors elected by the common stockholders.

Dueling Solicitations

TBE and Crown followed very different strategies in soliciting consents. Because Crown's preferred stock gave it the right to designate two directors and approximately 28% of the total vote on its bylaw amendments, Crown focused on winning the support of EMAK management and one large institutional holder.

TBE, meanwhile, conducted a typical solicitation of the common stockholders. As a publicly held company, most of EMAK's common stock is held in “street name.” A product of our securities markets' depository system in which the actual stock certificates are “immobilized” in a central depositary to facilitate securities trading, the holding of shares in “street name” splits stock ownership between two groups ' beneficial owners who possess the economic interest in the shares, and record owners who, while lacking an economic stake, are the registered holders on the corporations' stock ledgers and therefore possess the right to vote under the Delaware General Corporation Law (“DGCL”). DTC, the only remaining U.S. securities depository, plays a central role by both clearing trades and serving as the record owner of nearly all “street name” shares.

The “typical” solicitation of proxies (and consents) involves a series of steps. First, because DTC is the record holder of the shares held on deposit, it has been assumed to have power to vote those shares. Thus, an omnibus proxy that transfers DTC's voting authority to the banks and brokers that deposited the shares on behalf of their clients is usually obtained. Next, the banks and brokers shift voting authority to Broadridge Financial Services, which communicates with the beneficial owners via proxy materials and voting instruction forms. Finally, after receiving voting instructions from the beneficial owners, Broadridge votes in accordance with their wishes. It should be noted that neither DTC, Broadridge nor the banks and brokers generally has the authority to vote without instructions.

Four days before the deadline, TBE found itself 116,325 votes short. To overcome this, Kurz contacted Peter Boutros, a former EMAK employee who owned 175,000 shares. After some haggling, Boutros signed a purchase agreement for: 1) the sale of 150,000 shares to Kurz, at a premium price of $1.50 per share; and 2) the grant to Kurz of an irrevocable proxy to vote those shares in his discretion. The proxy was necessary because Boutros's shares were subject to certain restrictions preventing transfer of legal title at that time.

The Parties Go to Court

Convinced that the Boutros proxy had put it over the top, TBE claimed victory. Crown also believed that it had sufficient consents to adopt its bylaw amendments and take control of the board. Not surprisingly, each group challenged the other's consents, seeking relief under DGCL Section 225, which empowers the Court of Chancery to resolve election disputes.

TBE challenged Crown's consents on the basis that the proposed bylaw amendments violated Delaware law. With regard to TBE's consent solicitation, there was no dispute that Broadridge correctly collected, recorded and totaled the beneficial owners' voting instructions. Similarly, Broadridge received proper authorization from the banks and brokers to vote the EMAK shares on their behalf. Missing, however, was an omnibus proxy transferring voting authority from DTC to the banks and brokers. With this link missing, Crown argued that legal authority to vote remained with DTC, rendering TBE's consents ineffective. Crown also argued that the arrangements with Boutros violated the transfer restrictions on his shares and, in any event, constituted illegal vote buying.

After considering arguments from both sides, Vice Chancellor Laster declared TBE the winner. On appeal, however, the Delaware Supreme Court remanded the case to the Court of Chancery for further proceedings. As a result, neither Crown nor TBE has succeeded in taking control of EMAK's board, and the status quo continues.

The Courts' Analysis

Reducing the Size of the Board

It is not an uncommon tactic for an insurgent to seek control by soliciting stockholder votes to expand the size of a company's board through a bylaw amendment and fill the vacancies with the insurgent's nominees. However, prior to Kurz, Delaware courts had not been asked to consider an attempt to gain board control via a bylaw amendment to reduce the size of the board. In the words of Vice Chancellor Laster: “Our law has not addressed what happens when a bylaw amendment would shrink the number of board seats below the number of sitting directors. The DGCL does not address it. No Delaware court has considered it. None of the leading treatises on Delaware law mention it. Indeed, no one seems to have contemplated it.”

The Vice Chancellor observed that while DGCL Section 141(b) explains the process for filling vacant board seats if a bylaw amendment expands the board, it is silent on what happens if a bylaw amendment reduces the board. Accordingly, he considered ' and rejected ' “two possible consequences for the suddenly surplus directors”: 1) the termination of the terms in office of the “surplus directors”; or 2) the “surplus directors” continuing to serve without an underlying board seat.

Early Termination of  'Surplus Directors'

The Vice Chancellor concluded that this alternative conflicts with DGCL Section 141(b)'s “mandate that '[e]ach director shall hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal.'” In support, he observed that DGCL Section 141(k) provides that directors “may be removed, with or without cause, by the holders of a majority of the shares entitled to vote at an election of directors,” and then noted that “[t]he specific references to removal in Sections 141(b) and (k), the absence of any comparable provision addressing board shrinkage, and the background common law exception that a director otherwise would serve out a full term absent cause for removal reinforce my view that eliminating directorships through board shrinkage is not permitted.”

'Surplus Directors' Continue in Office

Next, the Vice Chancellor analogized the alternative that the “surplus directors” continue to serve, without official directorships, to “holdover directors,” who are permitted to serve beyond their terms under DGCL Section 211(c) if either the company fails to timely hold an annual meeting or a successor is not elected. Because DGCL Section 141(b) “does not contemplate a board with more directors serving (albeit without official seats) than the 'number ' fixed by ' the bylaws,'” he rejected this analogy, noting that “[i]f the excess directors are not eliminated, then for a time EMAK will have a greater number of directors serving than what the Bylaws provide, which cannot occur under Section 141(b).”

Unable to find a statutory basis for removing directors mid-term through bylaw amendment, Vice Chancellor invalidated Crown's consents. The Supreme Court supported this aspect of the decision.

There are several methods available to unhappy stockholders or acquisitive raiders to seek control of a company. Experienced practitioners understand how to parse corporate charter documents, searching for faulty defenses or loopholes by which to gain an advantage. But one important lesson of Kurz v. Holbrook is that Delaware courts will strictly adhere to statutory language when adjudicating election disputes. The technique pursued by Crown and its allies to take over the EMAK board, however, simply did not pass muster.

Third-Party Vote Buying

The Vice Chancellor prefaced his analysis of this issue by explaining that the historic vote buying cases generally involved “insiders using corporate resources to 'buy' votes” or “a fiduciary [who] receives inside information about how a vote is trending and then acts on the information to swing a close vote.” Although these circumstances were absent in Kurz, in confronting this “undeveloped area of our law,” the Vice Chancellor reasoned that “the concept of vote buying” is “broad enough to encompass” the purchase of votes without using corporate assets or taking advantage of inside information. The Vice Chancellor labeled this variation on vote buying as “third-party vote buying,” and declared that where third-party vote buying proves “deleterious to stockholder voting, this Court can and should provide a remedy.”

On this basis, the Vice Chancellor analyzed the arrangements between Kurz and Boutros. Although Kurz was an EMAK director, he “used his own resources to acquire Boutros's shares” and “did not take advantage of any inside information.” Thus, traditional vote buying analysis did not apply.

However, because Kurz's arrangements with Boutros “provided TBE with the votes they needed to prevail,” the Vice Chancellor considered them “potentially disenfranchising” and therefore subjected them to “a vote buying analysis.” While acknowledging that “the full measure of principles that will govern third-party vote buying must await case-by-case development,” the Vice Chancellor articulated “several broad concepts” to guide his analysis. First, third-party vote buying will “merit review only if it is disenfranchising, in the sense of actually affecting the outcome of the vote.” This includes vote buying that “delivers the swing votes” or “alters the voting pattern in a critical way.” Second, a third-party vote buying arrangement “must not be the product of fraud.” Fraud might be indicated by informational disparities or inadequate disclosures. Third, a stockholder's underlying economic interest should accompany the sale of voting rights to avoid Delaware law's close scrutiny of those who “divorce ' property interest from voting interest ' .”

Although the first of these elements, the delivery of “swing votes,” was present, the other two were not:

The Vice Chancellor found “no evidence of fraud”: Boutros “was fully informed about the ongoing consent solicitations,” “must have been cognizant” that “his shares were the swing shares,” and “was advised by counsel,” all “hallmarks of a transaction in which Boutros understood what he was selling, the circumstances under which he was selling it, and what he was getting in return.”

The Vice Chancellor found the economic and voting interests in Boutros's shares to be properly aligned. Even though the transfer restrictions prevented Kurz from taking title to the shares, because “he now bears 100% of the economic risk” under the purchase agreement, “Delaware law presumes that he should and will exercise the right to vote.” He also noted that Kurz had no “competing economic or personal interests that might create an overall negative economic ownership in EMAK”; he was “overwhelming long EMAK's stock” with “no countervailing short interest,” and his EMAK holdings “represented a sizable portion of his personal wealth.”

Despite conceding that “Kurz primarily wanted the voting rights carried by the shares, not the shares themselves,” the Vice Chancellor could “not perceive anything illicit in that fact given the nature of the transaction as a whole.” In short, he did not believe that “Kurz has any reason to vote other than in the manner he thinks would best maximize the value of EMAK as a corporation,” and concluded that “[t]he proxy granted to Kurz under the Purchase Agreement comports with what our law expects.”

The Supreme Court agreed with this analysis, focusing primarily on the continued alignment of the voting and economic interests in the Boutros shares. However, the Supreme Court went on to conclude that the purported transfer of shares from Boutros to Kurz was prohibited by the stock transfer restrictions and, therefore, “the Purchase Agreement did not operate as a legally valid sale or transfer of Boutros' shares, and ' Kurz was not entitled to vote those shares.” In this case, the alignment issue actually worked against TBE, as the Supreme Court noted that “Boutros' immediate divestiture of all voting and economic rights in his shares frustrates the purpose of the [transfer restrictions], because bare legal title, alone and without more, does not give Boutros a stake in the corporation's future.”

Although the Supreme Court determined that Boutros was not entitled to transfer his shares and grant the accompanying proxy to Kurz, the Court of Chancery's analysis in Kurz v. Holbrook does serve to expand Delaware's traditional vote buying jurisprudence, applying it to so-called “third-party vote buying.” In light of the still-strong market in derivatives, structured products and other forms of financial risk management that seek to separate voting rights and/or legal title from economic risk, the Kurz analysis could impact strategies and outcomes of future contests for corporate control. However, as the Supreme Court noted, where the voting and economic interests on shares remain aligned, arrangements that provide the deciding votes in an election contest will not be viewed as improper vote buying.

Voting 'Street Name' Shares

Before addressing the absence of a DTC omnibus proxy, the Vice Chancellor noted that DGCL Section 228(a) requires that stockholder consents be “signed by the holders of outstanding stock.” In the Vice Chancellor's view, this means that DGCL Section 228(a) “incorporates the concept of record ownership that governs voting at a meeting of stockholders.” And because DGCL Section 219(c) limits the right to vote to stockholders of record, he likewise determined that only record holders may sign a written consent. Without further analysis, this would have automatically voided the TBE consents executed by Broadridge. In fact, Vice Chancellor Laster noted that “I will confess that when I first learned about the absence of a DTC omnibus proxy, I thought it was a clear winner” for Crown.

Vice Chancellor Laster was not satisfied with this result, however. Delving deeper, the Vice Chancellor conducted a comprehensive review of the depositary system, leading him to conclude that DTC's company-specific breakdown of shares deposited by banks and brokers on behalf of their clients ' the true beneficial owners ' should be considered part of a corporation's stock ledger under DGCL Section 219(c). In reaching this conclusion, the Vice Chancellor observed that the DTC omnibus proxy does not appear to be governed by “any federal statute or regulation, any listing standard, or any state statute or decision calling for [its issuance].” Rather, it “appears to have evolved spontaneously in the 1970s after Congress and the SEC implemented a policy of share immobilization to the depository system.” Recognizing that “some mechanism would be needed for purposes of Delaware law to ensure that the depositories' voting authority was transferred to the brokers,” the Vice Chancellor reasoned that the omnibus proxy was likely utilized as “the improvised coupling by which the federally mandated system of indirect ownership through DTC links up with Delaware's traditional system of direct ownership evidenced through the stock ledger.” However, “when the system breaks down, as it did in this case, insisting on the need for the DTC omnibus proxy disenfranchises stockholders ' contrary to Delaware public policy, which rests on a 'general policy against disenfranchisement.'”

The Vice Chancellor added that he could find no “practical or policy-based impediments” to treating the DTC breakdown as part of the stock ledger. Because DTC breakdowns are readily available to corporations, and stockholders can obtain these materials by requesting a stock list under DGCL Section 220, Vice Chancellor Laster concluded that such access “fully addresses any concerns about efficiency, certainty, and predictability of application.” The Vice Chancellor also narrowed the potential impact of his ruling by stipulating that his analysis “does not apply to any entity other than DTC in its role as a federally registered clearing agency,” and does not otherwise “alter the traditional distinction between record and beneficial ownership.”

Because its ruling invalidating the purported transfer of shares and the accompanying proxy from Boutros to Kurz deprived TBE of the votes necessary to win the election contest, the Supreme Court did not find it necessary to decide whether or not it agreed with the approach taken by Vice Chancellor Laster in dealing with TBE's failure to obtain a DTC omnibus proxy. To emphasize its view that “a gratuitous statutory interpretation resolving this difficult issue” would not be “prudent,” the Supreme Court declared the Vice Chancellor's ruling that the DTC breakdown is part of a corporation's stock ledger to be “obiter dictum and without precedential effect.” Moreover, the Supreme Court noted that “[t]he human failures that occurred in this case are easily avoidable in the future and may be a one-time anomaly that may not again occur.” And, in any event, if issues over obtaining a DTC omnibus proxy were to persist in future election contests, the Supreme Court observed that “a legislative cure is preferable ' through a coordinated amendment process.”

Conclusion

Although the Delaware Supreme Court, in effect, rejected Vice Chancellor Laster's practical approach to dealing with TBE's failure to obtain a DTC omnibus proxy, the Court of Chancery's analysis of the solicitation process in Kurz v. Holbrook offers helpful insight into the impact of street name shares on proxy/consent solicitations. It will be interesting to see if the Delaware legislature agrees with the Supreme Court that the fact pattern in Kurz was indeed anomalous or is deserving of a legislative fix. For his part, Vice Chancellor Laster does “not foresee any headaches” in applying his analysis to either DGCL Section 219(c) or any other DGCL provision that relies on the concept of record ownership to trigger rights or protections, noting that “the consequences of treating banks and brokers on the DTC breakdown as record owners [for purposes of these other sections] appear to range from neutral to beneficial.”

Robert S. Reder, a member of this Newsletter's Board of Editors, is a New York-based partner in the Global Corporate Group of Milbank, Tweed, Hadley & McCloy LLP. The author gratefully acknowledges Alison S. Fraser, Dean W. Sattler and Brian P. Murphy, associates in the firm's Global Corporate Group, who assisted in the preparation of this article.