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Crown EMAK Partners, LLC v. Kurz, et al., No. 64, 2010, and Holbrook v. Kurz, No. 85, 2010 (Apr. 21, 2010) (Holland, J.)

April 21, 2010

In this opinion on a consolidated appeal, the Delaware Supreme Court sitting en banc affirmed in part and reversed in part the Court of Chancery’s February 9, 2010 post-trial opinion resolving competing claims for relief pursuant to Section 225 of the Delaware General Corporation Law (the “DGCL”), and remanded the matter for further proceedings. The primary issue in the litigation concerned which of two competing factions – Crown EMAK Partners, LLC (“Crown”) or Take Back EMAK, LLC (“TBE”) – lawfully controls the board of directors (“Board”) of EMAK Worldwide, Inc. (the “Company”). Although the Court affirmed various aspects of the Court of Chancery’s February 9th opinion, it held that outcome determinative shares had been improperly purchased by and transferred to a TBE-affiliated director in contravention of the plain language of a Restricted Stock Grant Agreement. Accordingly, TBE lacked sufficient consents to remove and appoint the Company’s directors so as to establish a new Board majority.

The Court noted that the underlying facts were not in dispute. As of December 18, 2009, the Board had seven directorships, two of which were vacant. At that time, only one of the five directors then in office – Donald Kurz (“Kurz”) – was a TBE member. TBE conducted a consent solicitation and, on December 20 and 21, purported to deliver sufficient written consents (the “TBE Consents”) to remove two additional directors without cause and to appoint three new directors, thereby establishing a new Board majority. The TBE Consents were provided by banks and brokers that had transferred their voting power to Broadridge Financial Services, Inc. (“Broadridge”) to process the votes of the beneficial owners. The inspector of elections declined to count the Broadridge consents, however, because TBE had failed to obtain an omnibus proxy from The Depository Trust Company (the “DTC”) transferring its voting power to the banks and brokers.

A separate dispute arose from the circumstances surrounding TBE’s purchase of outcome determinative shares. On December 20, Kurz reached agreement to purchase 175,000 shares of restricted stock from Peter Boutros (“Boutros”), a former employee of the Company, for $225,000 (the “Purchase Agreement”), notwithstanding that a Restricted Stock Grant Agreement between Boutros and the Company governed 150,000 of Boutros’ shares and prevented their sale, transfer or alienation from Boutros before March 3, 2011. The Purchase Agreement was crafted so that the shares would be transferred to Kurz at a future date, while Boutros would immediately execute an irrevocable proxy with respect to those same shares, thereby providing TBE with the consents it needed to prevail.

While this was occurring, Crown was pursuing its own consent solicitation, and on December 18, had delivered sufficient consents (the “Crown Consents”) to amend the Company’s bylaws to (i) reduce the size of the Board to three directors (two of which would be appointed by Crown) and (ii) add a new bylaws section providing that if more than three directors hold office, then a special meeting will be held for the stockholders to elect one of the “surplus” directors as the Company’s third director.

After trial, the Court of Chancery held that (i) Kurz had not engaged in improper vote buying; (ii) the Purchase Agreement, as crafted, did not violate the terms of the Restricted Stock Grant Agreement; and (iii) TBE’s failure to obtain a DTC omnibus proxy was not dispositive, as the banks and brokers appearing on the DTC’s “Cede breakdown” are to be considered stockholders of record under Section 219 of the DGCL (while the DTC omnibus proxy is, in essence, a “formality”). The Court of Chancery therefore concluded that the TBE Consents validly effected corporate action. The Court further determined that the Crown bylaw amendments conflicted with the DGCL and were therefore void. The parties cross-appealed, arguing that the Court of Chancery erred in concluding that (i) Kurz did not engage in impermissible vote buying; (ii) the Purchase Agreement did not violate the Restricted Stock Grant Agreement; (iii) Cede breakdowns should be treated as part of the “stock ledger” under Section 219 of the DGCL; and (iv) the Crown bylaw amendments were void.

The Supreme Court affirmed the Court of Chancery’s determination that Kurz had not engaged in improper vote buying, as there was no evidence of fraud and “the economic interests and the voting interests of the [purchased] shares remained aligned… .” The Court nevertheless held that the Purchase Agreement was ineffective because it violated transfer restrictions set forth in the Restricted Stock Grant Agreement. The Court reversed the Court of Chancery’s determination that Kurz and Boutros had successfully contracted around the sale and transfer restrictions by agreeing to a transfer at a future date, holding that such a conclusion was inconsistent with and contrary to the Court of Chancery’s parallel determination (with respect to vote buying) that Kurz had purchased and received the full economic interests associated with the Boutros shares. Because the Purchase Agreement conferred upon Kurz voting rights and the “functional equivalent” of full ownership of the shares through an irrevocable proxy, only the “bare legal title” to the shares would be subject to a future exchange. The Court concluded that the Purchase Agreement “frustrates the purpose of the Restricted Stock Grant Agreement” and could not operate as a legally valid sale. Accordingly, Kurz was not entitled to vote those shares in support of TBE’s consent solicitation.

Turning to the issue of whether the TBE Consents would be effective despite the absence of a DTC omnibus proxy, the Court recited the Court of Chancery’s reasoning for holding that Cede breakdowns are part of the “stock ledger” for purposes of Section 219 of the DGCL. The Court noted that the Court of Chancery had “declined to follow well-established prior precedents construing the meaning of the term ‘record holder,’” and that the Court of Chancery “recognized that its new interpretation ‘represents a change in how Delaware practitioners understand the stock ledger for purposes of voting… .’” Having already invalidated the votes arising from the improperly transferred Boutros shares, the Court held that it was “unnecessary” to decide whether Cede breakdowns are or are not part of the “stock ledger” under Section 219 of the DGCL, as “a legislative cure is preferable” and any such determination would not change the outcome. The Court therefore held the Court of Chancery’s interpretation of “stock ledger” under Section 219 to be obiter dictum and without precedential effect.

Finally, the Court affirmed the Court of Chancery’s determination that the Crown bylaw amendments were void and invalid. The bylaw amendment purporting to reduce the Board to three directorships at a time when five directors legally held office was void and contrary to the DGCL, as Section 141(b) neither contemplates (i) that a director’s term can end through “board shrinkage” nor (ii) that a board can have more directors than the number fixed by the bylaws. The other bylaw amendment, which purported to allow for the election of a director’s successor before the expiration of the incumbent’s term, was also held void and contrary to the DGCL.

The full opinion is available here