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Kurz v. Holbrook, C.A. No. 5019-VCL (Del. Ch. Feb. 9, 2010) (Laster, V.C.)

February 9, 2010

In a post-trial decision resolving competing claims for relief pursuant to Section 225 of the Delaware General Corporation Law (the “DGCL”), the Court of Chancery addressed for the first time the issue of whether failing to obtain an omnibus proxy from The Depository Trust Company (“DTC”) invalidated otherwise valid shareholder consents. Holding that banks and brokers who appear on DTC’s “Cede breakdown” are stockholders of record for purposes of Section 219 of the DGCL, the Court validated the challenged consents despite the absence of the omnibus proxy from the registered owner, DTC.

The Court also addressed the validity of purported bylaw amendments that sought to replace sitting directors by reducing the number of board seats and requiring the Company’s CEO to call a special meeting to elect a single replacement for those directors left without seats. The Court determined that the proposed bylaw amendments did not conform to the DGCL’s scheme for replacing directors and, accordingly, were void. Finally, the Court addressed and rejected allegations of improper “vote buying.”

The dispute over the DTC omnibus proxy arose in connection with an attempt by Take Back EMAK, LLC (“TBE”) to remove and replace certain directors of EMAK Worldwide, Inc. (“EMAK”) via written consent. TBE conducted a consent solicitation and purported to deliver sufficient consents from a combination of record holders and banks and brokers who held the shares indirectly by way of their participation in DTC (that is, in “street name”). The banks and brokers 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 because no DTC omnibus proxy had been submitted transferring DTC’s voting power to the banks and brokers. Without Broadridge, TBE lacked the number of consents needed to remove and replace the incumbent directors.

The Court described in detail the historical and legal evolution that led to use of the DTC omnibus proxy, and noted that, despite this long evolution, “[t]here is no legal authority addressing how [a DTC omnibus proxy] is obtained, by whom, or when it will be issued.” Describing the process as “mysterious,” the Court noted that in most cases DTC issues its omnibus proxy “as a matter of course.” In this case, however, it failed to do so. Nevertheless, the Court held that the street name consents were valid. The Court described the DTC omnibus proxy as a formality. The Court noted that the Court of Chancery has for 30 years recognized the Cede breakdown – a listing of the shareholdings of banks and brokers participating in DTC – as part of the stock ledger for purposes of Section 220 of the DGCL. The Court held that the Cede breakdown was part of the ledger for purposes of Section 219(c), also. Accordingly, the Court ruled that “banks and brokers who appear on the Cede breakdown have the power to vote as record holders,” and that the Broadridge consents should be counted.

The dispute over the bylaw amendments arose in the same contest for control of the EMAK board. Crown EMAK Partners LLC (“Crown”) held an interest in EMAK in the form of preferred stock that allowed it to elect only two directors. Crown could not vote in any other director elections. Under Section 141(k) of the DGCL, therefore, Crown had no power to vote for removal of the directors for whom it could not vote.

The bylaw amendments were Crown’s attempt to gain control of EMAK by effectively removing and replacing directors. The first amendment purported to immediately reduce the board to three seats, to include those elected exclusively by Crown’s preferred shares. The second amendment directed that, should the total number of directors ever be greater than three, the CEO would call a special meeting to elect a single director to replace all of those not elected by holders of the preferred stock. In combination, therefore, the amendments would allow Crown to immediately reduce the board to three directors, two of whom would be its own. The Court noted that the plan had a “statutory hook,” under Section 141(b) of the DGCL, but found that hook insufficient without further support elsewhere in the DGCL. Whereas the DGCL addresses what happens when board seats are added, it does not address what happens when seats (but not directors) are removed. The Court suggested two possible outcomes when the seats are removed but the directors are not: either the terms of the directors would suddenly end, or they would continue on “without official seats” until their terms ended by recognized means. Neither of these possibilities, the Court held, comported with the DGCL. The possibility of immediate termination conflicts with the means of terminating a director’s tenure as established by Section 141(b). Further, given that Section 109(a) allows directors to amend the bylaws under certain conditions, permitting amendments like those proposed would create a mechanism by which directors could remove other directors, a prospect long barred by Delaware law. The Court held that the possibility that directors might hold over, despite having lost their seats, similarly violated the DGCL. Although the Court recognized an analogy to the fate of directors who have held over for other reasons (such as where the corporation has failed to hold a timely meeting), it found that analogy unpersuasive because Section 211(c) of the DGCL explicitly authorizes holdover directors, whereas no section of the DGCL authorizes a director to continue service in the absence of a seat. In addition, the Court noted that the existence of directors without seats would cause other conflicts with Section 141(b) of the DGCL.

Finally, the Court resolved a claim that a TBE-affiliated director improperly purchased the vote of a former EMAK employee in connection with the control battle. The Court recognized that “third-party vote buying” (i.e., vote buying without use of corporate funds) has had little development under Delaware law. Despite dicta in previous cases that could suggest an absence of restrictions on so called third-party vote buying, the Court stated that it “can and should provide a remedy,” where improper activity “actually affect[s] the outcome of the vote.” The Court examined the disputed transaction because it provided the “swing vote” for TBE. Under the facts before it, however, the Court declined to disqualify the shares.

The director used his own funds to gain an interest in the shares, and did not do so by means of fraud or to exploit insider information. The Court noted certain unusual aspects of the share purchase, necessitated by the stock grant agreement under which the seller held them, that resulted in the director obtaining the right to take title at a future date rather than immediately. The Court observed that vote buying implicates the “consistent concern” in Delaware decisions “about transactions that create a misalignment between the voting interest and the economic interest.” The Court scrutinized the transaction but found no misalignment: even though he had not yet obtained title, the director had obtained both the voting and economic interest in the shares.

The full opinion is available here