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The Delaware Court of Chancery Redefines Record Holders, Addresses Vote Buying Claims and Invalidates Bylaw Amendment Resulting in Director Removal

February 13, 2010

On February 9, 2010, the Delaware Court of Chancery issued an opinion with substantial significance for corporate practitioners. In Kurz v. Holbrook, C.A. No. 5019-VCL (Feb. 9, 2010), the Court of Chancery addressed competing requests for relief with respect to control of the board of directors of EMAK Worldwide, Inc. ("EMAK"). In its post-trial opinion, the Court redefined the law on record holders of a corporation's stock, clarified what is, and is not, vote buying under Delaware law and addressed whether a bylaw provision that imposed a new qualification for service as a director could result in the termination of a sitting director's service.

The dispute in Kurz involved competing consent solicitations for control of EMAK. The first consent solicitation, run by insurgent Take Back EMAK, LLC ("TBE"), sought to remove two directors on the EMAK board and fill three of the four vacancies so as to establish a TBE majority on the board. In response, Crown EMAK Partners, LLC ("Crown"), a large preferred stockholder of EMAK, launched its own consent solicitation seeking to amend EMAK's bylaws to reduce the size of the board and effectively remove certain sitting directors, thereby maintaining Crown's control of the board and mooting TBE's consent solicitation. Ultimately, Crown secured consents from the holders of a majority in voting power of EMAK's stock to approve the bylaw amendments. A few days later, TBE also obtained consents from the holders of a majority in voting power of EMAK's stock in favor of its insurgent slate, but the inspector of elections subsequently invalidated consents representing more than 1,000,000 shares of EMAK stock that were held in "street name" for failure to obtain an omnibus proxy from DTC. TBE filed suit, challenging both the validity of the bylaw amendments and the invalidation of the consents as to the shares held in "street name."

The Court ruled in favor of TBE on both counts. With respect to the validity of the "street name" consents, the Court found that the TBE consents -- which evidenced authority from the participating banks and brokers who appeared on the DTC participant listing, but omitted the omnibus proxy from DTC -- had validly effected corporate action. In reaching its conclusion, the Court redefined Delaware's interpretation of "stockholders of record" to include the DTC participant banks and brokers listed on the Cede breakdown for purposes of determining the stockholders entitled to vote or act by written consent, thereby eliminating the need for a DTC omnibus proxy in such circumstances. The Court made clear, however, that its holding did not alter the traditional distinction between record and beneficial ownership, and that its analysis did not apply to any entity other than DTC in its role as a federally registered clearing agency. In its analysis, the Court also held that the Cede breakdown is part of a corporation's stock ledger for purposes of Section 219(c) of the General Corporation Law, just as it had long been part of the stock ledger for purposes of Section 220(b). The Court's holding aligns Delaware law's definition of record holders with federal regulations under which the participant banks and brokers are recognized as the record holders of the shares held by DTC. Further, the Court's holding may potentially impact the applicability of Sections 203 of the General Corporation Law, Delaware's anti-takeover statute, to certain corporations and Section 262 of the General Corporation Law, Delaware's appraisal statute, to certain transactions by increasing the number of record holders of a corporation.

The Court rejected Crown's claim that TBE had engaged in improper "vote buying" when Kurz, a TBE member and EMAK director, purchased the voting and economic rights to 150,000 EMAK shares thereby ensuring that the TBE solicitation would have sufficient votes. In beginning its analysis, the Court noted that vote buying that did not involve the use of corporate resources, so-called "third party vote buying," was an undeveloped area of Delaware law. The Court pointed out, however, that the concept of vote buying was broad enough to encompass practices and techniques whereby voting rights were manipulated, including the decoupling of economic interests from voting rights. The Court stated that where such practices proved deleterious to stockholder voting, the "Court can and should provide a remedy." To that end, the Court identified several broad concepts that would govern its analysis of third party vote buying, including (i) whether the practices were actually disenfranchising, e.g. delivering swing votes or altering the voting pattern in a critical way; (ii) whether the arrangement was the product of fraud or a disparity of information; and (iii) whether the transaction created a misalignment between the voting interest and the economic interest of the shares. Finding no evidence of fraud in the present case or disparity of information because, among other things, the seller was aware that the shares were the "swing votes," that in purchasing the shares Kurz had assumed the economic risks of ownership and that Kurz did not have any competing economic or personal interests that might create an overall negative economic ownership in EMAK, the Court concluded that the purchase by Kurz of the voting and economic rights to the EMAK shares was not a "legal wrong."

Finally, addressing Crown's bylaw amendments that purported to reduce the number of directors comprising the EMAK board, the Court found the amendments to be invalid. The Court held that a bylaw amendment that would eliminate directorships through shrinking the number of board seats below the number of sitting directors, and not by removal, conflicted with the provisions of Sections 141(b) and 141(k) of the General Corporation Law and was void. Similarly, the Court stated that a bylaw provision that established qualifications for directorships that would disqualify a sitting director and terminate his service would likewise violate such sections of the General Corporation Law and thus be invalid under Delaware law.

An appeal of this decision has been filed with the Delaware Supreme Court.