In analyzing whether the transaction constituted vote buying, VC Laster indicated that there needed to be either disenfranchisement or fraud.  Disenfranchisement occurred where the acquisition “actually affect[s] the outcome of the vote” or “it alters the voting pattern in a critical way, such as through coercive tactics reminiscent of tender offer strategies from pre-Williams Act days.”

Mostly, though, the court was interested in the possible separation of voting rights from economic ownership.  This has been a growing practical concern.  Those seeking to influence the outcome of an election (perhaps by acquiring control) can enhance the possibility of victory by acquiring votes without actually purchasing the underlying shares.  This can occur, for example, through the borrowing of stock (which is actually a purchase but guarantees that the shares will be sold back to the original owner, perhaps after the record date) or through the use of swaps and other derivatives.

VC Laster used the opinion to strongly emphasize the need for economic interests to align with voting rights, something he found hidden within legislative intent. 

• A Delaware public policy of guarding against the decoupling of economic ownership from voting power can be seen in the 2009 amendment to Section 213(a), which now authorizes a board to set one record date for purposes of giving notice of a meeting of stockholders and a second, later record date for determining which stockholders can vote at the meeting. 8 Del. C. 213(a).  

Thus, were “economic interests are fully aligned with voting rights do not raise concern, Delaware law does not restrict a soliciting party from buying shares and getting a proxy to bolster the solicitation's chance of success.” 

Kurz acquired the economic interests in the shares.  Even though actually title would not be transferred until a future date, he absorbed the economic risk associated with the shares.  In those circumstances, the court concluded that there was no separation of economic ownership and voting rights.  “Because Kurz now holds the economic interest in the shares, Delaware law presumes that he should and will exercise the right to vote.”

The analysis is fair enough.  The mere fact that Boutros could not deliver all of the shares because of transfer restrictions did not prevent Kurz from assuming the economic risks associated with ownership, thereby allowing him to dictate how they were voted.  Yet by emphasizing the negative -- the concern over the exercise of voting rights when the two interests are separated, facts not present in the case -- the opinion provided a clear basis for challenges to voting results where the two interests were not aligned.  This is a tough issue and VC Laster may ultimately be right, but the matter did not have to be reached in such a clear fashion under the facts of this case. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

There is often a debate over whether boards are really obligated to engage in profit maximizing behavior.  As commentators sometimes note, corporate statutes don't mention the phrase.  Boards instead are obligated to act in the best interests of shareholders, which may or may not equal profit maximization. 

We note only that VC Laster looks to be squarely in the profit maximization camp, at least from the shareholder perspective.  As he noted in Kurz:  "What legitimizes the stockholder vote as a decision-making mechanism is the premise that stockholders with economic ownership are expressing their collective view as to whether a particular course of action serves the corporate goal of stockholder wealth maximization."  In other words, shareholders do not want companies to engage in philanthropy or socially beneficial behavior unless also maximizing wealth. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

Another issue addressed by the court were allegations of vote buying.  These concerns arose because Kurz, a director and member of the TBE Group, acquired shares that could not yet be transferred (due to transfer restrictions) and in the process obtained an irrevocable proxy for the undelivered shares.  The votes were, apparently, outcome determinative. 

The court acknowledged that vote buying “is an incendiary phrase” that “carries connotations of bribery and corruption.”  Nonetheless, as VC Laster rightfully notes, the Delaware courts have, since Schreiber v. Carney, 447 A.2d 17 (Del. Ch. 1982), recognized that vote buying was a permissible practice.

The transaction raised three distinct issues.  First was whether the practice even involved vote buying since there were no corporate assets used in the transaction.  Assuming it did, the second was whether the purchases violated the standards for vote buying set out in Schreiber and its progeny.  The last was whether the acquisition of the votes without actually obtaining the shares was somehow improper. 

The prohibition on vote buying traditionally arose in the context of companies acquiring votes to facilitate shareholder approval.  In Schreiber, the court approved a transaction in which the company made a loan to a shareholder in return for support for a merger.  Moreover, in the HP case, the Chancery Court indicated that the use of corporate assets was a necessary condition in order to separate vote buying from identical behavior that could occur in a shareholder voting agreement.  As that court noted:

• The appropriate standard for evaluating vote-buying claims is articulated in Schreiber v. Carney. Schreiber indicates that vote-buying is illegal per se if "the object or purpose is to defraud or in some way disenfranchise the other stockholders." Schreiber also notes, absent these deleterious purposes, that "because vote-buying is so easily susceptible of abuse it must be viewed as a voidable transaction subject to a test for intrinsic fairness." At first blush this proposition seems difficult to reconcile with the General Assembly's explicit validation of shareholder voting agreements in Sec. 218(c).  Significantly, however, it was the management of the defendant corporation that was buying votes in favor of a corporate reorganization in Schreiber. Shareholders are free to do whatever they want with their votes, including selling them to the highest bidder. Management, on the other hand, may not use corporate assets to buy votes in a hotly contested proxy contest about an extraordinary transaction that would significantly transform the corporation, unless it can be demonstrated, as it was in Schreiber, that management's vote-buying activity does not have a deleterious effect on the corporate franchise.

Hewlett v. Hewlett-Packard Co., 2002 Del. Ch. LEXIS 44  (Del. Ch. April 8, 2002).  The distinction makes sense because directors have fiduciary obligations and, in general, shareholders do not.  In other words, vote buying if improper is a fiduciary duty violation and therefore ought not to be extended to shareholders, other than perhaps controlling shareholders. 

VC Laster saw things differently.  This case did not involve the use of corporate assts but did involve a fiduciary.  Nonetheless, VC Laster disregarded the distinction set out in Hewlett and instead likened the transaction to “third party” vote buying.   

• Vote-buying that does not involve use of corporate resources--which I will call "third party vote buying"--is an undeveloped area of our law. Although dictum in Hewlett-Packard could be read to suggest that there are no restrictions on the buying or selling of votes when corporate resources are not involved, I do not believe that was what Chancellor Chandler intended. Elsewhere in the Hewlett-Packard decision, Chancellor Chandler noted that "the principle that vote-buying is illegal per se if entered into for deleterious purposes survives." Recent scholarship has cast light on shadowy aspects of the voting process and techniques by which voting rights can be manipulated. I regard the concept of vote buying as broad enough to encompass these practices. When they prove deleterious to stockholder voting, this Court can and should provide a remedy.

The result is correct but the analysis suspect.  It’s true that no corporate assets were used in the transaction.  But the analysis ignores the fact that the purchaser was a director who had a fiduciary duty to shareholders.  Reliance on the purchaser’s fiduciary status would have allowed VC Laster to render a decision consistent with Hewlett, rather than try to explain away the inconsistency, and prevented the case from reaching true third party vote buying schemes. 

By characterizing the issue as third party vote buying (and ignoring the purchaser’s fiduciary status), the analysis unequivocally extends vote buying analysis to shareholder voting agreements by all shareholders, even shareholders without any fiduciary obligations.  In other words, ordinary shareholders seeking to organize through the use of shareholder voting agreements will now have to analyze their behavior for possible illegal vote buying. Indeed, as he notes later in the opinion:

• Nothing in Section 218 states or implies that every voting trust or voting agreement is valid, and nothing in Section 218 speaks to arrangements producing voting incentives directly contrary to ownership interests.  Section 218 does not limit this Court's equitable powers to address deleterious practices.

In short, shareholder voting agreements are in play.  It was an unnecessary step to take and arguably in conflict, as the court in Hewlett noted, with “the General Assembly's explicit validation of shareholder voting agreements in Sec. 218(c)." 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?  The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

In many ways, this is an unusual case.  Certainly, bylaws designed to reduce board size between meetings are not common.  Moreover, while VC Laster made his view clear, that these bylaws are invalid, any uncertainly left over by the case may require companies to address the issue more explicitedly.  Some already have.  Thus, for example, the articles at Lockheed Martin include the following language:  "However, no decrease in the number of directors constituting the Board of Directors shall shorten the term of any incumbent director."  This type of language is quite common and appears in hundreds if not thousands of constituent documents of public companies.   

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

We are examining the portion of the decision that struck down the bylaw submitted by Crown that would have reduced the size of the board from seven directors to three.

The decision went too far in determining that Section 141 was the exclusive method of removing directors.  Moreover, even if exclusive, dicta in the case went too far in concluding that directors forced out of office for not meeting board qualifications were subject to Section 141 and therefore could not be removed until their term expired.  

It would have been much cleaner and raise fewer questions about existing practice to simply hold that  directors "hold office until such director's successor is elected and qualified or until such director's earlier resignation or removal" and that this provision does not contemplate removal through a reduction in board size. See Section 141(b)

The conclusion is bolstered by the problems that would otherwise result from a different interpretation.  As the opinion pointed out, reducing board size leaves unanswered how to determine which directors are to be removed should that be necessary.  While Crown proposed a bylaw to resolve the issue, it does not address the circumstances where there is no bylaw or the bylaw is defeated.  In other words, to allow for removal by reducing board size would require the courts to create an entire framework for dealing with the consequences. 

To the extent the bylaw somehow leaves "seatless" directors (in other words, no one is actually removed), the court correctly noted that the quorum requirements would be impossible to meet in at least some cases.  See Section 141(b)(imposing a board quorum of a majority unless reduced to no less than one-third).  Because quorums depend upon directorships rather than directors, a board could be reduced to the point where a quorum is impossible. 

Moreover, the MBCA makes this restriction explicit, suggesting that the general practice is to not allow for director removal through a reduction in board size.  See RMBCA § 8.05(c)("A decrease in the number of directors does not shorten an incumbent director’s term."). 

In short, the conclusion was correct.  Directors cannot be removed through bylaws that reduce the size of the board.  The need to find that Section 141 was exclusive and that it applied to directors failing to meet board qualifications was not necessary in arriving at this conclusion. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

VC Laster concluded that a director meeting board qualifications at the time of election could not be removed if, after the election, he/she ceases to meet those qualifications.   

• For similar reasons, my reading of Section 141(b) is not affected by the possibility that a corporation might establish qualifications for directorship and provide that a director who ceased to meet them could no longer serve. This Court has upheld a limited example of such a provision that appeared in the certificate of incorporation.   In light of the three procedural means for ending a director's term in Section 141(b), I do not believe a bylaw could impose a requirement that would disqualify a director and terminate his service.  Section 141(b)'s  recognition of the bylaws as a locus for director qualifications instead contemplates reasonable qualifications to be applied at the front end, before a director's term commences, when the director is "elected and qualified." 8 Del. C. 141(b). The concept of a bylaw that would end a director's service through disqualification thus lends no support to a bylaw that would accomplish the same thing through board shrinkage. Neither is valid under Section 141(b) (citations omitted)

In fact, however, bylaws are commonly written to require directors to submit a letter of resignation in the event that they cease, after election, to continue to meet certain specified qualifications necessary to be elected in the first place.  This bylaw from Sachs Inc. is an example:  

• Mandatory Resignation. Directors who are also officers of the Corporation shall submit a letter of resignation as such to the Board of Directors upon any termination of employment as an officer of the Corporation, and directors who are not officers of the Corporation shall likewise submit a letter of resignation upon any change in that directors principal business or other activity in which the director was engaged at the time of his or her election.

Similarly, the bylaws of Harley Davidson provide:  

• Retirement . Notwithstanding that directors are elected for a three year term, a director shall automatically cease to be a director of the corporation effective upon the commencement of the Annual Meeting immediately following such director's seventy-second (72 nd ) birthday. Each director, other than a director who is serving or has served as the Chief Executive Officer of the corporation, whose position of principal employment, occupation or affiliation changes substantially, and each director who develops a conflict of interest with the corporation as a result of changes in the business of the corporation, such director's personal interests or such director's principal employer, after his or her most recent election to the Board of Directors shall submit his or her resignation as a director of the corporation promptly following such change, and the Board of Directors (without such director present if the Board of Directors so chooses) shall consider whether to accept such resignation in the interests of the corporation.

Presumably under VC Laster's analysis, these types of bylaws are invalid.  They essentially extend to the board the authority to remove directors who fail to meet specified qualifications during their term. 

This could be a significant problem where, for example, a director of an exchange traded company ceases to be independent and, as a result, the board violates the listing requirements.  Perhaps the director could be induced to resign or the board expanded and additional independent directors appointed.  Nonetheless, in at least some cases, directors may refuse to resign and the company may find itself in violation of the listing requirements.

This portion of the opinion was dicta and unnecessary.  Even assuming Section 141 contains the exclusive method of removing directors, mandatory resignation for failing to meet mandatory qualifications is not removal, at least not in the way contemplated by Section 141.  Section 141 contemplates volitional acts by shareholders.  No longer meeting qualifications seems more like death, a form of removal not influenced by directors or other groups.  Nonetheless, the dicta in the case throws these types of bylaws into doubt.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

One issue in the case was whether shareholders could adopt a bylaw that would reduce the size of the existing board from seven directors to three, effectively forcing off the board as many as four incumbent directors (because there were two vacancies and only five incumbents the bylaw actually threatened to unseat two directors).  The effect of the bylaw was to remove existing directors.

VC Laster struck down the bylaw, concluding that it conflicted with Section 141(b) of the Delaware General Corporation Law.  The Section provided that directors would hold office "until such director's successor is elected and qualified or until such director's earlier resignation or removal."  Removal, in turn, was set out in Section 141(k), which gave shareholders the right to remove directors, with or without cause, by majority vote.   

A sound enough conclusion (for reasons we will note in a later post), VC Laster used some unnecessary analysis that raise questions about existing practice.  He arrived at his conclusion by determining that Section 141 provided the exclusive means of removing directors.  The Section only explicitly allowed for removal by shareholders.  Because the bylaw added an additional form of removal, it violated the exclusive nature of Section 141. 

In reaching this conclusion, the opinion discussed whether in fact Section 141 was the exclusive method of removing directors.  VC Laster conceded that directors could be removed by reason of death, a form of removal not considered by Section 141.  Nonetheless, it was an exception that proved the rule.  As he noted:  "death is a not procedural means by which a director’s term can be brought to a close under a corporation’s constitutive documents and the DGCL. To impose death on a director is not a legitimate method of effecting board change. It is a felony."

True enough but he failed to address bylaws, which seem common enough, that provide a director will be removed if disabled.  See Bylaws of JetBlue ("Any person elected to a newly-created director position or any person elected to fill a vacancy on the Board of Directors shall serve until the next annual meeting of stockholders and until a successor has been elected and qualified, subject to such director's prior death, disability, resignation, retirement, disqualification or removal from office."). 

While disability may, like death, seem involuntary, it puts in the hands of existing directors considerable discretion to determine the onset of disability.  This is particularly true where the bylaws (and the statute) do not define disability.  By concluding that Section 141 is exclusive, VC Laster has at least raised doubts about every bylaw that provides for mandatory replacement upon a director becoming disabled.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

            One objection has not been addressed.  The objection is that even if increasing shareholder access to the directorial nominating process and efforts to increase diversity on boards allow the selection of board members who are not beholden to top management,  and who do not share the visions and viewpoints of that group, the new board members will be condemned to service as lonely and ineffectual dissenters and completely marginalized.  The predicate assumption of the objection is almost certainly correct.  Even the most ardent supporters of the reforms do not suggest that they will lead to boards of directors in which a majority of the members are truly independent of the CEO and other top managers.  Even if the reforms are fully implemented, the likelihood for the foreseeable future is that the boards of publicly held corporations will continue to be dominated by directors selected by top management who tend to think like top management.  However, the conclusion that the presence of one or two directors who do not share the viewpoints of top management will be totally ineffectual is not necessarily correct.

             Well established and tested principles of social psychology suggest that the mere presence of even solitary dissenters can have a significant impact on the quality of decision making of groups such as a board of directors.  Over sixty years ago, psychologist Solomon Asch demonstrated how group dynamics can lead to erroneous decision making.  In Asch’s most famous experiment he placed the subject of his experiments in a room with several other “subjects” who were in fact actors who were collaborating with Asch.  The subjects were instructed to pick out a which of three lines was closest in length to a fourth line.  The “fake subjects” all sequentially announced their choice of which line, and deliberately chose the same blatantly wrong answer.  Three quarters of the subjects were influenced by the fake subjects to choose the same wrong answer in at least one iteration of the experiment.

            The ability of a even a lone dissenter to break the hold of group conformity was demonstrated in later experiments by Asch, and even more dramatically by an experiment in the early 1970s by psychologists Vernon Allen and John Levine.  Allen and Levine used the same basic framework as Asch but expanded it in several respects.  One of those ways was to break the fake subjects into three different groups.  In one group, the “fake subjects” all unanimously adhered to the same opinion.  In a second group, a fake subject dissented from the group consensus.  However, the fake dissenting subjects convinced the real subjects (and the person purportedly “conducting” the experiment) that they were visually impaired and literally guessing at random.  The researcher purportedly conducting the experiment “informed” the fake subjects, in front of the real subjects, that the fake subjects’  answers would not be recorded or count in the study.   In the third group the dissenter was represented as no different from other members of the group.

            Not surprisingly, the third group showed by far the lowest conformity among the real subjects of the experiment to deliberately wrong answers chosen by the majority of fake subjects.  What is surprising is that conformity to wrong answers among the real subjects was significantly lower in the second group than in the group where no dissenter was present.  The presence of a dissenting person whom the real subjects viewed as physically unable to ascertain a correct answer still seemed to reduce by a meaningful amount group pressure on the real subjects to pick an incorrect answer.

            Do these experiments mean that directors who are selected by persons other than the top managers of publicly held corporations will routinely be able to prevent mistakes by directors who are dominated by the top managers of the corporation?  Hardly.  Unlike the true subjects in the psychological experiments, the continued participation of the board members on the board is usually dependent upon the good graces of top management.  Nonetheless, the experiments do give some hope that the presence of shareholder nominated directors may sway some other directors to challenge some of the more irrational or ill considered decisions pushed by top management of publicly held corporations.  We may not see a major change in the quality of board decision making, but we may see a decrease in decisions which, when considered in retrospect, cause observers to ask “how could the board possibly have believed that"? or “didn’t anyone see the obvious possible problems"?

Note: For a fascinating application of the above psychological studies to Supreme Court decision making (including very interesting comments on the process by Justice Breyer) see Ori & Rom Brafman, SWAY ch. 8 (2008).

One of the reasons given for striking down the bylaw that reduced the size of the board was that it amounted to a removal of incumbent directors.  Because directors had the same bylaw authority as shareholders, it potentially allowed directors to remove other directors by shrinking the size of the board.  This in turn conflicted with the proposition that directors cannot remove other directors.  As the court noted:

• If a bylaw amendment reducing the size of a board could eliminate sitting directors, then directors suddenly would have the power to remove other directors. For 89 years, Delaware law has barred directors from removing other directors. Bruch v. Nat’l Guar. Credit. Corp., 116 A. 738, 741 (Del. Ch. 1922); accord Robert Pennington, Pennington on Delaware Corporations 117 (1925) (“A director being an officer chosen by the stockholders cannot be removed by his fellow directors.”). In 1974, when the stockholders’ power to remove directors was confirmed and addressed through the adoption of Section 141(k), two leading authorities on the DGCL wrote that “by negative implication intended by the draftsmen, directors do not have the authority to remove other directors.” S. Samuel Arsht & Lewis S. Black, The 1974 Amendments To The Delaware Corporation Law 378 (1974). I do not believe the DGCL contemplates a bylaw amendment could overturn this rule.

In general, the prohibition on directors removing directors amounts to black letter law.  To do so would essentially allow directors to undo the will of shareholders.  Yet in fact, matters are not so clear.

First, some states expressly allow it, at least if for cause.  See Mass. Gen. Laws ch. 156B §51(c) ("any director, and any officer elected by the stockholders, may be removed from his office for cause by vote of a majority of the directors then in office.  A director or officer may be removed for cause only after a reasonable notice and opportunity to be heard before the body proposing to remove him.").  Some permit the removal of directors who were appointed by the board.  See Minn. Stat. § 301A.223(2)(permitting removal by directors, with or without cause, where the director was appointed by the board to fill a vacancy, "the shareholders have not elected directors in the interval between the time of the appointment to fill a vacancy and the time of the removal" and removal is approved by a majority of the remaining directors).  See also ND Cent. Code § 10-19.1-41(2)(same language). 

Others allow for the authority if in the articles or a shareholder adopted bylaws.  See NY Bus. Corp. Law § 706 ("The certificate of incorporation or the specific provisions of a by-law adopted by the shareholders may provide for such removal by action of the board, except in the case of any director elected by cumulative voting, or by the holders of the shares of any class or series, or holders of bonds, voting as a class, when so entitled by the provisions of the certificate of incorporation."). 

Second, Delaware has no statutory prohibition on directors removing other diretors.  The law in this area traced back to Bruch v. National Guarantee Credit Corp., 13 Del. Ch. 180 (Del. Ch. April 10, 1922).  As the court in that case concluded:

• But I am of the opinion that directors of an industrial corporation, such as is the defendant, cannot be removed by his fellow members. A director is an officer chosen by the stockholders. His title to the office is as good as the title of his fellows. His right to the office is quite different from that of those officers of the corporation who are selected not by stockholders but by the directors themselves. If the power of amotion of a director exists, it is reasonable to hold that it shall be exercised by the power that elected him, viz., by the stockholders. To allow directors to frame charges against one of their fellows and then to try and expel him, would open the door to possibilities of fraud which designing men might use to wrest control of corporate affairs from the stockholders, or their sympathetic representatives on the board, and transfer it to those who might seek to grasp the corporation for their own ends.

This is a surprisingly thin reed to draw conclusions about the right of directors to remove directors.  First it is only a Chancery Court decision.  Second, it is premised on the idea that directors are elected by shareholders.  Yet this is not true for directors elected by the board, suggesting that a different rule might be applicable.  Third, the court did not deal with circumstances involving removal neither by directors nor shareholders.  Thus, if directors were required to leave the board because of disability or the failure to meet board qualifications, the act of removal would be automatic and based upon criteria set forth at the time of election.

Finally, the court left often the possibility that such authority could be inserted into the articles.  As the opinion stated:  "Whether under the law of this state the certificate of incorporation may confer such power on directors is, of course, not a question involved in this case."

The usual rule that directors cannot remove directors is a sound one.  But without a statutory basis, it is not quite as clear as VC Laster suggests.  Moreover, the Delaware courts have shown a tendency to abandon black letter law when it is not in the statute and abandonment suits management.  Examples?  Vote buying and discrimination among shareholders of the same class of shares.

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

In one case, Crown Emak Partners, a shareholder holding 28% of the voting shares, solicited consents to reduce the size of the Board to three directors.  Because Crown had the right to designate two directors on the board, the effect would give Crown a majority.  A second bylaw provided that a special meeting would be called to elect the third director.  Crown succeeded in obtaining sufficient consents to adopt the bylaws.  The consents were executed by DTC on behalf of the beneficial owners. 

One group of shareholders (Take Back EMAK or TBE) sought to obtain the consents to replace two of the five directors and fill three of the vacancies, thereby obtaining control.  As the soliciation proceeded, the TBE Group obtained consents equal to 48.4% of the common stock.  In order to obtain the additional votes.  Donald A. Kurz, an incumbent director and member of the TBE Group, agreed to purchase from another shareholder, Boutros. 

Because, however, the shares were subject to restrictions on sale, Kurz could only obtained title after the restrictions were lifted.  Despite the future date of delivery, Boutros executed an irrevocable proxy.  According to the purchase agreement:

• Proxies.As a material part of the consideration for this Agreement, and an express condition precedent to the effectiveness hereof, Seller agrees to execute and deliver to Buyer by facsimile transmittal on the date hereof, time being of the essence, with originals to follow immediately by express delivery, (a) this Agreement, (b) an Irrevocable Proxy, (c) the Revocation, and (d) the White Consent Card solicited by Take Back EMAK LLC, each in the form attached hereto.

The consents apparently provided TBE with enough shares to implement their plan to take control of the board.  While the TBE Group appeared to have a majority, a portion of its support came from street name owners.  Because an omnibus proxy had not been obtained from DTC, the street name votes were disallowed.

In the litigation that followed, Vice Chancellor Laster had to determine:  (1) the legality of a bylaw that reduced the size of an incumbent board; (2) the validity of the purchase of votes by Kurz under vote buying analysis; and (3) the consequence of the failure to obtain the omnibus proxy.  We will deal with the issues seriatim. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility? 

The opinion and a number of primary materials are posted at the DU Corporate Governance web site.

Any notion that he would enter the legal fray quietly and gradually was dispelled with his 70 page decision in Kurz v. Holbrook, 2010 Del. Ch. LEXIS 24 (Del. Ch. Feb. 9, 2010).  The case is to some degree a tutorial on various aspects of Delaware law.  There is a detailed discussion about the appropriate methods of removing directors from the board.  The wide ranging discussion, however, likely invalidates certain types of bylaws that mandate the resignation of directors who cease to be qualified after joining the board.

Most interestingly is the discussion of the voting system for owners using street name accounts.  In public companies, these shares are typically held by brokers (and sometimes banks) who then place them into a central depository (The Depository Trust & Clearing Corporation or DTC).   It is the depository that ultimately holds record title and is treated as the owner under state law.  Typically, however, DTC executes an omnibus proxy in favor of the depositing banks and brokers, tranfering voting rights to them.

In this case, the parties engaged in a consent contest.  Both, however, failed to obtain the omnibus proxy.  The Chancery Court had to determine whether the votes cast by assorted brokers could be counted in the absence of the formalistic but necessary piece of paper.   In concluding that they could, VC Laster effectively set aside the obligation to focus on record ownership.  The case raises any number of questions about the continued reliance on record ownership in other circumstances.

We will spend a few posts exploring the case and its implications. 

For more on the entire system of beneficial ownership and the role of the depositories, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?

The opinion and a number of primary materials are posted at the DU Corporate Governance web site. 

The trial court judge granted summary judgment for the appellees stating that the appellant could not bring a direct action suit because he failed to allege injuries apart from those suffered by the other shareholders.  The only issue up on appeal was whether the appellant could bring a direct action for breach of fiduciary duty or whether the claim was derivative.  

Shareholders may bring a direct suit only in their own right to redress an injury sustained directly by them individually.  Based upon this rule, the Florida Appellate Court stated that none of the appellant’s alleged injuries established the individualized harm necessary to bring a direct action.  Furthermore, the court held that all allegations brought by the appellant affected all of the shareholders equally.  Thus, the Florida Appellate Court affirmed the trial court’s ruling that in order to pursue the appellant’s claim he must bring a derivative action.     

The primary materials for this post are available on the DU Corporate Governance website.

Paolino, the Chairman and Chief Executive Officer of Mace from 1999 until May 20, 2008 was terminated by the company.  Upon dismissal, he filed a demand for arbitration, and claimed that he was terminated in retaliation for insisting that the Board publicly disclose certain material facts and events affecting Mace’s business, which the Board refused to do. 

Mace filed counterclaims.  Mace argued that Paolino refused to follow the Board’s direction, refused to properly inform and/or seek Board approval for Paolino’s actions, refused to comply with Mace’s corporate governance principles and bylaws, refused to reduce corporate overhead and expense as directed by the Board, and inappropriately interfered with the Board’s investigation of matters.  Mace alleged that Paolino’s actions constituted willful misconduct, which according to the terms of an employment agreement, negated any severance payment Mace may have owed to Paolino.

Paolino sought indemnification and advancement of fees and expenses incurred in defending against counterclaims. Mace moved to dismiss the complaint alleging that Paolino was not entitled to advancements because Paolino was not defending against the counterclaims, a carve-out in the provision barred recovery, and the counterclaims did not arise out of Paolino’s role as a director or officer of Mace.

The court stayed the action to the extent it sought indemnification pending final disposition of the arbitration, but continued Paolino’s action to enforce the mandatory advancement right granted to him under Mace’s Bylaws.  Under Section 145(e) of Delaware’s General Corporation Law, corporations may pay expenses incurred by directors and officers in defending any civil, criminal, administrative or investigative action, suit or proceeding “in advance of the final disposition of such action.”  Pursuant to this authority, Mace adopted Bylaws that entitled current and former directors and officers of Mace to broad and mandatory indemnification and advancement rights.  As the Bylaws provided:  

• §6.01—Each person who was or is made a party…in any action, suit or proceeding, whether civil, criminal, administrative or investigative, by reason of the fact that he or she…is or was a director or officer of the Corporation…shall be indemnified and held harmless by the Corporation to the fullest extent authorized by the Delaware General Corporation Law…provided, however, that except as provided in paragraph (b) hereof, the Corporation shall indemnify any such person seeking indemnification in connection with a proceeding (or part thereof) initiated by such person only if such proceeding (or part thereof) was authorized by the Board of Directors of the Corporation.
• §6.02—The right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition, including without limitation, attorney’s fees, expert's fees and all costs of litigation.

Because Paolino was defending against the counterclaims, he was entitled to advances under the Bylaws. 

Mace argued, however, that Delaware precedents did not require the advancement of expenses.  Mace alleged that where a covered person initiated a proceeding and a corporation asserted counterclaims defensively, those claims were not defensive.  Mace further argued that the counterclaims were part of the covered person’s offensive proceeding and did not qualify for advancements. 

The Vice Chancellor held that Mace’s argument contradicted the core public policies underlying Section 145.  The Section was intended (a) to allow corporate officials to resist unjustified lawsuits so that the corporation will bear the expenses of litigation in the event the Plaintiffs are successful; and (b) to encourage capable candidates to serve as corporate officers and directors because the corporation will absorb the cost of defending their honesty and integrity.  The court held that the procedural posture of the claim wasn't important, only whether the office or director was placed in a posture of having to defend.  

• For purposes of determining whether someone is “defending” a proceeding, the operative question is not “who started the lawsuit?” as Mace suggests, but rather “has a claim been asserted against the covered person?” If a claim has been asserted, whether as an initial claim, counterclaim, or third party claim, then the covered person is “defending.”

The court also stated that the carve-out within the Bylaw did not bar Paolino from receiving advancements.  Mace argued that the carve-out in Section 6.01 foreclosed advancement because Paulino initiated the proceeding.  The carve-out provided that payments would not be made where the officer or director "initiated" the proceeding unless "authorized by the Board of Directors of the Corporation.”  Furthermore, Section 6.02 provided that “the right to indemnification conferred by Article 6 shall include the right to be paid by the Corporation the expenses incurred in defending any such proceeding in advance of its final disposition.”  The court held that Paolino was not seeking advancements or indemnification in connection with a proceeding initiated by him.  Rather, the counterclaims were part of the proceeding that Mace initiated because the counterclaims were a separate cause of action for purposes of Section 145 analysis. 

Lastly, the court stated that the employment agreement between Paolino and Mace did not alter his right to recover.  Mace argued that Paolino was not entitled to recover because the counterclaims did not arise “by reason of the fact” that Paulino was CEO and Chairman of Mace, but rather out of his employment agreement.  Plaintiff needed only to show the existence of a "nexus or casual connection between a claim and [the officer's] official capacity."  The court concluded that the counterclaims broadly asserted that Paolino breached his fiduciary obligations and contractual, statutory, and common law duties owed to Mace.  Thus, the counterclaims implicated his duties as an officer and director. 

Additionally, the requisite connection was established “if the corporate powers were used or necessary for the commission of the alleged misconduct.”  Under this test, a claim against a director or officer for matters that related to a corporation would fall within Section 145, even if the individual was a party to an employment agreement.  The court further stated that in order for the corporation to avoid advancements, the claim must involve a specific and limited contractual obligation without any nexus or casual connection to official duties.

The primary materials for this post are available on the DU Corporate Governance website.

According to the SEC, Assurant Solutions, a subsidiary of Assurant, entered into an Aggregate Stop Loss Reinsurance treaty with American Re-Insurance Company (“American”) dating back to 1992 and renewed annually.  The treaty consisted of a written policy shifting the risk of losses from Assurant Solutions to American in certain conditions and an oral verbal agreement on the side known as a “handshake” agreement.  The handshake agreement conveyed that if American paid more in claims than Assurant Solutions paid in premiums, then Assurant Solutions would reimburse American for the difference.  The handshake agreement also stipulated that if Assurant Solutions paid more in premiums than American paid in claims, then American would pay the difference to Assurant Solutions. 

Pursuant to the handshake agreement, American made a payment of $10 million to Assurant Solutions in 2004.  Assurant accounted for the $10 million using reinsurance accounting, whereas under generally accepted accounting principles (“GAAP”), Assurant should have accounted for the payment using deposit accounting. 

Under GAAP, the deposit accounting method treats the payment as a return of a deposit or loan payment.  The deposit accounting method is used where there is no risk transfer and only affects the balance sheet of a company’s financials.  The reinsurance accounting method is used when risk has been transferred to the reinsurer under a reinsurance treaty.  This method allows the company to offset losses with the recovery payment and reduces the amount of losses on a company’s income statement.  Since the handshake agreement contained a reimbursement provision, under GAAP this would negate the transfer of risk and require deposit accounting. 

Assurant’s agreed upon civil penalty of $3.5 million also takes into account failure to comply with subpoenas in a timely manner. 

The primary materials for this case may be found on the DU Corporate Governance Website. 

Shareholder Rights Plan: An effort to Control eBay’s Interest in Craigslist?

Defendants also adopted a Rights Plan (“Rights Plan” or “Poison Pill”) designed to address the threat of a potential hostile takeover, specifically in the event of a “death problem."  They explained that, so long as defendants, the majority stakeholders, held their shares and did not sell them, eBay could not  acquire the company.  However, the death of either majority stakeholder would result in automatic liquidation of their shares, which in turn would make Craigslist more susceptible to a hostile takeover.  Therefore, while the threat of a hostile takeover was not imminent, defendants argued that implementing a Rights Plans was justified because it mitigated against a potential future threat.

eBay contended that this Plan was an unnecessary measure and that effective estate planning could cure the “death problem."  Further, composition of the Plan benefited the defendants to the detriment of eBay.  Under the Plan’s terms, Newmark and Buckmaster could freely transfer shares to each other, whereas eBay would be limited to transfers of stock to a successor in interest by merger.  Moreover, the right of directors to veto or waive the Plan at their discretion creates an unfair disadvantage for eBay.

Defendants responded that Craigslist created a plan that protected the company from eBay and any acquisition.  Furthermore, the Rights Plan only took affect when eBay or one of the other shareholders decided to sell their respective shares.  The Plan allowed Newmark and Buckmaster the power to veto; however, defendants argued that long-term interests of the company, and not the personal interests of Newmark or Buckmaster, would guide use of the veto.

eBay argued that defendants’ power to waive the poison pill accentuated the defendants' control and disadvantaged eBay.  In response, defendants brushed aside eBay’s concern by concluding that sale of a director’s shares was not an imminent concern.  They added that eBay’s complaints about the Plan were based on speculation that future actions would trigger the Plan and that defendants would inevitably breach fiduciary duties.  Defendants’ also noted that because eBay had not submitted to the company’s Right of First Refusal agreement, it is currently able to sell its entire stake without triggering the Rights Plan and without Board approval, provided it does not sell more than 15% of the company to a single purchaser. 

Company ROFR: Cornering eBay to Surrender Liquidity of Shares? 

eBay’s complaint alleged that Newmark and Buckmaster approved a plan to authorize and implement a stock issuance program premised on a ROFR Agreement executed in early 2008 without financial advice, third-party expertise, or notice to and involvement of eBay. 

The ROFR, once accepted by a stockholder, provided Craigslist with the right of first refusal in the event that a stockholder desired to transfer its shares to a third party.  In return, the company would issue one “reorganization share” of common stock in Craigslist for every five shares of common stock owned by that stockholder.  According to defendants’ pretrial brief, the ROFR agreement allowed Craigslist to purchase shares whenever the Board determined the sale was below market price or to a purchaser that was hostile or incompatible with Craigslist.

The complaint asserted that because Craigslist was a privately held company comprised of only three stockholders, the ROFR was an effort to strip eBay of the ability to sell its interest to anyone not controlled by Newmark or Buckmaster.  Moreover, if either Newmark or Buckmaster exercised the ROFR with respect to the other's shares, they would own over 50% of the Craigslist shares.  

Exercise of the ROFR also unfairly disadvantaged eBay because Newmark and Buckmaster maintained the ability to waive the implication of the company ROFR.  Ed Wes, counsel hired by Craigslist to act on these transactions, was also hired by the insider directors in their personal capacity for estate planning matters.  Both the ROFR and the poison pill contained “carve out” provisions allowing the insiders to transfer shares for estate planning reasons without triggering the restrictions contained in either documents. 

Thirdly, there was little cost to Newmark and Buckmaster because they were already subject to personal refusal rights held over each other’s shares, while eBay had no such obligation.  Finally, because eBay was a competitor of Craigslist, eBay argued it deserves a higher premium for submission to the company ROFR. 

In contrast, defendants argued the ROFR encouraged full participation and achieved the greatest benefit for the corporation as opposed to diluting eBay’s shares.  eBay was offered the same opportunity to submit to the ROFR.  Moreover, eBay was not unfairly burdened by implementation of such a governance measure.  As eBay admitted, any acquisition of control by Newmark or Buckmaster under the ROFR was due to the equity stake of the shareholders at the time of exercising the ROFR and not inequitable treatment.  Secondly, defendants argued that their ability to veto ROFR would be guided by the best interests of the company and not their personal interests. 

Thirdly, while the defendants previously held personal refusal rights over each other’s shares, by submitting to the company ROFR they have in fact incurred a greater cost than eBay through the loss of those refusal rights by transferring them to the company.  On the other hand, eBay would not be giving up any such right. 

Finally, with respect to eBay’s assertion that its status as a competitor entitled eBay to a higher premium for the ROFR , the defendants stated this further supported the need for the ROFR.  Overall, eBay was given the option to (1) submit to the ROFR, surrendering its right to control the liquidity of its shares; or (2) refuse to accept the ROFR agreement and face substantial dilution of its interest while losing important minority shareholder protections.

The arguments on both sides are strong and the outcome is expected to shed light on rights of minority shareholders.  In its article, “Judge urges eBay, Craigslist to resolve dispute,” Associated Press highlighted the judge’s stance on the issue. Chancellor William Chandler III, the presiding judge, urged the parties to settle the dispute amongst themselves before he issues a ruling.  The judge stated that such a resolution would benefit both parties, much more than what he may decide.

The pleadings and other primary materials for the post are available on the DU Corporate Governance website.