Kurz v. Holbrook, No. 5019-VCL (Del. Ch., Feb. 9, 2010), read opinion here. This 80-page Delaware Court of Chancery opinion decided an expedited claim based on DGCL Section 225, challenging the election of board members.

Important Groundbreaking Issues Addressed.

This opinion is must reading for anyone who would seek to remove a sitting director or try to reduce the number of directors on a board. This decision addresses for the first time whether a bylaw amendment can reduce the size of a board. See, e.g., Slip op. at 24. This decision is also required reading due to its treatment of the issues that arise in connection with the right to vote shares that are held in street name, some of which are addressed authoritatively by a Delaware court for the first time. See, e.g., Slip op. at 60. The "underdeveloped" topic of "third-party vote buying" in connection with corporate elections is also addressed in a scholarly fashion, noting that the analysis is different than what might apply in the political arena. See, e.g., Slip op. at 64-65.

One of the best ways to highlight an opinion of "law review article length" for purposes of a blog, is to use the overview of the case provided by the Court itself in the opinion. The Court’s introduction to the case follows verbatim:

This post-trial opinion resolves competing requests for relief under Section 225 of the Delaware General Corporation Law (the “DGCL”). 8 Del. C. § 225. At stake is control of the board of directors (the “Board”) of EMAK Worldwide, Inc. (“EMAK” or the “Company”).

Prior to December 18, 2009, the Board had six directors and one vacancy. On December 18, one director resigned, creating a second vacancy. The plaintiffs contend that on December 20 and 21, Take Back EMAK, LLC (“TBE”) delivered sufficient consents (the “TBE Consents”) to remove two additional directors without cause and fill three of the vacancies with Philip Kleweno, Michael Konig, and Lloyd Sems. Incumbent director Donald Kurz is a member of TBE. The TBE Consents, if valid, would establish a new Board majority.

The defendants contend that on December 18, 2009, Crown EMAK Partners, LLC (“Crown”) delivered sufficient consents (the “Crown Consents”) to amend EMAK’s bylaws in two important ways. First, the Crown Consents purportedly amended Section 3.1 of the bylaws (“New Section 3.1”) to reduce the size of the Board to three directors. Because Crown has the right to appoint two directors under the terms of EMAK’s Series AA Preferred Stock, reducing the board to three, if valid, would give Crown a Board majority. Second, the Crown Consents purportedly added a new Section 3.1.1 to the bylaws (“New Section 3.1.1”) providing that if the number of sitting directors exceeds three, then the EMAK CEO will call a special meeting of stockholders to elect the third director, who will take office as the singular successor to his multiple predecessors. The defendants contend that the bylaw amendments are valid and that the next step is for the EMAK CEO to call a special meeting.

I hold that the bylaw amendments adopted through the Crown Consents conflict with the DGCL and are void. They were therefore ineffective to shrink the Board or to require the calling of a special meeting. I hold that the TBE Consents validly effected corporate action. The Board therefore consists of incumbent directors Kurz, Jeffrey Deutschman, and Jason Ackerman, and newly elected directors Kleweno, Konig, and Sems. One vacancy remains.

In addition to seeking relief under Section 225, the parties have asserted a panoply of claims, cross-claims, and third-party claims, and they have amassed an extensive record relating to those claims. My decision addresses only the requests for relief under Section 225, and I have sought to avoid resolving factual disputes that could have collateral implications if the other claims proceed. Contemporaneously with the issuance of this opinion, I am entering a partial final judgment under Rule 54(b) to implement my decision, thereby facilitating a prompt appeal should the defendants wish to pursue it. 

Of course, there is much more to commend this decision and it deserves more extended treatment than the time and space limitations of this blog allow. For example, the Court provides helpful definitions of terms that are often used but rarely explained in any detail. The Court refers to a treatise to explain exactly what it means, from a technical, legal viewpoint, to state that shares in a company are held in "street name".

A quote from the opinion with these definitions follows:

The vast majority of publicly traded shares in the United States are registered on the companies’ books not in the name of beneficial owners—i.e., those investors who paid for, and have the right to vote and dispose of, the shares—but rather in the name of “Cede & Co.,” the name used by The Depository Trust Company (“DTC”).

Shares registered in this manner are commonly referred to as being held in “street name.” . . . DTC holds the shares on behalf of banks and brokers, which in turn hold on behalf of their clients (who are the underlying beneficial owners or other intermediaries).

John C. Wilcox, John J. Purcell III, & Hye-Won Choi, “Street Name” Registration & The Proxy Solicitation Process, at 10-3 in Amy Goodman, et al., A Practical Guide to SEC Proxy and Compensation Rules (4th Ed. 2007 & 2008 Supp.) (hereinafter “Street Name”).

DTC figures prominently in this case. So does the Investor Communications Solutions Division of Broadridge Financial Services, Inc. (“Broadridge”). Although Broadridge’s role is also likely familiar to many readers, I again offer a quick summary:

For many years, banks and brokers maintained their own proxy departments to handle the back-office administrative processes of distributing proxy materials and tabulating voting instructions from their clients. Today, however, the overwhelming majority have eliminated their proxy departments and subcontracted these processes out to [Broadridge]. For many years, these proxy processing services were provided by Automatic Data Processing, Inc. (“ADP”), but on March 31, 2007, ADP spun off its Brokerage Services Group into a new independent company,
Broadridge, which now provides these services to most banks and brokers. To make these arrangements work, Broadridge’s bank and broker clients formally transfer to Broadridge the proxy authority they receive from DTC (via the [DTC] Omnibus Proxy) via written powers of attorney. On behalf of the brokers and banks, Broadridge delivers directly to each beneficial owner a proxy statement and, importantly, a voting instruction form (referred to as a “VIF”) rather than a proxy card. Beneficial owners do not receive proxy cards because they are not vested with the right to vote shares or to grant proxy authority—those rights belong only to the legal owners (or their designees). Beneficial owners merely have the right to instruct
how their shares are to be voted by Broadridge (attorney-in-fact of the DTC participants), which they accomplish by returning a VIF.

Id. at 10-14

Slip op. at 6-7.  The Court emphasized that there is NO legal authority on the issue of who has the authority or obligation to obtain the Omnibus Proxy.

As the Court  explained it: " DTC is generally understood to be the entity with the power under Delaware law to vote the shares that it holds on deposit for the banks and brokers who are members of DTC. Through the DTC omnibus proxy, DTC transfers its voting authority to the banks and brokers. The banks and brokers then transfer the voting authority to Broadridge, which votes the shares held at DTC by each bank and broker in proportion to the aggregate instructions received from the ultimate beneficial owners." Slip op. at 7.

Also described is the important concept known as a "Cede breakdown", referred to as follows: "If DTC holds shares of a corporation on behalf of banks and brokers, then the corporation can ask DTC to provide what is technically known as a participant listing and informally referred to as a “Cede breakdown.” The Cede breakdown for a particular date identifies by name each bank or
broker that holds shares with DTC as of that date and the number of shares held. In contrast to the DTC omnibus proxy, which is not governed by any legal authority, federal regulations require DTC to furnish a Cede breakdown promptly when a corporation requests it." Slip op. at 16.

Issue of First Impression: Reduction in Board Size via Bylaw Amendment

The Court observed that no Delaware decision has addressed the reduction of the size of the board via bylaw amendment. As the Court wrote: "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." (footnote omitted.) Slip op. at 20.

The Court observed three ways that a director’s term may end:

New [proposed bylaw] Section 3.1 would shrink the Board to three directorships at a time when five directors are in office. There are two possible consequences for the suddenly surplus directors. One is that their terms would end. The other is that they would continue to
serve, albeit without official seats, until their terms were ended by a statutorily recognized means. I find that both possibilities conflict with the DGCL.

The notion that the terms of the extra directors would end conflicts with Section 141(b)’s mandate that “[e]ach director shall hold office until such director’s successor is selected and qualified or until such director’s earlier resignation or removal.” 8 Del. C. §141(b). Section 141(b) thus recognizes three procedural means by which the term of a sitting director can be brought to a close: (1) when the director’s successor is elected and qualified, (2) if the director resigns, or (3) if the director is removed. Section 141(b) does not contemplate that a director’s term could end through board shrinkage. A bylaw that seeks to achieve this result conflicts with Section 141(b) and is void.

Slip op. at 21.

DGCL Section 141(k) supports the general rule that a director or the entire board may be removed  with or without cause by a majority of the shareholders entitled to vote. Slip op. at 23. Although it was observed that directors may, in certain instances, fill vacancies on the board, directors cannot remove a fellow director. Slip op. at 25.

Further reasoning by the Court supported its holding that the bylaw amendment at issue was in violation of the DGCL:

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. Rohe v. Reliance Training Network, Inc., 2000 WL 1038190, at *12 (Del. Ch. July 21, 2000). 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); see Triplex Shoe Co. v. Rice & Hutchins, Inc., 152 A. 342, 375 (Del. 1930).

Slip op. at 24.

UPDATE: Professor Bainbridge highlights the case here.  The Harvard Law School Corporate Governance Blog discusses the case here.