Corporate Governance Group. Client Alert. Pulling out the Seat from Under a Sitting Director Not Permissible under Delaware Law

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1 March 19, 2010 Corporate Governance Group Client Alert Bei j i n g Fr a n k f u r t Ho n g Ko n g Lo n d o n Lo s An g e l e s Mu n i c h Ne w Yo r k Si n g a p o r e To k y o Wa s h i n g t o n, DC Delaware Court Rejects Bylaw Amendment Seeking to Unseat Directors by Reducing Size of Board Pulling out the Seat from Under a Sitting Director Not Permissible under Delaware Law It is not an uncommon tactic for a dissident stockholder or hostile bidder to seek to expand the size of a company s board of directors through a bylaw amendment for the purpose of electing its own board members and, if successful, gaining control of the board. However, Delaware courts until recently have not been asked to consider an attempt to gain board control via a company bylaw amendment that reduces the size of the board. In ruling on this matter of first impression in Kurz v. Holbrook, 1 the Delaware Court of Chancery recently opined that a proposed bylaw amendment, sponsored by a preferred stockholder who already had two designees on a company board, that purported to reduce the size of the board to three in order to oust sitting directors between annual meetings, conflicted with, and therefore was ineffective under, the Delaware General Corporation Law ( DGCL ). The Court based its ruling on a strict reading of DGCL Sections 141(b) and 141(k). Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our Corporate Governance Group, whose names and contact information are provided at the end of this alert. In addition, if you would like copies of our other Client Alerts, please visit our website at and choose the Client Alerts & Newsletters link under Newsroom/Events. This Client Alert is a source of general information for clients and friends of Milbank, Tweed, Hadley & McCloy LLP. Its content should not be construed as legal advice, and readers should not act upon the information in this Client Alert without consulting counsel Milbank, Tweed, Hadley & McCloy LLP. All rights reserved. Attorney Advertising, prior results do not guarantee a similar outcome. 1 C.A. No VCL (Del. Ch. Feb. 9, 2010).

2 Background EMAK Worldwide, Inc., a Delaware corporation based in Los Angeles, has two classes of stock: common stock and Series AA preferred stock. All of the preferred stock is held by Crown EMAK Partners, LLC. The preferred stock does not vote in the election of directors, but entitles its holder to elect two members of the board, as well as a third director if the board is expanded to more than eight members. In addition, the preferred stock votes on an as-converted basis with the common stock on all other matters including bylaw amendments thereby entitling its holder to approximately 28% of the total voting power on such matters. In late 2009, EMAK found itself the subject of two competing consent solicitations to take control of its board of directors. As of December 18, 2009, EMAK s board consisted of five sitting directors two of whom Crown designated through its ownership of the preferred stock, and three of whom were elected by the holders of common stock and two vacant seats. One group, which adopted the name Take Back EMAK LLC ( TBE ) and was led by Donald Kurz, an EMAK director elected by the common stockholders, sought to remove the other two directors elected by the common stockholders, without cause, and at the same time elect three new directors. If successful, TBE would thereby gain majority representation on the board. 2 Crown opposed this effort by TBE, but because it could not vote its preferred stock to either elect or remove directors, it joined with company management and one institutional investor to seek control of the board through two bylaw amendments. First, the size of the board would be reduced to three members, metaphorically pulling their seats out from under two of the incumbent directors elected by the common stockholders. Because the preferred stock provided Crown with two designees, the effect of this bylaw amendment would be to give Crown a majority of the board. Second, a new bylaw would be added providing that if the board were subsequently expanded to more than three members, EMAK s chief executive officer would be required to call a special meeting of common stockholders to elect one new director to serve as the singular successor to his multiple predecessors elected as a result of such an expansion. Both groups submitted written consents to EMAK purporting to represent a majority of the total votes entitled to be cast on the subject matter of their respective solicitations. The various parties sought relief under DGCL Section 225, which gives the Court of Chancery power to resolve election disputes. The Court s Analysis Confronting this matter of first impression, Vice Chancellor Laster observed: 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. The Court first discussed whether a bylaw amendment could be an appropriate mechanism for altering the size of a company s board of directors. Noting that (i) DGCL Section 141(b) permits the size of a company s board to be fixed in its bylaws, unless the number of directors is set in the certificate of incorporation, and (ii) EMAK s certificate of incorporation is silent on the size of the board, the Court explained that stockholders controlling 2 Take Back EMAK s solicitation also is the subject of a ruling by the Court of Chancery in Kurz that will be discussed in a subsequent Client Alert. 2

3 a majority of EMAK s outstanding voting power could alter the size of its board through a bylaw amendment adopted via written consent. While DGCL Section 141(b) explains the process for filling vacant board seats if a bylaw amendment increases the size of a board, it is silent on what happens if a bylaw amendment purports to reduce the size of a board. Accordingly, the Court had to consider two possible consequences for the suddenly surplus directors : (i) the termination of the terms in office of the surplus directors or (ii) the surplus directors continuing to serve without an underlying board seat. The Court rejected both alternatives. Early Termination of the Surplus Directors The Court concluded that the first alternative, that the terms in office of the surplus directors end upon a reduction in the size of the board, conflicts with DGCL Section 141(b) s mandate that [e]ach director shall hold office until such director s successor is elected and qualified or until such director s earlier resignation or removal. Vice Chancellor Laster reasoned that a bylaw amendment that purports to end a director s term prematurely through a reduction in the size of the board conflicts with this provision and is void. To lend additional support to his conclusion, the Vice Chancellor observed that DGCL Section 141(k) provides that directors may be removed, with or without cause, by the holders of a majority of the shares entitled to vote at an election of directors, and then further noted that [t]he specific references to removal in Sections 141(b) and (k), 3 the absence of any comparable provision addressing board shrinkage, and the background common law exception that a director otherwise would serve out a full term absent cause for removal reinforce my view that eliminating directorships through board shrinkage is not permitted. 4 Vice Chancellor Laster also noted that DGCL Section 109(a) allows a company s certificate of incorporation to confer the power to adopt, amend or repeal bylaws upon the directors, and that [i]f a bylaw amendment reducing the size of a board could eliminate sitting directors, then directors suddenly would have the power to remove other directors. The Court found this to be contrary to 89 years of Delaware jurisprudence, and was not prepared to hold that a bylaw amendment could overturn this rule. The Court also observed that while a company may establish qualifications for its directors, it did not believe that a bylaw could impose a requirement that would disqualify a director and terminate his service. According to the Court, 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.... [emphasis added] The Court therefore opined that [t]he 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. 3 According to DGCL Section 141(b): Each director shall hold office until such director s successor is elected and qualified or until such director s earlier resignation or removal. 4 The Vice Chancellor, while recognizing that death also is not included on DGCL Section 141(b) s list of the means by which a director s term may end, and observing (with tongue firmly in cheek) that [b]arring a major breakthrough in séance technology, death remains an insurmountable barrier to board service, nevertheless concluded that such omission from DGCL Section 141(b) does not mean that the circumstances listed in that section are non-exclusive. 3

4 Surplus Directors Continue in Office Next, the Court addressed the second alternative, that the surplus directors continue to serve, without official directorships, until their own terms ended through removal, resignation, or the election and qualification of a successor in accordance with Section 141(b). The Court analogized this possibility to holdover directors, who are permitted to continue to serve beyond their election terms under DGCL Section 211(c) because either the company has not timely held an annual meeting or a successor is not duly elected. 5 Relying on the specific language of DGCL Section 141(b), which does not contemplate a board with more directors serving (albeit without official seats) than the number... fixed by... the bylaws, the Vice Chancellor rejected the analogy to holdover directors, noting that [o]ur law does not contemplate a liminal state in which suddenly surplus directors might continue to exist, untethered from the statute or any constitutive corporate document. In other words, [i]f the excess directors are not eliminated, then for a time EMAK will have a greater number of directors serving than what the Bylaws provide, which cannot occur under Section 141(b). For good measure, Vice Chancellor Laster also noted some practical issues created by Crown s bylaw amendments. For example, [q]uorum requirements would be impossible to apply if the number of directors could exceed the number of directorships. Next, the Vice Chancellor observed that, under the DGCL, stockholders wishing to seat new directors between annual meetings, either at a special meeting or by acting by written consent, must first remove sitting directors and then fill the resulting vacancies. Because the second of Crown s proposed bylaw amendments provides that if the number of directors in office is greater than three, then a special meeting of stockholders will be called at which one director will be elected by the common stockholders who shall be the successor to all directors previously elected by the common stockholders, the amendment is invalid inasmuch as stockholders cannot end a director s term prematurely by purporting to elect the director s successor early. Conclusion There are numerous methods that unhappy stockholders or acquisitive companies can pursue to gain control of a company s board of directors. Clever and experienced practitioners understand how to parse the terms of certificates of incorporation and bylaws, searching for faulty defenses or loopholes by which to gain an advantage. But one important lesson of Kurz v. Holbrook is that Delaware courts will strictly adhere to statutory language when adjudicating disputes arising from election contests. Although the technique pursued by Crown and its allies to take over the EMAK board was certainly clever, it simply did not pass muster under a long-standing principle of Delaware corporate law that a sitting director cannot be removed by a reduction in the size of the board, whether via a bylaw amendment or otherwise. 5 The latter possibility has arisen in the case of uncontested elections for boards of companies that have adopted a majority (as opposed to a plurality) voting standard. 4

5 Please feel free to discuss any aspect of this Client Alert with your regular Milbank contacts or with any of the members of our Corporate Governance Group, whose names and contact information are provided below. Beijing Units 05-06, 15th Floor, Tower 2 China Central Place, 79 Jianguo Road, Chaoyang District Beijing , China Anthony Root aroot@milbank.com Edward Sun esun@milbank.com Frankfurt Taunusanlage Frankfurt am Main, Germany Norbert Rieger nrieger@milbank.com Hong Kong 3007 Alexandra House, 18 Chater Road Central, Hong Kong Anthony Root aroot@milbank.com Joshua Zimmerman jzimmerman@milbank.com London 10 Gresham Street London EC2V 7JD, England Stuart Harray sharray@milbank.com Thomas Siebens tsiebens@milbank.com Los Angeles 601 South Figueroa Street Los Angeles, CA Ken Baronsky kbaronsky@milbank.com Neil Wertlieb nwertlieb@milbank.com Munich Maximilianstrasse 15 (Maximilianhoefe) Munich, Germany Peter Nussbaum pnussbaum@milbank.com New York One Chase Manhattan Plaza New York, NY Scott Edelman sedelman@milbank.com Roland Hlawaty rhlawaty@milbank.com Thomas Janson tjanson@milbank.com Robert Reder rreder@milbank.com Alan Stone astone@milbank.com Douglas Tanner dtanner@milbank.com Singapore 30 Raffles Place, #14-00 Chevron House Singapore David Zemans dzemans@milbank.com Naomi Ishikawa nishikawa@milbank.com Tokyo 21F Midtown Tower, Akasaka, Minato-ku Tokyo Japan Darrel Holstein dholstein@milbank.com Washington, DC International Square Building, 1850 K Street Washington, DC Glenn Gerstell gerstell@milbank.com 5