In Totta v. CCSB Financial Corp., C.A. No. 2021-0173-KSJM (Del. Ch. May 31, 2022) (McCormick, C.), the Delaware Court of Chancery held that a board of directors improperly applied a voting aggregation provision in the company’s charter that disenfranchised several stockholders. In so holding, Chancellor McCormick reinforced that Delaware twice-tests corporate conduct—first for legal validity, then second for equity. The Chancellor also emphasized that, unless specifically authorized by Delaware’s General Corporate Law (DGCL), the contents of a corporation’s charter do not displace directors’ fiduciary obligations or override the court’s “enhanced scrutiny” review for transactions implicating shareholders’ sacrosanct voting rights.
In Totta, an insurgent stockholder (the “Insurgent”) ignited a proxy battle against the board of directors of CCSB Financial Corporation, the holding company for a small community bank in Kansas City. To neutralize this perceived threat, the directors invoked a provision in the company’s charter that prohibited a stockholder, and other stockholders “acting in concert” with that stockholder, from exercising more than 10 percent of the company’s voting power in an election (the “Voting Limitation”). Pursuant to the Voting Limitation, the board determined that the Insurgent, his slate of nominees, and longtime friend of the Insurgent (together, the “Insurgent Group”), all of whom were company stockholders, were acting in concert with each other, and thus the board instructed the inspector of elections not to count 37,175 votes in total. As a result, the incumbent slate of directors won reelection by 698 votes and none of the Insurgent’s nominees were elected.
The Insurgent and his slate of nominees filed suit against the company under 8 Del. C. §225 seeking a declaration that the board’s interpretation of the Voting Limitation improperly disenfranchised the plaintiffs by interfering with their voting rights and otherwise was invalid under equitable principles.
Chancellor McCormick’s review reinforced the principle under Delaware law that director actions are “twice-tested.” Under the first layer of review—asking whether corporate conduct was legally authorized and/or permissible under the corporation’s constitutive documents—the Chancellor determined that the board’s instruction not to count all the votes cast by the Insurgent Group was legally invalid. While the Chancellor agreed that the Voting Limitation could legally be invoked to limit the votes of a stockholder and those acting in concert with that stockholder, it was held that the company had failed to prove that the individuals in the Insurgent Group were, in fact, acting in concert with one another. Accordingly, all their votes should have been counted.
Despite the invalidity of the board’s action, the Chancellor turned to the second layer of review—asking whether the board’s conduct complied with equitable principles. The company argued that the board’s conduct should be reviewed under the business judgment rule, the most deferential standard of review, based on a charter provision stating that any “constructions, applications, or determinations” made by the board “in good faith and on the basis of such information and assistance as was then reasonably available for such purpose shall be conclusive and binding upon the Corporation and its stockholders.” Conversely, the Insurgent and his slate of nominees argued that the board’s conduct should be subject to the Blasius standard of “enhanced scrutiny” review that asks first whether the board acted for the primary purpose of impeding the exercise of stockholder voting power, and second whether the board had a compelling justification for its actions.
The company’s argument was rejected under the well-established principle that when director conduct impacts either an election of directors or a stockholder vote touching matters of corporate control, the board must justify its action under enhanced scrutiny. In so holding, the Chancellor clarified that private ordering in corporate charters can only displace equitable obligations to the extent authorized by the DGCL. For example, DGCL Section 102(b)(7) authorizes corporations to displace equity as it pertains to monetary claims against directors for breach of the fiduciary duty of care. Similarly, in the alternative entity context, Delaware’s partnership and LLC statutes authorize the waiver of fiduciary duties altogether.
In Totta, the absence of authorization in the DGCL for the company to alter equity through a “conclusive and binding” charter provision meant that the court was free to review the board’s conduct consistent with the court’s precedent. Applying the Blasius test, the Chancellor found that the board’s primary purpose in applying the Voting Limitation and instructing the inspector of elections not to count the votes of the Insurgent Group was to interfere with stockholder voting power. Turning then to the second step of the Blasius analysis, the cChancellor found that the board’s sole justification for its actions—to protect shareholders from the Insurgent’s efforts to take control and consider a sale of the bank—was not compelling. The court explained that the decision of whether to elect an Insurgent’s slate of nominees, who presumably would attempt to carry out the Insurgent’s desires, should be made by the company’s stockholders via a vote and not by the board via a decision not to count votes under the Voting Limitation.
A key takeaway from Totta is that Delaware law disfavors conduct by a board and/or company that seeks to disenfranchise stockholders. Although challenged conduct in this arena is not subject to the most stringent level of review under Delaware law (i.e., entire fairness), an enhanced scrutiny review according to the two-step Blasius test has significantly more teeth than the more deferential business judgment standard of review. As the court highlighted in Totta, demonstrating a compelling justification for board action requires, as a general matter, that directors establish a closer fit between means and ends.
Another key takeaway is the reminder that private ordering in constitutive documents, whether in a corporation or an alternative entity, that displaces traditional notions of equity (e.g., fiduciary duties) is based on the legislature’s grant of authority to do so. This authorization is more prevalent in Delaware’s partnership and LLC statutes than in the DGCL, in part due to the recognition by Delaware’s legislature that partnerships and LLCs are, for the most part, creatures of contract.
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*Holly Habyan, a summer associate at McCarter & English not yet admitted to the bar, contributed to this alert.