Yesterday’s post concerned the Court of Appeal’s opinion in Busse v. United Panam Financial Corp., 2014 Cal. App. LEXIS 11 (Cal. App. 4th Dist. Jan. 8, 2014) holding that shareholders may not pursue monetary damages under Section 1312(b) of the California Corporations Code. That statute applies if “one of the parties to a reorganization or short-form merger is directly or indirectly controlled by, or under common control with, another party to the reorganization or short-form merger”. The Court of Appeal found that the plaintiffs had sufficiently alleged common control by averring that on defendant controlled about 40% of the company’s stock. In reaching, this conclusion, the court looked to Hellum v. Breyer, 194 Cal. App. 4th 1300 (2011), a case arising under the Corporate Securities Law of 1968, not the General Corporation Law. See Court Rejects Control Requirement For Director Liability.
The Court does not mention Section 160 which contains two definitions of “control” for purposes of the GCL:
(a) Except as provided in subdivision (b), “control” means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a corporation.
(b) “Control” in Sections 181, 1001, and 1200 means the ownership directly or indirectly of shares or equity securities possessing more than 50 percent of the voting power of a domestic corporation, a foreign corporation, or another business entity.
Thus, the test for ”control” under Section 1312(b) is “factual control of one corporation by another or by an individual and not any specified percentage ownership of voting shares . . .”. Busse involved an appeal from a demurrer. Thus, neither the trial court nor the Court of Appeal made a factual finding of common control. However, the Court of Appeal did conclude that the plaintiffs’ allegations of common control were sufficient. In doing so, the Court of Appeal cited the plaintiffs’ allegations that one of the individual defendants personally controlled 40% of the merging corporation’s shares. But does 40% ownership necessarily equate to the possession of the power to direct or cause the direction of the management and policies of a corporation?
Because Section 300(a) of the Corporations Code requires that the business and affairs of a corporation be by or under the direction of the board of directors, control under Section 160(a) must mean the power to control the board. If you control the board, then you have the power to direct or cause the direction of the management and policies of a corporation. So, how many seats does a 40% stake get a shareholder? Like all good legal questions, the answer is that it depends.
If straight voting is applied, the holder(s) of a majority of the outstanding shares will be able to elect the entire board. Thus, it is entirely possible that a 40% owner would have elected no directors. Of course, this ignores both apathy and the costs associated with collective action. If some or all of the other shares are not voted (i.e., shareholder apathy), then 40% may well be able to vote in the entire board. Similarly, the other shareholders may find it difficult or costly to act collectively. In fact, the Court of Appeal noted this factor in Busse: “A person who owns 40% of a company with the rest of the ownership not concentrated in any rival can easily put his allies on the board” (footnote omitted). As discussed Don’t Be a Dummy – Measuring Shareholder Voting Power, relative voting power can be measured by the number of times that a shareholder can change a losing coalition into a winning combination or vice versa. Using this analysis, it is possible for shareholders to have the same voting power even though they hold different numbers of shares.
According to the Court of Appeal, the corporation “may, or may not, have had cumulative voting for its board of directors.” When cumulative voting is in effect, the math becomes more complicated. Assuming a five member board, the number of votes required to elect a majority (i.e., three) directors is determined as follows:
X = (S * D/N+1 ) + 1 vote
In this equation, S is the number of shares voting, D is a specified number of directors to be elected, and N is the total number of directors to be elected. To keep the math easy, assume that 100 shares are voted, then this equation results in 51 votes being needed to elect three directors (100*3/6) + 1 vote). Thus a holder of 40 shares (votes) would could only elect a minority of the board. For an anomalous result involving cumulative voting, see An Unexpected Impasse.