Tuesday, September 19, 2023

Chancery blesses dual-class structure that empowers specific stockholders

By Anne Sherry, J.D.

The Delaware Court of Chancery upheld a governance structure that gave the lion’s share of voting power to two specified stockholders. Because the Delaware corporate statute allows rights to be set by way of a formula, the charter’s means of assigning rights to signatories to a stockholder’s agreement was permissible, and it didn’t matter that the rights were based on the identity of the stockholders instead of the class of stock (Colon v. Bumble, Inc., September 12, 2023, Laster, J.).

Up-C and dual-class explained. The court explained that an Up-C structure allows the public to participate in a company both economically and in governance through Class A shares, while insiders participate economically through their LLC units and in governance through Class B shares. A standard dual-class voting structure also creates two classes of stock, but with different voting rights. In short, “in an Up-C structure, the two classes have the same voting rights but different economic rights … In a dual class voting structure, the two classes have the same economic rights but different voting rights.”

Hybrid approach. In this case, corporate insiders wanted different economic and voting rights. They accomplished this by providing in the corporate charter that each Class A share carries one vote, unless the share is held by a “Principal Stockholder,” in which case it carries ten votes. There are two Principal Stockholders, and they each hold one of the only two Class B shares, which in turn carry the votes the holder would receive if its LLC units were converted into Class B shares. This allows the two Principal Stockholders to exercise over 92 percent of the company’s outstanding voting power.

Stockholder challenge. The plaintiff brought a class-action suit challenging the structure, which the plaintiff said amounts to “identity-based voting” and violates Sections 212(a) and 151(a) of the Delaware General Corporation Law. But the court, after a methodical turn through the workings of the DGCL, held that the structure is valid.

Section 151(a) authorizes a corporation to issue multiple classes of stock and makes clear that these classes may carry the default rights implicitly granted by the DGCL, the default rights specified explicitly in the charter, or whatever special rights the charter sets forth. Section 212(a) provides that if the certificate of incorporation is otherwise silent, then each share of stock carries one vote by default.

In the court’s read of Section 212(a), the provision provides for a default right of one vote per share while acknowledging that the charter can specify a different number. Nothing in the examined DGCL provisions requires the charter to frame the voting power in terms of a specific number of votes per share. The charter can set out a formula or procedure to calculate voting power, and Section 151(a) expressly permits voting rights to depend on facts ascertainable outside of the certificate of incorporation.

In Providence & Worcester Co. v. Baker, 378 A.2d 121 (Del. 1977), the Delaware Supreme Court upheld a scaled voting structure where the voting power of a share depended on the total number of shares that the owner held. (Each stockholder could cast one vote per share for its first 50 shares, then one vote for every 20 shares beyond that, and no stockholder could cast more votes than 25 percent of the total number of issued and outstanding shares.) In other words, the certificate of incorporation departed from the default right of one vote per share to provide for inferior voting rights based on a fact ascertainable outside of the certificate of incorporation: the number of shares that the stockholder held.

The plaintiff actually cited Providence as invalidating the challenged voting structure, arguing that under that case, a corporation cannot create a mechanism that confers different voting power depending on who holds the shares. But at the time Providence was decided, the DGCL did not yet contain the “facts ascertainable” language. Allowing that the Supreme Court’s analysis in Providence was “difficult to parse,” “confusing,” and a “puzzle,” the chancery court said it came to the right result. For purposes of a charter provision that establishes the voting power appurtenant to shares, there is no meaningful distinction between the voting rights of the stockholder and the voting rights of the stock. “We should not dissect [Providence’s] entrails to divine a prediction for future cases that does not make any sense,” the court wrote.

The chancery court also rejected the plaintiff’s argument that if a formula does not create the same outcome for each share in the class, it creates de facto subclasses that violate Section 151(a). The Supreme Court in Providence and the Chancery Court in several other cases have upheld formulas that applied identically across all shares, but created different outcomes for particular shares. The same could be said for other special attributes, like a formula that creates differing conversion rights to effect a poison pill.

The plaintiff attempted to distinguish the other cases by observing that any stockholder had an equal opportunity to gain the superior right; the charters did not create a closed set of stockholders that only insiders could modify. In the court’s view, this argument “intentionally appeals to American cultural ideals like equality of opportunity and resistance to entrenched hierarchies. … In many areas of the law, those noble sentiments could carry weight. They cannot overcome the plain language of the DGCL.”

In closing, however, the court left a door ajar by noting that corporate action in Delaware is “twice tested”: once for legal compliance and again in equity. The court’s decision only speaks to the legal validity of the challenged provisions.

The case is No. 2022-0824-JTL.