The Delaware Chancery Court recently held that it is empowered under Delaware statutory law to "appoint a custodian where, because of a deadlock, the shareholders fail to elect a sufficient number of directors to constitute a quorum of the board." The court further addressed the role a custodian should play in such circumstances.
Cumberland Farms, a family-owned Delaware retail corporation, had a board of directors initially comprised of four siblings, each of whom owned 25% of the company's voting stock. As a result of a voluntary reorganization of the company, five representatives of the company's unsecured creditors were appointed to the board, with their terms expiring at the end of 1998. At that time, the siblings disagreed on the number and composition of directors that should serve on the board; two siblings favored the four family members only as directors, while the other two siblings favored continuation of the nine member board, comprised of both family and outside directors. Consequently, the 1998 annual stockholders' meeting resulted in a shareholder deadlock on the appointment of any directors, and the nine incumbent directors continued in office. During 1999, the five outside directors departed the board, leaving the four family members as holdover directors.
When the 1999 annual shareholders meeting was canceled after two of the four siblings refused to attend it, the remaining two siblings filed suit in Delaware Chancery Court seeking, inter alia, the appointment of a custodian for the deadlocked corporation under 8 Delaware Code § 226(a)(1). That section empowers the Chancery Court to appoint a custodian for a Delaware corporation when "[a]t any meeting held for the election of directors the stockholders are so divided that they have failed to elect successors to the directors whose terms of office have expired or would have expired upon qualification of their successors . . . ." Defendants then moved to dismiss the complaint, and plaintiffs cross moved for partial summary judgment on the appointment of a custodian.
Rather than rule on the merits of the motions, the Delaware Chancery Court directed the parties to conduct a shareholders' meeting to elect directors. At the scheduled meeting, the plaintiff siblings were re-elected to the board, while the defendant siblings were not, resulting in their continuation as holdover directors. The plaintiff siblings then renewed their motion for partial summary judgment, asserting that the shareholders' failure to elect two of the four directors warranted the appointment of a custodian under 8 Delaware Code § 226(a)(1). Defendants, however, contended that a custodian could not be appointed, since the statute only allows for such appointment where there is a compete failure to elect any directors.
Rejecting the defendants' contention, the Delaware Chancery Court ruled that the shareholders' failure to elect some, but not all, of the directors was sufficient to empower it to grant custodianship relief under Section 226(a)(1). First, the court observed that there is no language in the statute that "fairly lends itself to, let alone compels, the defendants' construction" that a complete failure to elect all directors is a precondition to the appointment of a custodian. Rather, the court noted that the statutory language permits the appointment of a custodian when there is a failure to elect a "smaller subset" of all directors, i.e., "directors whose terms have expired or would have expired upon qualification of their successors."
Second, the court explained that the statutory history of Section 226(a)(1), the statutory governance scheme of which it is a part, and the public policy that underlies the statutory scheme support its construction of the statute. Specifically, the court stated that amendments to Section 226 reflect that it authorizes the appointment of a custodian where the shareholders fail to elect a sufficient number of directors to constitute a quorum of the board. The court further noted that the statutory governance scheme directs that corporations be governed by a board, that directors comprising the board be elected annually, that the court may order a meeting to elect directors if such election has not occurred within 13 months, and that a custodian may be appointed if the shareholders' attempt to elect successive directors is ineffective. In addition, the court noted that the public policy underlying the statutory scheme is to ensure that corporations are governed by directors who were elected by the stockholders in an annual election, for "[o]nly in that way can the directors' continued accountability to shareholders, and the legitimacy of their decisions that bind the corporation's stockholders, be assured."
Finally, the court stated that its construction of the statute "more faithfully carries out the statute's purpose, which is to afford '. . .a viable remedy for the injustices arising from a shareholder deadlock which permits control of a corporation to remain indefinitely in the hands of a self-perpetuating board of directors . . .'" Thus, the court granted plaintiffs' motion for partial summary judgment and appointed a custodian for the corporation.
The court then provided guidance on the role the custodian is to play in the corporation. According to the court, the custodian's role "is to assure that the board functions properly where because of a deadlock the shareholders have failed to elect a quorum of directors." The court stated that the custodian must be present and cast a vote at board meetings "where the board would otherwise be incapable of acting, either because the directors are equally divided on a particular proposal, or because the absence of directors threatens to defeat a quorum." Moreover, the court stated that the custodian must intervene and cast a vote only in disputes that he or she deems in good faith to be significant to managing the corporation's business and affairs. *
Bentas v. Haseotes, No. 117223, 2000 WL 364204 (Del. Ch. Mar. 9, 2000).