The Rules of Engagement

In the often rough-and-tumble arena of proxy contests, shareholder democracy sees its most colorful expression. Aggressive campaigns for shareholder votes are punctuated by forceful “fight letters” issued by the combatants, testing the mettle of even the most stalwart boards and reminding all participants that spirited tactics are the order of the day. While proxy contests are habitually bareknuckled, the incumbent slate of director nominees—which often includes one or more officers—enjoys inherent advantages over a dissident slate, particularly due to the support it almost always gets from management. Management can utilize a company’s coffers to finance the incumbents’ proxy campaign and has the levers of the corporate machinery at hand. This enables it to mount an effective public relations campaign, draw on existing relationships with the shareholder base to win votes, and exercise control over the scheduling and conduct of the shareholder meeting at which the fates of the competing slates are sealed.

However, in Portnoy v. Cryo-Cell International Inc., the Delaware Court of Chancery, supported by a rich factual record, recently set aside the results of a contested corporate election and ordered a new vote as a result of incumbent misconduct. The court reasoned that the incumbents’ advantages are accompanied by real responsibilities and that their electioneering tactics, while permitted to be vigorous, must ultimately be tested against their fiduciary duties. Incumbents’ fiduciary duties are prescribed by state law and therefore differ somewhat across jurisdictional lines. However, Delaware figures prominently in the national conversation, since many corporations are chartered in that state and its bench has produced a robust, thoughtful body of case law on the subject.

With sophisticated “say on pay,” majority voting, and bonus “clawback” proposals stealing the headlines last proxy season, the Portnoy decision is notable because it delivers several basic lessons for companies and dissidents alike about the fundamental limits of fair play—and the related legal standards— in contested board elections. The Portnoy decision, which was authored by Vice Chancellor Leo E. Strine, Jr., also furthers the recent trend evidenced by the Delaware courts of reviewing insider moves with a deeply furrowed brow, reminding incumbent boards that the power they have to influence the outcome of contested shareholder votes through tactical maneuvers has its limits.

Portnoy’s Complaint

Cryo-Cell, a struggling public company focused on cryogenic storage—primarily the freezing and preservation of cord blood—faced escalating unrest and the threat of a proxy contest in early 2007, after the company recorded several years of poor results. A shareholder with a significant stake in Cryo-Cell, Andrew Filipowski, seized on incumbents’ fear of losing a proxy contest to cut a deal for himself to be included on the incumbent slate at the company’s 2007 annual meeting. Another shareholder, plaintiff David Portnoy, ran an insurgent slate against the sitting board in a proxy contest. Ultimately, the incumbents prevailed in the election by a narrow margin, following a bruising campaign.

In a post-election suit, Portnoy challenged the seating of the incumbent slate, arguing that the incumbents prevailed in the proxy contest only as a result of the following alleged breaches of their fiduciary duties:

(1) an improper agreement by Cryo- Cell’s board to include Filipowski on the incumbent slate solely as consideration for Filipowski’s agreement to vote for the incumbent board members in the proxy fight rather than as a result of the board’s determination that Filipowski’s election was in the best interests of Cryo-Cell’s shareholders;

(2) an improper promise by Cryo-Cell’s CEO—who was on the incumbent slate herself—that the incumbent board members would, if re-elected, add another Filipowski designee to the board;

(3) a course of conduct by Cryo-Cell’s CEO employing both threats and inducements to influence an important shareholder to support the incumbent slate; and

(4) a self-serving, “falsely justified ‘lunch break’” lasting three hours, orchestrated by Cryo-Cell’s CEO at the annual meeting to give management additional time to gather votes for the incumbent slate.

The court took up each of Portnoy’s allegations in turn, ultimately determining that several instances of inequitable behavior perpetrated by the incumbents compromised the integrity of the election. However, the court did not buy into all of Portnoy’s complaints. For example, it concluded that the deal struck between the board of Cryo- Cell and Filipowski to add him to the incumbent slate in exchange for his support in the proxy fight was acceptable and should not be subjected to a test of “entire fairness,” an elevated standard of review that is difficult to meet, since what Filipowski sought from the arrangement was merely influence on the board of a company in which he held a large stake and, in any event, other shareholders affirmatively voted him into office at the annual meeting. “When stockholders can decide for themselves whether to seat a candidate who obtained a place on a management slate by way of such bargaining, it seems unwise to formulate a standard that involves the potential for excessive and imprecise judicial involvement,” the court wrote.