Delaware Chancery Court Holds Appraisal Rights Are Lost When Shares Are Transferred From DTC to Custodial Banks’ Nominees
Originally appeared in Kaye Scholer’s Summer 2015 M&A and Corporate Governance Newsletter.
—By Nicholas O'Keefe
In a recent appraisal proceeding, Vice Chancellor Laster held that institutional shareholders lost their appraisal rights when title to their shares was transferred from Cede & Co. (DTC’s nominee) to nominees of the custodial banks through which the institutions’ shares were held. See In re Appraisal of Dell Inc., C.A. No. 9322-VCL (July 13, 2015). In granting summary judgment for Dell, Vice Chancellor Laster held that retitling the shares in the names of the custodial banks violated the “Continuous Holder Requirement” (described below) under Delaware’s appraisal statute. However, in lengthy dicta, Vice Chancellor Laster explained that his hands were tied by Delaware Supreme Court precedent. Vice Chancellor Laster urged the Supreme Court to treat DTC participants as record holders and the DTC position list as part of the corporation’s books and records, for purposes of interpreting the appraisal statute.
The decision involved an appraisal action by five institutions in connection with Dell’s 2013 going-private transaction. The institutions held shares of Dell common stock in street name through custodial banks. The shares were therefore reflected on Dell’s stock transfer records as being held of record by Cede & Co., DTC’s nominee. In order to exercise appraisal rights, as explained further below, the five institutions had to cause DTC to demand appraisal on their behalf.
In accordance with its customary procedures for appraisal shares (to avoid inadvertently surrendering the shares for merger consideration), DTC removed the shares from the DTC FAST Account and caused physical stock certificates to be delivered to the custodial banks. The physical stock certificates could have been issued in the name of Cede & Co. However, the custodial banks had internal procedures that only permitted them to hold stock certificates issued in the names of the banks’ own nominees. As a result, the custodial banks arranged for Dell’s transfer agent to reissue the stock certificates in the names of their respective nominees.
The “Continuous Holder Requirement”
Section 262 of the Delaware General Corporation Law (DGCL) sets forth the statutory requirements for exercising appraisal claims in mergers involving Delaware corporations, like Dell. Only “holders of record” are entitled to exercise appraisal rights (known as the “Record Holder Requirement”). In order for holders of record to pursue appraisal claims for their shares, they must have “continuously [held] such shares [from the date of making an appraisal demand] through the effective date of the merger” (known as the “Continuous Holder Requirement”).
The summary judgment motion turned on the implications of changing the name on the share certificates from DTC’s nominee to the custodial banks’ nominees. Vice Chancellor Laster first looked at the meaning of “holder of record,” and noted that it was not defined under the appraisal statute or any other provision of the DGCL. Vice Chancellor Laster noted that Chancery Court precedent equated it to “the person appearing on the corporate records as the owner of stock in the corporation.” See Engel c. Magnavox Co., 1976 WL 1705 (Del. Ch. Apr. 22, 1976). He then considered what the “records” of the corporation are for purposes of determining legal ownership.
Whether “Records” Include DTC Position List for Purposes of Determining “Holders of Record”
Vice Chancellor Laster noted that if the only relevant records are those maintained by Dell or its Transfer Agent, then Dell was entitled to summary judgment because retitling the shares caused record ownership to change. Vice Chancellor Laster then engaged in a lengthy explanation of why the term “records” should include the DTC position list. According to Vice Chancellor Laster, such an approach would appropriately recognize the role of DTC and the DTC position list, which are integral parts of the federal share immobilization policy that was adopted in response to a paperwork crisis in the late 1960s and early 1970s that threatened to overwhelm US securities markets.
Vice Chancellor Laster noted that he previously considered whether DTC participants could be treated as holders of record, in the context of whether shares they held could be voted without a DTC omnibus proxy, in Kurz v. Holbrook, 989 A.2d 140 (Del. Ch. 2010). Reversing on appeal on other grounds, the Supreme Court characterized the discussion as dictum, and indicated that the topic required a legislative cure. In Dell, Vice Chancellor Laster stated that he disagreed with the Supreme Court’s views that a legislative cure was required, and that “what constitutes the records of the corporation for purposes of determining who is a “holder of record” is a quintessential issue of statutory interpretation appropriate for the judiciary to address.”
Early Precedent, Which Invoked Need for Certainty and Ability of Shareholders to Hold Shares Directly, Predated Federal Policy of Share Immobilization Through DTC
Vice Chancellor Laster then reviewed the relevant jurisprudential history. He discussed the decision in Schenck v. Salt Dome Oil Corp., 34 A.2d 249 (Del. Ch. 1943), rev’d, 41 A.2d 583 (Del. 1945), where the Supreme Court held that only a registered stockholder, and not a beneficial owner, was entitled to exercise appraisal rights. The Supreme Court in that case invoked the need for certainty, and reasoned that where shares were beneficially held through a broker, the decision to use a broker was a voluntary one, and thus the customer should bear the risks of that decision.
Vice Chancellor Laster noted that the Salt Dome decision predated the formation of DTC by three decades, and did not anticipate the compulsory nature of DTC’s role. In addition, the Salt Dome decision did not consider what documents might encompass the appropriate records for determining registered status and whether, after formation of DTC, they might include the DTC position list. Vice Chancellor Laster then discussed the decision in Olivetti Underwood Corp. v. Jacques Coe & Co., 217 A.2d 683 (Del. 1966), in which the Supreme Court expanded its decision to Salt Dome by stating that corporations “should avoid becoming involved in the affairs of registered stockholders vis-à-vis beneficial owners.” Id. at 686.
Vice Chancellor Laster noted that the 1967 revisions to the DGCL, which codified the Record Holder Requirement, incorporated the qualifications and limitations in the above case law. In addition, the 1967 amendments did not specify what constitute the appropriate records for determining who the stockholders of record are. The 1967 revisions predated the federal policy of share immobilization. According to Vice Chancellor Laster, in the 1970s, as “the SEC implemented the federal policy of share immobilization . . . Delaware decisions largely ignored this development . . . and treated [DTC] as a matter of convenience that resulted exclusively from the private contractual relationship between a broker and its clients.”
Supreme Court Missed Opportunity to Adopt New Approach in Enstar
In the appraisal decision Enstar Corp. v. Senouf, 535 A.2d 1351 (Del. 1987), the Supreme Court continued to adhere to precedent and treated the failure by holders in street name to cause Cede & Co. to make an appraisal demand as a failure of the brokers through which they held their shares, which was not the corporation’s concern. The Supreme Court continued to view ownership through DTC as the shareholder’s choice, and not as a necessary consequence of the federal policy of share immobilization.
Vice Chancellor Laster criticized the approach taken by the Enstar court on several grounds. First, although “it is true theoretically that any particular investor could opt out of the depository system and chose to hold in record name, only a few could do so before the system would break down. . . . The system was imposed by Congress and the SEC, and almost-universal participation is a de facto requirement.” Second, the Supreme Court in Enstar viewed DTC as only imposing costs on the corporation but did not recognize the benefits the corporation received through DTC having enabled public securities markets to operate. Third, the Supreme Court reiterated the Salt Dome court’s concern about the difficulties corporations would face in having to look beyond the stock ledger, even though the DTC position list was readily available. Finally, the Supreme Court in Enstar asserted that the nominee relationship was not a concern for the merging corporation. This ignored the fact that when a public corporation’s shareholders vote on a merger, the corporation must go through DTC to undertake a broker search for purposes of mailing proxy materials.
Vice Chancellor Laster viewed the Enstar decision as a missed opportunity to update Delaware law so that the law appropriately reflected the role of DTC. Vice Chancellor Laster noted, however, that the Enstar court did not rule on whether DTC participants should be treated as record holders, and the court did seem to view construing the Record Holder Requirement as an appropriate exercise of judicial authority.
Treating DTC Participants as Record Holders Could Lead to Judicial Developments in Appraisal Arbitrage Cases
Vice Chancellor Laster also briefly discussed the rise of appraisal arbitrage following the holding in In re Appraisal of Transkaryotic Therapies, Inc., 2007 WL 1378345 (Del. Ch. May 2, 2007), that funds that bought shares after the record date for the merger could seek appraisal for those shares without having to show that the shares were not voted in favor of the merger. The holding turned on the fact that Cede & Co. remained the record holder throughout the relevant period. The actions of the appraisal arbitrage fund, as beneficial holder, were irrelevant. Vice Chancellor Laster noted that looking through DTC would not eliminate the ability to seek appraisal for shares acquired after the record date. He expressed his view that appraisal arbitrage may be beneficial in a free market economy and should not be legally prohibited. Vice Chancellor Laster stated that looking through to DTC’s participants would nonetheless be an improvement on the current legal approach. If DTC participants were treated as holders of record, a more nuanced jurisprudence could be developed. For example, if a block of shares was purchased from a broker, it may be possible to verify how those shares were voted, for purposes of determining compliance with the appraisal statute’s requirement that appraisal shares should not have been voted in favor of the merger.
Vice Chancellor Laster concluded that under current law, Dell’s motion for summary judgment had to be granted. However, he made clear that if he were not encumbered by precedent, he would hold that the concept of a “stockholder of record” includes the DTC position list, which may have led to a different result.
The Dell decision has a number of implications:
- First, Delaware corporations in appraisal proceedings should inquire as to whether appraisal petitioners have similarly transferred title to shares from Cede & Co. to another entity in violation of the Continuous Holder Requirement. After the Dell decision, appraisal petitioners are likely to be attuned to the risks of doing so. However, there may be appraisal actions that predate the Dell decision where such transfers have taken place.
- Second, custodial banks should consider re¬examining their policies regarding holding stock certificates issued in the name of Cede & Co. Custodial banks will presumably want to avoid alienating their customers by requiring certificates to be retitled, where doing so will result in the loss of appraisal rights, as it did in Dell.
- Third, Vice Chancellor Laster’s opinion was an express invitation to the Delaware Supreme Court to adopt a new approach. It will be interesting to see whether the Supreme Court does so, if this decision is appealed. If the Supreme Court does endorse Vice Chancellor Laster’s views, it will have implications not only for appraisal proceedings, but also for the proxy voting process.
- Fourth, Vice Chancellor Laster noted that his proposed changes in case law would not prevent appraisal arbitrage funds from seeking appraisal with respect to shares purchased after the record date. The decision is, therefore, unlikely to have much of an impact on the appraisal arbitrage industry. Moreover, Vice Chancellor Laster’s statements that he views appraisal arbitrage as a beneficial activity may even provide tacit encouragement to additional fund sponsors looking to get into the appraisal arbitrage business.