Private Company Proxy Contest – Legal Basis

Is it possible for your closely held business to become the subject of a private company proxy contest?

Contrast with Public Companies

I ended the first part of this blog by noting that changes in control of public companies may be effected by purchasing publicly traded equity from the company's owners and thereby outflanking management; the new owner of that equity thereupon has the power to replace old management with management of his choosing; BUT private companies generally guard themselves against this maneuver by ownership transferability restrictions in their governing instruments.

As a result, an outsider — or a dissident insider who craves seizing control of the company, but is disfavored by existing management supported by the other owners — is easily frustrated from acquiring economic control and accompanying voting control of the privately held entity.

But another way to seize control of a public company is by acquiring only the voting power of its outstanding equity by means of a proxy contest.  Armed with the the power to vote a controlling percentage of the ownership equity, an outsider or dissident insider can replace existing management with his own selected management group.  Or he can impose his will indirectly, by exercising that voting power to compel existing management to accede to fundamental changes that, in the absence of that concentrated voting control, they would refuse to take.

Why Private Companies Can Be Vulnerable To a Proxy Attack

An outsider, or dissident insider, of a privately held corporation, partnership or LLC who wants to change management, force the entity's dissolution, merger or sale of assets, or otherwise take control of a company he thinks is being mismanaged, frequently cannot overcome the restrictions against transferability of ownership interests.  To do so might require bringing and winning a lawsuit over the validity of those restrictions, or making an offer to buy out the entire company, or at least a majority of its ownership interest, on financial terms that would result in a windfall to the existing owners and a financial sinkhole to the buyer [which, by the way, is yet another reason for those transferability restrictions: like poison pills and antitakeover bylaw provisions for public companies, transferability restrictions compel a potential acquirer to negotiate with existing management or to overpay existing owners to persuade them to amend or lift the restrictions].

But the contractual transferability restrictions generally set forth in private companies' governing instruments are almost always limited to the sale, gift, pledge or other transfer of a part or all of the economic interest of the ownership interests.

What is rarely covered by those restrictions — or any other limitation in the governing agreements, especially those of partnerships and LLCs— is the granting of a proxy to exercise the voting or participation in management rights of the ownership interests.

The first key to understanding why this gap exists, is found in the state statutes under which partnerships and LLCs are created, operated and governed.

Texas Statutes on Proxies

In Texas, the statutory rules regarding proxies are found in the Texas Business Organizations Code (TBOC).  The general rule is found in Section 6.151: Voting of ownership interests in a Texas corporation, partnership or LLC is determined by the entity's governing documents, EXCEPT TO THE EXTENT the provisions of the TBOC specifically applicable to that type of entity require otherwise.

Corporate Proxies

As one would expect, the corporations part of the TBOC contains the most extensive and binding rules on proxy use.  Sections 21.367 through .370 govern voting by proxy, revocability of a proxy, enforceability and term of a proxy.  The most significant point here is that the statute guarantees that a shareholder is entitled to vote either in person or by proxy.

A corporate proxy is limited in duration (11 months, unless otherwise expressly provided in the proxy itself) and is revocable unless stated otherwise in the proxy AND the proxy is "coupled with an interest."

What does that mean?

It means that the shareholder who grants an "irrevocable" proxy cannot later change his mind and revoke it, provided that the grant is "coupled" with one of the interests (enumerated in the statute) of the grantee or the person on whose behalf the grantee is acting.  Some of those listed interests do not concern me here; for example, a contract to sell the underlying shares or  pledge of the underlying shares is a valid interest to support a proxy's irrevocability, but the transferability restrictions under consideration here apply to sales and pledges.  Two recognized interests that may operate even in the presence of typical transferability restrictions are those of a creditor to the corporation (not the shareholder) and a party to a shareholders agreement or voting agreement.

Partnership Proxies

The simplest category, because there are NO statutory rules about voting or consenting as a general partner or a limited partner.  All such matters are left to the owners to address in their partnership agreement.

LLC Proxies

LLCs lie somewhere between corporations and partnerships.

Like corporations, there ARE default statutory rules (Sections 101.351 et seq.) which provide that each member has an equal vote with every other member on matters upon which members are entitled to vote (whether by the terms of the company agreement or the default rules of the TBOC).  And there is a default rule (Section 101.357) that entitles a member to vote in person or pursuant to a signed proxy.

Unlike corporations, there are NO conditions or limitations set by the statute about a proxy's duration or revocability or irrevocability.

Like partnerships, what matters members are entitled to vote upon, the manner in which votes may be cast,  what constitutes a quorum for acting on a matter, and what minimum vote is necessary to approve a matter, are subject to the members' agreement as expressed in their company agreement.  The statutory rules cited above apply ONLY if the company agreement is silent on those topics (which is why we refer to those rules as "default" rules).

 Delaware Statutes on Proxies

Unlike Texas, Delaware has not aggregated its business organizations statues within a single code.

Corporate Proxies

The Delaware General Corporation Law (DGCL) Section 212 covers voting by proxy.  Proxies are generally valid for three years and are only irrevocable if coupled with an interest "sufficient in law to support an irrevocable power."   However, Delaware recognizes a broader range of interests sufficient to support an irrevocable proxy than does Texas, because Section 212 provides that the coupled interest may be "an interest in the stock itself or an interest in the corporation generally."

Partnership Proxies

Delaware's Limited Partnership act provides in Section 17-302(e) that unless otherwise provided in the partnership agreement, the limited partners may vote in person or by proxy upon any matter they have the right to vote on.    Like Texas statutory law, there are no requirements or conditions on the proxy.

Delaware's Revised Uniform Partnership Act provides in Section 15- 407(d) virtually identical language regarding voting in person or by proxy.

LLC Proxies

Delaware's Limited Liability Company Act is modeled upon its Limited Partnership act, which explains why Section 18-302(d) contains voting language virtually identical with Limited Partnership act 17-302(e).

Summary

The governing documents of private entities should and usually do contain restrictions on the transferability of the economic interests of owners, but as I will show in the next installment of this blog series, those agreements rarely address the transferability of the voting powers of owners.   The Texas and Delaware statutes concerning partnerships, limited partnerships and LLCs in general leave owner voting procedures to be set forth, as the owners agree, in the governing documents of their entities, although both states establish "default" provisions in some cases  to govern in the event the governing documents omit to address that topic or the owners fail to enter into written governing documents for their entities.  Corporations differ significantly from partnerships and LLCs on this matter, as the state statute entitles equity owners to vote by proxy and set forth certain requirements for proxies which cannot be modified by agreement of the owners.

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