Under the Delaware General Corporation Law, and the laws of many other states, a merger can be approved by the holders of a simple majority of the outstanding shares of the target corporation entitled to vote on the merger, unless there is a charter provision requiring a higher approval threshold or a separate class vote.
California Corporations Code Section 1201(a)
However, this is not the case under California law, where a majority vote of the outstanding shares is not sufficient to approve a merger. California Corporations Code Section 1201(a) provides that the “principal terms of a reorganization” of a corporation must be approved by the outstanding shares of each class of the corporation’s stock and the definition of “reorganization” set forth in California Corporations Code Section 181 includes a broad range of merger transactions (the exception being a short-form merger between a parent corporation and its subsidiary).
Furthermore, the California Corporations Code does not permit California corporations to vary the separate class-vote requirement of Section 1201(a). Even a class of shares designated as non-voting in a charter document has the right to a separate vote on a merger transaction.
Accordingly, a shareholder or group of shareholders holding the majority of one class of shares can block a proposed merger, regardless of the approval of the corporation’s board of directors and shareholders holding the majority of the corporation’s outstanding shares of all classes.
The dilemma that Section 1201(a) creates often arises when a corporation has one or more classes of shares with liquidation preferences, which is typical in private equity and venture capital funded corporations, and the merger consideration is insufficient to satisfy the liquidation preferences of one or more classes of shares or to permit any distribution to the holders of the corporation’s common stock.
Application to Corporations Incorporated Outside of California
This dilemma doesn’t just affect corporations incorporated under California law. California Corporations Code Section 2115 sets forth a “long-arm statute” which requires corporations incorporated outside of California, but with significant California contacts, to comply with various requirements of the California Corporations Code ordinarily only applicable to California corporations.
An out-of-state private corporation is a so-called “quasi-California corporation” and is subject to Section 2115 if more than half its business during its latest full income year is conducted in California, as determined by a statutory formula weighing the corporation’s property, payroll and sales and more than 50 percent of the corporation’s outstanding voting securities are held of record by persons having addresses in California. See Locke Lord QuickStudy: Quasi-California Corporations - The Application of California’s Long-Arm Statute in Mergers and Acquisitions, October 29, 2014.
Strategies for Addressing California’s Separate Class-Vote Requirement for Mergers
Corporations subject to Section 1201(a) through advance planning may find solutions in mechanisms such as voting agreements, voting trusts or drag-along rights.
- Voting Agreements: California Corporations Code Section 706(a) expressly authorizes the creation of voting agreements. A voting agreement is an agreement between two or more shareholders to vote their shares as provided by the voting agreement. Voting agreements in which one shareholder or a group shareholders agree to vote all of their shares in favor of a merger approved by another shareholder or group of shareholders, are common.
- Drag-Along Rights: Drag-along rights allow a shareholder (usually a majority shareholder or institutional investor) to force the remaining shareholders to accept an offer from a third party to purchase the whole corporation, where the majority shareholder has accepted that offer, on the same terms. The other (usually minority) shareholders are then “dragged along” and forced to sell their shares at the same time and at the same price for each share.
But in the absence of these prophylactic mechanisms, Section 1201(a) can significantly complicate a merger and possibly make its consummation impossible. In these situations, shareholders with liquidation preferences must sometimes allocate part of the merger consideration that they would otherwise receive to holders of classes of shares with junior or no liquidation preferences in order to ensure that the merger receives approval by the requisite class vote. But this sort of deal-making is not always possible, or desirable, and invariably adds a layer of complexity to any merger.