How Not to Neutralize Boardroom Dissidents
from May/June 2003
by John R. Engen
Increasing the number of management-friendly members of the board might seem like a neat way to dilute the influence of dissident directors. Think again. Liquid Audio, an online music distributor, tried it, and Delaware’s chancery court backed the company when the dissidents protested. But the Delaware supreme court thought otherwise, and in January declared that the tactic was a no-no.
Founded by former Grateful Dead sound engineer Gerald Kearby, Liquid Audio went public in 1999, and its stock soared to $49.25 by the end of that year. But while the Redwood City, California, company was good at raising money—its balance sheet boasted $80 million in cash as of last June—it never turned a profit and was soon burning greenbacks at a $2 million-a-month clip. Some of the shareholders began agitating for Liquid to be liquidated. In late 2001 investor Seymour Holtzman’s MM Companies Inc., owner of some 7% of the stock, offered about $3 per share for the company, which was then trading in the $2.50 range. His goal was to divvy up whatever cash was left among shareholders. He says he never got a response to his proposal.
With the backing of other big investors, Holtzman and his partner, James Mitarotonda, decided to run for the two board seats that would come up for election in 2002, one of them held by Kearby, the chairman and CEO. And that’s when things got complicated. Last June, just three days after MM formally filed its proxy materials, Liquid’s board announced a merger with Alliance Entertainment Corp., a Coral Springs, Florida, distributor of CDs and videos, and postponed its July annual meeting “indefinitely.”
The dissidents, fearful that Liquid’s shareholders were getting shortchanged by the deal, kept pressing. And by August it was clear that they would win the election, which a court ordered rescheduled for September. So the directors amended the bylaws, increasing the board’s size to seven and naming two allies to those extra seats.
As expected, Holtzman and Mitarotonda both won handily with 81% of the vote, ousting Kearby and director Raymond Doig, a former CEO of 20th Century Fox International. With two more seats coming up for election the following year, it looked as though shareholders would soon be handing control of the company over to dissidents. The ploy of adding two management-friendly directors would at least delay the inevitable.
The dissidents sued and lost their case in chancery court, but won on appeal in the Delaware supreme court, which ruled that while it’s legal for a board to amend its bylaws and add directors, Liquid’s timing clearly had the “primary purpose of diminishing the influence of MM’s two nominees.” Adding directors “for the primary purpose of impeding and interfering with the efforts of the stockholders’ power to effectively exercise their voting rights in a contested election” runs “contrary to established principles of corporate democracy . . . and may not be permitted to stand,” the court ruled.
Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware, says the ruling codifies what had long been assumed—“that the courts would look askance at such an expansion. The message here is, you can’t use the size of the board to frustrate the intent of a shareholder election.”
Relations between the three original and two new directors have been uneasy at times, says Holtzman. For one thing, while Kearby left the company in November to become a consultant, his job as CEO has been temporarily taken by none other than Doig. The chairman’s job remains to be filled.
“Life is full of compromises,” Holtzman says with a chuckle. He should have a smile on his face, given that what he pushed for has taken place: The company has distributed $55 million of its cash hoard to shareholders, which works out to $2.50 a share. It has also pulled in $3 million from the sale of its music-distribution technology and certain R&D know-how to a new subsidiary of Anderson Merchandisers.
Small-world department: The head of that subsidiary is Gerald Kearby.
