Kurz v. Holbrook: Record Ownership and the SEC

We did a lengthy discussion of the Chancery Court's recent opinion in Kurz v. Holbrook.  The decision contains a lengthy discussion of the voting system for street name owners.  One of the interesting asides concerns the interpretation of record ownership at the federal level.  The opinion noted that under federal law, companies must register with the Commission to the extent having "500 or more record holders of a class" of equity securities and that in counting equity securities, "DTC does not count as a single holder of record." 

Section 12(g) requires companies with 500 shareholders and $10 million (as modified in Rule 12g-1) in assets to register with the Commission.  In counting that number, the statutory language of Section 12(g) refers to equity securities "held of record."  Held of record in turn is defined in Rule 12g5-1.  The rule contains a number of counting rules (dealing, for example, with shares held in more than one name or by an entity).  The rule also provided that:  

• Securities identified as held of record by one or more persons as trustees, executors, guardians, custodians or in other fiduciary capacities with respect to a single trust, estate or account shall be included as held of record by one person.

In other words, it is the custodian, not the beneficiaries, who count for purposes of record ownership.  Adopted in 1965, see Exchange Act Release No. 7492 (Jan. 5, 1965), long before the widespread use of depositories, the rule seemed to explicitly count depositories as a single record owner.  

Nonetheless, the staff of the Commission relied on the same language in Rule 12g5-1 to conclude that depository participants, rather than the depositories themselves, counted as record owners. 

• Rule 12g5-1 defines “held of record” for purposes of Exchange Act Section 12(g) and 15(d). It is the counting rule for determining whether an issuer has sufficient security holders to become or remain subject to Section 12(g) and to remain subject to Section 15(d). Rule 12g5-1(a)(3) provides a special counting method for securities held in a custodial capacity for a single trust, estate or account. In such a case, each trust, estate or account is a distinct holder of record for purposes of Sections 12(g) and 15(d). Institutional custodians, such as Cede & Co. and other commercial depositories, are not single holders of record for purposes of the Exchange Act’s registration and periodic reporting provisions. Instead, each of the depository’s accounts for which the securities are held is a single record holder.

There was no analysis and no support.  The position (a phone interpretation) merely stated, by staff fiat, that the counting rules looked through the depositories.  In addition to conflicting with the language of the rule, the position also seemed inconsistent with other Commission pronouncements.  See In re BACARDI CORPORATION, Exchange Act No. 27255 (admin proc Sept. 18, 1989)("The emphasis in both the statute and the rule is not on the term 'persons,' but on 'persons identified as stockholders on the issuer's records.' Thus, extrinsic evidence contradicting those records is irrelevant under the above provisions."). 

The same rule did not, of course, apply to street name owners.   

• In contrast, securities held in street name by a broker-dealer are held of record under the rule only by the broker-dealer. The Commission originally proposed a version of the rule that would have looked through to the beneficial owners of the street-name securities, but adopted the rule in a form that does not produce this result.

This position has been criticized and challenged.  See Exchange Act Release No. 53385 (Feb. 28, 2006)("The substantial increase in securities held by nominees or in street name has led to the circumvention of the intention of Section 12(g) by enabling issuers with a significant number of shareholders to avoid registration, or deregister, if their equity holders are aggregated into a smaller number of nominee or record holders."). 

As in Kurz, the two interpretations are inconsistent.  Either a company ought to be limited to the list of record holders (with Cede counting as a single shareholder) or ought to be required to look through to all street name owners. Moreover, there is an illogic to the approach.  In most instances, counting depository participants does not result in a total number of owners even marginally consistent with the actual number of owners.