Chancery Appoints Custodian to Break Deadlock of Profitable Corporation

In re: Shawe & Elting LLC, C.A. No. 9661-CB (Del. Ch. Aug. 13, 2015).

There are many important principles of Delaware corporate law addressed in this 104-page post-trial opinion, but for the benefit of busy readers, I will highlight those aspects of this decision that have the widest practical applicability to those involved in corporate and commercial litigation.

Background

The factual background of this case involves a company called Transperfect Global, Inc., owned by two 50% stockholders who were also the only two directors of the company.

The primary issue addressed was whether the court should grant a petition to appoint a custodian under DGCL § 226 even though the corporation is highly profitable.  The court found that the state of management of the corporation devolved into one of complete dysfunction between the two directors/stockholders who were also co-CEOs.  The irretrievable deadlocks over significant matters caused the business to suffer and threatened the business with irreparable injury notwithstanding its profitability.

The court found that the requirements of both § 226(a)(1) and § 226(a)(2) were satisfied.  A separate request for dissolution of a LLC subsidiary  pursuant to 6 Del. C. § 18-802 was also granted to dissolve that entity.  DGCL § 273, which provides a summary basis to dissolve a joint venture which is owned 50/50, could not be used because technically speaking, the stockholders in this case were not 50/50 stockholders.  They were 50/50 on a de facto basis, but 1% was actually held by a third party who was controlled by one of the directors/co-CEOs.

Painfully detailed facts take up more than half of the opinion.  The factual background could be the basis for a compelling novel, but for purposes of this brief blog post, I will focus on the most useful legal principles involved.

Key Legal Principles

  • DGCL § 226(a)(1) allows the court to appoint a custodian for a solvent corporation when “at any meeting held for the election of directors the stockholders are so divided that they have failed to allow successors to directors whose terms have expired or would have expired upon qualification of their successors.” This provision does not require irreparable harm as a prerequisite.  The court found that the requirements of this statute were met, but even so, the appointment of a custodian is discretionary.
  • DGCL § 226(a)(2) is slightly different, and allows the court to appoint a custodian for a solvent corporation when the business is suffering or is threatened with irreparable injury because the directors are so divided respecting the management of the corporation that the required vote for an action by the board cannot be obtained, and the stockholders are unable to terminate the division.
  • The court explains in extensive detail why the deadlock on substantive matters was real. The court distinguished at footnote 291 a decision that denied relief under § 226(a) based on the conclusion that the alleged deadlock was caused by one of two directors who “sought to create a deadlock by refusing to consider any issue until the deadlock is resolved.” That opinion concluded that such facts were not the type of conduct that should support the appointment of a custodian, unlike the instant case.
  • The parties in this case engaged in what was described as “mutual hostaging” in which one party refused to agree to any action unless his or her demands were met. [It is not readily apparent how this differs from the facts of the case distinguished at footnote 291 above.] The court distinguished this case from the case at footnote 291 based on the reasoning that the disputes in this case were “genuine, good faith divisions” between the two parties, of a “fundamental and systemic nature on how the company should be managed.”
  • The court discussed other cases where deadlocks existed in a solvent and profitable corporation, and for which custodians were appointed, as well as those instances where a custodian was not appointed. See, e.g., footnotes 320 and 321.
  • In connection with appointing a custodian to evaluate the possible sale of this company, the court provided options including a “Texas shootout”, which is a type of auction in which either party would specify a price, and the other party would have the option to either buy the other’s interest at that specified price or sell his or her own interest at that price.
  • The court explained why it would not exercise its equitable authority to order a dissolution of the company which it had the power to do, for example, in extreme cases as a remedy for breach of fiduciary duty. See footnotes 330 through 335.
  • The articulation of the fiduciary duty of directors is always useful. In this opinion the court reiterated that:

    “Directors of a Delaware corporation owe fiduciary duties of care and loyalty to the corporation and to its stockholders.  The duty of care requires the exercise of an informed business judgment.  The duty of loyalty mandates that the best interest of the corporation and its shareholders takes precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally.  To that end, a director may not allow his self-interest to jeopardize his unyielding obligations to the corporation and its shareholders.  A director must, therefore, exercise good faith in advancing the corporation’s interest.”  (footnotes omitted.)

  • The court held that the breach of fiduciary duty claims were barred by both unclean hands and acquiescence.
  • A separate analysis of the dissolution claim for an LLC subsidiary under § 18-802 is helpful. Also useful is the court’s reference to § 18-402 of the Delaware LLC Act which provides for the majority owner of an LLC or members constituting more than 50% of the LLC to prevail in the absence of any contrary provision in the limited liability agreement.  Also of practical application is a discussion of the distribution of assets upon dissolution of an LLC.[1]

 [1] The court also referred to § 18-804(a) which provides that unless otherwise specified in connection with the dissolution of an LLC, the assets of the company shall be distributed to the company’s creditors and then to its members in connection with the dissolution.

  • Lastly, I want to note a quote of widespread applicability that needs to be credited to The Chancery Daily which referred to a case involving another dysfunctional business relationship in a Chancery decision that was not quoted in this opinion but that The Chancery Daily provided. The quote is as follows:

“The Chief Justice once observed, with respect to business co-managers or co-owners whose relationships have soured, that ‘if people are really good business people . . . you just wonder . . . whether they’re only able to use their brains in some limited compromised way that allows them to make money, then, when they function on a broader dynamic, all their economic rationality and intuition just goes out the window.”

Utilisave, LLC v. Khenin, C.A. No. 7796-CS, Transcript (Del. Ch. Jan. 11, 2013; filed Jan. 15, 2013).  See also more recent decisions in the Khenin case, unrelated to this quote: Utilisave, LLC, et al. v. Mikhail Khenin, C.A. No. 7796-ML, final report 2 (Del. Ch. Aug. 18, 2015).

Scholarship On Delaware Corporate Litigation

Courtesy of a friendly email from Professor Larry Hamermesh, one of Delaware’s favorite corporate law professors, who is also a former Delaware corporate litigator, we have the good professor’s latest scholarship on cutting edge issues regarding Delaware corporate litigation. His latest article, co-authored by Professor Michael L. Wachter, is entitled The Importance of Being Dismissive: The Efficiency Role of Pleading Stage Evaluation of Shareholder Litigation. The abstract of the article follows:

Abstract:

It has been claimed that the risk/reward dynamics of shareholder litigation have encouraged quick settlements with substantial attorneys’ fee awards but no payment to shareholders, regardless of the merits of the case. Fee-shifting charter and bylaw provisions may be too blunt a tool to control agency costs associated with excessive shareholder litigation, and are in any event now prohibited by Delaware statute. We claim, however, that active judicial supervision of public company shareholder litigation at an early stage reduces the costs of frivolous litigation to shareholders by separating meritorious from unmeritorious litigation before the full costs of discovery are incurred. Using procedures and doctrines that have not previously been catalogued and appreciated as a coherent set of interrelated dynamics, the Delaware Court of Chancery has relied on the motion to dismiss as the primary procedural vehicle for accomplishing that early stage triage. Such early stage analysis depends upon consideration of essentially undisputed facts, and upon the availability of such facts to the plaintiff shareholder through sources that compensate for the problem of asymmetric access to relevant information. The motion to dismiss in representative shareholder litigation has thus come to resemble, and substitute for, the motion for summary judgment. The Delaware courts’ atypical demand for, and unusual willingness to consider, extensive facts in resolving motions to dismiss encourage defendants to supply relevant information voluntarily, on a cost efficient basis that avoids largely unlimited discovery. Where time constraints preclude disposition via a motion to dismiss, the motion for expedited discovery must necessarily come to serve the same efficiency promoting functions as the motion to dismiss, and the Court of Chancery has come to apply essentially the same level of substantive factual review of the merits encountered in resolving motions to dismiss. The result is a system in which cases are dismissed or settle at the motion to dismiss stage: from 2011 through 2014, for example, there were only four public company shareholder class or derivative suits in which the Court of Chancery resolved the case after trial. With the likely concentration of deal litigation in the Delaware courts resulting from increasingly prevalent exclusive forum charter and bylaw provisions, the motion to dismiss and the motion to expedite discovery are likely to become even more important in promoting the efficient conduct of shareholder class and derivative litigation involving public companies.

 

Chancery Imposes Fees for Errant Deposition Conduct

The Delaware Court of Chancery recently imposed penalties on a non-Delaware attorney for behavior during a deposition that was not in compliance with the applicable Delaware deposition standards. The letter decision in the matter styled In Re: Shawe & Elting LLC, C.A. No. 9661-CB (Del. Ch. Aug. 14, 2015), provides helpful guidance on the types of obstructionist conduct during a deposition that can be the subject of penalties imposed by the court.

Although such behavior during a deposition may be common in some fora, and in my experience is not often penalized even in Delaware, this ruling provides specific guidelines that can be used by those who have the time, money and inclination to seek enforcement of the rules against those who obstruct depositions or interfere with the questioning during a deposition by both subtle and not-so-subtle “cues” to the deponent, such as speaking objections, “questions to the defending attorney”, and the “nuclear option”–instructing the deponent not to answer a question.

Highlights of this useful ruling include the court’s reliance on the following rules:

  • Court of Chancery Rule 30(d)(1) only condones an instruction to a deponent not to answer a question in three instances: (i) to preserve a privilege; (ii) to enforce a limitation on evidence based on an existing direction by the court; or (iii) to present a motion under Rule 30 (d)(3)[e.g., to seek a protective order].
  • Rule 30(d)(2) provides that: “if the court finds … conduct that has frustrated the fair examination of the deponent, it may impose upon the persons responsible an appropriate sanction, including the reasonable costs and attorney’s fees incurred by any party as a result thereof.”

We have previously included on these pages materials that can be used by those who are interested in the standards applicable to depositions in Delaware cases–even when those depositions are taken outside of Delaware, or when they are taken or defended by non-Delaware attorneys, as in this matter, admitted pro hac vice. See, e.g., here and here. In corporate litigation, it remains common for out-of-state attorneys to be admitted pro hac vice and to take or defend depositions in Delaware cases, but when they do so, they are still bound by the Delaware rules.

The sad reality is that parties or their counsel often do not have the time, or the client’s authorization to spend the money needed to file a motion to compel or related motion to “play policeman” when an attorney interferes with the questioning at a deposition–especially when the obstructions are not as clear-cut as they were in the instant case.

This decision was issued on the day after the court’s 106-page decision addressing substantive matters and granting a request for dissolution in this “business divorce” dispute.

Chancery Declines To Allocate Expert Expenses in Advancement Action

In the third ruling by the Court of Chancery in the advancement action styled Holley v. Nipro Diagnostics, Inc., C.A. No. 9679-VCP (Del. Ch. Aug. 14, 2015), the court addressed a request that expenses for third-party vendors of nearly $300,000 be allocated between a criminal action in which the former CEO pled guilty, and which was not covered by a former advancement order, and an SEC civil suit for insider trading which was covered by an advancement order. The background of this case, which involved a former CEO who pled guilty to insider trading, included requests for advancement of fees and expert expenses in civil actions that the former CEO claimed were not subsumed by his guilty plea. That prior decision, referred to by the court as Holley I, was highlighted on these pages here.

In sum, this short letter ruling declines to determine that the expenses sought for third-party vendors should be allocated only to the criminal proceeding that was not covered by the advancement order. In essence, the reasoning, not unfamiliar to readers of prior Chancery decisions on this topic, was that allocation of expenses of this nature may be done at the indemnification stage, but is not something the court will inquire into at the advancement stage of a case.

Chancery Invalidates Attempt of Majority Stockholder to Appoint Officers

In Gorman v. Salamone, C.A. No. 10183-VCN (Del. Ch. July 31, 2015), the Court of Chancery   The new Kent County Superior Court  affirms the board-centric foundation of Delaware corporate law, and describes the limitation on the ability of a majority stockholder to appoint officers directly–even though a majority stockholder might have the ability to appoint board members. In sum, the majority stockholder must use her power to appoint at least a majority of board members (absent a voting agreement or other restrictions in derogation of the default rule), as the admittedly indirect manner by which she might hope to control who the officers of the corporation will be.

To put a sharper point on it, one of the key roles of a board is to appoint the officers of a corporation. Thus, the court invalidated a bylaw amendment that the majority stockholder purported to authorize, to the extent the majority stockholder attempted to usurp the board’s role.

There are many quotable excerpts from this opinion that is the latest in a series of Delaware decisions involving a struggle for control of Westech Capital Corp., and in particular, a fight pursuant to DGCL section 225 over who the proper members of the board are. See In re Westech Capital Corp., 2014 WL 2211612 (Del. Ch. May 29, 2014), reversed in part by Salamone v. Gorman, 106 A.3d. 354 (Del. 2014). The Supreme Court decision was highlighted briefly on these pages. That decision should be consulted for background facts, in addition of course, to the facts in the current opinion which largely focus on events that occurred after the Supreme Court opinion.

For present purposes, the following bullet points may entice the interested corporate litigator to read the whole opinion, which invalidated written consents based on the stricken bylaw.

  • stockholders may not remove directly corporate officers–and a bylaw that purports to confer such authority would improperly interfere with one of the most important functions of the board of directors
  • DGCL section 142(e) provides that any corporate vacancy shall be filled as the bylaws provide, but in the absence of such provision, the vacancy shall be filled by the board of directors
  • stockholders do not have unlimited power to amend bylaws, and their ability to do so is not coextensive with the board’s concurrent power. Moreover, DGCL section 141(a) grants prerogatives to the board that limit the power of stockholders to interfere with board powers. See also DGCL section 109
  • Money quotes are provided on page 12 and footnote 25 that describe the “director primacy” theory of Delaware corporate law which prohibits the stockholders from directly managing the business and affairs of the corporation–without specific authority in either the statute or the certificate of incorporation.
  • Thus, bylaws may not control specific substantive (as opposed to procedural) business decisions.
  • If a majority stockholder wants to appoint or remove a corporate officer, she must do so only through her ability to appoint board members. Otherwise, she would compromise the board’s core functions and duties–which include appointment of corporate officers. See footnote 35.

Status Quo Orders

  • Status quo orders are common in Section 225 battles for board composition, but such an endeavor may be akin to “musical chairs” to the extent it may not be predictable who the court will temporarily maintain in place as a board member. For example, is it the board who was seated “just before the music stopped” or “after the music stopped”, if the “music stopping” is akin to who filed suit asking for the status quo order–or who took unilateral self-help action just before filing suit.
  • The prerequisites for obtaining a status quo order, which are close cousins to the prerequisites for a TRO or related injunctive relief, are itemized on page 20 and noted in footnote 49 and 51

UPDATE: The “father” of the director primacy theory of corporate law, Professor Stephen Bainbridge, who has published extensively on the topic, provides commentary about this case and its reference to his theory. As readers will recall, Prof. Bainbridge is often cited in  corporate decisions of Delaware courts, but curiously he was not cited in the instant ruling.

Independent Directors Have New Ammunition to Obtain Dismissal of Suits

A recent Delaware Supreme Court decision that provides independent directors with a new basis to be dismissed from lawsuits against them, was highlighted in my latest article published in Directorship, the magazine of the National Association of Corporate Directors. The case is styled:  In re Cornerstone Therapeutics Inc. Stockholder Litigation, No. 564, 2014; Leal et al. v. Meeks et al., No. 706, 2014, opinion issued (Del. May 14, 2015).  Highlights of the case previously appeared on these pages.

Advancement Claim Addressed in Receivership Context

The Chancery opinion in Andrikopoulos v. Silicon Valley Innovation Company, LLC, C.A. No. 9899-VCP (Del. Ch. July 30, 2015), addressed the priority of an advancement claim in the context of a receivership under Delaware law. Bottom line: The court ruled, on this issue of first impression, that the claims for advancement in this case are not entitled to administrative priority, and should be treated as pre-petition, unsecured claims without administrative priority.

The odd procedural context of this case is not likely to be replicated often for the average practitioner of corporate or commercial litigation, but the court does refer to some of the well-known and frequently applied Delaware principles and Delaware policy regarding advancement for directors and officers. I suggest that this opinion may be most useful to those dealing with the priority of claims generally in receiverships under Delaware law, as well as bankruptcy lawyers to the extent the court refers to bankruptcy by analogy to a receivership, and cites to many decisions of bankruptcy courts that have dealt with advancement under Delaware law (though the decision refers to some courts that conflate the concepts of advancement and indemnification–which is not uncommon among some courts and lawyers alike.)

ABA Journal’s Annual Blog (Blawg) Contest

The ABA Journal is conducting its annual contest of the top legal blogs in the U.S. This hyperlink brings you to the ABA survey page. The full explanation from their website follows:

Blawg 100 Amici
We’re working on our annual list of the 100 best legal blogs, and we’d like your advice on which blogs you think we should include.

Use the form below to tell us about a blog—not your own—that you read regularly and think other lawyers should know about. (Please note that law blogs in the Blawg 100 Hall of Fame are not eligible for this year’s list.) If there is more than one blog you want to support, feel free to send us additional amici through the form. We may include some of the best comments in our Blawg 100 coverage. But keep your remarks pithy—you have a 500-character limit.

Friend-of-the-blawg briefs are due no later than 11:59 p.m. CT on Aug. 16, 2015.

About Blawg 100 Amici

Bloggers, by all means tell your readers about Blawg 100 Amici and invite them to send us messages on behalf of your blog.

But please know that we discourage amici from:

• Bloggers who nominate their own blogs or nominate blogs to which they have previously contributed posts.
• Employees of law firms who nominate blogs written by their co-workers.
• Public relations professionals in the employ of lawyers or law firms who nominate their clients’ blogs.
• Pairs of bloggers who have clearly entered into a quid pro quo agreement to nominate each other.

There is no specific criteria that a blogger can meet to be guaranteed a spot on the Blawg 100. And we think our list would suffer if there were. A blog’s whole can be greater than the sum of its parts, and a blog that never fails to post that daily update, has a beautiful design and an unwavering topical focus can very often have less of an impact than another blog that is less consistent on all fronts.

That said, please keep these criteria in mind when submitting Blawg 100 amici:

• We’re primarily interested in blogs in which the author is recognizable as someone working in a legal field or studying law in the vast majority of his or her posts.
• The blog should offer insights into the practice of law and be of interest to legal professionals or law students.
• The majority of the blog’s content should be unique to the blog and not cross-posted or cut and pasted from other publications.
• We are not interested in blogs that more or less exist to promote the author’s products and services.

 

Chancery Awards Damages Related to Intentionally Low Valuation

The Delaware Court of Chancery’s opinion in Fox v. CDx Holdings, Inc., C.A. No. 8031-VCL (Del. Ch. July 28, 2015), addresses a complex set of facts relating to the liability resulting from the intentionally inaccurate valuation of a spin-off in order to avoid tax consequences to the controlling stockholders, which wrongly minimized the value of stock options.chanceryseal

There are a number of eminently quotable insights and observations in this 82-page decision that could easily be the subject of a lengthy synopsis, but for busy readers who would prefer highlights until they can devote more time to reading the whole opinion, I offer a few selected bullet points that should be of interest to corporate and commercial litigators:

  • In addition to reciting important concepts of Delaware law, the Court provides insight into what might motivate a person who sold a business, that he founded, for $7 billion dollars over a decade before the facts giving rise to this case, to risk the ignominy described in the opinion in order to avoid paying taxes in connection with the spinoff of a subsidiary of his new company.
  • The Court found that: (i) the company breached the applicable agreement that required the board to determine the fair market value of a share of common stock–which impacted the value of options that the plaintiff owned; and (ii) the determination of FMV was not a good faith determination and “resulted from an arbitrary and capricious process.”
  • The Court reasoned that Grant Thornton, in essence, copied the valuation report of another major accounting firm, and provided a valuation report in an intentionally low amount that the controlling stockholder requested in order to avoid his tax burden. The Court explained in detail why it reached the conclusion, somewhat startling, that the valuation by one of the country’s leading accounting firms, was done “not in good faith” and was the result of an “arbitrary and capricious” process. Footnote 21 cites to other Delaware opinions that have critiqued misleading and incorrect reports of other iconic firms.
  • The board was required to make the determination of FMV but instead the majority stockholder did so. The Court emphasized that “director primacy” is the foundation of the DGCL even if there is a controlling stockholder, and that the board cannot shirk its duties in the face of a controlling stockholder. That is:
  • Although some controllers and boards may act this way [i.e., letting the controlling stockholder displace the board], Section 141(a) of the Delaware General Corporation Law (the “DGCL”) establishes ―the bedrock statutory principle of director primacy.” Klaassen v. Allegro Dev. Corp., 2013 WL 5967028, at *9 (Del. Ch. Nov. 7, 2013). “[D]irector primacy remains the centerpiece of Delaware law, even when a controlling stockholder is present.” In re CNX Gas Corp. S’holders Litig., 2010 WL 2291842, at *15 (Del. Ch. May 25, 2010).

  • The Court explained that an option is not a stock, and holders of an option are not stockholders. The rights of an option holder are based on the document that created the option.
  • The following quote is an example of insights the Court provides, with citations to scholarly journals, regarding what motivates people, other than greed, to breach their duties:
  • I reach these conclusions about Martino and Halbert reluctantly. Other aspects of their testimony were credible, and I am not suggesting that either is inherently bad or malicious. Like all of us, they are multidimensional. Martino appears to have had a respectable career, and he testified to other instances when he has done the right thing. Halbert has achieved great things and, at least through Caris, devoted much of his time and treasure to improving the lives of others. But humans respond to incentives, and powerful incentives can lead humans to cross lines they otherwise would respect. This is particularly true when the transgression can be rationalized, the benefits are immediate and concrete, and the potential costs are distant, conditional, and readily discounted by the chance of detection and the possibility of a successful defense or settlement. (citations omitted)

  • For example, the Court quotes from articles that define the psychological explanation of “hindsight bias”, to explain why the wrongdoers in this case may have tried to justify their actions in forcing an artificially low valuation:

    “Hindsight bias has been defined in the psychological literature as the tendency for people with outcome knowledge to believe falsely that they would have predicted the reported outcome of an event.” Hal R. Arkes & Cindy A. Schipani, Medical Malpractice v. the Business Judgment Rule: Differences in Hindsight Bias, 73 Or. L. Rev. 587, 591 (1994). “[S]tudies have demonstrated not only that people claim that they would have known it all along, but also that they maintain that they did, in fact, know it all along.” (citations omitted)

Equitable Standing Exception For Derivative Suits Not Applied

In Re AbbVie Inc. Stockholder Derivative Litigation, C.A. No. 9983-VCG (Del. Ch. July 21, 2015). This Court of Chancery decision addresses the rare situation where equitable circumstances will allow an exception to the standing requirement for filing a derivative suit, which otherwise necessitates stock ownership at the time of the challenged transaction, based on Chancery Court Rule 23.1 and DGCL section 327.

The Court reasoned based on the circumstances of this case that the facts did not support an application of that equitable exception to the standing requirement, which was first articulated in the Delaware Chancery opinion of Shaev v. Wyly, 1998 WL 13858 (Del Ch Jan. 6, 1998) aff’d, 719 A.2d 490 (Del. 1998). This might be a somewhat esoteric aspect of corporate litigation but is still an important one for the right set of facts.