Chancery Examines Fiduciary Duties Owed to Preferred Stockholders

Fletcher International, Ltd. v. ION Geophysical Corp., C.A. No. 5109-VCP (Del. Ch. May 28, 2010), read opinion here.  A prior Chancery decision in this case was highlighted here. This 23-page opinion provides substantial analysis on contract interpretation, but I will focus on that aspect of the opinion that discusses the fiduciary duties, if any, owed to preferred shareholders.

Procedural History
The complaint in this matter was filed in November 2009, and less than one month later a Motion for Partial Summary Judgment was filed. Although the complaint was amended on January 14, 2010, the Court heard oral argument on the Motion for Partial Summary Judgment on January 19, 2010. That motion was denied in part, with judgment being reserved on certain other issues that are now decided in this opinion.

Background Facts
Fletcher was the sole holder of all outstanding Series D Preferred Stock. A Certificate of Rights and Preferences established the terms by which the holders of the preferred stock were governed. There was a substantial dispute which involved whether Fletcher had a right to consent to the issuance of any securities by a subsidiary of ION and whether a promissory note involved was a security. For purposes of this blog summary, however, I will focus on the more noteworthy aspect of the opinion that addressed the claim that the board of directors breached their fiduciary duty to Fletcher by failing to seek his consent to the issuance of a note or to disclose material facts in connection with that note.

Do Directors Owe Fiduciary Duty of Disclosure to Preferred Stockholder?
Having determined that ION violated the contractual rights of Fletcher by issuing a note without his consent, the Court turned to the issue of whether the directors breached their fiduciary duties as a preferred stockholder by: (1) Failing to provide Fletcher with a timely, meaningful and informed vote in connection with the issuance of the note; or (2) Disclosed fully and fairly all material information within the board’s control in connection with the issuance of the note.

Although the Court agreed with the defendants that there is no difference between the contractual claims and the fiduciary duty claims, which required the denial of the summary judgment motion on that issue, the Court’s discussion generally of the rights and duties relating to preferred stock is especially important as a statement of Delaware law in this area.

The Court observed that the so-called “duty of disclosure” is not a distinct fiduciary duty but is often referred to as a “combination of” or a “derivative of” the fiduciary duties of care and loyalty. (citing Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163, 1166 (Del. 1995)). The Court began with the truism that the “rights of preferred stockholders are primarily contractual in nature.” See footnote 52.

However, the Court also recognized that “directors may owe duties of loyalty and care to preferred stockholders, particularly in cases where nonexistent contractual rights leave the holder of preferred stock in an exposed and vulnerable position vis-à-vis the board of directors.” See footnote 53. Moreover, footnote 53 includes a discussion of caselaw which the Court reads as follows: “There is, however, no established rule clearly answering whether a board of directors ‘does or does not owe fiduciary duties of loyalty to the holders of preferred stock’ (internal citations omitted).”

Moreover, the Court cited to a recent Chancery case that observed as follows: “If preferred stockholders share a right equally with the common shareholders the directors owe the preferred shareholders the same fiduciary duties they owe the common shareholders with respect to those rights.” See footnote 54. An example of this common right would be that “directors owe preferred stockholders a duty to disclose material information in connection with common voting rights. But, rights arising from documents governing a preferred class of stock, such as the Certificates, that are enjoyed solely by the preferred class, do not give rise to fiduciary duties because such rights are purely contractual in nature.” See footnotes 55 and 56.

Primacy of Contract Versus Fiduciary Duties
Moreover, the Court recognized that the primacy of contract law over fiduciary law in matters involving contractual rights and obligations prohibit, in general, a fiduciary duty claim to co-exist in parallel with a contractual claim. See footnote 58. Thus, the Court reasoned:

“Even when directors do owe fiduciary duties to preferred stockholders, however, if claims for breach of such duties are based on the same facts underlying their breach of contract claim and relate to rights and obligations expressly provided by contract, then such claims are ‘superfluous.’ As a result, unless the fiduciary duty claims are based on duties and rights not provided for by contract, a plaintiff cannot maintain both contractual and fiduciary duty claims arising out of the same alleged wrongdoing.”  See footnotes 57 and 58.

In this case, the Court concluded that because the rights of the preferred stockholder were based in contract, and that contract violation can be remedied through a breach of contract claim, there was no need to assert a fiduciary duty claim based on the same contract rights. Moreover, there was no right to a vote in the context of this case and therefore the fiduciary duty of disclosure was not triggered. Thus, any remedy in this case must be based on contract law.