Court of Chancery Validates Written Consents in Section 225 Action; Finds Directors Breached Fiduciary Duty in Issuance of Preferred Shares

 In Johnston v. Pedersen, C. A. No. 6567-VCL (Del. Ch. September 23, 2011), read opinion here, the Court in a post-trial decision, found that that the defendant directors breached their fiduciary duties when issuing the Series B Preferred Stock and as a result, the holders of the Series B Preferred were not entitled to a class vote in connection with the removal of the incumbent board and the election of a new slate by written consent.

This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.

Background

By way of background, on August 24, 2010, the Xurex board exercised its authority under the blank check provision of the Xurex certificate of incorporation to authorize the issuance of up to 20 million shares of Series B Preferred. Like the Series A Preferred, the Series B Preferred carries one vote per share and votes with the common stock on an as-converted basis. However, unlike the Series A Preferred, the Series B Preferred had a class voting right which required a majority vote approving any matter that is subject to a vote of the common stockholders.

In April 2011, DuraSeal Pipe Coating Company began soliciting proxies from Xurex stockholders to remove the incumbent Xurex directors and elect a new board. In May, the Xurex board learned of the solicitation and began a counter-solicitation. On June 14, 2011, the plaintiffs delivered written consents which purported to remove the defendants as Xurex directors, fix the number of directors on the board at five, and elect five directors including plaintiffs Johnston and Rose. Also on June 14, 2011, the plaintiffs initiated an action seeking an order pursuant to 8 Del. C. § 225 declaring that the written consents were valid and effective.

Plaintiffs contend that the written consents represent approximately 69% of the outstanding common stock, 51% of the outstanding Series A Preferred Stock, and 13% of the outstanding Series B Preferred Stock. The defendant directors contend that they could not be removed or a new slate elected without the consent of a majority of the Series B Preferred Stock.

Analysis

The Court reviewed the directors’ action under the enhanced scrutiny test because the directors facing a proxy contest face an inherent positional conflict – enhanced scrutiny mandates that the directors persuade the Court that: (i) their motivations were proper and not selfish; (ii) they did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way; and (iii) their actions were reasonably related to a legitimate objective. When the vote involves an election of directors or touches on matters of corporate control, the directors cannot claim that the stockholders may vote out of ignorance or mistaken belief about what course of action is in their own interests.

Here, the Court found that the defendant directors adopted the class vote provision in the Series B Preferred for the specific purpose of preventing holders of a majority of Xurex’s common stock and Series A Preferred from electing a new board. The directors admitted at trial that they believed another control contest would be detrimental to the company, and that they wanted two particular directors to have time to implement their business plan. The Court, however, was unpersuaded and stated:

As a result of his discussions with supportive investors, Pedersen decided that the Series B Preferred should have some type of “super vote right” that would prevent a change of board control without the approval of the holders of the Series B Preferred. The board then implemented the “super vote right” in an expansive form that gave the Series B Preferred a veto over any action submitted to stockholders. The directors have attempted to justify this provision by claiming that Xurex needed capital and that key investors wanted assurance that Pedersen and the incumbent board would remain in charge. But the directors also admittedly wanted to preserve the incumbent board in place. Under the circumstances, the defendants failed to carry their burden of persuasion that the class vote provision was adopted in furtherance of a legitimate corporate objective. The incumbent directors could not act loyally and deprive the stockholders of their right to elect new directors, even though they believed in good faith that they knew what was best for the corporation.

Even assuming that the directors subjectively intended only to raise capital, the Court found that was “not a sufficiently compelling justification for issuing the Series B Preferred with a class vote on any issue that could be submitted to the corporation’s stockholders.” In the end, the Court found that even though the board acted in good faith, the defendant directors breached their duty of loyalty by issuing the Series B Preferred. While the board may have honestly believed that “a period of “stability” (i.e. entrenched incumbency) would be in the best interests of Xurex,” the Court noted that “[a]n inequitable purpose is not necessarily synonymous with a dishonest motive. Fiduciaries who are subjectively operating selflessly might be pursuing a purpose that a court will rule is inequitable.”