Appeal of Chancery Ruling on Ouster of CEO by Board

Klaassen v. Allegro Dev. Corp. et al., No. 8626-VCL (Del. Ch. Nov. 7, 2013).

This Chancery decision is the subject of an appeal to the Delaware Supreme Court. Among the issues to be addressed by Delaware’s high court is whether the actions of a board to dismiss the CEO, who also had voting power over a controlling percentage of shares, are void — as compared to voidable? Also at issue is whether a controlling shareholder is entitled to notice of the intent of a board to remove him as CEO at the board meeting.

This is the second opinion in less than a month in this matter. This latest trial court opinion in this case considered a motion for a stay pending appeal and provides a mini-treatise on the Delaware law applicable to notice requirements for board meetings and the consequences of ineffective notice. The opinion is also must-reading for anyone interested in the proper approach to contests for control among warring factions of dissident directors and competing shareholder groups.

The court’s first opinion in this case denied much of the relief requested based on the equitable defenses of laches and acquiescence because the former CEO waited about 7 months before filing suit and during that time his actions indicated his consent to his ouster in place of a new CEO. Importantly, the court explained that the defense of acquiescence does not require reliance as an element to establish that defense.

The Court of Chancery, in this second trial court opinion in this matter, also recognizes the importance of prompt rulings and status quo orders in proceedings pursuant to DGCL Section 225, which are summary proceedings that involve disputes over the right of a director to hold office, or contests regarding the proper membership in, or who properly constitutes, the board of directors.

The first brief was recently filed in the expedited appeal to the Delaware Supreme Court.

Frank Reynolds of Thomson Reuters provides a helpful summary in his article on the case.

The initial post-trial opinion, issued prior to the most recent opinion addressing the issues raised in the motion for stay pending appeal, is styled as: Klaassen v. Allegro Dev. Corp. et al., No. 8626, 2013 WL 5739680 (Del. Ch. Oct. 11, 2013). The subsequent trial court opinion in this case, as highlighted below, was issued a few weeks after the first post-trial opinion and provides a more tightly focused treatment of the key issues (as one would expect when the trial court is, in effect, justifying its holding to an appellate court.)

Supplemental Synopsis 

This supplemental synopsis focuses on the second of two trial court opinions in this matter because the second trial court opinion within three weeks of the first is in part a justification of the first opinion in connection with the expedited appeal pending before the Supreme Court.

The first post-trial opinion held that the doctrine of laches and acquiescence barred the plaintiff, Eldon Klaassen, from challenging his removal as CEO of Allegro Development Corporation.  That  first opinion reasoned that because Klaassen challenged his removal on equitable grounds, the defendants could raise equitable defenses to defeat his claims.  The trial court held that when the board of directors removed Klaassen, that action was voidable, not void.  The second opinion maintained only part of the status quo order that was entered shortly after the case was filed.

The second opinion explains the standard for granting a motion to stay pending appeal based on Court of Chancery Rule 62(d) and explained why only a partial stay was granted in this matter.  Supreme Court Rule 32(a), as well as Section 24 of Article IV of the Delaware Constitution were also discussed in connection with the stay.

In connection with analyzing the criteria for granting a stay pending appeal, the court had to examine whether there was a likelihood of success on appeal.  That was the procedural context of the court’s consideration of its first opinion.

The primary issue examined was whether the actions of the board in removing Klaassen as the CEO and as a director without prior notice before the meeting in which they took that action was either “void” or merely “voidable.”

The court closely examined the line of cases beginning with Koch v. Stearn, as cited in footnote 1, which Klaassen relied on to support the view that he was entitled to notice as a matter of equity because he was both an officer and a director who could exercise a right that could alter the composition of the board.  Klaassen argued that the board could not terminate such an officer without first providing advance notice of the intent of the board to remove him in order to enable that officer to preempt the board by changing its composition.  The trial court referred to this as a “super-director,” whose powers would trump the statutory authority of the board pursuant to DGCL Section 141(a).  The court cited cases that revealed the tension between this position and the director-centric system of Delaware Corporate Governance.  See authority cited at footnote 2.

The court reviewed the Koch line of cases that support Klaassen’s argument but observed that those cases did not acknowledge that the Supreme Court vacated the Chancery ruling in Koch after remand of that decision based on its mootness.

Importantly, the Supreme Court has never had the opportunity to rule on the significant analysis in Koch or to consider the tension between the alleged equitable advance notice right for the CEO and its tension with DGCL Section 141(a), which provides the doctrinal basis for the board to manage the affairs of the corporation.

In reviewing the Koch line of cases, the court recited several bedrock principles of Delaware Corporate Governance including the following:

  •   The directors owe fiduciary duties to the corporate entity and the stockholders as a whole, but no one individual stockholder.
  •  Although equity will protect the controlling stockholder against the dilution of its position when the board acts for an improper purpose, such as entrenchment, that is adverse to the interests of the entity as a whole, a board otherwise does not have a duty to protect a controlling shareholder.  If a board is acting loyally, it may take action to oppose or even dilute a large or controlling stockholder when in the best interests of the corporation.  See footnotes 3 and 4  (referring to cases where a board may act on the belief that a controlling shareholder is abusing its power and exploiting the vulnerability of minority shareholders.) (citing Mendel, 651 A.2d 304.)
  •  The court also cited authority for the principle that although a stockholder may appoint or elect a majority of the directors, that does not entitle the stockholder to control the board.  See footnote 5.
  • Delaware decisions have rejected the concept of “constituency directors” as well as the notion that a director appointed by a particular minority stockholder or holders of a series of stock, can or should serve the particular interest of that appointing stockholder.  See slip op at 24-25.
  • Although the court found a basis to distinguish or otherwise diminish the persuasiveness of the decisions cited by Klaassen that support the view that under some circumstances a person who is both a director and a controlling stockholder has a right to advance notice of a meeting at which his removal is on the agenda, the court acknowledged that such case law did exist, however flawed the trial court suggested that case law might be.

The court emphasized the well settled truism in Delaware that one of the most important tasks of a board of directors is to hire, monitor and fire the CEO.  See footnote 8.

Distinction Between Void and Voidable

The trial court opinion also addressed the Supreme Court precedent explaining the distinction between corporate acts that are either voidable or void.  The former are those which have been performed in the interest of the corporation but are beyond the authority of management, as distinguished from actions that are ultra vires.  (citing Michelson v. Duncan, 402 A.2d 211, 218-19 (Del. 1979)).

Similar to the lack of coherence in the Koch line of cases regarding the requirement for notice before a board meeting to remove a director/controlling shareholder, the trial court explained that the decisions discussing the distinction between void and voidable do not offer definitive guidance.  See footnotes 9 and 10.

The trial court made a distinction between: (i) the failure to give notice of a board meeting in the specific manner required in the by-laws; and (ii) contention that the lack of notice was inequitable.

The trial court observed that Delaware has recognized the role of by-laws to restrict or define the power of the board to manage a corporation so long as they are not so onerous as to interfere with the power of the board pursuant to Section 141(a).  See footnotes 11 and 12.

N.B.: Notably, recent amendments to the Delaware General Corporation Law added Sections 204 and 205 which are designed to address the power of the Court of Chancery to remedy voidable acts and also to provide a non-judicial option to address that situation.  Those amendments will be in effect on April 1, 2014 and they seek to bring more clarity to the situations that develop when certain corporate formalities are not followed in connection with corporate acts that require approval that was not properly obtained, for example.