Green v. LocatePlus Holdings, Corp. et al., C.A. No. 4032-CC (May 15, 2009), read opinion here.

Kevin Brady, a well respected Delaware litigator, provides us with the benefit of his following review of this Chancery Court decision.

On May 15, 2009, Chancellor Chandler granted defendants’ motion to dismiss the amended complaint without prejudice for failure to comply with Court of Chancery Rule 23.1, but he did so with some words of advice for the pro se plaintiffs. He “strongly encourage[d] plaintiffs to obtain counsel to assist them in properly obtaining access to LocatePlus’ books and records, and in adequately articulating their allegations.”

This case involves a transaction where defendant corporation LocatePlus allegedly diluted the value of LocatePlus’ common equity. In March 2007, LocatePlus issued a $6 million secured convertible debenture to Cornell Capital Partners L.P. (“CCP”) which allowed CCP to convert the outstanding principal into shares of common stock of LocatePlus at a fixed conversion price of $0.314 per share. Shortly after the debentures were issued, the company issued approximately 7.4 million additional shares allegedly to pay off outstanding corporate debt. As a result of the share issuance, plaintiffs claim that their interest in LocatePlus was wrongfully diluted from 5% to 3% and they filed a direct action against LocatePlus and the director defendants.

Direct v. Derivative Claim and the Tooley Test

The defendants challenged plaintiffs’ actions arguing that under Delaware law, these types of allegations (with certain exceptions involving controlling shareholders that not applicable here) are derivative not direct claims, citing Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A. 2d 1031, 1033 (Del. 2004). In discussing the Tooley decision and the Supreme Court’s test to determine whether a stockholder can bring a direct claim, Chancellor Chandler noted that: “[t]he Court held that the distinction between derivative and direct claims ‘must turn solely on the following questions: (1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?’ In other words, “[t]he stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.”

Dilution Claim Here is Derivative; No Demand Made

Chancellor Chandler found that the plaintiffs in this action had made conclusory allegations in their amended complaint that they were directly harmed by the dilution of stock. He noted that “[p]laintiffs failed to allege specific facts or even explain how the dilution harmed them directly or how the harm they suffered differed from the harm suffered by LocatePlus itself or the other holders of LocatePlus’ stock.” In short, there were no allegations to show that the plaintiffs were harmed independent of the company. As a result, the Chancellor concluded that plaintiffs’ claims were strictly derivative and that the plaintiffs had to comply with the requirements of Rule 23.1. He went on to note that “[t]he right of a stockholder to prosecute a derivative suit is limited to situations where either the stockholder has demanded the directors pursue a corporate claim and the directors have wrongfully refused to do so, or where demand is excused because the directors are incapable of making an impartial decision regarding whether to institute such litigation.” And since plaintiffs had not made a demand upon the board of directors of LocatePlus to pursue their claim, the plaintiffs were required to show why demand should be excused. Chancellor Chandler noted:

Rule 23.1(a) provides that “[t]he complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiff’s failure to obtain the action or for not making the effort.” In addition, to determine demand futility the Court must exercise its discretion in deciding whether “a reasonable doubt is created that: (1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.” [citing Brehm v. Eisner, 746 A.2d 244, 253 (Del. 2000) (quoting Aronson v. Lewis, 473 A.2d 805, 814 (Del. 1984)).] Plaintiffs have failed to comply with this pleading standard. In their amended complaint, plaintiffs have not alleged that demand is excused or pled with any measure of particularity facts that would demonstrate that the Director Defendants are not disinterested or independent, or that the dilution was not a proper exercise of the board’s business judgment. Indeed, plaintiffs’ conclusory allegation that the Director Defendants caused the dilution to enrich themselves is insufficient to meet the standard under Rule 23.1. Plaintiffs fail even to allege how the dilution in exchange for financing from CCP was not in the best interests of LocatePlus.

In addition to the plaintiffs’ failure to comply with the requirements of Rule 23.1, the Chancellor found that plaintiffs had failed to comply with the procedural requirements for an inspection of books and records under 8 Del. C. § 220 (among other things, the plaintiffs failed to set forth any purpose for their inspection, failed to send their letters under oath and they failed to provide proper evidence of beneficial ownership.)