Grayson v. Imagination Station, Inc., C.A. No. 5051-CC (Del. Ch. Aug. 16, 2010), read opinion here.

Factual Background

The intriguing background facts of this case involve a company’s founder and sole shareholder, Grayson, who sold additional shares in return for investments by Defendants Collins and Goss. In connection with that new investment, a Voting Agreement was entered into among the new shareholders and directors. The Voting Agreement provided for Collins and Goss to each appoint a director. They appointed themselves. The agreement also provided for Grayson, the founder, to appoint two directors. A fifth director would be selected by all shareholders.

The discord began when Collins purchased the shares of Goss for one million dollars. At a subsequent board meeting , Grayson announced that one of his appointees to the board was resigning from the board and that Grayson was appointing a new appointee named Kittleson. After that board meeting, however, Collins, who by agreement was chairman of the board, had the attorney for the company write a letter to Grayson and Kittleson with an interpretation of the bylaws which, according to Collins, gave only Collins authority to appoint any replacement directors until the next shareholders’ meeting.

At the next board meeting, Grayson and Kittleson participated by phone. Collins, however, determined not to allow Kittleson to speak because Collins did not recognize Kittleson as a current director. Because Kittleson would not remain silent, Collins had his phone line disconnected. Because both Grayson and Kittleson were on the same phone line, Grayson was also disconnected. (Though Collins claims that he was not aware that they were both disconnected, in any event he tried to reconnect Grayson unsuccessfully).

Nonetheless, without Grayson’s participation, Collins continued the board meeting and along with other affiliated directors (that Collins appointed or controlled), approved an interested transaction between Collins and the company which had the net result of giving Collins 52% of the stock ownership in the company.

At the next shareholders’ meeting, Kittleson was approved by the shareholders as the replacement director. However, Collins refused to call another board meeting to reconsider the interested transaction.

Procedural Setting

This opinion is based on a motion to dismiss claims that were brought by Grayson. Grayson’s suit seeks to void the transaction approved by an improperly appointed director based on both a breach of the Voting Agreement and a breach of fiduciary duties.

Issues Addressed

The Court addressed whether the claims were either direct or derivative, as well as whether the fiduciary duty claims were duplicative of the contract claims.

Legal Analysis

The motion to dismiss was based on the argument that Grayson did not fulfill the requirements of Rule 23.1 and 23.1(b) which require that derivative claims plead facts sufficient to demonstrate that demand on the board would be futile. The motion also alleged that Grayson failed to file an affidavit stating that as the plaintiff he has not and will not accept compensation for bringing the derivative action except (1) as approved by the court, or (2) as reimbursement for reasonable expenses incurred and paid by his attorneys. The Court determined that the claims were direct and therefore Rule 23.1 did not need to be satisfied.

The reasoning of the court was based in large measure on the Delaware Supreme Court ruling in Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d, 1031, 1033 (Del. 2004). The two factors described in that decision which distinguish a direct and a derivative claim are: (1) who suffered the alleged harm (the shareholder or the corporation), and (2) who would receive the benefit of the remedy. In order for the claim to be direct, the shareholder must be the one purportedly harmed and the injury must be “independent of any alleged injury to the corporation.” Id. at 1039. Moreover, the shareholder 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.”

By disconnecting Grayson and Kittleson from the board meeting while they were participating by phone, and therefore neutralizing their ability to participate in the board meeting, and by then creating and causing an illegitimate board to approve the interested transaction, the defendants are alleged to have gone beyond the authority granted them by the shareholders of the company. Also by allegedly allowing unauthorized directors to participate in the management of the company and denying authorized directors the ability to participate in the management, the allegations assert a violation of the structural relationship established by the shareholders, and therefore, the shareholders are directly harmed and not the company. If a corporate officer acts in a manner prohibited by the DGCL, then the officer has violated the structural relationship among shareholders, officers and directors. In that instance, the rights of the shareholders, and not those of the corporation, are injured.

The Court also relied on prior case law for the position that when the structural relationship between a corporation and shareholders established by DGCL § 141 was violated, it raises a question of law that can only be determined by the Court, and therefore, the business judgment rule does not apply, making the derivative analysis irrelevant. See Grimes v. Donald, 673 A.2d 1207, 1212-1213 (Del. 1996).

The Court also reasoned that the second factor in the Tooley analysis supported the characterization of the claims as direct, to the extent that the remedy sought was voiding the interested transaction by means of injunctive relief. The allegations are that Collins violated the structural relationship between the company and its shareholders by allowing illegitimate directors on the board to take certain actions, and by preventing legitimate directors from participating. Grayson now seeks to void the actions taken by the illegitimate board. Such relief would not necessarily benefit the corporation. Thus the Court determined that Rule 23.1 did not apply.

The next issue examined by the Court is whether the claims for fiduciary duty were duplicative of the breach of the Voting Agreement. The Court reiterated Delaware law on this topic, which provides that:

“If the contract claim addresses the alleged wrongdoing by the director, any fiduciary duty claim arising out of the same conduct is superfluous. The reasoning behind this is that: to allow a fiduciary duty claim to coexist in parallel with a contractual claim, would undermine the primacy of contract law over fiduciary law in matters involving contractual rights and obligations.” (citing Gale v. Bershad, 1998 WL 1188022 at *5 (Del. Ch. 1998)).

The relevant inquiry in this situation is whether the obligation sought to be enforced arises from the parties’ contractual relationship or from a fiduciary duty of the shareholders. If the obligation to be enforced arises from a fiduciary duty owed to the shareholders, then the count is not duplicative and will not be dismissed. See footnotes 25 and 26.

Delaware law recognizes a narrow exception under which breach of contract and breach of fiduciary duty claims can both arise from the same nucleus of operative facts, which involves a situation where there is “an independent basis for the fiduciary duty claims apart from the contractual claims; even if both are related to the same or similar conduct the fiduciary duty claims will survive.” See footnotes 23 and 24.

The Court noted an important concept that may appear fundamental but is noteworthy nonetheless. In footnote 26, the Court cited to prior cases recognizing that directors have a duty to deal fairly, openly and honestly with one another and that Collins may have breached this duty to Grayson by disconnecting him from the board meeting.

After reciting its reasoning in fairly extensive detail, however, the Court concluded that both the remedies and the claims are based in contract and that it would be duplicative to allow fiduciary duty claims to continue parallel to the breach of contract claims. Therefore, those fiduciary duty claims were dismissed.