Whether the last minute removal of an incumbent director from the company slate shortly before an annual shareholders’ meeting created irreparable harm due to the threat of an uninformed shareholder vote that warranted a TRO.
Short Answer: Yes. The director suing the company was granted a TRO.
This case is another installment in the Court of Chancery’s recent “China Series” (i.e., my term for an increasing number of cases involving Delaware entities doing business in or with operations based in China). Sherwood moved for a TRO to enjoin ChinaCast Education Corporation (the “Company”) from holding its annual shareholder meeting scheduled to take place on December 21, 2011 in Beijing, China. Sherwood is currently a director of the company and until recently had been among the nominees on the Company’s slate for reelection to the board. On December 8, 2011, however, the board removed Sherwood from the Company’s slate and no longer recommended his election. He sued, claiming that the board breached its fiduciary duty of disclosure when communicating its reasons for taking him off the slate.
The plaintiffs argued that the TRO was necessary to provide sufficient information to the shareholders of the Company and to provide them with sufficient time to consider the corrected disclosures and a competing slate of nominees. The Court determined that due to the short time frame involved, there would not be time for a competing proxy contest.
Sherwood was designated as a member of the board based on the contractual rights of an investment company that purchased shares. He was, allegedly, an independent thinker who often disagreed with the other directors, and apparently the other directors were not fond of the fact that he always spoke his mind and was not compliant. Sherwood alleged that one of the reasons they did not support his reelection to the board was due to his alleged unwillingness to be agreeable.
This action was filed on December 12, 2011 and the plaintiff concurrently moved for a TRO and expedited proceedings. The following day the Court granted an expedited briefing schedule and on December 16, 2011 heard arguments on the TRO which was granted by this 40-page decision with 101 footnotes, a mere 4-days later.
The Court explains the nuances of the prerequisites for a TRO at pages 14 and 15 of the slip opinion. The typical iteration of the standard for a TRO requires a party to demonstrate 3 things: (i) the existence of a colorable claim, (ii) the existence of irreparable harm if relief is not granted, and (iii) a balancing of hardships favoring the moving party, which standard is known as the “less exacting merits-based scrutiny,” applicable when there is a limited factual record. The Court also explained that when there is a more complete factual record, the traditional TRO standard does not apply and the Court considers whether there is a “probability of success on the merits.”
An initial issue was whether the less exacting “merits-based scrutiny” standard applied, or the more strenuous standard applicable to a more fully developed factual record and referred to as the “probability of success standard.” The Court concluded that due to the less developed factual record at this early stage of the proceeding, that it would apply the less exacting merits-based scrutiny standard.
Existence of a Colorable Disclosure Claim
The Court explained that the duty of disclosure is a specific application of the fiduciary duties of care and loyalty which corporate directors are required to observe. The Court explained that because considerations to which the business judgment rule applies are not present in the shareholder voting context, the Court does not defer to the judgment of directors about what information is material, and determines materiality for itself from the record at the particular stage of the case when the issue arises. The Court went on at page 17 to define the applicable definitions for material.
The Court explained the proxy materials in this case may be misleading in their explanation about the reasons why certain actions were taken. The Court found that there was a colorable claim that the proxy materials might be misleading based on the impression they gave for the reasons that Sherwood was removed as an incumbent director from the company’s slate and why they did not nominate him for reelection to the board.
The Court explained that irreparable harm in the context of a shareholder vote can established by a mere threat that a stockholder is uninformed. See page 22. The Court also emphasized the importance of a “withhold vote” even in an uncontested election such that an uninformed shareholder in an uncontested election can still constitute a situation that causes irreparable harm for purposes of satisfying the TRO standard. See page 24. The Court found this case reminiscent of the venerable decision in Blasius Industries, Inc. v. Atlas Corp. where a board’s “good faith effort to protect its incumbency, not selfishly, but in order to thwart implementation of a corporate policy that it feared, reasonably, would cause great injury to the company, nevertheless constituted an unintended violation of the duty of loyalty because that effort interfered with the effectiveness of a stockholder vote.” See 564 A.2d 651, 658-59, 663 (Del. Ch. 1988).
The Court emphasized that, “occasions do arise where board inaction, even where not inequitable in purpose or design, may nonetheless operate inequitably” (citing Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (Del. 1971), and Hubbard, 1991 WL 3151, at *10).
Fairness of Elections
The Court also emphasized in its reasoning that:
“The corporate election process, if it is to have any validity, must be conducted with scrupulous fairness and without any advantage being conferred or denied to any candidate or slate of candidates. In the interest of corporate democracy, those in charge of the election machinery of a corporation must be held to the highest standards in providing for and conducting corporate elections”
(citing Aprahamian v. HBO & Co., 531 A.2d 1204, 1206-07 (Del. Ch. 1987)).
The Court concluded that holding the annual meeting on December 21, 2011 would not comport with the “scrupulous fairness” required of corporate elections.
The Court also emphasized that in the context of a dissident slate of directors the shareholders should decide who their directors should be and not the Court or other directors (citing Hubbard v. Hollywood Park Realty Enterprises, Inc., 1991 WL 3151 (Del. Ch. 1991)).
The defendants estimated that the cost of postponing the annual meeting would be $250,000 and the Court required as a condition of granting the TRO that the plaintiff post a secured bond in that amount. The exact terms of the TRO are provided in the last two pages of the 40-page opinion.