Southeastern Pennsylvania Transportation Authority v. Volgenau, C.A. No. 6354-VCN (Del. Ch. Aug. 31, 2012).

Issue Presented:  Whether Section 124 of the Delaware General Corporation Law (DGCL) prevented a claim for breach of fiduciary duty against the directors in connection with a merger that was in violation of the provisions of the Certificate of Incorporation?

Short Answer:  No.

Brief Background

This letter ruling from the Delaware Court of Chancery addressed the nuances of a very narrow issue of law that is rarely addressed.  This class action challenges a merger involving SRA International, Inc., and SRA has moved for judgment on the pleadings.  The basis of the complaint was a provision in the Certificate of Incorporation of SRA which provided that:  “Holders of each class of common stock will be entitled to receive equal per share payments or distributions.”  This purported direct class action sought to hold the merger invalid, and asserted claims that the directors breached their fiduciary duty of loyalty by violating the terms of the Certificate of Incorporation.

Defendants base their argument on DGCL Section 124 which provides in essence that “no act of a corporation shall be invalid by reason of the fact that the corporation was without capacity or power to do such act, but such lack of capacity or power may be asserted in three defined instances.”

Analysis

The Court explained that the focus of Section 124 is on the validity of corporate acts in order to prevent both corporations and those contracting with them from avoiding contracts that could be classified as “outside the scope of a corporation’s authorized powers.”  With those purposes in mind, the Court of Chancery explained that Section 124 only provides that acts will be deemed valid, and that the corporation’s capacity to undertake them may not, in most instances, be challenged. 

However, the Court emphasized that Section 124 does not bar all challenges to the acts it covers.  See footnote 9.

Section 124 provides that corporate actions will not be set aside and that the capacity of the corporation can only be challenged in three instances.  Importantly, even though those corporate actions may be deemed valid:  “it does not follow, however, that the conduct of those persons who caused such actions to occur may not be challenged on legal or equitable grounds.  Indeed, this Court has determined that direct claims by shareholders for breach of a certificate of incorporation are permissible.”  See footnote 11.  See also footnote 13, explaining that Section 124 does not prevent former shareholders of SRA from claiming that the directors breached their fiduciary duties by causing SRA to take actions violative of rights in the certificate of incorporation, which the Court describes as:  “that most important of corporate contracts.”

The Court further instructed that:  “The line between a corporation’s invalid acts and the conduct of directors in causing the corporation to undertake those acts is a fine one, but it does exist.”

The Court provided the following guidance:  “A decision to cause a corporation to act in violation of its certificate of incorporation would appear analogous to a decision to cause the corporation to take an illegal act, which is typically viewed as a breach of the duty of loyalty.”  See footnote 16, (citing Hampshire Group Ltd. v. Kuttner.  (Del. Ch. 2010)).  See also footnote 9 (citing Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del. 1971) (“Inequitable action does not become permissible simply because it is legally possible”)). 

Bonus: Professor Larry Hamermesh provides scholarly insights about the case here.