A recent Delaware Court of Chancery opinion needs to be read by anyone who wants to fully understand the requirements for the appointment of a custodian of a company deadlocked due to stockholder and director dysfunction. Kleinberg v. Aharon, C.A. No. 12719-VCL (Del. Ch. Feb. 13, 2017).

Background:  This carefully reasoned opinion describes in extensive factual detail the dysfunctional relationships among stockholders and directors.  The thorough recitation of the factual context supported the conclusion of the court, in addition to the legal analysis, that the only judicial solution to the irreparable harm suffered by the company due to a deadlock in this case was the appointment of a guardian pursuant to DGCL Section 226(a).

The extensive factual details provided by the court are essential to the court’s analysis and conclusion, and must be reviewed in order to gain a complete understanding of this opinion.

Analysis:  The court’s analysis of the prerequisites of DGCL Section 226(a) and the challenges in satisfying those prerequisites, are among the most lucid explanations that this writer has read on this topic.

Section 226(a)(2) sets forth three conditions that must be satisfied before the court may exercise its authority under the statute to appoint a custodian when “the business of the corporation is suffering or is threatened with irreparable injury because the directors are so divided respecting the management of the affairs of the corporation that the required vote for action by the board of directors cannot be obtained and the stockholders are unable to terminate this division.”

First, the directors must be deadlocked.  Second, the business of the corporation must either be suffering or threatened by irreparable injury because of the deadlock.  Third, the shareholders must be “unable by shareholder vote to terminate the division between the directors.”

Importantly, when the factors are met, still “there is no right to the appointment of a custodian.”

Regarding the first requirement, the court explains that a court will not recognize a deadlock if one side sought to manufacture the deadlock “by refusing to consider any issue.”  The court explains in great detail, based on the extensively described facts involved in this case, why the first requirement is satisfied in this case.

Regarding the second requirement of irreparable harm due to the divisions between the directors, the requisite harm in order to satisfy this requirement can include damage to “a corporation’s reputation, goodwill, customer relationships, and employee morale.”  The court reasoned based on the facts of this case that:  “until the deadlock is resolved, the company will lack captain, heading, keel, and rudder.”  Regarding the third requirement, the court found that the stockholders were unable to break the deadlock because of a voting agreement that the stockholders signed and that conferred the right to appoint an even number of directors which resulted in an impasse.  Nonetheless, the court explained that a “deadlock, itself is not an injustice.  The consequences of that deadlock for the stockholders and the enterprise must be assessed.”

The court defined the general powers of the custodian, but said that a subsequent order with a more detailed description of the authority of the custodian would also address exculpation, indemnification and advancement.

Additional useful guidance for the conduct of board meetings was also provided in this opinion.  The following bullet points are helpful tools for the toolbox of corporate lawyers:

  • Directors cannot act by proxy;
  • Section 144 does not require board members to abstain from voting simply because they may not be disinterested; and,
  • All board members must understand the language spoken by others speaking at the board meetings.