A recent Delaware Court of Chancery decision provides noteworthy rulings on the limited scope of a Section 225 summary proceeding regarding the proper composition of the board of directors, as well as the notice requirements for a written consent in lieu of a stockholders’ meeting pursuant to Section 228 of the Delaware General Corporation Law (DGCL). See Brown v. Kellar, C.A. No. 2018-0687-MTZ (Del. Ch. Dec. 21, 2018). Many Section 225 cases and Section 228 cases have been highlighted on these pages over the last 14 years.

Three Important Topics Addressed:

Although the factual details of this case are necessary to understand the holding that denied in part the motion for summary judgment, for purposes of the most widespread applicability for those involved in corporate litigation, I will highlight the key takeaways that include memorable statements of Delaware law on three important topics:

(1) the circumscribed scope of Section 225 summary proceedings;

(2) the impact of not providing prompt notice of a written consent of stockholders under Section 228; and

(3) the impact, if any, on the effectiveness of a Section 228 written consent if the notice requirements under Rule 14c-2 of the Securities Exchange Act of 1934 are not complied with—assuming full compliance with Section 228.

Brief Background:

This case involved a stockholder who brought an action to determine the composition of the board of directors pursuant to Section 225 of the DGCL.

Procedurally, the opinion addressed a motion for summary judgment to determine the proper members of the board. As often happens in these matters, there is a parallel plenary action that raises issues regarding a breach of fiduciary duty and which also seeks a declaratory judgment.

At the heart of the dispute is whether certain written consents in lieu of a stockholders’ meeting to remove an incumbent director, then to replace him with another director, was valid and effective upon delivery.  The counterargument was that the court should not grant summary judgment in order to allow it to consider issues of inequitable conduct that would allegedly void the written consents.

In addition to the issue of whether prompt notice under Section 228(e) of the DGCL was a condition precedent to effectiveness of the written consent under Section 228, another issue addressed is whether or not the notice requirements under Rule 14c-2 of the Securities Exchange Act of 1934 supersede the notice requirements under Section 228.

Key Takeaways

Section 225 Principles:

  • Whether or not an issue other than the proper composition of the board should be considered by the court in a summary Section 225 proceeding turns: “upon a determination of whether it is necessary to decide in order to determine the validity of the election . . . by which the defendant claims to hold office.” See footnotes 41 through 44 and accompanying text.
  • Although the summary nature of a Section 225 proceeding limits the scope of issues that will be addressed, Delaware courts “reject the notion that rigid, inflexible rules preclude this court from hearing anything but the narrowest arguments in Section 225 cases.”
  • Rather, the court may adjudicate a claim that a director does not validly hold corporate office because that director obtained the office through fraud, deceit, or breach of contract . . . but only for the limited purpose of determining the corporation’s de jure directors and officers. See footnote 40 and accompanying text.
  • Section 225 proceedings are in rem, meaning that the defendants “are before the court, not individually, but rather, as respondents being invited to litigate their claims in the res (the disputed corporate office) or be forever barred from doing so.” See footnote 39 and accompanying text.
  • Prior decisions by the Court of Chancery exemplify the ability of the court to review appropriate claims of inequitable conduct within the boundaries of a Section 225 case. See footnotes 47 through 49 and accompanying text.
  • The court will review issues “that could infect the composition of a company’s de jure directors and officers under Section 225, notwithstanding formal compliance with the voting procedures and requirements for those offices.” See footnotes 50-51 and accompanying text.
  • The court explained that it may consider the well-known principle announced in Schnell v. Chris-Craft Industries, 285 A.2d 437, 439 (Del. 1971), that “inequitable action does not become permissible simply because it is legally possible.” Schnell, 285 A.2d at 439.
  • The court reasoned that Schnell empowers the court in a Section 225 case to look at both technicalities and equities notwithstanding the relatively narrow scope of a Section 225 proceeding.
  • The “twice tested principle” of Delaware corporate law applies in 225 cases. That is, under Delaware law: “in every case, corporate action must be twice tested: first, by the technical rules having to do with the existence and proper exercise of the power; second, by equitable rules.” See footnote 52.

Section 228 Principles:

The court quoted from subsection (e) of Section 228 which requires prompt notice of the taking of corporate action by less than unanimous written consent of stockholders in lieu of a meeting. The sub-issue involved in this case was whether the absence of that notice under Section 228(e) prevents an otherwise valid written consent from taking effect. Based on the facts of this case, the court answered that question in the negative.

  • Section 228 unambiguously permits a majority of the stockholders of a corporation to act immediately and without prior notice to the minority. See footnotes 58-59.
  • Section 228(a) provides as a condition precedent that pursuant to Section 228(c) the consents must be “properly delivered” in order to be effective. See footnote 60 and accompanying text. In contrast, Section 228(e) does not make notice to the minority a condition precedent to an effective written consent.
  • Section 228(e) is not a condition precedent or a prerequisite to a corporate action by written consent but, the court explained that it is: “rather an additional obligation resulting from that corporate action.” See Slip op. at 23.
  • Nonetheless, the court emphasized that “prompt notice to the minority stockholders is of critical importance. Failure to provide that notice has, in unique circumstances, compelled the Court to deviate from the default rule that written consents are effective upon delivery.” Id.
  • The court referenced cases where egregious failure to provide that notice to non-consenting stockholders for several months resulted in the effectiveness under the default rule being delayed until notice requirement was remedied. See footnotes 65 through 71 and accompanying text.
  • The court found based on the facts of the instant matter that the foregoing “extreme” exception to the default rule was an applicable. Slip op. at 25.

Interface of Section 228 and Rule 14c-2 of the Exchange Act:

The court referred to other Delaware decisions that addressed the interfacing between Delaware corporate law requirements and Federal securities law and regulations.

  • The failed argument in this case was that Rule 14c-2 of the Securities Exchange Act of 1934 provided an independent notice requirement that precludes effective written consents until notice is given but “at the same time prevents [the company in this case] from giving that notice.” See footnotes 72 through 79 and accompanying text.
  • The court explained that the parties did not brief the issue of the jurisdiction of the Court of Chancery to interpret Rule 14c-2, but the court assumed without deciding that it could address the impact of that Rule on the validity of the written consents at issue in this case—based on Delaware law.
  • The parties also agreed that the Exchange Act Rules did not preempt Delaware law. See footnotes 79-80.
  • The court wrote that important policies underlying the Internal Affairs Doctrine suggest that the power of the state of incorporation should not be lightly overturned, but in any event the court held that its application of Section 228 to the written consents at issue “is not affected by Rule 14c-2.” Slip op. at 29.
  • The court reasoned that “even if Rule 14c-2 imposes a notice requirement beyond that found in Section 228, the Director Consents would still be effective under Delaware law. This court has consistently found that corporations cannot avoid their obligations under Delaware law, like holding annual meetings, by pointing to additional or reportedly conflicting obligations under Rule 14 of the Exchange Act.” See footnotes 81-82 for supporting case law.
  • The court observed a fundamental problem with the argument made by the Director Defendants as it relates to the interaction between federal law and Delaware law. The federal rule was meant to reinforce management accountability to stockholders and it cannot be used as a tool to indefinitely deprive stockholders of the franchise. See footnote 88. The Director Defendants in this case offer Rule 14c-2 as a basis to avoid giving stockholders notice, and the court rejected that argument.
  • The argument that Rule 14c-2 and Section 228 operate together to prevent the company from making any disclosure to the stockholders in this situation “stands the purpose of corporate and securities law on its head.” See footnote 91 and accompanying text.
  • Ultimately, the court found that it need not make a ruling on the substance of Rule 14c-2, because Rule 14c-2 did not “inform” its rulings on Section 228.