The Delaware Court of Chancery opinion styled:  Zhou v. Deng, C.A. No. 2021-0026-JRS (Del. Ch. April 6, 2022), is notable for addressing two useful aspects of Delaware corporate and commercial litigation:

First, DGCL Section 225 is a very narrowly focused summary proceeding that is considered to be “in rem”.  This limits the ability to join others who might not be subject to the personal jurisdiction of the court.  See Slip op. at 8-9.

Second, this opinion features useful references to authority that describe when issues will be considered waived: for example, when they are raised for the first time in a pretrial brief, or only “generally addressed,” such as in background facts.  See footnotes 61 and 64.

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.

The Delaware Court of Chancery in Kerbawy v. McDonnell, C.A. No. 10769-VCP (Del. Ch. Aug. 18, 2015), addresses whether written consents of stockholders were effective in replacing the board members of the company involved.  The case features the interplay between DGCL § 225 and § 228 in this corporate litigation over control of the company. DGCL § 228 is the provision that allows written consent of stockholders in lieu of a meeting and without prior notice to the minority stockholders.  DGCL § 225 is the provision that allows for summary proceedings on an expedited basis to determine who the proper directors of a company are, for example, when there is a dispute about the results of an election or, as in this case, the validity of written consents of stockholders purporting to remove directors or elect directors, or both.

This case provides a playbook of sorts on how to take control of a board via written consents.

Highlights from 59-page Post-Trial Decision

DGCL § 228(a), unless otherwise provided in the Certificate of Incorporation, allows stockholders to take action by written consent that might otherwise be taken at an annual or special meeting of stockholders.  The written consent is effective “without a meeting, without prior notice and without a vote.”  The written consents must be signed and bear the date of signature of each stockholder who signs the consent.  Action by written consent is effective only if the required number of consents are delivered within 60 days of the earliest date of consent.  See § 228(c).

The court observed that when a majority of stockholders have executed written consents to remove a board, the burden of proving that a director should not be removed or that an election is invalid, rests with the party challenging its validity.  This is a heavy burden, especially in light of “the importance Delaware law places on protecting the stockholder franchise, which has been characterized as the idealogical underpinning upon which the legitimacy of the director’s managerial power rests.”  See footnote 115.

The parties did not dispute the validity of the consents on technical grounds, but rather the argument was made that the court should set aside the otherwise valid consents on equitable grounds, based on allegations that: (1) the consents were based on misleading disclosures; (2) they were based on the misuse of confidential information; and (3) they were procured by tortious interference with an applicable agreement.

Key Principles

  • The court emphasized that a minority stockholder does not owe a fiduciary duty in general nor a duty of disclosure in particular.
  • Although directors of Delaware corporations have a duty to disclose fully and fairly all material information within the board’s control when seeking shareholder action, a party who is neither a director nor an officer, controlling stockholder or member of the control group has no such obligation. The court distinguished cases cited at footnote 118 where equitable relief was available for failure to disclose material facts in soliciting consents.
  • The court explained that: “Just as Delaware law does not require directors-to-be to comply with fiduciary duties, former directors owe no fiduciary duties.”  See footnote 127 (discussing the theoretical basis of the duty of disclosure).
  • But, if the written consents were procured by misleading disclosures, as opposed to the absence of any required disclosure, that fact could support an equitable claim to set those consents aside. One takeaway that a skeptic might extract from this opinion is that consent solicitations might more easily be performed by a person without a fiduciary duty.
  • The court describes the limited scope of a § 225 action and the limited relief available in such an action in light of its status as an in rem proceeding. See footnotes 148 through 149.
  • The court found that the sharing of confidential information that the fiduciary should have not shared was not ideal, but no harm was shown from the sharing of that information such that it would impact the analysis to set aside the written consents on an equitable basis.
  • DGCL § 228 enables stockholders to act independently of the board, and allows them to act without prior notice, and without discussion. By definition, that allows for a “secret compilation of consents” which might otherwise surprise the board when the board members learn of it.
  • In sum, there was no breach of fiduciary duty, fraud or other wrongdoing that “so inequitably tainted the election” for the court to intervene.

 

 

 Salvatore v. Visenergy, Inc., C.A. No. 10108-CB (Del. Ch. Oct. 6, 2014). This short letter ruling is noteworthy in passing as a reminder that in Section 225 cases, a trial date will often be scheduled within 60 days of filing a complaint. The substantive issue in this case surrounded a written consent of shareholders to elect board members, but this decision related to a request for a continuance of the trial

In this decision, the court refused to postpone a trial date set for 45 days from the complaint being filed. The “intervening holidays” and related excuses did not prevail. Nor did the fact that one party was pro se. DGCL Section 225 allows for expedited proceedings to determine the validity of board elections. This type of expedited proceeding is one of the “sweet spots” of Delaware corporate litigation.

Flaa v. Montano, C.A. No. 9146-VCG (Del. Ch. (Feb. 24, 2014). Takeaway: One point that can be taken from this pithy Chancery ruling is that it is not necessary for a director to be actually seated on the board in order to use DGCL Section 225 to ask the court to determine if that person should be deemed a validly elected director.

A prior Chancery decision in this case was highlighted on these pages.

Aequitas Solutions, Inc. v. Anderson, et al., C.A. No. 7249-ML (September 28, 2012).

Issue Presented:

Whether a Section 225 action fails to state a claim where plaintiff was not seeking relief against the defendant in his individual capacity and the defendant did not purport to be a director, officer or shareholder of the target company.

Answer:  No.  Motion for judgment on the pleadings denied.  

Background

This is a statutory proceeding pursuant to 8 Del. C. § 225 where plaintiff Aequitas Solutions, Inc. is seeking a judicial declaration that the director plaintiffs elected to the board of C Innovation, Inc. were validly elected and constitute the entirety of C Innovation’s board of directors.  Aequitas acquired 100 shares of C Innovation stock, which Aequitas contended constituted all of the duly authorized, issued, and outstanding shares of C Innovation.  Aequitas then removed the existing board of directors and filled the resulting vacancies by electing three new board members who in turn appointed new officers to manage C Innovation.  Aequitas alleged that Anderson and Loyd have refused to recognize the Aequitas directors, have interfered with efforts of Aequitas’s directors and officers to manage the company, and continue to assert that they control Aequitas and its assets. Defendant Loyd argued that Aequitas’s complaint did not state a cause of action against him, because Aequitas did not allege that Loyd is a director, officer, or shareholder of C Innovation, and did not seek any substantive relief against Loyd in his individual capacity. In response, Aequitas argued that Loyd has asserted “direct or indirect control” over C Innovation, and that it therefore properly named Loyd as a defendant in this action.

The Court noted that a Section 225 proceeding is not an in personam action but rather an in rem proceeding, where the defendants are before the court, not individually, but rather as respondents being invited to litigate their claims to the res (here, the disputed corporate office) or forever be barred from doing so.  Thus by filing this action, Aequitas invited Loyd to litigate any claim he may have to the corporate office.”  In denyng the motion, the Court found that “Loyd’s actions in refusing to recognize the Aequitas Directors, in inserting himself in C Innovation’s relationships with its customers, and in hiring counsel to represent C Innovation, as alleged in the complaint, fairly supports Aequitas’s allegation that Mr. Loyd has asserted control over the corporation.”

 In Johnston v. Pedersen, C. A. No. 6567-VCL (Del. Ch. September 23, 2011), read opinion here, the Court in a post-trial decision, found that that the defendant directors breached their fiduciary duties when issuing the Series B Preferred Stock and as a result, the holders of the Series B Preferred were not entitled to a class vote in connection with the removal of the incumbent board and the election of a new slate by written consent.

This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.

Background

By way of background, on August 24, 2010, the Xurex board exercised its authority under the blank check provision of the Xurex certificate of incorporation to authorize the issuance of up to 20 million shares of Series B Preferred. Like the Series A Preferred, the Series B Preferred carries one vote per share and votes with the common stock on an as-converted basis. However, unlike the Series A Preferred, the Series B Preferred had a class voting right which required a majority vote approving any matter that is subject to a vote of the common stockholders.

In April 2011, DuraSeal Pipe Coating Company began soliciting proxies from Xurex stockholders to remove the incumbent Xurex directors and elect a new board. In May, the Xurex board learned of the solicitation and began a counter-solicitation. On June 14, 2011, the plaintiffs delivered written consents which purported to remove the defendants as Xurex directors, fix the number of directors on the board at five, and elect five directors including plaintiffs Johnston and Rose. Also on June 14, 2011, the plaintiffs initiated an action seeking an order pursuant to 8 Del. C. § 225 declaring that the written consents were valid and effective.

Plaintiffs contend that the written consents represent approximately 69% of the outstanding common stock, 51% of the outstanding Series A Preferred Stock, and 13% of the outstanding Series B Preferred Stock. The defendant directors contend that they could not be removed or a new slate elected without the consent of a majority of the Series B Preferred Stock.

Analysis

The Court reviewed the directors’ action under the enhanced scrutiny test because the directors facing a proxy contest face an inherent positional conflict – enhanced scrutiny mandates that the directors persuade the Court that: (i) their motivations were proper and not selfish; (ii) they did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way; and (iii) their actions were reasonably related to a legitimate objective. When the vote involves an election of directors or touches on matters of corporate control, the directors cannot claim that the stockholders may vote out of ignorance or mistaken belief about what course of action is in their own interests.

Here, the Court found that the defendant directors adopted the class vote provision in the Series B Preferred for the specific purpose of preventing holders of a majority of Xurex’s common stock and Series A Preferred from electing a new board. The directors admitted at trial that they believed another control contest would be detrimental to the company, and that they wanted two particular directors to have time to implement their business plan. The Court, however, was unpersuaded and stated:

As a result of his discussions with supportive investors, Pedersen decided that the Series B Preferred should have some type of “super vote right” that would prevent a change of board control without the approval of the holders of the Series B Preferred. The board then implemented the “super vote right” in an expansive form that gave the Series B Preferred a veto over any action submitted to stockholders. The directors have attempted to justify this provision by claiming that Xurex needed capital and that key investors wanted assurance that Pedersen and the incumbent board would remain in charge. But the directors also admittedly wanted to preserve the incumbent board in place. Under the circumstances, the defendants failed to carry their burden of persuasion that the class vote provision was adopted in furtherance of a legitimate corporate objective. The incumbent directors could not act loyally and deprive the stockholders of their right to elect new directors, even though they believed in good faith that they knew what was best for the corporation.

Even assuming that the directors subjectively intended only to raise capital, the Court found that was “not a sufficiently compelling justification for issuing the Series B Preferred with a class vote on any issue that could be submitted to the corporation’s stockholders.” In the end, the Court found that even though the board acted in good faith, the defendant directors breached their duty of loyalty by issuing the Series B Preferred. While the board may have honestly believed that “a period of “stability” (i.e. entrenched incumbency) would be in the best interests of Xurex,” the Court noted that “[a]n inequitable purpose is not necessarily synonymous with a dishonest motive. Fiduciaries who are subjectively operating selflessly might be pursuing a purpose that a court will rule is inequitable.”

 

In re Native American Energy Group, Inc., C.A. No. 6358-VCL, 2011 WL 1900142 (Del. Ch. May 19, 2011).

Issues Addressed

The Court addressed a petition seeking a declaratory judgment under Section 225(b) of the Delaware General Corporation Law (DGCL), 8 Del. C. § 225(b).

Procedural Setting

On October 19, 2009, Native American Energy Group, Inc. (“Old Energy Group”) merged into Flight Management International, Inc. (“FMGM”).  Shortly thereafter, FMGM assumed the name of Native American Energy Group, Inc. (“New Energy Group”).  On May 27, 2010, the Depository Trust & Clearing Company (“DTC”) placed a “Global Lock” on New Energy Group’s shares because of uncertainty about the validity of shares (“Old Halstead Shares”) arising from a erroneous transaction back in the days of Old Energy Group.  The New Energy Group board of directors acted to resolve the situation by acknowledging and confirming that the capital stock of New Energy Group currently includes those shares derived from the Old Halstead Shares.  On April 8, 2011, New Energy Group, Inc. filed this litigation seeking an unopposed declaratory judgment under 8 Del. C. § 225(b).

The Court’s Obligation

The first obligation the Court of Chancery has is “to determine whether it can properly exercise jurisdiction over a matter, ‘regardless of whether the issue has been raised by the parties.’” Op. at 4.  The court must determine whether an actual controversy exists sufficient to warrant adjudicating the dispute.  The court recited the following four elements for determining jurisdiction:

(1) It must be a controversy involving the rights or other legal relations of the party seeking declaratory relief; (2) it must be a controversy in which the claim of right or other legal interest is asserted against one who has an interest in contesting the claim; (3) the controversy must be between parties whose interests are real and adverse; (4) the issue involved in the controversy must be ripe for judicial determination.

Section 225(b)

The Court of Chancery observed that prior to its amendment, Section 225 only authorized a stockholder to bring a summary proceeding to determine the result of a stockholder vote.  Even when a corporation was faced with a ripe dispute, it lacked standing under 225 to seek a judicial determination and was forced to wait for the filing of an action by a stockholder.  Op. at 5.

In 2008, the General Assembly amended Section 225(b) to “authorize a corporation to file a petition in the Court of Chancery to ‘determine the result of any vote of stockholders upon matters other than the election of directors or officers.’” (citing 8 Del. C. § 225(b)).  The synopsis of the bill amending the statute supports a legislative intent that “the bill amended § 225(b) to include the corporation itself as a permissible applicant in an action brought under that subsection.” Op. at 5. In an earlier case, the Court of Chancery found that § 225 was not to be used as a means of seeking declaratory relief, “particularly where no actual controversy exists.” (citing Palmer v. Arden-Mayfair, Inc., 1978 WL 2506 (Del. Ch. July 6, 1978)).  The Court of Chancery then reasoned that there is nothing in the amendment or associated commentary “which would suggest a legislative intent to alter the basic nature of Section 225(b)” by allowing a corporation “to seek an advisory opinion from this Court.”  Op at 5.

In analyzing New Energy Group’s petition for declaratory judgment, the court determined that there is no actual controversy over the board and stockholder consents, and concluded that if there were an actual controversy over the outcome of a vote that turned on the validity of the Old Halstead Shares, then the Court could adjudicate the issue under § 225(b). The court determined that New Energy Group only sought a determination on whether non-unanimous ratification can validate invalidly issued shares.  The court found that New Energy Group’s petition did reveal an actual adversary in DTC and thus concluded that:

If New Energy Group believes that its securities have been issued validly and that DTC breached its contractual obligations by imposing the Global Lock, then New Energy Group can seek relief against DTC.  In that action, there would be true adversity and a litigable controversy.

The Court of Chancery concluded that it lacks jurisdiction to render an advisory opinion in this case under Section 225(b).

In Genger v. TR Investors, LLC, No. 592, 2010 (Del. Supr., July 18, 2011), read opinion here, the Delaware Supreme Court addresses electronic discovery issues and contested elections for directors, in a 45-page opinion that warrants close examination by those engaged in business litigation. This short post will highlight a few “bullet points” until a more fulsome analysis can be provided. A few of the prior Court of Chancery opinions in this case were highlighted here.

Background

  • This appeal arises out of a contest for control of Trans-Resources, Inc. and proceedings under DGCL Section 225 to determine the valid membership on the board of directors.
  • The Court of Chancery imposed sanctions of $3.2 million and $750,000 for spoliation of evidence in violation of a status quo order prohibiting the destruction of certain electronically stored documents relating to the Section 225 case
  • Other issues were raised on appeal regarding the merits of the Section 225 issues.

Issues on Appeal

Three issues on appeal related to : (i) whether spoliation occurred and if so, whether the sanctions were too high; (ii) whether the trial court erred on the merits of the Section 225 decision; and (iii) whether the trial court had personal jurisdiction to adjudicate the beneficial ownership of parties not properly before the trial court.

Key Rulings

A.) Spoliation of ESI

  • The standard of appellate review for discovery sanctions is “abuse of discretion” and none was found here by the Delaware Supreme Court.
  • Every Delaware litigator must read the Supreme Court’s substantial discussion of “unallocated space” as those words are used in connection with a computer’s operating system, and how that interfaces with a duty to preserve ESI. See, e.g., footnotes 39 and 40 and accompanying text.
  • Perhaps to allay fears of those concerned about the scope of a general duty to “preserve unallocated space”, Delaware’s High Court explained that:

“We do not read the Court of Chancery’s Spoliation Opinion to hold that as a matter of routine document-retention procedures, a computer hard drive’s unallocated free space must always be preserved. The trial court rested its spoliation and contempt findings on more specific and narrow factual grounds—that Genger, despite knowing he had a duty to preserve documents, intentionally took affirmative actions to destroy several relevant documents on his work computer. These actions prevented the Trump Group from recovering those deleted documents for use in the Section 225…. “

  • The Court added that:

“Our affirmance should not be viewed as extending beyond the confines of this setting— i.e., where a party is found intentionally to have taken affirmative steps to destroy or conceal information to prevent its discovery at a time that party is under an affirmative obligation to preserve that information. It is noteworthy that there is no evidence or claim in this case, that the use of the SecureClean program fell within Trans-Resources’ ordinary and routine data retention and deletion procedures.”

  • The Court noted in footnote 49 that the result in this case may have been different if the challenged conduct, such as using the SecureClean wiping software, was part of the company’s routine data retention policy.

B.) Scope of DGCL Section 225 Proceedings

  • The Court discussed the purpose of a proceeding pursuant to DGCL Section 225 as one intended “to provide a quick method for review of the corporate election process to prevent a Delaware corporation from being immobilized by controversies about whether a given officer or director is properly holding office. A Section 225 proceeding is summary in character, and its scope is limited to determining those issues that pertain to the validity of actions to elect or remove a director.” (footnotes omitted.)
  • A Section 225 proceeding, the Court explained, is in the nature of an in rem proceeding, and not an in personam proceeding.
  • The Court of Chancery’s scope of adjudication in a Section 225 proceeding is limited to “determining the corporation’s de jure directors and officers.” Only in a plenary action in a court with in personam jurisdiction over any necessary parties can ultimate relief, such as rescission or money damages be awarded.
  • See footnotes 94 to 98 and accompanying text for a discussion of the difference between in rem and in personam, jurisdiction and the corresponding limitations on the court’s ability to adjudicate or grant relief.

Blades v. Wisehart, C.A. No. 5317-VCS (Del. Ch. Nov. 17, 2010), read 34-page opinion here.

Issues Decided
In this action pursuant to DGCL Section 225, the Court of Chancery addressed whether unanimous written consents validly removed the defendant directors from the board and whether the same written consents validly elected new directors for a company called Global Launch, Inc.  In connection with making its decision on the validly elected directors, the Court also needed to decide who the valid shareholders were.

Practice Note: This opinion should be required reading for any lawyer responsible for creating the formation documents of a corporation, or for ensuring proper authorization for the issuance of an increased number of shares. It is also instructive for those who seek to avoid the pitfalls and litigation mess suffered by the corporate counsel and parties involved in this matter.

Brief Background
The business plan of Global Launch was based on an idea of the plaintiff, Blades, an ousted co-founder, to bring to the internet the concept of layaway purchasing.

The Court describes Global Launch as a Delaware corporation that was formed by an Ohio lawyer without the benefit of Delaware counsel. The formation was based on a merger with an Ohio corporation into an empty shell Delaware corporation. In its description of the documentation that set up the company, the Court eviscerates the Ohio lawyer who did a less than stellar job in documenting the corporate transactions that form the basis for many of the issues in the lawsuit. An example of the Court’s factual description of the messy state of affairs includes the following: “Without exaggeration, it is fair to say that a thousand hours could be spent trying to fathom the implications of the various actions [the attorney] took, often unilaterally it seems, as Global Launch’s counsel and one would still be left with serious questions, so pervasive were the departures from expected norms in the execution of important corporate transactions.” However, the Court also noted that some of the errors were so fundamental that they obviated the need to address other issues presented in the case. [Editor’s Note: In order to avoid mentioning the name of the attorney who was pilloried in this opinion, only indirect reference is made to him, even though the directness or active voice of this summary may be otherwise sacrificed.]

The initial shareholders of Global Launch were only two: a company called The Ohio Company, an Ohio corporation, and the plaintiff, Rusty Blades, the latter owning two-thirds of the authorized stock. Based on two separate shareholders’ agreements, the parties consented to an initial board or four people.

Lack of Proper Corporate Formalities and Inadequate Documentation of Stock Split

In order to raise funds, the parties appeared to have intended to increase the authorized shares from $10 million to $50 million “and then to engage in a stock split in which the shares held by Blades and The Ohio Company would be split one for five.” The problem, however, was that the only validly authorized amendment to the Certificate of Incorporation, if any, was to increase the number of authorized shares from $10 million to $50 million. That is, no proper documentation was ever completed in order to consummate a stock split.

Nonetheless, shares were purportedly issued to many shareholders based on the faulty assumption that the stock split had been effectuated. Among those shares issued without the number of authorized shares being properly increased, were shares to the law firm (to be held in escrow) of the lawyer who was roundly criticized by the Court for botching the corporate documentation that is at the heart of this case.

Despite the lack of proper authorization for the stock split and despite the lack of clear authorization for the increased shares that were issued, a private placement memorandum was distributed to potential investors and investor presentations were made and created by the same hapless lawyer who is at the center of this imbroglio.

In November 2008, matters took a turn for the worse. Blades was arrested amid embarrassing publicity which led to his resignation as president and a director. After the departure of Blades from the board, the attorney at the heart of this case made purported transfers of shares that did not comply with the provisions of a March 2008 agreement which granted Blades a right to notice and a right of first refusal. Nor did the transfers comply with the provisions of that same agreement that prohibited any transfer of Global Launch stock within two years of acquisition “except from an opinion of counsel to the company.” Footnote 33 refers to trial testimony of the attorney at the heart of this case from whom the referenced opinion was required. The Court describes that opinion contemplated by the agreement, as not being satisfied because the beleaguered attorney testified that the opinion that he was required to give to the company was addressed as follows by him: “He orally gave undated and unspecified opinions to this effect to himself.”

In sum, the original two shareholders were Blades and The Ohio Company. Because the stock split that was intended to increase the number of shares available was never validly consummated, those new shareholders were never validly in receipt of shares. Despite the lack of compliance with the formalities of the DGCL, the defendants argued that as a matter of equity, because the original two shareholders supported the concept of a split (even though they acknowledged the necessary formalities were not met), the Court should treat the shares as being validly issued. The Court rejected these arguments for the reasons explained in the legal analysis that follows.

Notably, among the individual defendants was the lawyer for the company who was responsible for the documentation regarding the authorization of increased shares, its capital structure, its formation and for other documentation that is at issue in this case. That same attorney was also a director whose directorship was contested in this case.

Legal Analysis

In explaining why the stock split was invalid, the Court provides a primer on the required Delaware statutory corporate formalities that must be adhered to in order to implement a stock split. The Court explained that the term "stock split" is never specifically used in the DGCL, but it is a means by which a corporation changes the number of outstanding shares either by increasing them or reducing the number. A reverse stock split involves dividing the existing number of outstanding shares by a specific number. A forward stock split multiplies the existing number of outstanding shares by a specific multiplier. Section 242(a)(3) of the DGCL provides that a corporation may amend its certificate to change the number of outstanding shares.

Statutory Requirements for Stock Split or Increasing Number of Authorized Shares

Thus, in order to properly implement either a forward or a reverse stock split, the corporation must follow the prescribed corporate formalities to amend its Certificate of Incorporation. Specifically, Section 242(b)(1) of the DGCL governs amendments to the Certificate of Incorporation and requires that the board do three things. (1) The board must duly adopt the resolution setting forth the amendment proposed, declaring its advisability, and either calling a special meeting of the stockholders entitled to vote or directing that the amendment proposed be considered at the next annual meeting of stockholders. Alternatively, the proposed amendment may be submitted to the stockholders entitled to vote thereon for their adoption by written consent. (2) The board must give the stockholders proper notice of the proposed amendment and a stockholder meeting before asking the stockholders to vote on it. (3) If the stockholders vote to approve the amendment, in order to give effect to the amendment, “a certificate setting forth the amendment and certifying that such amendment has been duly adopted in accordance with Section 242 shall be executed, acknowledged and filed . . . [with the Delaware Secretary of State].” The Court explained that the temporal sequence of the order of the above three requirements is essential and must be followed precisely.

The Court concluded that there was insufficient evidence presented at trial to demonstrate that these three prerequisites were satisfied.

Strict Compliance with Statutory Requirements and Requisite Formalities of Capital Structure of a Corporation will be Enforced–"Law Trumps Equity"

The Court made it clear that “law trumps equity” in this area of corporate decision-making involving the capital structure and ownership of a corporation in terms of the number of shares authorized. See cases cited at footnotes 81 and 82. The cases relied on by the Court made it clear that the otherwise broad remedial capacity of a court of equity was unavailable in this context because the Delaware Supreme Court has made it clear that the statutory prerequisites regarding the issuance of new stock, like a stock split, require strict adherence to the statutory formalities. See STAAR Surgical Co. v. Waggoner, 588 A.2d 1130, 1136 (Del. 1991). See generally footnote 84 (quoting from the STAAR case with a description of the Certificate of Incorporation as a contract between the corporation and its shareholders, the corporation and the state, and among the shareholders themselves. Moreover, the Court explained that the DGCL is a part of the Certificate of Incorporation of every Delaware company.)

Despite the plea of the parties that they “intended to properly authorize the additional issuance of shares", the Court explained in detail why there was simply not enough evidence to support the position that the statutory prerequisites and formalities had been satisfied. Moreover, the Court said even if, hypothetically, it were able to weigh the equities, even then, the Court was not convinced that the equities favored the defendants, especially “given the primary role [that the beleaguered attorney] played in creating pervasive uncertainty about Global Launch’s ownership.”

Conclusion

Based on the Court’s conclusion that there were only two valid shareholders, the shares that were purportedly issued to other shareholders–in light of the lack of a properly authorized stock split, were “void and a nullity.”

Thus, the only valid written consent was the written consent by the original two shareholders which was sufficient to remove all the members of the board and to elect a new board. That conclusion, the Court emphasized, does not mean that a new board was insulated from any challenges. For example, the Court observed that there were “nearly 50 minority shareholders” who hold invalid share certificates that the company will need to address. The Court cited in footnote 100 to the classic text entitled: “Plutarch’s Lives” for a description of the victory at battle of Pyrrhus from which our expression "Pyrrhic victory" comes. See also footnote 101 citing the Delaware Supreme Court decision of Liebermann v. Frangiosa, 844 A.2d 992, 1009 (Del. Ch. 2002), which involved a similar situation of a board needing to deal with the multiple claims that would likely arise from invalidly issued stock, or put differently,  from stock that was not properly authorized and not properly issued. The Court indicated that the shares that were invalidly transferred would undoubtedly lead to claims being made by those who received those purported shares, and the board would need to deal with those issues.

In conclusion, the Court held that the written consents of the two original shareholders were effective to remove the insurgent slate of directors, and that the directors appointed by the two original shareholders by written consent were properly seated. The written consent of the two shareholders was also a valid ratification of the actions taken at a meeting that they sought to ratify.