Two recent Delaware Court of Chancery decisions serve as a reminder to board members to put their duty of loyalty first when making decisions on behalf of the company.
In the most recent case, New Jersey Carpenters Pension Fund v. Infogroup, the court found that “independent directors” lose that status if they allow themselves to be intimidated into a particular course of action by an executive director. The court denied the directors' motion to dismiss the lawsuit.
“Any decision that refuses to dismiss loyalty claims against outside directors deserves a lot of attention,” says Steven Haas, an associate of law firm Hunton & Williams and an adjunct professor at the University of Richmond School of Law.
“Traditionally, outside directors have had little reason to fear personal liability,” says Haas. “Generally, if a director goes about his duties in good faith and avoids conflicts of interest or self dealing, that director can sleep comfortably at night.”
The decision stemmed from a lawsuit filed by the New Jersey Carpenters Pension Fund, an Infogroup stockholder, alleging that Vinod Gupta, former chief executive officer, chairman, and the company's largest shareholder, intimidated his fellow directors into selling the company at an unfair price in order to fulfill a personal need for liquidity. Gupta was motivated to sell the company, stated the lawsuit, by $13 million in loans incurred to purchase Infogroup stock and over $12 million in litigation-related debt.
According to the allegations, Gupta engaged in “a pattern of threats aimed at other board members and unpredictable, seemingly irrational actions that made managing [Infogroup] difficult and holding the position of director undesirable.” Gupta dominated fellow directors by:
Threatening to sue them if they did not pursue a sale of the company;
Acting “generally disruptive” at board meetings;
Issuing a press release without board approval to recommend a sale of the company;
Tainting the sale process by speaking to potential bidders without board supervision; and
Leaking confidential information.
Given that Gupta owned 37 percent of the corporate stock, “it seems to be that this board was in a very difficult position,” says Haas.
“I've seen board meetings where one director really throws his or her weight around,” says Reder. It's tough, he says, because directors want to be collegial and do what's in the best interest of stockholders, “but sometimes these large stockholders demand to be heard, and if they take it too far, it can backfire on them, which is what happened here.”
The court, however, didn't seem to show much sympathy for Gupta and his fellow board members. It first held that Gupta stood to receive a material financial benefit from the merger due to his need for liquidity that was not equally shared by other investors.
Although all of the company's shareholders received the same amount of cash per share as Gupta in the merger, the court reasoned that, unlike Gupta, the other shareholders did not receive the benefit of liquidity, “because their investment in Infogroup stock was already a relatively liquid asset prior to the merger.”
“As a board, you really have to do something extreme to have the court intercede, and one of the extreme things a board can do is impact shareholder voting rights.”
—Robert Reder,
Consulting Attorney,
Milbank, Tweed, Hadley & McCloy
The court further held that, even though none of the directors were affiliated with Gupta, the merger was not approved by an “independent” majority of the directors, because their decision making was dominated by Gupta. As a result, the Court refused to dismiss duty of loyalty claims brought against the directors.
Under Delaware law, an independent director typically is defined as someone who is not an employee of a company, or affiliated with a significant customer or supplier, or is not an immediate family member of anyone who is. “None of that was the case here,” says Robert Reder, a consulting attorney for Milbank, Tweed, Hadley & McCloy, and an adjunct professor at Fordham Law School.
Infogroup is an “important case,” says Haas, “because it raises the prospect of personal liability for outside directors who didn't receive any special or unique benefit in the transaction.”
The decision also serves as a warning to directors to keep an arm's length relationship with non-independent directors and to beware undue influence. “It reaffirms that boards have to do what they believe is in the best interest of the corporation, potentially regardless of what shareholders want the directors to do,” says Haas.
Xurex Case
The other significant decision affecting directors came this fall, when the court held in Johnston v. Pedersen that incumbent board members of Xurex, a specialty chemical company, breached their fiduciary duty of loyalty when they issued a new series of preferred stock with the sole intention of preventing a majority of the company's outstanding shareholders from electing a new board.
Delaware courts generally do not like to second guess the discretion of directors. “The theory is that courts shouldn't be making business decisions,” says Reder. “As a board, you really have to do something extreme to have the court intercede, and one of the extreme things a board can do is to impact shareholder voting rights.”
“If the board takes steps to poison that process and take away, or in this case restrict, the right of stockholders to vote, then that basic principle of Delaware law goes away,” Reder adds.
LEGAL ANALYSIS
The excerpt below from Johnston v. Pedersen provides a legal analysis of the case:
During both discovery and trial, the plaintiffs attacked the defendants' record as
stewards of the company, and the defendants responded in kind. It is not my place to
evaluate the qualifications of the competing slates. For good or ill, Xurex's stockholders
have the right to choose those individuals who, as members of the board, will direct and
oversee the business and affairs of the corporation. Stockholders representing a majority
of the company's outstanding voting power have endorsed the insurgent slate. My more
limited task is to determine whether the written consents can be given effect without the
affirmative vote of holders of a majority of the Series B Preferred. Because the defendant
directors issued the Series B Preferred in breach of their duty of loyalty, I will not enforce
the class vote provision.
Source: Johnston v. Pedersen.
Since its establishment in 2005, Xurex had secured only one major customer, DuraSeal, which was responsible for 99 percent of the company's revenue. Between 2005 and 2009, Xurex additionally raised over $10 million from outside investors, but Xurex's two founders continued to control a majority of the company's outstanding voting shares. Ultimately, Duraseal entered into an exclusive agreement to market and sell all Xurex products until October 2018.
In an effort to maintain control following the agreement, Xurex's board issued a new Series B Preferred stock with class-voting rights. Those rights stipulated that the holders of the new preferred stock would have to approve by vote “separately as a single class” any matter that is subject to a vote of the corporation's stockholders, “whether or not a class vote is required by law.”
Then the relationship between DuraSeal and Xurex's founders soured. DuraSeal removed Xurex's current board and elected a new slate of directors by purchasing 15 million shares of common stock and soliciting proxies and written consent from a majority of Xurex shareholders. In opposition, the incumbent directors argued they were not validly removed because a majority of the shareholders of Series B Preferred Stock, voting separately as a class, did not approve the removal.
The incumbent directors argued their decision to issue the preferred shares was justified because “Xurex needed capital” and large investors wanted assurance that the incumbent board would remain in charge.
The court disagreed. “Although [Xurex directors] honestly believed they were acting in the best interests of the company, they breached their duty of loyalty by structuring the stock issuance to prevent an insurgent group from waging a successful proxy contest,” the court stated. Thus, the court stripped the Series B Preferred Stock of the voting right and found the new slate of directors to be valid, “which is a very extraordinary remedy,” says Reder.
REMEDY
The following excerpt from Johnston v. Pedersen explains how the situation will be remedied:
Because the defendants adopted the class vote provision in breach of their duty of
loyalty, the holders of the Series B Preferred are 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. Any further remedy must await a plenary action. The written consents submitted by plaintiffs and other Xurex stockholders were therefore effective to remove the defendant directors from office and replace them with the new directors.
Source: Johnston v. Pedersen.
In Infogroup, the court found the board did not act in good faith. In the Xurex case it found that they did, but still considered their actions to be a breach of their duty of loyalty. The lesson for directors: “What is in the best interest of shareholders is not synonymous and, does not alone, fulfill fiduciary duties,” says Jeannie Shin, a partner in the law firm of Orrick.
In rendering its decision, the court subjected Xurex's board to the “enhanced scrutiny” test, which requires that:
Defendant fiduciaries persuade the court that their motivations are proper, not selfish;
That they neither precluded stockholders from voting nor coerced them to vote a certain way; and
The fiduciaries' actions were reasonably related to a legitimate objective.
The court said Xurex's board failed to meet this test, and stressed that, where a stockholder vote involves a director election or matters of corporate governance, it will apply the “compelling justification” standard, “which is a very difficult standard for any defendant to satisfy,” says Reder.
“Any action must be narrowly construed,” Shin says. In this case, the court points out that the separate class-vote provision was broader than necessary to achieve the stated goal of getting financing in place.
The case highlights the important of a board's fiduciary duties, no matter whether a company is large or small, private or public. Concludes Shin: “Fiduciary duties are just as important and can't be ignored, especially the duty to respect voting rights of the stockholders and the integrity of the franchise.”
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