Originally published by Law360
The following is Kaye Scholer's second annual review of significant Delaware court decisions relating to private merger and acquisitions transactions and disputes.This article was published as a three-part series in Law360 the week of January 11, 2016.
Read Part 1: Proxy Contests and Other Disputes Involving the Board on Law360
Read Part 2: Fraud Claims in M&A Transactions | Deal Mechanics on Law360
Read Part 3: Employee and Options Matters | Ratification of Corporate Acts on Law360
Proxy Contests and Other Disputes Involving the
Board
1. Elite Horse Investments Ltd. v. T3 Motion Inc., C.A.
No. 10550-CB (Del. Ch. Jan. 23, 2015)
This decision serves as a reminder to companies engaging in
equity financings that they should consider the risk of investors
undertaking a hostile change of control. The decision also provides
guidance on three statutory provisions of Delaware law, including
that stockholder-written consents that are not individually signed
may be vulnerable to challenge.
This decision was a transcript ruling on a motion for a
temporary restraining order brought by a stockholder (EHI) of T3
Motion Inc., an OTC Bulletin Board company (the company). EHI
sought to enjoin the board of directors of the company from taking
certain actions and to maintain the status quo pending resolution
of a declaratory judgment proceeding in which EHI sought a
declaration that four individuals elected by EHI and seven other
stockholders had been validly elected to the board. The eight
stockholders held about 65 percent of the outstanding shares of the
company, as a result of purchases they made in a financing
transaction of the company on Dec. 1, 2014. On Dec. 26, 2014, the
stockholders delivered an executed written consent to elect the
four individuals to fill vacancies on the board. At that time,
there were three directors in office — William Tsumpes (the
CEO and chairman), Steven Healy and Ki Nam — and the
company's bylaws provided for a seven-person
board.
On Jan. 15, 2015, Tsumpes contacted Healy and Nam (but not
the four new directors) to hold a board meeting. The tentative
agenda included selling company equity to a third-party investor,
converting company debt to equity and converting Tsumpes'
unpaid salary to common stock. On Jan. 16, 2015, EHI brought the
declaratory judgment action. On Jan. 15 and 16, 2015, the four new
directors and Nam executed a unanimous board consent to remove
Tsumpes as CEO and appoint a new CEO, effective upon Tsumpes'
removal from the board. The board consent was delivered to the
company on Jan. 20, 2015. Also on Jan. 20, 2015, EHI and six other
stockholders, holding approximately 58 percent of the company's
stock, delivered a signed written consent dated Jan. 15, 2015, that
ratified the earlier stockholder consent and removed Tsumpes and
Healy from the board. EHI then sought the TRO that was the subject
of the transcript ruling.
In granting the TRO, the court dispensed with three
substantive issues raised by the company. First, the company argued
that the first stockholder consent was unlawful because it was not
a unanimous stockholder consent under Section 211(b) of the
Delaware General Corporation Law (DGCL). Section 211(b) provides in
relevant part:
Unless directors are elected by written consent in lieu of an annual meeting as permitted by this subsection, an annual meeting of stockholders shall be held for the election of directors on a date and at a time designated by or in the manner provided in the bylaws. Stockholders may, unless the certificate of incorporation otherwise provides, act by written consent to elect directors; provided, however, that, if such consent is less than unanimous, such action by written consent may be in lieu of holding an annual meeting only if all of the directorships to which directors could be elected at an annual meeting held at the effective time of such action are vacant and are filled by such action.
Rejecting the company's argument, the court noted that
Section 211(b) applies when a stockholder written consent electing
directors purports to be in lieu of an annual meeting. However, the
eight stockholders purported to elect directors by written consent
in lieu of a special meeting. Moreover, no provision of the
company's charter or bylaws had been identified that would
prohibit stockholders from filling vacancies by written
consent.
Second, the company argued that the first stockholder consent
was invalid because the signatures of the consenting stockholders
were not individually dated, in violation of DGCL §228(c).
Section 228(c) provides that "[e]very written consent shall
bear the date of signature of each stockholder or member who signs
the consent ...." The court noted that the date was on the
first stockholder consent, and the signature page referenced
execution being effective "as of the date first written
above." The court also noted that the 60-day period for
delivery of consents to the company under DGCL §228 had not
lapsed. The court then raised the question of what harm the
requirement for dated signatures, from an equitable perspective,
was designed to prevent. Nonetheless, the court noted that the
company had raised a legitimate issue, although not one that needed
to be resolved because the second stockholder consent appeared to
be valid.
The third issue raised by the company was that the first
stockholder consent was invalid because "prompt notice"
of it had not been given in compliance with DGCL §228(e). The
court noted that the first stockholder consent was delivered less
than 30 days prior to the hearing, and the second one was delivered
just three days prior to the hearing. The court then rejected the
company's argument because the company had not identified any
authority interpreting the prompt notice requirement, and the court
could not conceive of any prejudice to the company or any
stockholders.
The ruling provides a cautionary tale for companies
undertaking equity financings: consider the company's
vulnerability to a hostile change of control and consider the need
for incorporating standstill and other protections into the
financing terms. The ruling also provides interpretive guidance
with respect to DGCL Sections 211(b), 228(c) and 228(e). Perhaps
the most useful guidance is that stockholder written consents that
are not individually signed may be vulnerable to
challenge.
2. Partners Healthcare Solutions Holdings LP
v. Universal American Corp., C.A. No. 9593-VCG (Del. Ch.
June 17, 2015)
The decision provides that a Delaware corporation can impose
reasonable restrictions on director designees, such as those
relating to confidentiality or conflicts of interest, beyond the
requirements expressly set forth in a board seat
agreement.
As a result of a merger, pursuant to which an entity
(Partners) sold a business to another company (UAM), Partners
became a large stockholder of UAM and obtained the right to
designate a director to the UAM board. The sold business
performed poorly after the merger, and litigation ensued between
Partners and UAM. After Partners' initial designee resigned
from the UAM board, Partners sought to have a successor
designee seated. UAM insisted that the successor designee sign a
confidentiality agreement, and forego representation by the same
law firms representing Partners in the litigation against UAM. The
designee refused, and Partners brought an action in the Delaware
Court of Chancery to enforce the board seat agreement by specific
performance, and sought monetary damages.
The parties settled the specific performance action by
agreeing that the law firm representing the designee in his
individual capacity could construct an ethical wall and allow
different lawyers at the firm to represent the designee and
Partners, respectively. Partners continued the suit seeking damages
and attorneys' fees. Vice Chancellor Sam Glasscock granted
summary judgment to UAM.
Under the board seat agreement, the director designated by
Partners was required to be "independent" under stock
exchange rules. Partners had a right to designate a successor
director if its designee resigned. Further, the agreement provided
information rights to certain funds affiliated with Partners,
subject to confidentiality obligations and other restrictions not
applicable to the designated board member.
The business performed poorly and UAM sent an indemnification
demand to Partners. Eventually, settlement discussions broke down
and UAM sued Partners, former officers of the business, and the
director designated by Partners sitting on the UAM board, among
others, alleging fraud. The designated director resigned and
Partners designated a new director to fill the vacancy created. UAM
presented the designee with a confidentiality agreement, pursuant
to which he would be prohibited from sharing confidential
information with any third party "other than counsel in
connection with fulfilling [his] duties as a director ...."
The agreement also specified that the director designee could not
use the counsel representing UAM in the litigation. The specific
performance claim was resolved after "substantial
effort," by a confidentiality agreement and establishment of
an ethical wall, a solution that "in hindsight, appears
obvious."
In the damages action, Partners alleged that UAM breached the
board seat agreement by requiring the second designee to sign a
confidentiality agreement because the board seat agreement did not
impose any conditions on the designee, other than that the designee
be independent under the relevant stock exchange rules. Finding for
UAM, the court wrote: "I do not find that UAM breached the
Board Seat Agreement. The Board, in a faithful discharge of its
fiduciary duties, recognizes a conflict in the Designee engaging as
counsel, in his capacity as a director and on behalf of UAM, the
same counsel that was adverse to UAM in the Fraud Litigation."
The court also noted that it was important that "UAM did not
outright refuse to seat [the designee], but instead agreed to seat
him once the problem of conflicted representation was solved. That
cannot be said to be a breach of the Board Seat
Agreement."
The merger agreement provided a waiver by UAM of conflicts of
interest in the law firm's representation of Partners and its
affiliates in any dispute with UAM over matters relating to the
merger agreement. (This type of waiver provision is quite common
now in merger agreements involving private company targets.)
Partners argued that this waiver extended to the conflict arising
in the proposed representation by the law firm of the Partner
designee as a UAM director.
The court disagreed, and held that the waiver was simply
inapplicable to the designee's representation by counsel also
representing Partners — that representation of the designee
did not "relate to" the merger agreement. In addition,
the court held that the designee was not an "affiliate"
of Partners protected by the conflict waiver provisions. The court
noted that "[a]s a director, [the designee's] duties run
to UAM and its stockholders, not to Partners.
The decision shows that a buyer may impose reasonable
conditions relating to conflicts of interest or confidentiality of
company information on a director, regardless of whether these
issues are covered in a board seat agreement. The board's
fiduciary duties require the board to impose these conditions to
protect the company and its confidential information, and a court
will uphold the board's exercise of its fiduciary duties. This
case is helpful in confirming that not every conflict or issue
regarding confidentiality has to be addressed in a board seat
agreement.
3. Gorman v. Salamone, C.A. No. 10183-VCN (Del. Ch.
July 31, 2015)
The decision clarifies the respective rights of stockholders
and the board of directors to govern the corporation by confirming
the board's power to manage the corporation, that stockholders
do not have the right to make substantive business decisions
through stockholder-adopted bylaws, and that the removal of
officers is a substantive business decision reserved to the board
of directors.
The case arose when stockholder John Gorman, a stockholder
and director of Westech Capital Corp., attempted to amend the
corporation's bylaws by written consent of stockholders. The
bylaw amendment allowed stockholders to remove any officer of
Westech by written consent with or without cause. Gorman then
purported to remove the current CEO, Gary Salamone, and to elect
himself into the role.
Gorman sought declarations from the Delaware Court of
Chancery that Salamone was no longer an officer or director. He
argued that DGCL Section 142(b), addressing officer selection,
permitted the bylaw amendment.
The court held that Section 142(b) does not speak to how
officers may be removed, nor does it expressly grant such a right
to stockholders. The court then considered Section 109 of the DGCL,
which grants stockholders the authority to adopt and amend bylaws.
The court explained that "stockholders' ability to amend
bylaws is not coextensive with the board's concurrent
power," and is limited when it conflicts with the board of
directors' power to manage the business and affairs of the
corporation under Section 141(a) of the DGCL. Stockholders may not
amend the bylaws of the corporation to make substantive business
decisions, as their power under Section 109 is limited to defining
"the process and procedures by which these decisions are
made." The court held that removing a corporate officer is
indeed a substantive business decision that may only be made by the
board. The proper way for stockholders to influence these
management decisions is through their power to elect the board of
directors.
4. Kerbawy v. McDonnell, C.A. No. 10769-VCP (Del. Ch.
Aug. 18, 2015)
This decision provides that while written consents delivered by
holders of a majority of a privately held company's stock can
be set aside on equitable grounds, there is a high burden on the
incumbent board challenging the consents, and the equities will be
weighed with a goal of supporting the will of the
stockholders.
The plaintiff in this case was a stockholder, Kerbawy, who
had solicited written consents for the purpose of replacing the
current board of a privately held company with the plaintiff's
nominees. The company had about 150 stockholders. The company was
in the midst of a U.S. Department of
Justice investigation of regulatory compliance, and that
investigation, the company's strategy with respect to it and
who was to blame for the situation was the crux of the consent
solicitation, with the stockholder wanting a new approach to the
DOJ investigation and new management.
Kerbawy emailed the consent forms to a group of stockholders
he believed would be supportive of the solicitation, and by the end
of the day he had obtained consents totaling 43 percent of the
stock. He had support and some assistance from a current board
member, DeFrancesco, who also held 24 percent of the stock, and a
former officer, Bosley. These two had previously attempted to
remove and replace the incumbent board when the board sought their
resignation as employees during the pendency of the investigation.
That prior solicitation failed, and Bosley had entered into a
separation agreement with the company. DeFrancesco helped Kerbawy
analyze the stockholder base and asked employees he knew to
determine the level of support likely from employee stockholders.
Bosley suggested candidates for the new slate. DeFrancesco sent
Kerbawy confidential company information, including a stock ledger
and a strategic planning document sent to the board.
The board found out about the Kerbawy solicitation the day it
commenced, when a stockholder forwarded the email to the CEO. The
board immediately took a defensive position seeking to defeat the
effort. The board sent out a letter via email to all stockholders
two days later, purporting to correct misinformation. The court
found that this letter gave a reasonable stockholder the impression
that DeFrancesco was aligned with the board, and did not disclose
that the board was excluding him from board meetings and treating
him as an adversary. Five days after the solicitation launched, the
plaintiff delivered written consents representing 53.3 percent of
the outstanding shares.
The board had determined it was not going to accept the
consents as valid and would not vacate seats until ordered to do
so. Kerbawy commenced an action seeking a declaratory judgment that
the new director nominees were validly elected. The incumbent
directors filed a counterclaim to set aside the consents, arguing
that the stockholder's disclosure in the solicitation was
misleading, the consents used confidential information supplied by
DeFrancesco in breach of his fiduciary duties and the plaintiff had
tortiously interfered with the separation agreement with
Bosley.
The court noted that the "burden of proving that a
director's removal or election is invalid rests on the person
challenging the invalidity" and that "where a majority of
stockholders have executed written consents removing the Board, and
the Board asks the court to set aside the consents on equitable
grounds, that burden is a heavy one." The board argued that
the plaintiff, a minority stockholder, had fiduciary duties because
he was being assisted by a director. Directors owe a duty of
disclosure (or candor), the "duty to disclose fully and fairly
all material information within the board's control when it
seeks shareholder action." The court rejected the notion that
a minority stockholder has this duty. A stockholder might have an
action against another stockholder soliciting written consents for
fraud, but no stockholder alleged that he or she was defrauded by
the plaintiff.
DeFrancesco, the director working with the plaintiff
stockholder, allowed the plaintiff to use documents and information
obtained as a result of his current role as director and prior role
as CEO of the company, and he allowed the plaintiff to use the
director's name and a quote from him in support of the
solicitation. Thus, that director would have had a duty of
disclosure, but the court found that all the challenged disclosures
were those of the plaintiff stockholder, not the director assisting
that stockholder. The court was reluctant to impute the fiduciary
duties of the director to the stockholder he was assisting.
However, the court didn't reach this question definitively,
because the court concluded that the disclosure violations alleged
were in any case insufficient to justify setting aside the consents
solicited.
The defendants alleged that the misleading statements
underplayed the role of director DeFrancesco and also Bosley. The
court concluded that the roles of DeFrancesco and Bosley were not
mischaracterized by Kerbawy, and even if they had been, the
defendant board had made equally misleading statements about the
role of the two participants in question. DeFrancesco had been
frozen out of board meetings discussing the solicitation and all
board communications on the matter. The board implied in its
communication to stockholders that DeFrancesco remained on the
board and therefore was "vehemently" opposed to the
solicitation. Given the misleading statements going both directions
by the plaintiff and the defendants, the court did not believe it
was equitable to set aside the consents on the grounds that the
plaintiff did not disclose something that the board itself failed
to disclose "when it had the time and ability to do
so."
The court also concluded that Bosley had breached his
separation agreement with the company, which contained a standstill
preventing the former employee from directly or indirectly
soliciting consents or becoming a "participant" in or
assisting any other person in a solicitation, or misusing company
confidential information. Bosley had provided some minor assistance
to the stockholder, but he was not a party to the action, and the
board had to prove that the stockholder Kerbawy had tortiously
interfered with the agreement. Further, the shares voted by the
employee were insufficient to reduce the total affirmative consents
below a majority.
Even if the tortious interference was proven, the court
concluded that it would have to weigh the harm of not invalidating
a consent solicitation advanced in part by that employee's
breach of his separation agreement against the harm of frustrating
stockholder intent seeking to replace the board. Here, if the
employee had not helped the stockholder, the solicitation would
still have succeeded, but if the consents were set aside the
incumbent board would remain in control. The court concluded that
enforcing the contract would not further a valid corporate or
stockholder interest, but rather would benefit primarily, if not
solely, the incumbent board.
Finally, the court confirmed that stockholders can act by
written consent without notice, unless notice is prescribed by the
company's bylaws or certificate of incorporation, not the case
here.
This case clarifies that incumbent boards cannot thwart
stockholder consent solicitations without establishing sufficient
equitable grounds, which is a heavy burden. Where a company
actively solicits against a stockholder, the merits of its
disclosure will be weighed against any allegations of misleading
statements by the stockholder. The Delaware courts will not take
sides on the merits of a solicitation, leaving the decision as to
who would be the best directors to the stockholders themselves.
Delaware courts will seek to uphold the will of the stockholders in
support of the stockholder franchise in the absence of "a
breach of fiduciary duty, breach of contract, fraud or other
wrongdoing that so 'inequitably tainted the election" that
the court must intervene. The court found no reason to do so in
this case.
Fraud Claims in M&A
Transactions
1. Aviation West Charters LLC v. Jeremy Freer, C.A. No.
N14C-09-271 WCC CCLD (Del. Super. Ct. July 2,
2015)
The court ruled that (1) integration clause does not preclude
fraudulent inducement claim based on materially false financial
statements where the integration clause does not contain an express
disclaimer of reliance, and (2) the founder, president and CEO
could be liable for fraudulent inducement, even though he did not
make representations under the purchase agreement, where the
plaintiff alleged he made oral and written representations and
concocted the fraudulent scheme.
This decision involved a motion to dismiss in a dispute
stemming from the sale of an air ambulance business (the company).
Prior to its sale, the company was operated by another company
(JTF), of which defendant Freer (together with JTF, the
"JTF defendants) was the founder, owner and president.
The company's business model was to charge a $14,000 retainer
and seek the remaining fees, which averaged $380,000 per flight,
from the patient's insurer. Collections from insurers varied
significantly.
The company's financial statements were prepared on a
modified cash (as opposed to accrual) basis and were typically
reviewed but not audited. In connection with its sale, the company
prepared accrual financials intended to comply with generally
accepted accounting principles (GAAP) for its 2013 fiscal year, and
retained an independent accountant, CliftonLarsonAllen
LLP
(CLA) to audit them. CLA proposed adjustments, principally to the
valuation of net accounts receivable, which resulted in an increase
in net income of approximately $30 million, and which the company
accepted prior to CLA issuing a clean audit opinion. The 2013
audited financials showed 2013 earnings before interest, taxes,
depreciation, and amortization (EBITDA) of $40.8 million and net
accounts receivable (A/R) as of Dec. 31, 2013, of $38.4
million.
In June 2014, following a marketed sale process, the company
was sold to a private equity acquirer pursuant to an asset purchase
agreement (the APA) for $80 million. The acquirer (the plaintiff)
subsequently brought claims against the JTF defendants and
another party for fraudulent inducement, and breach of contract,
warranty and implied covenant of good faith and fair dealing, among
others, based on allegations that the company intentionally
overstated its accounts receivable and revenue by approximately $30
million.
In considering the motion to dismiss the fraudulent
inducement claim, the court noted that in order to survive the
motion, a plaintiff must allege that "(1) defendant falsely
represented a material fact or omitted facts that the defendant had
a duty to disclose; (2) defendant knew the representation was false
or made with a reckless indifference to the truth; (3) defendant
intended to induce the plaintiff to act or refrain from action; (4)
plaintiff acted in justifiable reliance on the representation; and
(5) plaintiff was injured by its reliance on defendant's
representation."
With regard to the first element, Freer claimed that he could
not be personally liable because he did not personally make any
contractual representations. Rejecting this argument, the court
noted that "it is well-settled law that officers and directors
may be liable for tortious misconduct even though they were acting
on behalf of the business." The court found that Freer
"not only made numerous oral and written representations to
Plaintiff about [the company], Plaintiff also alleges that Freer
'concocted' the fraudulent scheme .... Because of
Freer's role as a President and CEO, and his involvement in the
negotiation and sale of [the company] to Plaintiff, Plaintiff has
sufficiently alleged a claim against him for fraudulent
inducement."
The JTF defendants also argued that the plaintiff's
fraud claims were impermissibly bootstrapped to its breach of
contract claims, citing to authority that "where an action is
based entirely on a breach of the terms of a contract ... and not
on a violation of an independent duty imposed by law, a plaintiff
must sue in contract and not in tort." The court rejected this
argument, which equates to nonrecognition of claims for fraudulent
breach, because it does not apply with respect to claims for
fraudulent inducement.
With regard to the second element, the JTF defendants
contended that the fraud claim related to a calculation of a
GAAP-compliance estimate of A/R and not a misstatement of fact.
Rejecting this argument, the court noted that the allegations
related to improper inflation of A/R and 2013 EBITDA, which
involved a statement of past fact and not of opinion or future
conduct. The court also found that the third element was satisfied
because the plaintiff alleged that Freer "knowingly
concealed" the company's true financial condition,
"knew all along" that Medicare flights were unprofitable,
"knew" that the 28 percent collections rate was an
overstatement, and "knew" that the EBITDA representation
"was false" and the 2013 financials were "knowingly,
intentionally, and purposefully false."
With regard to the justifiable reliance element, Freer
contended that Section 12.2 of the APA precluded the plaintiff from
relying on any representation made prior to entering into the APA.
Section 12.2 set forth an integration clause, which provided in
relevant part:
The court noted that Delaware courts have "held that
integration clauses will not be given effect to bar allegations of
fraudulent inducement based on extracontractual statements made
before the effectuation of the contract unless such clauses contain
an explicit anti-reliance representation." The court found
that Section 12.2 did not contain an explicit disclaimer of
reliance, and thus did not bar the plaintiff's fraudulent
inducement claim.
The court dismissed the breach of contract and warranty
claims against Freer because the representations and warranties
were only made by the "seller", which was JTF, and not by
Freer. In denying the motion to dismiss the claim for breach of
implied covenant of good faith and fair dealing, the court noted
that the plaintiff's implied covenant contained in the
financial statements representation "is that JTF would not
artificially inflate any of the A/R in the Financial Statements
that would induce Plaintiff to pay a higher price than it otherwise
would if it knew the truth of the financial condition of
AMF."
This decision provides a useful drafting tip with respect to
integration clauses. In order to be able to rely on these clauses
to dismiss fraudulent inducement claims, sellers should ensure that
the clauses contain express disclaimers of reliance. The decision
also provides a reminder to officers and directors that they can be
held personally liable for fraudulent inducement, even though they
may be acting on behalf of the company being sold. (The same judge
provided similar guidance in another decision later in the
year, TrueBlue Inc. v. Leeds Equity Partners IV
LP, 2015 Del. Super. LEXIS 524 (Del. Super. Ct. Sept. 25,
2015)).
2. Prairie Capital III LP v. Double E Holding Corp.,
C.A. No. 10127-VCL (Del. Ch. Nov. 24, 2015)
The court gave expansive interpretation to "exclusive
representations" language to preclude fraud claims based on
alleged representations and omissions outside the share purchase
agreement, and eschewed need for "magic words" as
reliance disclaimer.
This case arose from the sale of Double E Parent LLC, a
portfolio company of private equity firm Prairie Capital Partners,
to an affiliate of another private equity firm, Incline Equity
Partners (together with the affiliate, referred to as
Incline).
In early 2012, while the sales process was ongoing, the
company's CEO and chief financial officer recognized that the
company was not going to meet the March sales target provided to
Incline, and fabricated roughly $650,000 of sales in March to make
it appear that the company had met its target.
Incline decided to buy the company after receiving the
fabricated information. The parties executed a stock purchase
agreement (SPA) and closed the same day. Among the SPA's
representations and warranties were those for absence of changes,
accounts receivable, financial statements and undisclosed
liabilities, and compliance with laws. There was an escrow fund
established to fund indemnification obligations from breach of
representations and warranties. The SPA contained an
"exclusive representations" provision that
stated:
The exclusive representations clause was backed up by a
standard integration clause, which provided that the SPA
"set[s] forth the entire understanding of the Parties with
respect to the Transaction, supersede[s] all prior discussion,
understandings, agreements and representations
...."
Two days before the escrow release date, Incline submitted a
claim notice, which indicated that Incline believed the company had
engaged in fraud. The sellers' representative filed suit to
compel the release of the escrow and Incline counterclaimed,
asserting in part a claim for fraud by the company and its CEO and
CFO, based both on the SPA representations and on extracontractual
statements and omissions during the sale process and due
diligence.
The court granted in part and dismissed in part Incline's
motion to dismiss. The court found that Incline had waived the
right to bring a claim of fraud regarding the extracontractual
representations and omissions, but that Incline had shown it was
reasonably conceivable that the CEO, CFO and selling stockholders
could be held liable for the fraudulent contractual
representations. The court also found Incline had sufficiently
plead the claim of breach of several representations in the
SPA.
The court held that Incline's claims based on
extra-contractual representations were foreclosed by the exclusive
representations and integration language in the SPA. The court
noted that Delaware law enforces clauses that identify the specific
information on which a party has relied and which forecloses
reliance on other information, citing RAA Mgmt LLC. v. Savage
Sports Hldgs Inc., 45 A.3d 107, 118-119 (Del. 2012). Incline argued
that the language in the SPA, quoted above, was not a clear
anti-reliance clause, relying on Anvil Holding Cor. v. Iron
Acquisition Co., (Del. Ch. May 17, 2013).
The court acknowledged that disclaimer clauses are often
stated negatively (i.e., the buyer is not relying on any statements
not included in the agreement), while the clause in the SPA was
framed positively (the buyer is only relying on the representations
included in the agreement). The court concluded, however, that it
was irrelevant whether the disclaimer was framed positively or
negatively, so long as it clearly defined the universe of
information Incline had relied upon, and in so doing excluded any
other information on which Incline could state a claim. The court
would not read Anvil to require "magic words" such as
"disclaim reliance."
As a second argument, Incline attempted to avoid the
exclusive representations language by claiming that it did not
apply in the case of fraudulent omissions. In
TransDigm Inc. v. Alcoa Global Fasteners
Inc., (Del. Ch. May 29, 2013), then-Vice Chancellor Donald
Parsons had held that an adequate disclaimer of reliance does not
bar claims of fraudulent concealment if the buyer has not
disclaimed reliance on extracontractual omissions; rather, the
buyer must also disclaim reliance on "the accuracy and
completeness" of the information provided to it by the
seller.
The court rejected this reasoning, stating that "to the
extent TransDigm suggests that an agreement must use a magic word
like 'omissions,' then I respectfully disagree with that
interpretation." Vice Chancellor Travis Laster noted that
every misrepresentation involves to some extent an omission of the
truth, and held that the SPA's exclusive representations and
integration language, which defined the universe of information
Incline was relying on, was sufficient to exclude a fraud claim
based on an extracontractual omission.
It is worth noting that in Prairie Capital, Incline had
simply recast its claims of affirmative misstatements as claims of
omissions, with the same underlying facts giving rise to both the
misstatements and the omissions. In contrast, in TransDigm the
buyer had alleged that the seller had concealed the fact that it
had offered a major customer a discount and was at risk of losing
about half of that customer's business. The court there had
held that the buyer could rely on the assumption that the seller
had not actively concealed information or engaged in a scheme to
hide that material information. Thus it is possible that a claim of
concealment of information could survive an exclusive
representations provision, so long as it is not simply a mirror
image of the claims of reliance on misstatements. However, the two
decisions cannot be wholly reconciled and it may be that the issue
of when omissions are disclaimed will require the input of the
Delaware Supreme Court.
As a third argument, Incline attempted to avoid the exclusive
representations language by arguing that a separate "exclusive
remedy" clause was evidence that Incline had a right to sue
for extracontractual fraud. The "exclusive remedy" clause
provided that "[e]xcept as provided in [specified sections],
equitable remedies that may be available, or in the case of fraud,
the remedies set forth in this Article X [relating to
indemnification] constitute the sole and exclusive remedies for
recovery of Losses incurred after the Closing arising out of or
relating to this Agreement and the Transaction."
Incline argued that because the provision stated that
contractual indemnification is not the sole and exclusive remedy in
the case of fraud, Incline had a right to bring fraud claims. The
court instead found that the exclusive remedy provision only
provided that in cases of fraud, Incline was not limited to the
contractual indemnification provisions, but had other available
remedies. The court noted that the exclusive remedy provision did
not address the representations that Incline may rely upon to
establish a fraud claim, which were expressly addressed in the
exclusive representations provision. Thus, the exclusive remedy
provision did not reinstate a claim Incline had disclaimed
elsewhere in the agreement.
The court also held that Incline had adequately pled claims
based on the absence of changes and accounts receivable
representations and on the financial statements and undisclosed
liabilities representation but only for the periods of time
specified in the representations. The director and officer
defendants sought to dismiss claims against them individually, but
the court held that neither officers nor directors could escape
liability if they actively participated in the fraud, even if
acting "for the corporation." The officers of the company
were communicating with Incline, and the directors were
communicating to the officers with the intent that their statements
would be repeated to Incline, oversaw the process, actively engaged
in the preparation of presentation materials and approved the
creation of false sales numbers. Thus the claims against the
individual defendants were not dismissed.
The decision gives buyers and sellers useful drafting
guidance in how to limit (or avoid limiting) recourse for fraud
claims based on extracontractual representations.
Deal Mechanics
1. Halpin v. Riverstone National Inc., C.A. No.
9796-VCG (Del. Ch. Feb. 26, 2015)
The decision highlights the importance of exercising drag-along
rights strictly in accordance with their terms if parties want to
obtain the intended benefits, such as waiver of appraisal
rights.
This decision involved competing motions for summary judgment
in an appraisal action and counterclaim following the sale of
Riverstone National Inc. (the company) pursuant to a merger
agreement. The company's counterclaim was for specific
performance by the appraisal petitioners (the minority
stockholders) for compliance with the drag-along provisions of a
stockholders agreement and waiver of their appraisal
rights.
The minority stockholders entered into the stockholders
agreement with the company in June 2009. Section 3 of the
stockholders agreement set forth a drag-along provision, pursuant
to which the company could compel the minority stockholders to
tender and/or vote their shares in favor of a change-in-control
transaction approved by the majority stockholders. Section 3
provided the following in relevant part (the voting
right):
On May 29, 2014, the company's controlling stockholder
provided its written consent for the company to enter into a merger
agreement pursuant to which the company would be sold in a reverse
triangular merger. The company executed the merger agreement the
next day and completed the merger on June 2, 2014. On June 9, 2014,
the company sent an information statement to its stockholders
informing them of the merger, and attempting to invoke the
drag-along provisions and compel compliance with the voting right.
The information statement provided that stockholders may be
entitled to appraisal rights, but they would only be entitled to
the merger consideration if they relinquished the appraisal rights
by executing an attached written consent. It also provided that if
the stockholders failed to execute the written consent, they would
be in breach of the stockholders agreement.
The court first noted that it was a matter of first
impression as to whether a common stockholder could waive its
statutory appraisal right ex ante. However, the court did not need
to resolve that issue because the summary judgment decision would
be resolved on other grounds. The court noted that the information
statement attempted to invoke the voting right, and that this
involved a prospective obligation: the stockholders agreed to vote
in favor of a prospective transaction, not consent to a merger that
had already been consummated. Therefore, the company was not
entitled to specific performance of the drag-along because the
drag-along involved a right that was different from the one the
company was trying to exercise. The court also rejected the
company's claim for specific performance based on the implied
covenant of good faith and fair dealing, because that doctrine does
not apply with respect to rights that were not contracted but which
were foreseeable.
The decision provides useful guidance regarding the exercise
of drag-along rights and the need to strictly comply with their
terms. It also cautions that while holders of preferred stock can
be required to sign prospective waivers of appraisal rights,
Delaware courts have not ruled on the enforceability of such
waivers as applied to common stock.
2. Lazard Technology Partners LLC v. Qinetiq
North America Operations LLC, 114 A.3d 193 (Del. Apr. 23,
2015)
The court ruled that earnout language prohibiting a buyer from
taking any action to "divert or defer [revenue] with the
intent of reducing or limiting the Earn-Out Payment" bars the
buyer from taking action "specifically motivated by a desire
to avoid the earn-out" but not action that the buyer merely
"knew would have the effect of compromising seller's
ability to receive the earn-out".
This decision involved an appeal on behalf of former
stockholders (collectively, the seller) of a target company in an
earnout dispute arising under a merger agreement. The appellee (the
buyer) paid $40 million at closing and agreed to pay up to an
additional $40 million under a revenue based earnout provision.
When the revenue targets were not achieved, the seller brought an
action in the Delaware Court of Chancery for breach of Section 5.4
of the merger agreement, which prohibited the buyer from
"tak[ing] any action to divert or defer [revenue] with the
intent of reducing or limiting the Earn-Out Payment," and for
violation of an implied covenant of good faith and fair
dealing.
In a post-trial bench ruling, the Court of Chancery found
that Section 5.4 was not breached because the seller had not proven
that any business decision of the buyer was motivated by a desire
to avoid an earnout payment. The Court of Chancery also rejected
the implied covenant claim because, consistent with the language in
Section 5.4, the buyer had a duty to refrain from conduct only if
it was taken with the intent to reduce or avoid an earnout
altogether.
On appeal, the seller argued that Section 5.4 prohibited
conduct that the buyer "knew would have the effect of
compromising the seller's ability to receive an earn-out."
In upholding the Chancery Court's ruling, the Delaware Supreme
Court ruled that by its unambiguous terms, Section 5.4 "only
limited the buyer from taking action intended to reduce or limit an
earnout payment. Intent is a well-understood concept that the Court
of Chancery properly applied. The Seller seeks to avoid its own
contractual bargain by claiming that Section 5.4 used a knowledge
standard, preventing the buyer from taking actions simply because
it knew those actions would reduce the likelihood that an earn-out
would be due." The Delaware Supreme Court also noted that the
Court of Chancery "never said that avoiding the earn-out had
to [be] the buyer's sole intent, but properly held that the
buyer's action had to be motivated at least in part by that
intention."
The Delaware Supreme Court also rejected the seller's
argument that the Court of Chancery erred by holding that the
implied covenant had to be read consistently with Section 5.4. In
upholding the Court of Chancery's ruling that the implied
covenant did not inhibit the buyer's conduct unless the buyer
acted with the intent to deprive seller of an earnout payment, the
Delaware Supreme Court noted that the implied covenant is a
cautious doctrine that involves inferring contractual terms to
handle developments or contractual gaps, and that the Court of
Chancery was "very generous in assuming that the implied
covenant of good faith and fair dealing operated at all ... [given]
the negotiating history that showed that the seller had sought
objective standards for limiting the buyer's conduct but lost
at the bargaining table."
The decision serves as a reminder that sellers need to
clearly designate in the purchase agreement the standards to which
buyers are to be held in earnout provisions.
"Knowledge-based" prohibitions on buyer actions need to
be specifically written into the contract and will not be implied
from "intent-based" prohibitions.
Employee and Options
Matters
1. Ascension Insurance Holdings LLC v. Underwood, C.A.
9897-VCG (Del. Ch. Jan. 28, 2015)
A Delaware choice of law for an employee noncompete that was
entered into several months after an asset purchase agreement
became effective was unenforceable given California public policy
against enforcement of noncompetes against California residents
employed and seeking to compete largely in California.
This decision addressed a request for preliminary injunction
against the defendant and his current employer from breaching a
covenant not to compete entered into by the defendant as part of an
employee investment agreement (EIA) that was executed several
months after an asset purchase agreement (the APA). The APA and a
contemporaneous employment agreement contained five-year
noncompetes. The noncompete in the subsequent EIA extended for a
period of two years after defendant's termination of
employment. The EIA was between a California-resident employee and
a Delaware limited liability company (the LLC) that had its
principal place of business in California, and contained Delaware
venue and choice-of-law provisions.
The Delaware Court of Chancery first noted California's
statutory prohibition of noncompetes under Cal. Bus. & Prof.
Code §16600, which contains an exception relating to the
protection of goodwill where the noncompete is part of a sale of
equity (or assets). The court then noted Delaware's policy
favoring the right to freedom of contract, and that Delaware
follows the Restatement (Second) of Conflict of Laws (the
Restatement). According to the court, the Restatement generally
favors the parties' choice of law, except where, absent a
choice-of-law provision, the contract would be governed by the law
of a state that has a public policy under which a contractual
provision would be void or limited. Given that the defendant was a
California resident, the LLC had its principal place of business in
California, and the EIA was negotiated in California and involved a
noncompete that was limited almost completely to areas within
California, the court concluded that absent the choice-of-law
provision, California law would apply.
The court then considered whether enforcement of the covenant
would conflict with a "fundamental policy" of California
and, if so, whether California has a materially greater interest in
the issue than Delaware. The court first considered the
plaintiff's argument that the exception under the California
statute relating to the sale of assets applied. The court noted
that while the EIA was contemplated at the time of the APA, the
parties had not discussed including a noncompete in the EIA. The
fact that the APA and a contemporaneous employment agreement signed
by the defendant contained five-year noncompetes indicated that the
noncompete in the EIA could not have been relied on as part of the
asset purchase. The court also rejected the plaintiff's
argument that the decision in Fillpoint LLC v. Maas, 146 Cal. Rptr.
3d 194 (Cal. Ct. App. 2012), showed that enforceability did not
require that the EIA have been signed contemporaneously with the
APA.
The Fillpoint case involved the enforceability of a
noncompete in an employment agreement that was signed one month
after a stock purchase agreement. The stock purchase agreement
contained a three-year noncompete, and the employment agreement
contained a noncompete that extended for one-year post-termination.
The Ascension court noted that while the Fillpoint court read the
stock purchase agreement and the employment agreement together, the
Fillpoint court held that the noncompete in the employment
agreement did not fall within the exception to the California
noncompete statute. Noting that Fillpoint therefore did not support
the plaintiff's argument, the Ascension court found that the
noncompete provisions of the EIA would violate a fundamental public
policy of California. In balancing the interests of the two states,
the court held that "California's specific interest is
materially greater than Delaware's general interest in the
sanctity of a contract that has no relationship to this
state."
The decision serves as a reminder that noncompetes tied to,
and that extend beyond, the term of employment are very unlikely to
be enforceable in California, even if entered into around the time
of the sale of a business. Moreover, parties should not assume that
they can avoid California's public policy disfavoring
noncompetes simply by contractually designating the law and venue
of another state.
2. Calma v. Templeton, C.A. No. 9579-CB (Del. Ch. April
30, 2015)
This decision highlights the importance of designing option
plans with director-specific limits and taking care in the
selection of peer group members.
The case arose when a stockholder challenged a board decision
to award restricted stock units (RSUs) to the nonemployee directors
of Citrix Systems Inc. These grants were awarded
to the nonemployee directors under a compensation plan that also
covered employees, officers, consultants and advisers and it was
approved by a majority of disinterested stockholders. The only
compensation limits of the plan were that no beneficiary could
receive more than 1 million RSUs per calendar year, which at the
time could total as much as $55 million.
The compensation committee had approved grants to all
nonemployee directors, including the members of that committee, and
therefore the business judgment rule did not apply. Stockholder
ratification is an affirmative defense to the alternate standard of
entire fairness, and leads to waste being the standard of review.
However, the court ruled that the prior approval by stockholders of
the compensation plan did not constitute ratification of the
board's later grant of RSUs to the nonemployee directors. The
stockholders' approval was merely a generic approval of a
compensation plan covering multiple and varied classes of
beneficiaries and the stockholders were not asked to ratify any
decision "bearing specifically on the magnitude of
compensation to be paid to its nonemployee directors." Because
stockholders had not been asked to ratify the specific RSUs granted
to the nonemployee directors, or to approve any sublimit in the
plan relating to compensation payable to such directors, the court
concluded the stockholders could not be said to have ratified the
grants.
Absent stockholder ratification, the RSU grants were
self-dealing transactions, subject to review under an entire
fairness standard. Entire fairness requires a showing of fair price
and fair dealing. With respect to fair price, the parties framed
the issue as whether the grants were in line with a peer group of
companies, and the court held that the plaintiff had raised
"meaningful questions" as to the appropriateness of the
composition of the peer group employed by the board for this
compensation decision, and therefore denied the motion to dismiss
claims of breach of the duty of loyalty and unjust
enrichment.
3. Fox v. CDX Holdings Inc., C.A. No. 8031-VCL (Del.
Ch. July 28, 2015)
The decision highlights the importance of following the
valuation and other terms of stock option plans when cashing out
options in a merger, including whether a portion of option proceeds
can be withheld to fund a deal escrow.
This case involved a class action brought by an option holder
who challenged the consideration option holders received for their
options in a merger. The option holders held options in a privately
held Delaware corporation, Caris Life Sciences
Inc. (the company). The company operated three business
units: Caris Diagnostics, TargetNow and Carisome. In order to
realize a partial exit for stockholders and to generate funding for
TargetNow and Carisome, the company engaged in a spin/merger
transaction that involved spinning off TargetNow and Carisome to
its stockholders and having the resulting business (the AP
Business) then enter into a cash merger with a subsidiary of a
third party, Miraca Holdings Inc., for aggregate proceeds of $725
million.
In connection with the merger, the option holders were cashed
out based on a price of $5.07 per share, which represented $4.46
per share for the value of the AP Business acquired by Miraca in
the merger, and 61 cents per share for the value of the two
spun-off businesses. Approximately 8 percent of the option proceeds
were withheld and contributed to the deal escrow. The plaintiff
brought a class action for damages based on breach of the terms of
the company's stock option plan in three ways: (1) failure by
the board of directors of the company to determine the fair market
value of a share of company common stock and to adjust the options
for the spinoff, (2) the valuation work performed was not done in
good faith and was arbitrary and capricious, and (3) the option
plan did not allow the company to escrow a portion of the option
consideration.
Following a trial, the Court of Chancery found for the
plaintiff with respect to its claims based on breach of the stock
plan and awarded the class damages of $16,260,332.77. The plaintiff
also advanced a claim for breach of the implied covenant of good
faith and fair dealing, which the court did not reach, given its
decision on the breach of contract claim.
The company was 70.4 percent owned by its founder, David
Halbert, and 26.7 percent owned by a private equity fund, JH
Whitney VI LP (Fund VI). The remaining 2.9 percent of the fully
diluted equity of the company was held by option holders. Under the
terms of the plan, option holders were entitled to receive in the
merger an amount per share underlying their options equal to the
excess of the "fair market value" of each share of
company common stock over the option strike price. The plan
provided that the fair market value was to be determined by the
plan administrator, and that the administrator was required to
adjust the options to take account of the spinoff. The board
functioned as the administrator.
The spin/merger structure was a way to achieve a
tax-efficient sale of the AP Business. However, it presented one
large challenge. In order for the spinoff to be accomplished
without triggering a corporate-level tax, the fair market value of
the spun-off businesses could not exceed their respective tax
bases. This was a sensitive issue in the negotiations with Miraca,
and Miraca insisted that the spun-off businesses (owned by Halbert
and Fund VI) retain responsibility for any such tax. Halbert
therefore had a significant incentive to ensure that the fair
market value of the spun-off businesses be low. This, in turn,
would result in a low valuation for the options, because that value
incorporated an upward adjustment based on the value of the
spun-off businesses.
Evidence at trial showed that the valuation of the spun-off
businesses, and the resulting value of the options, was determined
by Gerard Martino, the company's executive vice president and
chief financial officer, with sign-off from Halbert. Given that the
fair market value of the options was not determined by the board,
as was required by the terms of the plan, the court found for the
plaintiff with respect to the first contention.
The valuation was based on an intercompany tax transfer
analysis (as opposed to a fair market value analysis) prepared by
the company's tax adviser, using projections that Martino had
manipulated downwards. At the insistence of Miraca, a second firm
was retained to do an analysis. But the second firm understood its
mandate as being to rubber-stamp the first firm's analysis. The
$65 million valuation of the spun-off entities was also
significantly lower than recent estimates used for other purposes,
such as that prepared by an investment bank in the sale process
that resulted in the sale to Miraca, estimates derived from
bidders' indications of interest in the sale process, internal
estimates of the Fund VI, and 409A valuations. Accordingly, the
court found that the valuation work was not determined in good
faith and was arbitrary and capricious.
With regard to the plaintiff's third contention, the
court noted that unlike for shares, Section 251(b) of the Delaware
General Corporation Law (DGCL) does not authorize the conversion of
options in a merger. Options are instead rights governed by DGCL
§157, and are governed by the terms of their contract, in this
case the stock plan. The court noted that "the Plan gave the
Board discretion as to whether to cancel the options in connection
with the Merger, but if it did, then the option holders were
entitled to receive 'the difference between the Fair Market
Value and the exercise price for all shares of Common Stock subject
to exercise.' The Plan did not permit an escrow holdback."
As a result, the company breached the terms of the plan by
withholding a portion of the option proceeds to fund the
escrow.
The decision illustrates a failure of process by the company
and its board when cashing out options in a merger. It is a
reminder of the risks of failing to follow an option plan's
terms, and of backing into a predetermined valuation as opposed to
following a principled analysis. It also serves as a caution to
drafters to ensure that option plans are drafted flexibly enough to
accommodate escrows in sale transactions.
Ratification of Corporate Acts
1. In re Numoda Shareholders Litigation, C.A. No.
9163-VCN (Jan. 30, 2015), aff'd, (Del. Oct. 22, 2015); In re
CertiSign Holding, C.A. No. 9989-VCN (Aug. 31,
2015)
Delaware courts provided important guidance as to the
applicability and scope of Delaware's new statutory provisions
regarding ratification and validation of corporate acts.
In 2014, two new provisions, Sections 204 and 205, were
adopted to the Delaware General Corporation Law (DGCL). These
provisions permit, among other things, boards to ratify, and the
Court of Chancery to validate, prior corporate acts. The provisions
were the subject of two Delaware court decisions in
2015.
Numoda was a post-trial decision of the Court of Chancery
(later affirmed by the Delaware Supreme Court) that involved a
dispute about the capital structures of two privately held
corporations. The Court of Chancery in Numoda considered the
validity of several acts that generally lacked the requisite
corporate formalities, such as noticing board meetings, taking of
minutes and issuing accurate stock certificates. As a preliminary
matter, the court considered the extent of the powers conferred
under Sections 204 and 205. The court noted that Section 205
allowed the court to declare that a defective corporate act is
effective as of the time of the act, and make such related orders
as the court deems proper under the circumstances. The court noted
that Section 205(d) provides that in deciding whether to exercise
its authority, a court may consider:
(2) Whether the corporation and board of directors has treated the defective corporate act as a valid act or transaction and whether any person has acted in reliance on the public record that such defective corporate act was valid;
(3) Whether any person will be or was harmed by the ratification or validation of the defective corporate act, excluding any harm that would have resulted if the defective corporate act had been valid when approved or effectuated;
(4) Whether any person will be harmed by the failure to ratify or validate the defective corporate act; and
(5) Any other factors or considerations the Court deems just and equitable.
The court noted that the legislative synopsis for
Section 204 indicates that Section 204 is intended as a safe harbor
to fix void or voidable acts, and is intended to overturn the
holdings in cases where, for example, many of the indicia of a
valid stock issuance or stock split were present, but the courts
refused to give effect to them because of the parties' failure
to scrupulously follow the statutory requirements. The court noted
that the language of Section 205 did not give the court clear
guidance as to the scope of its remedial power, but the scope could
not be unlimited. The court noted that there must first be some
underlying "corporate act," and observed:
The court therefore employed a two-part test: first, there
must be an identifiable corporate act, and then the court must
consider the five factors noted above in determining whether to
validate the corporate act.
With regard to board approvals for some of the stock
issuances in dispute, the court noted that stock certificates had
been issued (albeit with alleged defects), there were unsigned
board minutes supporting an issuance, the board of directors had
attempted to ratify the issuances, and the parties had acted as
though the issuances were valid. The court held that this was
sufficient proof that the underlying board approvals constituted
corporate acts. In determining whether to validate the corporate
acts, the court noted that the second, fourth and fifth factors
listed above were the most important. The parties had operated for
years as though the issuances were valid, one of the parties could
lose a significant voting interest absent validation, the board
members had purported to ratify the issuances, and the relevant
stock was no longer in dispute. Thus, the court held that the board
approvals for the stock issuances were valid.
In contrast, with regard to another issuance, the court held
that the purported holder of the stock had not been able to
establish when the board approved the issuance, and thus there was
no corporate act to validate. With regard to a third issuance, the
court found that there was a corporate act because two of the
directors had met with an intent to discuss board business,
including the grant of the applicable shares. The court then
validated the board approval for this third issuance under the
five-factor test, noting that prior to the litigation, the parties
accepted a capital structure that incorporated the shares, the
purported holders relied on the issuance, and one of the holders
would be harmed if the issuance were not validated. The court also
considered other issuances, including a purported spinoff of a
subsidiary corporation, under the two-part test.
CertiSign was a Delaware Court of Chancery action brought by
CertiSign Holding Inc. (CHI) and another person pursuant to Section
205, seeking an order declaring that certain shares of putative
stock were valid, and approving a corresponding stock ledger.
Shortly after CHI's formation in 2005, the initial board of
directors approved an amendment and restatement of CHI's
original charter, which authorized several classes and series of
stock. CHI then issued the stock to various parties in two
transactions. However, the amended and restated charter was not
filed with the Delaware secretary of state until a few days after
these issuances. When the error was discovered in 2012, CHI sought
to take remedial steps, which would have required approval by the
current directors and two of the original board members. One of the
original board members, Sergio Kulikovsky, refused to assist. As a
result, CHI filed the Chancery Court action. Kulikovsky intervened
in the court proceedings and filed a corresponding counterpetition.
Kulikovsky acknowledged that CHI would ultimately obtain relief,
but contended that it would not be fair and equitable to grant
CHI's requested relief without also determining the validity of
other securities, some of which were held by him. CHI responded
that the relief sought by Kulikovsky was subject to factual
disputes that would require extended proceedings.
The court noted that CHI's petition appeared to be
tailor-made for Section 205 relief, given in part that all
stockholders agreed that it arose from a ministerial error and all
record stockholders signed written consents supporting it. In
objecting to the petition, Kulikovsky relied on Section 205(d),
which requires the court to consider "[w]hether any person
would be harmed or was harmed by the ratification or validation of
the defective corporate act, excluding any harm that would have
resulted if the defective corporate act had been valid when
approved or effectuated."
Kulikovsy claimed that he would be harmed if the court did
not also validate options awarded to him, because he would be
unable to exercise the options and obtain shareholder rights,
without which petitioners would be able to take whatever action
they wanted without considering his rights as a shareholder. The
petitioners responded that such harm could not prevent entry of
relief because the court was prohibited from considering "any
harm that would have resulted if the defective corporate act had
been valid when approved or effectuated." The court ruled that
Kulikovsky had not identified any persuasive reason why relief
should not be granted, and granted petitioners' motion for
partial judgment on the pleadings.
The Numoda and CertiSign decisions provide important guidance
as to the type of actions to which Section 205 applies and the
circumstances under which Delaware courts will grant relief. In
determining whether to validate prior acts under Section 205,
courts will first look for evidence of a "corporate act,"
through documentation such as organizational documents, official
minutes, duly adopted resolutions, and a stock ledger, and through
actions of the parties. Courts draw a distinction between informal
intentions or discussions and corporate acts. Thus Section 205
should be viewed as a tool for fixing ministerial errors and not as
a backdating mechanism. Many of the same types of evidence used to
show the existence of a corporate act are also relevant to the
five-factor test used by courts under Section 205(d) to determine
whether to validate the act. However, opponents of the validation
cannot bootstrap objections by claiming a harm that would have
resulted if the defective corporate act had been valid when
approved.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.