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Johnston v. Pedersen: Court of Chancery Holds That Directors Violated Their Duty Of Loyalty When Issuing Preferred Stock To Friendly Stockholders

October 31, 2011

In Johnston v. Pedersen, C.A. No. 6567-VCL (Del. Ch. Sept. 23, 2011), the Court of Chancery held that the directors of a Delaware corporation violated their duty of loyalty when designing and issuing a new series of preferred stock because those directors intentionally “structure[d] the stock issuance to prevent an insurgent group from waging a successful proxy contest.” 

In Johnston, an action brought pursuant to 8 Del. C. § 225, the Court was called on to determine the proper board of directors of Xurex, Inc. (“Xurex” or the “Company”). Xurex is an early stage company which sells protective coatings primarily used in the oil and gas industry. Between 2005 and 2009, Xurex raised over $10 million through the sale of common stock and Series A Preferred Stock. Notably, however, two founders continued to control a majority of the Company’s outstanding voting power. 

Despite its substantial fundraising, Xurex had never developed a commercial product of its own. Rather, 99% of Xurex’s sales were to one distributor, DuraSeal Pipe Coatings Company (“DuraSeal”), which had developed unique methods of using Xurex’s coatings in the oil and gas industry. As a result of Xurex’s lack of commercial success, and following allegations of financial misconduct by one of its founders, the Company underwent several director changes in 2009 and early 2010. The board that was eventually elected in early 2010 was concerned about the Company’s financial viability. Also, because of the Company’s tumultuous relationship with the founders (who continued to hold a majority of the outstanding shares), the board was concerned that the founders would again support an effort to change the board. The Court found that the board decided to address both of these issues at once through the issuance of a new series of preferred stock. 

The board first pursued a bridge loan offering in the spring of 2010. Investors in the bridge loan had the right to convert their bridge loan notes into a planned new preferred stock series at a 50% discount to its issue price. Several months later, in August 2010, the board offered the Series B Preferred Stock (the “Series B”). The Series B contained an expansive class voting provision (the “Class Vote Provision”) which required the affirmative support of a majority of the Series B for the approval of “any matter that is subject to a vote of the [Company’s] stockholders.” The Court found that the board had developed the idea of vesting the Series B with a “super vote right” during the bridge loan offering. However, the board only selectively disclosed this information to stockholders whom the directors believed were likely to support the incumbent board in a future control contest. Similarly, even though the defendants argued that the Class Vote Provision was necessary to induce investment in the Series B, the Series B private placement memorandum only contained a brief discussion of the provision on page 29 of the 34-page document. The Court found that the apparent tension between the avowed necessity of the Class Vote Provision and the lack of disclosure was easily resolved: “the directors needed to provide the class vote to induce favored (viz. incumbent-supporting) stockholders to invest. There was no need to call this attractive feature to the attention of other non-favored and potentially non-incumbent-supporting investors.” 

In April 2011, DuraSeal began soliciting proxies from Xurex stockholders to remove the incumbent directors and elect a new board. On June 14, 2011, five written consents and supporting proxies (the “Written Consents”) representing a majority of the outstanding shares of the Company were delivered to the Company and its registered agent. The Written Consents purported to remove the board and elect a new slate of directors. Although the Written Consents represented a majority of the Company’s outstanding voting power, they were not supported by a majority of the outstanding shares of the Series B. 

Promptly after delivering the Written Consents, the plaintiffs filed suit seeking a determination that the consents were valid and effective. In opposition, the incumbent directors argued that they were not validly removed because the Class Vote Provision of the Series B required that the Written Consents be supported by a majority of the shares of the Series B. 

After trial, the Court held that the board issued the Series B in breach of their duty of loyalty. Therefore, the Court would not enforce the Class Vote Provision of the Series B in connection with the removal of the incumbent board and the election of a new board. The Court held that enhanced scrutiny applied because the board’s actions in issuing the Series B affected the stockholder franchise. Additionally, because the Class Vote Provision affected the ability of stockholders to vote for directors or determine corporate control, the Court found that the defendant directors must demonstrate a “compelling justification” for their actions in accordance with Blasius Indus., Inc. v. Atlas Corp., 813 A.2d 1113 (Del. Ch. 1988). 

The Court held that the record established that the board specifically intended for the Class Vote Provision to prevent the common stock and the Series A Preferred holders from electing a new board. While the Court credited the defendants’ position that they honestly believed that the Company would benefit from a period of “stability,” the Court noted that “[w]hat the directors actually meant by ‘stability’ was to prevent themselves from being removed from office, making ‘stability’ a euphemism for entrenchment.” Thus, even though the Court found that the directors in good faith believed that preventing another control dispute would best serve the Company, the Court held that the directors essentially usurped the stockholders’ ability to choose the directors of Xurex. The Court stated that the board could not act loyally while depriving stockholders of this right. 

Also, the Court noted that even if the board had subjectively intended to include the Class Vote Provision solely to raise capital, it would still be invalid. Two defendants admitted at trial that the Class Vote Provision was broader than necessary to achieve its stated goal (i.e., to entice investment). The Court further noted that the board effectively transferred negative control of Xurex to the Series B holders for too low of a price. For these reasons as well, the defendants were unable to satisfy the compelling justification standard. 

Thus, the Court concluded that while the board honestly believed that preventing a change of control was in the best interests of Xurex, their efforts to deprive stockholders of the ability to elect new directors constituted a violation of the duty of loyalty. As such, the Court refused to enforce the Class Vote Provision with respect to the Written Consents.