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Sherwood v. Chan: Court of Chancery Grants Temporary Restraining Order Enjoining Corporation's Annual Meeting for 20 Days to Allow Adequate Time for Corrective Disclosures and Consideration of a Competing Slate of Director Nominees

March 2, 2012

In Sherwood v. Chan, C.A. No. 7106-VCP (Del. Ch. Dec. 20, 2011), the Court of Chancery issued a temporary restraining order enjoining ChinaCast Education Corporation (“ChinaCast”) and certain of its directors (collectively, “Defendants”) from holding ChinaCast’s annual meeting for a period of 20 days so that stockholders could express their “fully informed” views in the corporate election. Plaintiffs Ned Sherwood and ZS EDU, L.P. (collectively, “Plaintiffs”) brought the action on December 12, 2011, asserting claims for breach of fiduciary duty and defamation and seeking a temporary restraining order against Defendants so that certain corrective disclosures could be made and Plaintiffs’ competing slate of nominees could be considered prior to the annual meeting, which was scheduled to take place on December 20, 2011. The Court noted that, of the Plaintiffs’ claims, only the disclosure claims could warrant a temporary restraining order, and proceeded to find that: (i) those claims were colorable, (ii) irreparable harm existed because of the threat of an uninformed stockholder vote, and (iii) while the equities claimed by both Plaintiffs and Defendants might be in equipoise, the balance of equities as between Defendants and ChinaCast’s stockholders tipped decidedly in favor of granting the temporary restraining order.

In a definitive proxy statement filed with the SEC on November 14, 2011, ChinaCast recommended Sherwood, a ChinaCast director and stockholder, for reelection to its board of directors. Then, on December 8, 2011, 12 days before the scheduled annual meeting, the board issued supplemental proxy materials (the “Proxy Supplement”) removing Sherwood from ChinaCast’s slate of nominees to the board. Among the reasons provided in the Proxy Supplement for removing Sherwood from the slate were alleged insider trading activity in violation of ChinaCast’s internal policies, and behavior that was deemed detrimental to “a productive and professional working relationship.” The Proxy Supplement stated that Sherwood’s alleged insider trading activity was reported to the SEC, but it did not disclose the existence or status of any SEC investigation.

The Court found that Sherwood had shown two possible ways in which the Proxy Supplement could be misleading, sufficient to support a finding that a colorable disclosure claim existed. First, the Court found that the Proxy Supplement might be misleading by failing to disclose candidly the board’s motivations for removing Sherwood from ChinaCast’s slate of nominees, which could have been based on avoiding policy disputes between Sherwood and other directors. Second, the Court found that the Proxy Supplement might be misleading in that it stated that management informed the SEC of Sherwood’s alleged insider trading activity (thus creating the impression that Sherwood was unsuitable to serve as a director because of a possible criminal or civil enforcement action), but failed to state that Sherwood informed ChinaCast that he had been told that the SEC had determined not to pursue an action against him. Defendants contended that any SEC action was not material. The Court rejected this, noting that “if the SEC’s actions were not material . . . it begs the question why the Company disclosed their reporting of the [alleged insider trading activity] to the SEC at all.”

Next, the Court found irreparable harm because, absent a temporary restraining order, ChinaCast’s stockholders would not have adequate time to consider corrective disclosures or Plaintiffs’ competing slate of nominees prior to the vote, thereby rendering the vote uninformed. Defendants argued that there was no risk of harm with respect to Plaintiffs’ competing slate, because Plaintiffs could not comply with the advance notice bylaw and thus were prevented from nominating a competing slate at the upcoming election. The Court stated that a finding of irreparable harm was not dependent on two properly nominated slates, because misleading disclosures might affect reasonable stockholders’ decisions to vote “for” or “withhold,” and therefore, “a threat of irreparable harm may exist in even an uncontested election where shareholders are not fully and fairly informed.” Furthermore, the Court found that Defendants’ argument that the advance notice bylaw precluded Plaintiffs from nominating their slate was “less than compelling,” and that absent a temporary restraining order, federal regulations guaranteed Plaintiffs would lose because their proxies would not become effective until after December 21.

The Court also found that the balance of the equities weighed in favor of granting a temporary restraining order. Although the parties disputed whether Plaintiffs acted in a timely fashion to present their grievances to the stockholders, the Court found that the facts supported a reasonable inference that both parties pursued aggressive, but good faith, negotiating strategies to resolve their disputes leading up to the date of the Proxy Supplement, and that Plaintiffs acted relatively quickly to preserve their rights once they learned Sherwood would not be on ChinaCast’s slate. The Court noted that the situation was reminiscent of Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988), where a board’s good faith effort to protect its incumbency in order to thwart implementation of a corporate policy that it reasonably feared would be harmful to the company interfered with the effectiveness of a stockholder vote. In this instance, the board’s inaction in failing to resolve differences among its members and not taking steps to alleviate the issues created by belatedly removing Sherwood from the slate operated inequitably against the Plaintiffs and the interests of corporate democracy. The Court concluded that allowing the annual meeting to proceed on December 20 would not comport with the “scrupulous fairness” required in corporate elections, and thus enjoined the meeting for 20 days. However, to allay Defendants’ concerns that delaying the annual meeting would require ChinaCast to incur additional significant expense, the Court required Plaintiffs to post a $250,000 bond.