DE Chancery Enjoins Board in Potential Stockholder Dilution Scheme

Directors and officers of struggling corporations seeking capital or startups willing to trade equity for cash should carefully read the Delaware Court of Chancery's recent transcript ruling in Elite Horse Investments Ltd. v. T3 Motion, C.A. No. 10550-CB (Del. Ch. Jan. 23, 2015), and consider it a cautionary tale. If control of a business can be purchased, sitting directors and officers should not be surprised when the new controlling stockholder or control group installs its own directors and replaces management. Moreover, directors and officers should think long and hard before attempting defensive measures aimed at protecting their positions or other entrenchment motives. As discussed below, the Court of Chancery will not hesitate in enjoining such conduct.

Background

Elite Horse Investments Ltd. (EHI) is one of a group of stockholders of T3 Motion Inc., a Delaware corporation headquartered in Costa Mesa, CA, that designs, manufactures and markets electric-motor-powered personal mobility vehicles. In or around December 2014, EHI and a group of seven others invested $6 million in T3 Motion in exchange for approximately 60 million shares or roughly 60% of T3 Motion's equity. At the time of EHI's investment, T3 Motion's board of directors was composed of three members: CEO William Tsumpes, Steven Healy and Ki Nam. However, T3 Motion's bylaws authorized the company to have seven directors on the board.

On Dec. 26, 2014, EHI and seven other T3 Motion stockholders, holding in excess of 60% of T3 Motion's shares, delivered a signed stockholder written consent dated Dec. 17, 2014, electing four individuals to T3 Motion's board, thus filling the four vacant director seats. In response, on Jan. 15, Tsumpes contacted Healy and Nam to hold a board meeting, excluding the directors appointed to the T3 Motion board by the December 2014 written consent. The tentative agenda of the board meeting included the “urgent” matter of selling T3 Motion equity to a third-party investor, converting T3 Motion debt held by Tsumpes and an entity called T-Energy to equity and converting Tsumpes' unpaid salary to common stock. The motive behind these actions was to dilute EHI's and the other seven investor stockholders' interests in T3 Motion to less than a controlling majority.

EHI initiated the underlying action Jan. 16, pursuant to Section 225 of the Delaware General Corporation Law, and sought a declaratory judgment that the new directors were validly elected. Around the time EHI filed its Section 225 action, the four “new” T3 Motion directors, along with existing director Nam, executed a written consent removing Tsumpes as CEO and appointing one of the new directors in his stead.

On Jan. 20, EHI and six other stockholders collectively holding approximately 58% of T3 Motion's stock issued a written consent dated Jan. 15 that ratified and retook the actions in the December 2014 written consent ' and removed Tsumpes and Healy from the T3 Motion board of directors. On Jan. 21, EHI filed an amended complaint seeking declarations that the director consent and the second stockholder consent were also valid and enforceable. In addition, EHI filed a motion for a temporary restraining order seeking to enjoin the T3 Motion board of directors and Tsumpes from taking certain actions that could harm the company, including the dilution of T3 Motion's stock. T3 Motion opposed the motion on three bases. First, the defendant argued that the stockholders' consents ran afoul of Section 211(b) of the DGCL. Second, the defendant contended the consents failed to comply with the date and signature requirements of Section 228(c) of the DGCL. And third, the defendant alleged that EHI failed to comply with the prompt notice requirement in Section 228(e) of the DGCL when delivering the consents.

The Ruling

The court was unmoved by the defendant's argument that, pursuant to Section 211(b), the December 2014 stockholder consent was unlawful because, as a less than unanimous stockholder consent, the December 2014 stockholder consent did not remove all T3 Motion's directors before filling vacancies on the board. Rather, Chancellor Andre G. Bouchard indicated that Section 211(b) applies when a stockholder written consent electing directors purports to be in lieu of an annual meeting. Because the December 2014 stockholder consent did not intend to replace an annual meeting, Section 211(b) was inapplicable.

The court noted that Section 228 of the DGCL allows for written consents to be utilized in these circumstances unless otherwise provided in a company's charter. In fact, T3 Motion's bylaws include language permitting stockholders to take any action that is required or permitted to be taken at an annual or special meeting by written consent. The chancellor also noted that support for this position can be found in the relatively recent Delaware Supreme Court decision in Crown EMAK Partners LLC v. Kurz, 992 A.2d 377 (Del. 2010). Relying on Crown EMAK, the chancellor stated that a company's charter must be explicit in prohibiting stockholders from filling board vacancies by written consent. Clearly, that was not the case here. For those reasons, the chancellor found it reasonably probable that EHI would succeed on its argument that the consenting directors had the ability to appoint directors to the vacant board seats by written consent and that the Section 211(b) defense was without merit.

The court also dispatched the two technical defenses raised by the defendant. The first argument centered on the purported failure of the December 2014 written consent being properly signed and dated. The court found that regardless of the validity of the defendant's argument, it was subsequently mooted by the January stockholder consent, which there was no argument that it was properly signed and dated. The January stockholder consent both retook and ratified the December 2014 stockholder consent. Similarly, the court found no support for the defendant's final argument that T3 Motion was not given prompt notice of the consents consistent with Section 228(e). The defendant failed to identify any authority for the proposition that Section 228(e) requires notice in less than 30 days. Without any support for its untimely notice argument, the court found the defendant's Section 228(e) defense lacked merit. After sorting through the various defenses, the chancellor granted the motion for a temporary restraining order, noting that it was similar in nature to status quo orders that are customarily imposed in Section 225 actions.

'Plainly Irreparable Harm'

Of particular note, the chancellor stated that the uncertainty of the composition of T3 Motion's board of directors put a cloud over how the company would be managed, which is “plainly irreparable harm.” The value in this statement, however, may be limited by the circumstances confronting the court. Since a majority of the T3 Motion board of directors (four of seven) were appointed by the disputed stockholder consents, irreparable harm to the company is more likely, since interim actions for the company would be taken by a minority of directors. Whether the same threat of imminent irreparable harm exists where a minority of the directors' seats are in dispute is debatable. Nevertheless, the Court of Chancery demonstrated, yet again, its willingness to act quickly and decisively in order to protect Delaware companies and their stockholders from potential harm.

Brett M. McCartney ([email protected]) is a partner at Morris James in Wilmington, DE. He practices primarily in the Delaware Court of Chancery and Delaware Superior Court, and focuses on corporate governance and complex commercial litigation, stockholder litigation, fiduciary duties, alternative entity disputes, class action, and derivative litigation. This article also appeared in the Delaware Business Court Insider, an ALM sister publication of this newsletter.

Directors and officers of struggling corporations seeking capital or startups willing to trade equity for cash should carefully read the Delaware Court of Chancery's recent transcript ruling in Elite Horse Investments Ltd. v. T3 Motion, C.A. No. 10550-CB (Del. Ch. Jan. 23, 2015), and consider it a cautionary tale. If control of a business can be purchased, sitting directors and officers should not be surprised when the new controlling stockholder or control group installs its own directors and replaces management. Moreover, directors and officers should think long and hard before attempting defensive measures aimed at protecting their positions or other entrenchment motives. As discussed below, the Court of Chancery will not hesitate in enjoining such conduct.

Background

Elite Horse Investments Ltd. (EHI) is one of a group of stockholders of T3 Motion Inc., a Delaware corporation headquartered in Costa Mesa, CA, that designs, manufactures and markets electric-motor-powered personal mobility vehicles. In or around December 2014, EHI and a group of seven others invested $6 million in T3 Motion in exchange for approximately 60 million shares or roughly 60% of T3 Motion's equity. At the time of EHI's investment, T3 Motion's board of directors was composed of three members: CEO William Tsumpes, Steven Healy and Ki Nam. However, T3 Motion's bylaws authorized the company to have seven directors on the board.

On Dec. 26, 2014, EHI and seven other T3 Motion stockholders, holding in excess of 60% of T3 Motion's shares, delivered a signed stockholder written consent dated Dec. 17, 2014, electing four individuals to T3 Motion's board, thus filling the four vacant director seats. In response, on Jan. 15, Tsumpes contacted Healy and Nam to hold a board meeting, excluding the directors appointed to the T3 Motion board by the December 2014 written consent. The tentative agenda of the board meeting included the “urgent” matter of selling T3 Motion equity to a third-party investor, converting T3 Motion debt held by Tsumpes and an entity called T-Energy to equity and converting Tsumpes' unpaid salary to common stock. The motive behind these actions was to dilute EHI's and the other seven investor stockholders' interests in T3 Motion to less than a controlling majority.

EHI initiated the underlying action Jan. 16, pursuant to Section 225 of the Delaware General Corporation Law, and sought a declaratory judgment that the new directors were validly elected. Around the time EHI filed its Section 225 action, the four “new” T3 Motion directors, along with existing director Nam, executed a written consent removing Tsumpes as CEO and appointing one of the new directors in his stead.

On Jan. 20, EHI and six other stockholders collectively holding approximately 58% of T3 Motion's stock issued a written consent dated Jan. 15 that ratified and retook the actions in the December 2014 written consent ' and removed Tsumpes and Healy from the T3 Motion board of directors. On Jan. 21, EHI filed an amended complaint seeking declarations that the director consent and the second stockholder consent were also valid and enforceable. In addition, EHI filed a motion for a temporary restraining order seeking to enjoin the T3 Motion board of directors and Tsumpes from taking certain actions that could harm the company, including the dilution of T3 Motion's stock. T3 Motion opposed the motion on three bases. First, the defendant argued that the stockholders' consents ran afoul of Section 211(b) of the DGCL. Second, the defendant contended the consents failed to comply with the date and signature requirements of Section 228(c) of the DGCL. And third, the defendant alleged that EHI failed to comply with the prompt notice requirement in Section 228(e) of the DGCL when delivering the consents.

The Ruling

The court was unmoved by the defendant's argument that, pursuant to Section 211(b), the December 2014 stockholder consent was unlawful because, as a less than unanimous stockholder consent, the December 2014 stockholder consent did not remove all T3 Motion's directors before filling vacancies on the board. Rather, Chancellor Andre G. Bouchard indicated that Section 211(b) applies when a stockholder written consent electing directors purports to be in lieu of an annual meeting. Because the December 2014 stockholder consent did not intend to replace an annual meeting, Section 211(b) was inapplicable.

The court noted that Section 228 of the DGCL allows for written consents to be utilized in these circumstances unless otherwise provided in a company's charter. In fact, T3 Motion's bylaws include language permitting stockholders to take any action that is required or permitted to be taken at an annual or special meeting by written consent. The chancellor also noted that support for this position can be found in the relatively recent Delaware Supreme Court decision in Crown EMAK Partners LLC v. Kurz , 992 A.2d 377 (Del. 2010). Relying on Crown EMAK, the chancellor stated that a company's charter must be explicit in prohibiting stockholders from filling board vacancies by written consent. Clearly, that was not the case here. For those reasons, the chancellor found it reasonably probable that EHI would succeed on its argument that the consenting directors had the ability to appoint directors to the vacant board seats by written consent and that the Section 211(b) defense was without merit.

The court also dispatched the two technical defenses raised by the defendant. The first argument centered on the purported failure of the December 2014 written consent being properly signed and dated. The court found that regardless of the validity of the defendant's argument, it was subsequently mooted by the January stockholder consent, which there was no argument that it was properly signed and dated. The January stockholder consent both retook and ratified the December 2014 stockholder consent. Similarly, the court found no support for the defendant's final argument that T3 Motion was not given prompt notice of the consents consistent with Section 228(e). The defendant failed to identify any authority for the proposition that Section 228(e) requires notice in less than 30 days. Without any support for its untimely notice argument, the court found the defendant's Section 228(e) defense lacked merit. After sorting through the various defenses, the chancellor granted the motion for a temporary restraining order, noting that it was similar in nature to status quo orders that are customarily imposed in Section 225 actions.

'Plainly Irreparable Harm'

Of particular note, the chancellor stated that the uncertainty of the composition of T3 Motion's board of directors put a cloud over how the company would be managed, which is “plainly irreparable harm.” The value in this statement, however, may be limited by the circumstances confronting the court. Since a majority of the T3 Motion board of directors (four of seven) were appointed by the disputed stockholder consents, irreparable harm to the company is more likely, since interim actions for the company would be taken by a minority of directors. Whether the same threat of imminent irreparable harm exists where a minority of the directors' seats are in dispute is debatable. Nevertheless, the Court of Chancery demonstrated, yet again, its willingness to act quickly and decisively in order to protect Delaware companies and their stockholders from potential harm.

Brett M. McCartney ([email protected]) is a partner at Morris James in Wilmington, DE. He practices primarily in the Delaware Court of Chancery and Delaware Superior Court, and focuses on corporate governance and complex commercial litigation, stockholder litigation, fiduciary duties, alternative entity disputes, class action, and derivative litigation. This article also appeared in the Delaware Business Court Insider, an ALM sister publication of this newsletter.