Delaware Corporate Law and Chancery Review

The recent decision from the Delaware Court of Chancery in Williams v. Ji, C.A. No. 12729-VCMR (Del. Ch. June 28, 2017), provides important insights into the Delaware law applicable to challenges to voting agreements among stockholders, as well as to director compensation packages.

Background

The allegations were based on a plan in which directors granted themselves options and warrants for the stock of five subsidiaries over which the corporation had voting control. Around the time those options were granted, the board transferred valuable assets and opportunities of the corporation to the subsidiaries. A stockholder challenged the grants as a breach of fiduciary duty due to the excessive value that was given in the form of compensation. The complaint also alleged that the voting agreements amounted to illegal vote buying to the extent that a stockholder was required to vote its shares in a manner that the board of directors instructed.

Issues

The key issues addressed included whether the business judgment rule or the entire fairness standard would apply to the decisions by the board to grant themselves options as a form of compensation, and whether or not the voting agreements were deficient in some manner. The court also addressed the issue of ripeness and whether or not the issues relating to the voting agreement were hypothetical, because the voting agreement only represented a small percentage of the voting shares and did not determine the outcome of any elections to date.

Legal Principles

The court relied on a recent Delaware Supreme Court decision that defined ripeness to include claims that have “matured to a point where judicial action is appropriate.” Moreover: “a dispute will be deemed ripe if litigation sooner or later appears to be unavoidable and where the material facts are static.” (citing XL Specialty Ins. Co. v. WMI Liquidating Trust, 93 A.3d 1208, 1217 (Del. 2014). In this instance, the court found sufficient static material facts to determine whether entering into the voting agreement constituted a breach of fiduciary duty.

Analysis

Regarding the standard applicable to executive compensation decisions, the court explained the well-settled Delaware law that “self-interested compensation decisions made without independent protections are subject to the same entire fairness review as any other interested transaction” (citing Valeant Pharm. Int'l v. Jerney, 921 A.2d 732, 745 (Del. Ch. 2007). The court explained the well-known aspects of the entire fairness standard that include both fair dealing and fair price. The court also observed that application of entire fairness review typically precludes dismissal of a complaint on a Rule 12(b)(6) motion to dismiss.

Where a complaint adequately pleads that the board lacks independence, and alleges a claim for excessive compensation, the plaintiff “only need allege some specific facts suggesting unfairness in the transaction in order to shift the burden of proof to defendants to show that the transaction was entirely fair” (citing In re: Tyson Foods, Inc., 919 A.2d 563, 589 (Del. Ch. 2007). In this case, the court determined that the complaint satisfied that standard by pleading “some specific facts suggesting unfairness” in the options involved — thereby shifting to defendants the burden of proving that the grant of the options was entirely fair.

Regarding the unfair process analysis, the complaint alleged that no one other than the interested directors ever approved the challenged grants. The grants were also timed around the transfer of valuable assets or opportunities to subsidiaries and the grants were not disclosed as compensation but rather were disclosed in a proxy statement as “related-party transactions.” The court reasoned that those allegations gave rise “to at least a reasonably conceivable inference of unfair process.”

With respect to the fair price element, the court referred to an allegation where one of the defendants alone was granted the right to 18% of the economic value of one of the subsidiaries, which was estimated, to be worth $178 million, thereby making his interest worth over $30 million. The court cited to the 1995 decision in Steiner v. Meyerson, 1995 WL 441999 at * 7 (Del. Ch. July 19, 1995), which refused to grant a motion to dismiss when merely $20,000 per year compensation for director service was challenged under the entire fairness standard.

Regarding the voting agreement issue, DGCL Section 218(c) explicitly authorizes certain voting agreements to be entered into. The Court of Chancery, in unrelated decisions in the past, previously ruled that the transfer of stock voting rights without the transfer of ownership is not per-se illegal. In order to be illegal, a vote-buying agreement must have as its primary purpose either to defraud or in some way to disenfranchise other stockholders. In a prior decision involving voting agreements, the court explained that two or more stockholders may “do whatever they want with their votes, including selling them to the highest bidder.” However, the counter balance to that statement is that “management may not use corporate assets to buy votes unless it can be demonstrated, as it was in Schreiber, that management's vote-buying activity does not have a deleterious effect on the corporate franchise.”

In this case, corporate assets were used to buy the votes. Based on the facts of this case, the burden shifted to the defendants to prove that the agreement was intrinsically fair and not designed to disenfranchise other stockholders. Making reasonable inferences in favor of the plaintiff at this early stage, the complaint adequately alleged a disenfranchisement purpose.

No Fiduciary Duty Owed By Minority Owner

A recent letter opinion provides a practical description of the elements required to satisfactorily plead a breach of fiduciary duty claim, as well as a definition of situations where a fiduciary relationship may be found. In Beach to Bay Real Estate Center, LLC v. Beach to Bay Realtors, Inc., C.A. No. 10007-VCG (Del. Ch. July 10, 2017), the Court of Chancery also observed the non-controversial truism that minority members of LLCs generally do not owe fiduciary duties to the LLC or other members.

The court explained that in Delaware, a fiduciary relationship may be found in ” … a situation where one person reposed special trust in and reliance on a judgment of another or where a special duty exists on the part of one person to protect the interest of another.”

Moreover, the court explained that there “ must be an allegation of an agreement supplying such a duty or a special relationship creating such a duty.” The court observed that in its experience, “thieves and their victims rarely consider their relationship an equitable one on account of that status alone. Rather, there must be some repose of special trust … or reliance … .”

The court allowed, however, for the possibility that “in certain circumstances a minority member of an LLC, with access to confidential information, could stand in a fiduciary relationship to the entity or other members.” But, non-conclusory allegations in support of a relationship creating such a duty were found lacking in the complaint in this case.

Stock Transfer Restrictions Explained

A recent decision of the Delaware Court of Chancery needs to be consulted by anyone who seeks to fully understand the prerequisites under the Delaware General Corporation Law for effective restrictions on the transfer of stock. Henry v. Phixos Holdings, Inc., C.A. No. 12504-VCMR (Del. Ch. July 10, 2017).

The prerequisites under DGCL Section 202 include actual knowledge of the restrictions and consent by the stockholder to the stock transfer restrictions. The court explained in this useful decision why the requirements of Section 202 were not met based on the facts of this case, and why those restrictions cannot be retroactive unless additional requirements are satisfied.

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Francis G.X. Pileggi is the member-in-charge of the Wilmington, DE, office of Eckert Seamans Cherin & Mellott, LLC. He can be reached at [email protected]. Mr. Pileggi summarizes key corporate and commercial decisions of Delaware Courts at www.delawarelitigation.com.