United States: Significant 2015 Decisions Affecting Private M&A: Part 1

The following compilation is Kaye Scholer's second annual review of significant Delaware court decisions relating to private merger and acquisition transactions and disputes. The decisions here, all issued in 2015, are organized in the following sections: proxy contests and other disputes involving the board, fraud claims in M&A transactions, deal mechanics, employee and options matters, and decisions interpreting Delaware's recently adopted statutes governing ratification and validation of corporate acts.

This review is split into a three part-series. Part one includes decisions that relate to proxy contests and other disputes involving the board.

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:

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.

This is part one of a three-part series that originally appeared in Law360 on January 12, 2016.

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.