Delaware Court Applies Enhanced Scrutiny, Invalidates Vote Blocking
Provisions of Preferred Stock
Although the directors of Xurex, Inc., a company with at best a painful history, acted with subjective good faith when they authorized additional equity classes that served to dilute certain voting blocks and thereby provide stability to management, applying strict scrutiny, the directors were found to have violated their fiduciary obligation of loyalty. Johnson v. Pedersen, ___ A.3d ___, 2011 WL 4435806 (Del.Ch.).
Without reciting the history of the company’s financial woes and abrupt changes in management, the company was without cash, entirely dependent on one licensee for income, had suffered several abrupt changes in the board and was subject to further changes by reason that a majority of the shares were held by two shareholders. Attempting to raise new equity, a Series B Preferred class was proposed. Pursuant to the Board’s authority under a blank check provision, the Series B was defined as being voting and while any Series B shares are outstanding the consent of a majority of the of its holders, “voting separately as a single class, shall be required for the approval of any matter that is subject to a vote of the Corporation’s shareholders….”
The battle over the Series B Preferred came to a head when the acquirer of its sole customer sought to gain control, though a proxy contest, of Xurex. While the challenger had proxies for more than half of the total equity, they held proxies for only 13% of the Series B Preferred. If the right to block shareholder action as embodied in the terms of the Series B was valid the proxy contest would fail, but if it was invalid then once again control of Xurex would pass to a new board.
The Court (V.C. Laster) applied the intermediate stage of enhanced scrutiny analysis, it applying “where the law provides shareholders with a right to vote and the directors take action that intrudes on the space allotted for stockholder decision-making.” 2011 WL 4435806, *10, quoting Reis v. Hazelett Strip-Castings Corp., 2011 WL 4346913, *8 (Del. Ch. 2011). The Court went on to observe:
When tailored for reviewing director action affecting a stockholder vote, enhanced scrutiny requires that the defendant fiduciaries bear the burden of persuading the Court that their motivations were proper and not selfish, that they did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way, and that the directors’ actions were reasonably related to a legitimate objective. If the fit between means and end is not reasonable, then the directors fall short. When the vote involves an election of directors or touches on matters of corporate control, the directors must support their decisions with a compelling justification. The shift from “reasonable” to “compelling” requires that the board establish a closer fit between means and end. Moreover, in such a context, there is one justification that the directors cannot invoke: they cannot claim that the stockholders may vote out of ignorance or mistaken belief about what course of action is in their own interests. Id. (citations omitted).
Determining that the director’s duty of loyalty has been violated and that the holders of the Series B Preferred were not entitled to a class voting right, the Court wrote:
The incumbent directors could not act loyally and deprive the stockholders of their right to elect new directors, even though they believed in good faith that they knew what was best for the corporation …. The right to choose who should be members of the Xurex board did not belong to the Xurex directors; it belonged to the Xurex stockholders. 2011 WL 4435806, *11.
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