Litigation: Disloyal director conduct doesn’t always constitute bad faith

Recent decision shows that Delaware courts continue to carefully guard stockholder voting rights.

In 2006, in Stone v. Ritter, the Delaware Supreme Court held that the duty of good faith was not an independent fiduciary duty, but was instead a subsidiary of the duty of loyalty.

The rationale is that a director who acts in bad faith cannot simultaneously be loyal to the corporation. But if all bad faith acts constitute disloyalty, do all disloyal acts constitute bad faith? The answer is “no,” according to a recent decision by the Delaware Court of Chancery.

Johnston v. Pedersen, decided on Sept. 23, 2011 by Vice Chancellor J. Travis Laster, dealt with an action brought pursuant to Section 225 of the Delaware General Corporation Law (DGCL) by a group of stockholders seeking a declaration that they validly removed the incumbent directors of Xurex Inc.

In an effort to win the contest for control, the incumbent directors issued Series B Preferred Stock with class voting rights to incumbent-friendly investors. The incumbent directors then argued that the insurgent’s efforts to remove them were invalid because, although the consents they obtained represented a majority of the company’s voting power, the removal was not approved by a majority of the holders of Series B Preferred Stock voting separately as a class.

In declining to enforce the class vote provision, the Court of Chancery applied the rarely invoked Blasius standard of review (derived from the 1988 case of Blasius Indus. Inc. v. Atlas Corp.), which requires directors to establish a “compelling justification” when they take action that impinges on the stockholder franchise, and held that the incumbent directors breached their fiduciary duty of loyalty.

However, the court also found that the directors acted in the subjective good faith belief that their actions to stave off the insurgent stockholders were in the best interest of the company and all of its stockholders. The company had already undergone two contests for control and the board wanted to avoid a third because the company needed to raise money and “the prospect of another election contest loomed like the sword of Damocles.”

The court began its legal analysis by dilating on the “inherent positional conflict” faced by directors and officers standing for election. Simply because the candidate is likely to prefer to be elected rather than defeated, there exists a personal interest in the outcome (even if not financial).

That inherent personal interest, which can “subtly undermine the decisions of even independent and disinterested directors,” results in the application of Delaware’s intermediate standard of review: enhanced scrutiny, which scrutiny has contextualized application in different settings.

When tailored for review of director action affecting a stockholder vote, enhanced scrutiny requires that:

  1. The defendant fiduciaries persuade the court that their motivations were proper and not selfish
  2. That they neither precluded stockholders from voting nor coerced to them to vote a certain way
  3. That the fiduciaries’ actions were reasonably related to a legitimate objective

When the fit between the means and the end are not reasonable, the defendant fiduciaries fail to carry their burden. When the stockholder vote at issue involves a director election or touches on matters of corporate control, the defendant directors then face Delaware’s most stringent test for director conduct and they must establish that their decisions are supported by a “compelling justification.”

After a two-day trial, the court found that the Xurex board failed to meet its burden. Nonetheless, the court found that the director defendants believed in good faith that they were acting in the best interests of Xurex by attempting to achieve “stability.”

However, by denying Xurex stockholders the fundamental right to elect directors of their choice, the directors breached their duty of loyalty (albeit in the subjective good faith belief that they were advancing the bests interests of the company).

This decision underscores that Delaware courts continue to carefully guard stockholder voting rights. And, in that context, directors need to be wary that they sometimes can “subjectively operat[e] selflessly,” but nevertheless find themselves pursuing a purpose that a reviewing court will find inequitable or disloyal.

A disloyalty finding is significant because Section 102(b)(7) of the DGCL prohibits exculpation by the corporation for such conduct, requiring the director to make a special request for indemnification under Section 145.

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