Recent Judicial Developments in Delaware Corporate Law

A number of recent decisions from the Delaware courts are discussed below. The decisions involve developments relating to mergers and acquisitions, venture capital and corporate governance.  One Chancery Court decision discussed below is the subject of an expedited appeal before the Delaware Supreme Court and involves, among other things, the circumstances under which the failure to give advance notice to a director that his removal as an officer of the corporation may be voted on at a board meeting might render the actions taken at the meeting voidable or even void despite literal compliance with the notice provisions for board meetings contained in the corporation’s bylaws.

Chancery Court Dismisses Claims that Board Breached Fiduciary Duties by Agreeing to Contractual Restrictions to a Takeover.

In In re Sirius XM Shareholder Litig., C.A. No. 7800-CS (Del. Ch. Sept. 27, 2013), the Delaware Court of Chancery dismissed plaintiffs’ claims that the Sirius XM Radio board breached its fiduciary duties by agreeing to forego implementation of specific defensive devices to a takeover at the end of a three-year standstill period in exchange for a much-needed capital infusion of $530 million by Liberty Media Corporation (“Liberty”).  The Court found that plaintiffs’ claims accrued in 2009 when Sirius XM Radio, Inc. (“Sirius”) and Liberty entered into the agreement, not in 2012, when Liberty secured the practical ability to take control of Sirius as a result of the expiration of the standstill. As a result, the Court found that the equitable doctrine of laches barred plaintiffs’ claims.  The Court also noted, in dicta, that a board’s approval of a contract which constrains the corporation’s ability to prevent a change in control does not necessarily constitute a breach of fiduciary duty:

There are many situations when corporations enter into contractual arrangements that have important implications for corporate control in conceivable future situations; for example, debt instruments commonly give creditor’s rights that, if used, may result in their assuming control.  The use of such rights to obtain control in the situations specifically contemplated by those contracts does not constitute a fiduciary breach.

Slip op. at 22.

In February 2009, Liberty Media agreed to provide Sirius with a total of $530 million in loans to avert a bankruptcy in return for specified governance rights.  Specifically, Liberty Media received preferred stock convertible to 40 percent of the outstanding shares of Sirius common stock and entitling Liberty Media to designate directors to the Sirius board in proportion to its equity ownership in Sirius.  Liberty Media also received the contractual right to veto extraordinary corporate actions, including any merger or sale of all or substantially all of Sirius’s assets.  The parties’ agreement also prohibited Liberty from increasing its ownership interest in Sirius beyond 49.9 percent for a period of three years, and Sirius agreed that, after the standstill period expired in 2012, it would not adopt a poison pill or any other defensive measure that could adversely affect Liberty Media’s ability to take control of Sirius.  The parties’ agreement was filed with the SEC on a form 8-K, and Sirius made additional disclosures about the parties’ agreement in its 2009 10-K.

During the three years following Liberty Media’s investment, Sirius’s financial performance improved, and Sirius stockholders reaped the benefits of an increased stock price.  The standstill period expired on March 6, 2012.  Shortly thereafter, Liberty Media informed Sirius that it planned to acquire more than 50 percent of the company’s outstanding stock, and Liberty Media began buying substantial quantities of Sirius’s stock in the open market.  In this ensuing action, plaintiffs argued that the Sirius board breached its fiduciary duties by entering into the standstill and governance agreement with Liberty Media and that Liberty Media breached its fiduciary duties as a controller by buying additional shares of Sirius stock after the standstill period expired.

The Court dismissed plaintiffs’ claims.  The Court noted that plaintiffs had been on full notice since 2009 that Liberty Media would be able to acquire majority control without interference from Sirius in three years.  Further, the Court noted that the plaintiffs failed to identify any reason why they did not challenge the parties’ agreement within the required three-year statute of limitations period and concluded that: “the plaintiffs may not sue at this late date, especially given the undisputed reality that Liberty Media put $530 million at risk for over three years by investing in Sirius, in reliance on the contractual consideration it received in return.”  Plaintiffs also argued, but the Court rejected that, regardless of the bargain struck in 2009, Liberty Media still owed a duty of fairness at the end of the standstill period in 2012, to only obtain control through a transaction that was approved as fair by the independent members of the Sirius board.  According to the Court, absent fraud or the use of material, non-public information to gain an advantage in trades, Delaware’s fiduciary duty law does not preclude a stockholder (even if an effective controlling stockholder) from acquiring a majority stake by making open market purchases.  The Court declined to deprive Liberty Media from the benefits of its bargain and further held that any such claim was merely a disguised attack on the terms of the parties’ 2009 agreement and was barred on laches grounds.

Chancery Court Holds that a Vice President Does Not Possess the Inherent Authority to Vote the Corporation’s Equity Interests in other Entities

In an action to determine the lawful directors of a Delaware corporation, the Delaware Court of Chancery considered whether a “vice president” of a Delaware corporation has the inherent authority to vote stock owned by the corporation in another corporation and concluded that the title of “vice president” alone does not confer such authority.  Flaa v. Montano, C.A. No. 8632-VCG (Del. Ch. Oct. 4, 2013).  Rather, in Flaa v. Montano, the Court held that an independent authority, such as a bylaw provision or board resolution, must confer the vice president with the authority to vote the corporation’s interests in other entities.

Delaware Supreme Court Affirms Chancery Court Decision Interpreting An Earn-Out Provision in a Merger Agreement

In Winshall v. Viacom International Inc., C.A. No. 39, 2013 (Del. Oct. 8, 2013) (Jacobs, J), the Delaware Supreme Court affirmed a Delaware Court of Chancery decision which dismissed, among other things, (1) a claim by a stockholders’ representative that an acquiror breached the implied covenant of good faith and fair dealing by not taking affirmative steps to maximize the potential payments to former stockholders of the target company under an earn-out provision in the parties’ merger agreement, and (2) a claim by the acquiror, which asserted that it was entitled to indemnification under the merger agreement for alleged breaches of the target’s representations and warranties.

The dispute arose out of a 2006 merger, wherein Harmonix Music Systems, Inc. (“Harmonix”), a video game development company, was acquired by Viacom International, Inc. (“Viacom”), pursuant to a merger agreement, dated September 20, 2006 (the “Merger Agreement”), and an escrow agreement dated October 27, 2006 (the “Escrow Agreement”).  Plaintiff Winshall was the designated representative of Harmonix’s stockholders under the Merger Agreement.  Under the Merger Agreement, Viacom agreed to pay Harmonix’s stockholders two forms of consideration: (1) a $175 million cash payment payable at closing, plus (2) a contingent right to receive incremental uncapped earn-out payments, based on Harmonix’s financial performance, during the two years after the merger, i.e., 2007 and 2008.  The Merger Agreement did not require Viacom or Harmonix to conduct their businesses, post-merger, so as to ensure or maximize the earn-out payments.

The Merger Agreement and Escrow Agreement also provided that, under the Merger Agreement, Harmonix’s stockholders would indemnify Viacom for the costs of defending against third-party claims arising out of a breach of representations and warranties in the Merger Agreement.  Those agreements further provided that, for a period of 18 months, $12 million of the initial $175 million payment would be held in escrow and made available to satisfy those indemnification obligations.  Harmonix’s stockholders were obligated, however, to indemnify Viacom against any covered liabilities above the escrowed $12 million, from the monies otherwise payable under the earn-out provisions.

By the time the merger closed in October 2006, Harmonix was engaged in developing a new video game, Rock Band.  Following closing, Harmonix (now a subsidiary of Viacom) entered into agreements with third parties for the distribution of Rock Band.  The distribution fees significantly affected the earn-out payments to Harmonix’s stockholders because it was one of the largest single post-merger expenses that Harmonix incurred.  In addition, during 2007 and 2008, four claims for violation of intellectual property rights relating to Rock Band were asserted by third parties against Harmonix.  On April 24, 2008, three days before the deadline for giving notice of claims under the Merger Agreement, Viacom informed Winshall of the third-party claims and advised Winshall that Viacom might seek to be indemnified from the escrowed funds for expenses associated with these lawsuits on the basis that Harmonix had breached representations and warranties in the Merger Agreement relating to these claims.

In September 2008, four months after the contractual escrow period had ended, Winshall demanded the release of the escrowed funds. Viacom refused on the basis that it was entitled to all of the escrowed funds as indemnification for breaches of the Merger Agreement.

In December 2010, Winshall filed a complaint in the Delaware Court of Chancery against Viacom, alleging that Viacom breached the implied covenant of good faith and fair dealing by failing to minimize post-closing distribution fees which reduced the amount of the earn-out.  The Court of Chancery dismissed this claim. In a later decision, the Court of Chancery granted Winshall’s motion for summary judgment on claims seeking the release of the escrowed merger consideration and rejected Viacom’s claims that it was entitled to all of the escrowed funds as indemnification for Harmonix breaches of representations and warranties.

In this appeal, Winshall appealed the dismissal of its implied covenant claim and Viacom appealed the Chancery Court’s grant of summary judgment in Winshall’s favor on his claims for the release of the escrow funds.  The Delaware Supreme Court affirmed both Chancery Court decisions.  The Court held that the “implied covenant of good faith and fair dealing cannot properly be applied to give the plaintiffs contractual protections that they failed to secure for themselves at the bargaining table.”  The Court noted that the parties could have agreed in the Merger Agreement that Harmonix would take steps to maximize the amount of the earn-out post-closing, but failed to do so.

With respect to Viacom’s appeal, the Delaware Supreme Court rejected Viacom’s argument that it was entitled to the escrowed funds as indemnification for breaches of representations and warranties.  Specifically, the Delaware Supreme Court found that the representations and warranties at issue only spoke to whether Harmonix possessed adequate intellectual property rights to operate its business as then conducted.  Because all of the patent infringement claims related to Rock Band, a game that was only in development at the time of the closing of the merger, the Court found that no representation and warranties were breached.

A Properly Placed Director Qualification May Cut a Director’s Term Short

In Klaassen v. Allegro, C.A. No. 8626-VCL (Del. Ch. Oct. 11, 2013), the Delaware Court of Chancery held, among other things, that: (1) the failure of a director to meet a director qualification contained in a stockholders’ agreement could not cut the director’s term short, but a self-executing charter provision could, and (2) an election or removal of a director by a party to a stockholders’ agreement that otherwise would be valid under the common law and Delaware General Corporation Law (“DGCL”), could be ineffective if it conflicted with a stockholders’ agreement.  The decision has been certified for an expedited appeal to the Delaware Supreme Court.

This Section 225 action arose from the ouster of Eldon Klaassen, the founder, majority stockholder and former CEO of Allegro Development Corporation (“Allegro”), a privately held Delaware corporation.  In 2007, Allegro secured financing from North Bridge Growth Equity I L.P. (“North Bridge”) and Tudor Ventures III, L.P. (“Tudor” and, together with North Bridge, the “Series A Investors”) in the amount of $40 million.  In return, the Series A Investors received Allegro Series A Preferred Stock, which represented approximately 30% of Allegro’s voting power.

As part of the Series A investment, Allegro amended its certificate of incorporation (the “Certificate”) and bylaws and its stockholders entered into a governance agreement (the “Stockholders’ Agreement”).  The Certificate provided: (1) the holders of a majority of the common stock, voting as a separate class, with the right to elect one director (the “Common Director”), (2) the holders of Allegro’s outstanding preferred stock, voting separately as a class, with the right to elect three directors (the “Series A Directors”), and (3) the holders of a majority of Allegro’s outstanding voting power, voting together as a single class, with the right to elect the remaining three directors (the “Remaining Directors”).  Under the Stockholders’ Agreement, Klaassen and the Series A Investors agreed to vote their shares to fill the Remaining Directors’ seats with: (1) Allegro’s current CEO (the “CEO Director”), and (2) two unaffiliated individuals to be designated by the CEO and approved by the Series A Investors (the “Outside Directors”).  Immediately prior to the actions at issue in this Section 225 action, the Common Director seat and one Series A Director seat was vacant.  The CEO Director seat was occupied by Klaassen.

By 2012, the Series A Investors had become extremely dissatisfied with Allegro’s and Klaassen’s performance.  As a result, the Series A Investors sought to, but were unsuccessful in, exiting their investment or buying out Klaassen.  Eventually, the Series A Investors convinced the Outside Directors to join their board designees in removing Klaassen as CEO at a regularly scheduled board meeting held on November 1, 2012.  Klaassen was not informed in advance that his removal as CEO would be voted on at the board meeting.  At the November 1 meeting, Klaassen was removed as CEO, and defendant Raymond Hood, an Outside Director, was appointed Klaassen’s replacement.  In the first six months following Klaassen’s removal as CEO, Klaassen did not contest his removal as CEO, but used his position as a director to make excessive demands for information from Allegro.  One month later, Klaassen purported to (1) remove by written consent (the “June 2013 Consent”) the two Outside Directors (defendants’ Hood and Simpkins), and (2) fill the resulting vacancies with non-parties Stritzinger and Velidi.  The June 2013 Consent also purported to fill the Common Director seat with non-party Brown.

In this action filed by Klaassen, the Court determined the validity of (1) the removal of Klaassen as CEO, and (2) the June 2013 Consent.  As to the first issue, Klaassen argued that his removal as CEO was void because he did not receive advance notice that his removal would be considered at the November 1 board meeting.  The notice of the November 1 board meeting undisputedly complied with the DGCL and Allegro’s organizational documents.  However, Klaassen argued that, despite technical compliance with the DGCL and Allegro’s organizational documents, his removal was void because he was also a majority stockholder and could have preempted his removal as an officer by changing the board’s composition prior to the meeting.  Without ruling on Klaassen’s arguments, the Court held that the equitable defenses of laches and acquiescence applied to bar the claim—Klaassen failed to contest his removal for seven months and took numerous actions that necessarily conceded the validity of his termination.

The Court also held that the June 2013 Consent only validly removed one of the Outside Directors and filled the Common Director seat.  However, contrary to defendants’ arguments, the Court held that Klaassen did not cease to be a director of Allegro or become the Common Director when he ceased to be the CEO.  According to the Court: “if a clear, self-executing qualification for board membership appears in the certificate of incorporation, and if a director serving in a seat subject to the qualification no longer meets it, then the director is no longer qualified and ceases to be a director in a manner―akin to a resignation.”  In this case, the director qualification was set forth in a stockholders’ agreements and therefore Klaassen’s failure to meet the director qualification for his board seat did not cut short his directorship.  Therefore, the Common Director seat was vacant immediately prior to the June 2013 Consent and could be filled with Brown.

The Court also held that the June 2013 Consent only validly removed one Outside Director.  Allegro’s bylaws purported to limit the ability of stockholders to remove directors “without cause”—permitting directors to be only removed “for cause” unless removal “without cause” complied with the Stockholders’ Agreement.  Although the bylaw provision conflicted with the DGCL, the Court held that a party to a stockholders’ agreement could agree not to vote to remove a director except upon a specified event.  Under the Stockholders’ Agreement, the parties agreed not to remove the Outside Directors without cause unless:  (1) such removal was directed or approved by the affirmative vote of the person or persons entitled to designate the director, or (2) if the designation rights of the person originally entitled to designate the director had ceased.  Klaassen had been Allegro’s CEO and had designated Simpkins to the board.  According to the Court, Klaassen could therefore use his voting power to remove Simpkins without cause under clause (2) above and did so through the June 2013 Consent.  However, this was not the case for Hood.  Klaassen therefore did not validly remove Hood.

Finally, the Court found that Klaassen could not fill the vacancy created by his removal of Simpkins.  By entering into the Stockholders Agreement, Klaassen bound himself to support only nominees designated by the CEO and approved by the Series A Directors.  He was not the CEO when he purported to fill Simkins’s vacancy and did not obtain the Series A Directors’ approval for Simpkins’s replacement.

Chancery Court Relies Exclusively on Merger Price in Determining Appraisal Value

After concluding that neither party had presented a reasonable valuation alternative method, the Court of Chancery used the merger price to determine “fair value” in a recent statutory appraisal proceeding where the sales process leading up to the merger had been judicially challenged, reviewed and found to be free of fiduciary issues.  In Huff Fund Investment Partnership d/b/a Musashi II, LTD, v. CKx, Inc., C.A. No. 6844-VCG (Del. Ch. Nov. 1, 2013), petitioners sought to perfect their appraisal rights in connection with the acquisition of CKx, Inc. (“CKx”), a publicly traded entertainment company, by the private equity firm Apollo.  Prior to the 2011 acquisition, CKx’s primary assets consisted of: (1) 19 Entertainment, Inc., which owned the distribution rights to the hit reality competition, American Idol, (2) Elvis Presley Enterprises, Inc., which owned the name and image of Elvis Presley, and (3) Muhammad Ali Enterprises, Inc., which owned the name and image of the boxing champion, Muhammad Ali.  The nature of CKx’s assets proved to be a challenge to the Court’s determination of the “fair value” or going-concern value of CKx at the time of the merger.  CKx’s future revenue streams were uncertain because the popularity of American Idol had waned over the prior five years, and CKx’s contract with Fox for its redistribution was set to expire at the time of the merger.

Petitioners’ expert witness used a variety of valuation methodologies to derive CKx’s going-concern value, including the discounted cash flow method, a “guideline” comparable company method and a “guideline” comparable transactions method.  However, the unpredictable nature of CKx’s historical cash flows and the complete lack of any truly comparable companies or transactions rendered the various methodologies unreliable in the Court’s view.  Management estimates of future revenues from the American Idol franchise supplied to petitioners’ valuation expert for his DCF analysis were markedly lower than projections supplied to potential buyers and lenders of CKx prior to the merger.  Given the lack of other reliable valuation methodologies, the Court noted that “an arms-length merger price resulting from an effective market check is entitled to great weight in an appraisal.”  The Court also noted that the Court of Chancery had previously placed 100% weight on the merger price in determining “fair value” in at least one prior appraisal action.  The Court also rejected petitioners’ argument that the Delaware Supreme Court’s decision in Golden Telecom, Inc. v. Global GT LP, 11 A.3d 214 (Del. 2010), rendered the merger price irrelevant in an appraisal proceeding.  The Court read the proffered Delaware Supreme Court decision as merely declining to impose a presumption systematically favoring one of the relevant factors in conducting an appraisal proceeding—merger price—over other relevant factors.

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