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Johnston v. Pedersen, C.A. No. 6567-VCL (Del. Ch. Sept. 23, 2011)

September 23, 2011

Plaintiffs brought an action pursuant to 8 Del. C. § 225 to determine whether action taken by written consent of a majority of the outstanding voting power of the capital stock of Xurex, Inc. (“Xurex” or the “Company”), voting together as a single class, validly and effectively removed and replaced the incumbent defendant directors of the Company. At issue before the court was whether such removal was effective without the consent of a majority of the Series B Preferred Stock, voting as a separate class.  After reviewing the circumstances upon which the Board adopted the terms of the Series B Preferred Stock and applying enhanced scrutiny, the Court of Chancery concluded that although the defendant directors honestly believed they were acting in the best interest of the Company, they nevertheless breached their duty of loyalty by structuring the issuance of the Series B Preferred Stock in a manner designed to entrench themselves. Because the defendants adopted the class vote provision in breach of their duty of loyalty, the Court declined to give effect to the class vote provision and found the written consents removing the incumbents and electing the new slate of directors to be valid. 

In 2005, Bo Gimvang (“Gimvang”) founded Xurex to develop and sell protective coatings derivedfrom nano-technology. Despite initially raising over $10 million from outside investors, Xurex was not successful in developing a commercial product of its own, although another company, DuraSeal Pipe Coatings Company (“DuraSeal”), had developed a viable product using the Company’s technology. By 2009, stockholder discontent had risen to a point where then CEO, Bob Bishop (“Bishop”), stepped down in favor of a new CEO. Soon thereafter, the new CEO began an investigation into allegations that Gimvang and Bishop defrauded investors and misused company funds. Gimvang and Bishop, who together controlled a majority of Xurex’s outstanding voting power, responded by granting proxies for their shares to Rex Powers (“Powers”), who removed the CEO and the entire Xurex board and elected himself, Robert Clifford (“Clifford”), and Ken Pedersen (“Pederson”) as replacement directors. Two additional directors joined the Board following a mail-in election.

The new Board faced a number of issues, including the Company’s need for additional capital as well as the prospect of suing Bishop for misappropriated funds. Initiating litigation against Bishop, however, created concerns for Clifford and Pederson, in particular, who benefitted materially from their annual salaries and did not want to face another control contest. In response, the Board determined to raise additional capital through a new equity issuance. As an initial step, the Board authorized Pederson to pursue a bridge loan (the “Bridge Loan”) convertible into stock at the next private placement financing.  The Court found that when the Board approved the Bridge Loan, it not only sought to raise capital, but also to dilute the Gimvang/Bishop voting block in order to have a chance at winning a future proxy contest and to provide the Company with a period of “stability” (the term used by defendants). Although the Court found the term “stability” to be a euphemism for entrenchment, it also determined that the Board subjectively believed in good faith that preventing another control dispute was in the best interest of the Company and its stockholders. In addition, the Court concluded that the Board did not anticipate at the time it authorized the Bridge Loan that the subsequent equity issuance would provide for a class voting right.

In April 2010, the Board notified all stockholders of the opportunity to participate in the Bridge Loan, stating that the loan “may be converted at a 50% discount to the Series B Preferred offering price per share.” However, no Series B Preferred Stock terms or voting rights were mentioned in the offering materials. Although the loan offering materials noted that the directors would not participate if the Company received sufficient commitments, the Board imposed a short participation timeframe for stockholders, which the Court concluded was designed “to help ensure that the bulk of the bridge loan ended up in friendly hands,” both by facilitating director participation and increasing the likelihood that investors would not participate unless personally solicited by management. The Company eventually opened the offering to the directors and waived deadlines for other favored investors. Additionally, it was during the loan solicitation period that Pedersen advised select investors that the Series B Preferred Stock would include a “super voting right” to protect against an unwanted change of control in the then current Board.

In August 2010, the Board approved and circulated a private placement memorandum (“PPM”) offering shares of Series B Preferred Stock, but capped investments per stockholder to ensure that investors who had not participated in the Bridge Loan could not obtain a substantial position. The terms of the Series B Preferred Stock provided for one vote per share, with the Series B Preferred voting with the common stock on an as converted basis, but also provided the Series B Preferred with a class voting right on any matter subject to a vote of the Xurex stockholders. The PPM, however, failed to highlight the class voting provision as a material term.

Thereafter, in December 2010, DuraSeal began to consider the notion of acquiring Xurex and identified the class voting provision to be an obstacle thereto. To that end, DuraSeal CEO, Joe Johnston, contacted the Company and offered to purchase $1 million of Series B Preferred Stock, but the Board took the position that the offering had closed, having already successfully placed the Series B Preferred with investors who supported the incumbent Board. Undaunted, in April 2011, DuraSeal began soliciting proxies from Xurex stockholders to elect a new Board. The plaintiffs delivered written consents to remove the defendant directors and to elect five new directors, which consents represented a majority of the Company’s outstanding voting power and would be effective but for the Series B Preferred class vote provision. The plaintiffs then initiated the action pursuant to 8 Del. C. § 225.

Because the actions of the Board affected the stockholder franchise, the Court determined that the defendants bore the burden under the enhanced scrutiny test of persuading the Court that their motivations were proper and that the defendants did not preclude stockholders from exercising their right to vote or coerce them into voting in a particular way. Moreover, because the Board’s actions involved the election of directors and involved matters of corporate control, the directors had to demonstrate a compelling justification for such decisions. The Court found that the defendant directors adopted the class vote provision for the specific purpose of preventing the Xurex stockholders from electing a new Board, noting that “[t]he 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.” Moreover, the Court concluded that even if the Board’s subjective intent had only been to raise capital, this purpose did not provide a sufficiently compelling justification for issuing the Series B Preferred with a class vote right on every issue subject to a stockholder vote. Similarly, the Court found the structure and timing of the Bridge Loan solicitation and Series B Preferred offering was not sufficiently tailored to its capital-raising purpose.

The Court also concluded that the equitable defenses of laches and unclean hands did not apply.  Regarding laches, the defendants did not demonstrate any prejudice from the plaintiffs’ purported delay.  The Court did not reach the merits of the unclean hands defense, because it did not apply to two of the plaintiffs whose participation supported relief regardless of any defense against the other plaintiffs.

The full opinion is available here