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Fletcher Int’l, Ltd. v. ION Geophysical Corp., C.A. No. 5109-VCP (Del. Ch. Mar. 24, 2010) (Parsons, V. C.)

March 24, 2010

In this letter decision, the Court of Chancery denied a preferred stockholder’s motion for summary judgment insofar as it could be construed as a request for a preliminary injunction effectively invalidating the issuance of a promissory note by a subsidiary of a corporation. The preferred stockholder argued that the issuance of the promissory note by the subsidiary, which was convertible into stock of the parent corporation, violated the preferred stock terms, which required the consent of the holders of the preferred stock of the parent corporation for any issuance of any “security” by a subsidiary of the parent corporation. Although the Court did not decide the issue as to whether the promissory note was a “security” under the terms of the preferred stock and ultimately denied the preliminary injunction, the Court found the preferred stockholder had shown “at least marginally” a reasonable probability of success on the merits of the claim that the promissory note was a “security” of the subsidiary and that the consent rights of the preferred stock had been violated by the issuance.

At issue in the case was the issuance of a promissory note by a wholly-owned subsidiary of ION Geophysical Corp., a Delaware corporation (the “Company”). The issuance of the promissory note was one of a number of transactions intended to lead to the formation of a joint venture between the Company and a third party (the “Transaction”). Plaintiff, Fletcher International, Ltd. (“Plaintiff”), was the owner of shares of several series of the Company’s preferred stock. The certificates of designations for those series of preferred stock provided that the vote of the holders of the preferred stock was necessary to permit any subsidiary of the Company to issue, sell or commit to issue or sell, any security of the subsidiary. Plaintiff sought a declaratory judgment that: (i) under the terms of the preferred stock, Plaintiff had the right to consent to the issuance or sale of securities by a subsidiary of the Company; and (ii) the issuance of the promissory note violated those rights and was thus invalid and unenforceable. Plaintiff further sought repayment of the funds borrowed under the promissory note and an injunction against further borrowing under the promissory note without Plaintiff’s consent. Because the requested relief would become impracticable following the imminent closure of the Transaction, Vice Chancellor Parsons considered those portions of the Plaintiff’s motion under the preliminary injunction standard. Under that standard, the plaintiff must demonstrate: (i) a reasonable probability of success on the merits, (ii) an imminent threat of irreparable harm, and (iii) a balance of the equities that favors the issuance of the requested relief.

The Court found that Plaintiff had shown, “at least marginally,” a reasonable likelihood of success on the merits of the claim that the Company violated Plaintiff’s consent rights when the subsidiary issued the promissory note without first obtaining the consent of the holders of the preferred stock. Plaintiff contended the promissory note was a security because an instrument that is convertible into a security is itself considered to be a security. The Company argued that under the standard articulated in Reves v. Ernst & Young, 494 U.S. 56, 63 n.2 (1990), the promissory note was not a security because of the commercial context in which it was issued. In the alternative, the Company argued that even if the promissory note were considered a security, Plaintiff’s voting rights were not violated because the promissory note is convertible into shares of the Company and not the subsidiary. In response, Plaintiff contended that the option to purchase stock is a security of the entity that issues the option, regardless of whether the option converts into shares of an entity other than the issuing entity. The Court noted that relevant case law supports the view that the promissory note is a security, but declined to make a final ruling on the issue.

Despite finding a reasonable probability of success on the merits of the claim, the Court refused to grant a preliminary injunction, finding that Plaintiff made only a slight showing that it may suffer irreparable injury and the balance of the equities weighed heavily in favor the Company. With respect to irreparable injury, the Court conceded that it may be difficult to quantify monetary damages, but expressed confidence that it could do so. When weighing the equities, the Court found that if the injunction issued the defendants could suffer great harm, noting the likelihood that repayment of the funds borrowed under the promissory note would jeopardize the pending Transaction and result in significant adverse financial consequences to the Company. If the injunction were denied, Plaintiff could seek monetary damages. Further, the Court noted Plaintiff did not act to defend “its purported consent rights with the degree of alacrity that the Court would expect” given the imminent joint venture transaction. Accordingly, the Court found the equities weighed against granting injunctive relief and denied Plaintiff’s motion for partial summary judgment to the extent it sought to require immediate repayment of funds borrowed under the promissory note or otherwise block the transaction.

The full opinion is available here