October 3, 2011

Delaware: Breach of Duty of Loyalty Due to Entrenchment Through Preferred Stock

From John Grossbauer of Potter Anderson: Recently, Vice Chancellor Laster issued this decision in Johnston v. Pedersen. In this case, Plaintiffs brought an action pursuant to 8 Del. C. ยง 225 to determine whether action taken by written consent of a majority of the outstanding voting power of the capital stock of Xurex, 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.

The opinion is particularly interesting because the Court essentially applied the Blasius standard, but under the more generic label of “enhanced scrutiny. ” Chancellor Strine had taken a similar approach to Blasius in Mercier v. Inter-Tel.