Delaware Court Affirms Limited Director Duty to Preferred Shares

On April 14, 2017 (corrected April 25, 2017), the Delaware Court of Chancery partially rejected a motion to dismiss a complaint (the “Complaint”).  The Complaint was brought by the trust of founder of a venture capital company who was also a common stockholder against an investor in Series A Preferred Stock (the “Preferred”) of ODN Holding Corporation (the “Company”, a holding company for, the Company’s Board of Directors (the “Board”) and certain of the Company’s officers. The Frederick Hsu Living Trust v. ODN Holding Corporation, et al., C.A. No. 12108-VCL, (Del. Ch. April 14, 2017, corrected April 25, 2017). The court found that the Complaint supported a reasonable inference that the defendants acted in bad faith to benefit the investor by maximizing the value of its contractual redemption rights, and that the “entire fairness” standard should apply because there were insufficient disinterested directors.

In brief summary, the defendants are alleged to have acted in bad faith by moving from a growth strategy to working for two years to put the Company in a position to redeem the Preferred by selling lines of business and hoarding cash.  In this case, the facts, taken in the light favorable to the plaintiff, showed a breach of the duty of loyalty because the directors did not act primarily to benefit the whole equity of the corporation, but rather to benefit the Preferred.  The Preferred was not owed fiduciary duties to protect its special contractual rights.  “Because the fiduciary principle does not protect special preferences or rights, the fiduciary-based standard of conduct requires that decision makers focus on promoting the value of the undifferentiated equity in the aggregate.” P. 44. A corporation is bound by it contractual obligations, but those require it to make an analysis of whether it is efficient to breach the contract and pay damages. Fiduciary principles do not apply.

The “entire fairness” standard would apply at the pleading stage, rather than the lower “enhanced scrutiny” or “business judgment” standards, where the Complaint adequately alleged that there were not enough sufficiently informed, disinterested directors acting in good faith to comprise a majority of the Board.  Three were investor directors. In addition, the investor controlled the Company so that a highly compensated senior officer of the Company was not a disinterested director.  Furthermore, the three “outside directors” were not disinterested because, according to the Complaint, they had acted to benefit the investor.  One of them was long-term corporate counsel to the investor, and another received $24 million from the investor to purchase illiquid stock.

The case suggests that investors in preferred stock of venture companies should examine their contractual rights to ensure that they will accomplish what is intended, rather than relying solely on the fiduciary duties of the directors and officers.