Delaware recognizes the need to promptly resolve disputes over the composition of the board of directors of a Delaware corporation. Section 225 of the Delaware General Corporation Law provides that the Delaware Court of Chancery may “hear and determine” who is on the board. Those proceedings are “summary” in nature meaning that the entire case can go to trial in 90 days or less from the date the complaint is filed or even less when the circumstances warrant extra expedition. This fast adjudication, however, warrants special caution as a recent Court of Chancery decision points out.

Southpaw Credit Opportunity Master Fund v. Roma Restaurant Holdings, Del. Ch. C.A. 2017-0059-TMR (Oct. 13) involved a dispute over the right of Scott Wilson and Kenneth J. Reimer (the defendant directors) to be on the board of directors of Roma Restaurant Holdings, Inc. When two large Roma stockholders acquired just over 50 percent of the Roma stock, they voted to remove Wilson and Reimer. Roma then delayed actually issuing the stock certificates that otherwise would give the plaintiffs a majority ownership. During the delay, Roma purported to dilute the plaintiffs' ownership by issuing new stock to Roma's officers in the form of a “Long-Term Incentive Plan” (the LTIP stock). Roma then claimed the plaintiffs' attempt to remove the defendant directors was ineffective because they did not retain a majority of the Roma stock. Trial was then set for just 120 days after the plaintiffs filed a Section 225 complaint challenging that new stock issuance (the Southpaw Action).

Initially, the director defendants conceded the validity of the plaintiffs' written stockholder consents removing them from the Roma board. The Southpaw Action was then dismissed. But two months later, the director defendants had second thoughts and filed their own Section 225 complaint claiming that the LTIP stock was validly issued and those shares were voted to put them back on the Roma board. When the plaintiffs objected to this maneuver, the director defendants argued that the Court of Chancery lacked jurisdiction to invalidate the LTIP stock owned by persons not party to the litigation.

Not surprisingly, the court was not sympathetic to the defendant directors' maneuvering. Instead, the court vacated the order that had dismissed the Southpaw Action and set it for a prompt trial. In doing so, the court held that the defendant directors' lack-of-jurisdiction defense was without merit. The court began its analysis of that issue by noting that the Southpaw Action did “not seek to rescind stock from anyone.” Instead, it held the “plaintiffs [only] ask the court to determine whether the LTIP issuance were valid such that those shares should be counted” in deciding who was on the Roma board.

The court supported this conclusion by citing to a list of prior Court of Chancery decisions where the validity of a transaction was decided when to do so was “necessary to determine the proper board composition.” Those other decisions involved a merger, stock issuances, stock transfers, stock conversions and stock acquisitions. That result is justified by the need to resolve a board of director's composition. That need would otherwise be frustrated if a Section 225 case would be dismissed every time key stock was issued to third parties as a way to defeat the court's jurisdiction.

Nonetheless, the questions remain of: what happens next after the new board is seated and the new stock's voting rights are neutered; and is it fair to the third parties not before the Court who own that contested stock. The first question seems to have been resolved by the business demands faced by the entities involved. Once the correct board is seated, they inevitably work out some arrangement with the third party stockholders that ends the dispute. After all, those stockholders are facing a decision that the transaction that gave them stock was not valid. Even if technically that decision is not binding on them as non-parties to the litigation, the handwriting is on the wall for all to see. Better to settle under the circumstances.

The result in those decisions cited in Southpaw is also fair. A person who takes her stock from a fiduciary who is acting to breach her fiduciary duty of loyalty to her corporation by acting to retain her board seat is chose to falling under the old rule that you cannot take valid title from a thief. That person has other remedies, including acting to rescind the stock she purchased.  In virtually every one of these areas, the issuance of new stock was to friendly hands who would vote in favor of the board members who sought to retain control. They would not issue that stock unless they were sure how it would be voted.

The lesson from Southpaw is that a Section 225 case can get well beyond just a simple exercise in vote counting. Whether a plaintiff or a defendant, a litigant needs to understand that significant past transactions can come under judicial scrutiny in those “summary” cases. You need to be prepared. Certainly it did not help the director defendants that they apparently were unprepared when Southpaw was first set for trial and had to concede the LTIP stock could not be voted in their favor. Their “gamesmanship” does not improve their chances of success when Southpaw does finally go to trial.

Edward M. McNally ([email protected]) is a partner at Morris James in Wilmington and a member of its corporate and fiduciary litigation group. He practices primarily in the Delaware Superior Court and Court of Chancery, handling disputes involving contracts, business torts, and managers and stakeholders of Delaware business organizations.