Friday, January 04, 2019

Company cannot wield its failure to provide notice as sword against stockholders

By Anne Sherry, J.D.

The Delaware Court of Chancery ruled that while an action to determine board composition under Section 225 is narrow in scope, the court may consider allegations of inequitable conduct to the extent germane. The dispute, between a stockholder of SPAR Group, Inc., and its board, is still in discovery, and the court will permit the directors to advance their defense that the plaintiff acted inequitably. Ruling against the directors, however, the court held that the company’s failure to provide prompt notice of director consents to shareholders did not preclude the consents’ effectiveness (Brown v. Kellar, December 21, 2018, Zurn, M.).

The plaintiff’s action under Section 225 of the Delaware General Corporation Law sought a determination that written consents he and another stockholder delivered to the board in July 2018 removed and replaced an incumbent director. The director defendants opposed the plaintiff’s motion for summary judgment and sought to advance a defense based on inequitable conduct by the two shareholders. They also argued that the written consents were not yet effective because the corporation did not send the required prompt notice to stockholders.

Directors may supplement the record. Section 225 proceedings are summary in rem actions with a limited scope: determining issues that pertain to the validity of actions to elect or remove a director or officer. Although the scope of Section 225 is narrow, the plaintiff was incorrect in saying that allegations of inequitable conduct cannot be considered. An issue can be litigated in a Section 225 proceeding if it is necessary to decide in order to determine the validity of the election or designation by which the director or officer claims to hold office.

In light of precedent, the court concluded that it could adjudicate the question of inequitable conduct to the extent germane to determining the board’s composition. Furthermore, the directors’ defense could be cognizable under Section 225 because it alleged inequitable conduct that could, when developed, affect the director consents and the plaintiff’s requested board composition. The court denied the plaintiff’s motion for summary judgment, allowing the director defendants to develop and test the defense’s allegations at trial.

Consents were effective despite lack of notice. Turning to a “more classic” Section 225 dispute, the court determined that the director consents were effective under Section 228 upon delivery of the July 5 consent. The consents complied with all the provisions of Section 228 except for the prompt notice requirement, but the court concluded that this notice requirement is not a prerequisite to a corporate action by written consent, but rather an additional obligation resulting from the action.

Although written notice is critical, and a Delaware case under specific facts found an exception to the general rule that notice is not a prerequisite to effectiveness, the instant case was governed by the rule rather than the exception. “Where the parties acting by written consent clash with the companies that must deliver the notice, as here, applying Di Loreto’s exception would grant the companies a sword with which to delay or thwart written consents by slow-rolling notice to the stockholders,” the court reasoned.

Neither did the Securities Exchange Act provide an independent notice requirement that precluded the consents’ effectiveness: even if Rule 14c-2 imposed a notice requirement beyond that of Section 228, corporations cannot avoid their obligations under Delaware law by resorting to purportedly conflicting obligations under Rule 14. Furthermore, permitting the directors to delay notice by playing Rule 14c-2 and Section 228 against each other, when each independently encourages that notice, “would pervert the incentives of both the SEC regulations and Delaware law.”

The case is No. 2018-0687-MTZ.