November 27, 2013
Lewis H. Lazarus
Delaware Business Court Insider

If there is a dispute over the identity of the directors of a Delaware corporation, the corporation, its stakeholders and those with whom it does business require prompt certainty as to who is in charge. For that reason, Section 225 of the Delaware General Corporation Law provides for a summary proceeding to determine who rightfully comprises the board and officers of a Delaware corporation. While there is a rich body of Section 225 case law, there are few decisions addressing whether the party who loses at the trial court level is entitled to a stay of the court's order pending an appeal. The Court of Chancery recently addressed this issue in Klaassen v. Allegro Development, C. A. No. 8626-VCL (Del. Ch. November 7, 2013), known as Klaassen II, and partially stayed its post-trial order to allow the losing CEO to pursue an expedited appeal. In this decision, the court provided guidance on how it may limit the conduct of a judicially sanctioned board while a party challenges that outcome on appeal. The court also identified a significant issue that, once resolved by the Delaware Supreme Court, likely will affect how parties resolve leadership transitions when they are at odds over how to manage the company's business and affairs.

In Klaassen v. Allegro Development, C. A. No. 8626-VCL (Del. Ch. October 11, 2013), known as Klaassen I, the Court of Chancery rejected as barred by laches and acquiescence a CEO/stockholder/director's challenge to his removal at a board meeting seven months earlier. Plaintiff Eldon Klaassen was the founder and CEO of Allegro Development Corp. Allegro had a five-person board consisting of Klaassen, two directors designated by a preferred stockholder investor and two directors recommended by Klaassen and approved by the preferred stock investor. In Klaassen I, the court outlined the four non-management directors' growing frustration with the company's performance and with Klaassen's management style, culminating in a Nov. 1, 2012, regular meeting of the board.

Unbeknownst to Klaassen, the other four members of the board had met several times in advance of that board meeting and determined that they would remove Klaassen. Resolutions to that end were prepared, but nothing about the termination was shared with Klaassen. As was customary at Allegro, the non-management directors met in executive session at the conclusion of the Nov. 1 board meeting. During that meeting, they asked key officers to secure the company's bank accounts, intellectual property and other key assets. They then asked Klaassen to rejoin the meeting, told him they had decided to remove him and voted on the earlier-prepared resolution to do so.

By a vote of 4-0 with Klaassen abstaining, the board acted to remove Klaassen and to replace him with Ray Hood, one of the non-management directors. For seven months thereafter, Klaassen did not challenge his removal. On June 5, he contended that his removal was ineffective and, in his capacity as CEO, purported to remove Hood and another officer and also exercised a written consent to change the composition of the board. That same day, he initiated the Section 225 action.

Klaassen alleged that the board members who voted to remove him at the Nov. 1, 2012, regular board meeting violated their duty of loyalty due to conflicting economic interests, that their conduct therefore was measured by entire fairness and they could not meet their burden. Alternatively, Klaassen argued that even if the board complied with its statutory and fiduciary duties and the company's charter and bylaws, the board violated a common-law requirement that notice of removal be given to any director whose rights include the capacity to change the composition of the board. Because the court found that Klaassen had challenged his removal on equitable grounds in Klaassen I, the court held that the board's actions at the meeting were voidable, but not void, and subject to equitable defenses. The court denied Klaassen's challenge as barred by laches and acquiescence. The issue of whether to grant a stay of the court's order denying Klaassen's reinstatement as CEO arose when Klaassen undertook an expedited appeal to the Delaware Supreme Court.

The court assessed Klaassen's stay application under Kirpat v. Delaware Alcoholic Beverage Control Commission, 741 A.2d 356 (Del. 1998). That case identified four factors to guide a trial court in the exercise of its discretion of whether to grant a stay: (1) "a preliminary assessment of likelihood of success on the merits of the appeal"; (2) "whether the petitioner will suffer substantial harm if the stay is granted"; (3) "whether any other interested party will suffer substantial harm if the stay is granted"; and (4) "whether the public interest will be harmed if the stay is granted."

If the latter three factors strongly favor granting a stay, then Kirpat directs that "a court may exercise its discretion to reach an equitable resolution if the petitioner has presented a serious legal question that raises a fair ground for litigation and thus for more deliberative investigation." The court found that Klaassen faced a risk of irreparable harm if a board whose composition he challenged took actions that could not be unwound, that with a properly tailored status quo order interested parties would not suffer substantial harm if the stay were granted, and that the lives of employees, suppliers and customers could potentially be harmed absent a stay. It was the court's explanation of the serious legal question that is of most interest to practitioners.

In deciding that Klaassen's appeal presented a fair legal issue, the court examined 100 years of decisions involving the effect of lack of sufficient notice to a director. The court held that while the case law was not consistent, its view was that when a litigant could demonstrate a per se failure to comply with notice requirements in a statute, charter or bylaw, Delaware courts found that all actions taken at such a board meeting were void and hence not subject to ratification. The court found that in other circumstances where a litigant demonstrated that a lack of notice was inequitable, the board's actions were voidable, but whether its actions could be sustained was subject to equitable defenses.

The court focused on Koch v. Stearn, C.A. No. 12515 (Del. Ch. July 28, 1992), vacated as moot, 628 A.2d 44, 46-47 (Del. 2001), which the court believed was a departure from precedent in three ways.

First, according to the court, Koch held that the CEO was tricked into attending the board meeting where he was removed, even though he had reason to believe his removal would be discussed at that meeting. The court believed that having chosen to participate in the meeting and being prepared to deliberate on many issues, the CEO was not tricked into attending in a manner consistent with the holdings of prior case law.

Second, the court stated that the Koch court had not evaluated whether Leathem Stearn was capable of participating in the meeting, and focused instead on whether he chose to speak once the board began to address his removal.

Finally, the court held that the Koch court departed from precedent in considering whether Stearn was disadvantaged: Prior "cases found a disadvantage when the director lacked the ability to engage, either because he was deceived into not attending or because the issue raised was entirely new and unanticipated. None of the precedents considered disadvantage in terms of rights held in other capacities, such as stockholder voting rights, nor did they frame the concept in terms of the individual's ability to affect the board's composition and pre-empt the board's decision. In taking this analytical turn, the Koch decision did not discuss the resulting tension between an equitable requirement of prior notice that would enable a CEO-director to pre-empt a board decision and the bedrock statutory principle of director primacy established by Section 141(a) of the DGCL. Nor did the Kochdecision address any potential issues of entrenchment raised by the CEO's removal of an independent director to protect the CEO's incumbency."

The court noted that because the KochCEO resigned, thereby mooting his appeal, the Supreme Court vacated the lower court decision and had not had the opportunity to "consider the tension between the equitable advance notice right for the CEO and the structural premise of Section 141(a)." The court thus granted the stay by continuing the status quo order with minor modifications to enable the current board to develop a budget for 2014 as long as no single budget category received a greater percentage increase than the percentage growth in Allegro's 2013 growth over 2012. The court also permitted the current board to hire or fire two ranks below the executive rank and required Klaassen to post a $1 million bond.

How the Supreme Court resolves the appeal likely will be important to practitioners trying to decide whether and how they can remove a CEO. That question often arises when the goals of a preferred investor conflict with the plans of a founder and CEO. Sorting out issues of loyalty when one side alleges entrenchment and the other side alleges that an investor is pursuing its private interests at the expense of the company and its stockholders can be difficult. Whether a failure to provide notice is inequitable and thus allows for equitable defenses that the actions at a board meeting are voidable but not void can materially affect the outcome of a control dispute, as reflected in Klaassen I. The court in Klaassen II preserved the status quo pending appeal, but the reach of the Supreme Court's resolution of that appeal likely will extend beyond the parties in that case.