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Court of Chancery Permits Derivative Action to Proceed Because Alleged Facts Created Reasonable Doubt that Directors were Disinterested and Independent

Feldman v. Cutaia, C.A. No. 1656-N, 2006 WL 920420 (Del. Ch. Apr. 5, 2006). This action involved a series of transactions in which the Telx defendant directors allegedly granted themselves a significant equity stake in the company for little or no consideration. Plaintiff alleged that these transactions significantly diluted his equity position. This action also involved a self tender-offer by the company for $5 million worth of its securities. Defendant argued that plaintiff did not make a demand on the Telx board before proceeding with the derivative action and that the complaint did not plead with particularity facts that created a reasonable doubt as to the ability of the Telx board to independently consider such a demand. The Court of Chancery denied the defendants' motion to dismiss and permitted the plaintiff to proceed with his derivative suit.

Telx conducted a private placement offering in which it offered common stock and debt in the form of senior secured and subordinated convertible promissory notes at a 16% interest rate. Plaintiff alleged that millions of dollars worth of these notes were issued to Telx directors and officers, individually and through their family members and entities they control. A year later these same parties allegedly participated in an exchange transaction and also allegedly participated in a recapitalization of the company. The company then conducted a ten-to-one reverse stock split. Plaintiff alleged that these transactions enabled the company's board and senior management, and their family members and entities they control, to amass holdings of approximately 60% of Telx's equity and 89% of Telx's outstanding options and warrants. Another of Telx's complained about transactions was an offer to repurchase up to $5 million worth of its securities. The repurchase was open to all holders, including directors and senior management, of common stock, Series A preferred stock, and vested options and warrants with an exercise price of less than $10 a share. Plaintiff alleged that the company did not disclose any information indicating how it derived the $10 per share repurchase price, or the uniform pricing structure it offered for common and preferred stock classes as well as options and warrants. A stockholder wanting to initiate a lawsuit on behalf of a corporation pursuant to Court of Chancery Rule 23.1 must first make a demand on the corporation's board of directors to take the requested remedial action or demonstrate the futility of such a demand. The Aronson v. Lewis, 473 A.2d 804 (Del. 1984), test for determining demand futility is a two prong test under which the plaintiff must create a reasonable doubt that: (1) the directors are disinterested and independent; and (2) the challenged transaction was a valid exercise of business judgment. Applying that test, the court here stated, "[t]o establish director interest sufficient to excuse demand, the plaintiff must plead particularized facts showing that a majority of the Telx board had either a financial interest not equally shared by the stockholders, or an entrenchment purpose." Here, the first prong of the Aronson test was satisfied by the plaintiff's allegation that a majority of the directors received securities of the company in the private placement transaction for little or no consideration. By deciding to include options and warrants in the repurchase, the directors, who owned approximately 89% of Telx's options and warrants, allowed themselves to claim a larger percentage of the repurchase proceeds. By setting the purchase price at $10 per share, the directors made it possible to receive cash for their options and warrants at a price allegedly far in excess of the value of these securities. For these reasons, the court concluded that the plaintiff alleged sufficient facts which, if true, raise a reasonable doubt as to whether the directors could properly entertain the plaintiff's demand.