Must Board Elections Be Fair?
Proxy contests can be as contentious as political elections. Fight letters inundate stockholders. Charges and countercharges abound. But does all this fighting need to follow any rules? In its Oct. 23 decision in Red Oak Fund L.P. v. Digirad, Del. Ch. C.A. 8559-VCN, the Delaware Court of Chancery attempted to answer that question.
Briefly, Red Oak lost its attempt to oust the board of Digirad by a proxy contest. Red Oak then filed suit complaining that the election was conducted unfairly. It claimed Digirad had: (1) leaked false preliminary proxy results, (2) postponed unfavorable quarterly financial results until after the election, and (3) failed to disclose a plan to safeguard valuable net operating losses.
Red Oak lost its case, largely because it failed to convince the court that Digirad had acted unfairly. But what exactly that means for other contests is what makes the Red Oak case interesting. The decision adopts some broad statements of principle that both boards and insurgents need to keep in mind or risk having a proxy victory set aside.
The Red Oak guidelines begin with noting that a board of directors must "disclose fully and fairly all material information" that would be important to a reasonable stockholder considering how to vote. Importantly, there is no requirement that a plaintiff in litigation over an election contest prove either causation or actual reliance. The court will assume both are present if the false or omitted information is material in an objective sense. These rules are founded on the board's fiduciary duty. Hence, the logical question is whether the same rules apply to the insurgent slate whose members presumably do not have any such fiduciary duties. If management cannot lie, can its opponents do so?
The Red Oak court was not called upon to answer that question. The victorious board of directors did not allege any improper conduct by Red Oak. Nonetheless, the court did hold that there is also a duty to avoid "unfair" conduct in a proxy contest. That duty is distinct and in addition to any fiduciary duty and presumably would apply to nonfiduciaries who are seeking election to the board. What sort of unfair conduct that might cover is not clear. The court did say that intimidation or other conduct that improperly affects the voting itself could be "unfair" enough to justify setting aside the election results.
Of course, this leaves a whole range of other conduct that proxy wars might include that could be considered unfair. Is unfairness just limited to intimidation? That is potentially a real problem if incumbent management is limited to "full and fair" disclosures, but the insurgents lie to persuade the voters. There is no easy answer as to how to resolve this question. The court clearly does not want to be put in the position of upsetting election results based on its own subjective sense that one side acted badly to win the election. After all, if the best antidote to a lie is the truth, incumbent management is free to correct any false statements by sending out management's own communications. The greater freedom to advocate that insurgents may have is balanced by management's access to the corporate checkbook. While that may mean the better proxy solicitor will win the war, there is little alternative to letting the combatants fight it out, at least within some loose boundaries.
How the court will deal with the claims of breach of fiduciary duty or unfair conduct may well be influenced by its perception of the underlying reasons for the actions attacked by the losing party. In Red Oak, for example, Red Oak claimed that management had delayed announcing very unfavorable quarterly earnings results until after the election. That is the sort of information a reasonable stockholder would want to know in deciding whether to retain current management. Hence, it was clearly "material" and subject to a duty to be disclosed. Nonetheless, the court held that the delay in disclosing the bad results did not violate management's duty to stockholders.
Management proved that it delayed the disclosures due to reasons other than an attempt to influence the proxy voting. The information was not "final" and the time when earnings had to be disclosed under the U.S. Securities and Exchange Commission rules had not yet passed. The court reasoned that requiring disclosures of less than final accounting matters should not be required under those circumstances. But the court also cautioned that had the information been "finalized," the delay in disclosing it might have been enough to warrant holding the election was tainted.
The court will also consider whether the alleged disclosure violations did actually affect the election. While causation and reliance are presumed, that does not eliminate the requirement that the misinformation was actually communicated to the stockholders. The inaccurate preliminary proxy counts at issue in Red Oak, for example, were not actionable because they were not sent to the stockholders. That only makes sense.
Red Oak provides needed guidance to those in a proxy fight. It does leave some questions unanswered, such as the limits on insurgent conduct. But as is usually the way the law develops, those limits will be defined as the precedents are decided.