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Court of Chancery Awards Damages for Breach of a Director’s Duty of Loyalty

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June 27, 2018
Lewis H. Lazarus
Delaware Business Court Insider

When friends go into business, their ties may fray if the business experiences difficulty and the parties have different views of how to proceed and who is responsible. If the principals are directors of a Delaware corporation, however, their duty of loyalty requires them to eschew self-interest and to do what is best for the corporation and its stakeholders. Moreover, when conflict arises, vague promises among friends do not supplant the requirements for binding agreements. The recent case of CertiSign Holdings, Inc. v. Kulikovsky, C. A. No. 12055-VCS (Del. Ch., June 7, 2018) well illustrates these principles. The court found after a four-day trial that the defendant had breached his duty of loyalty in refusing to do as a director what was best for the corporation to try to gain leverage in other disputes. The court also found that defendant had failed to establish that the parties had entered into binding agreements regarding the issuance of options and the payment of a debt owed the defendant.

Factual Background

CertiSign (the company) underwent a recapitalization in 2005 in which it issued substantial amounts of stock. Among other things, the recapitalization would have clarified the entities that owed a debt to Defendant Kulikovsky for a payment Kulikovsky’s holding company made on behalf of the company several years earlier. Kulikovsky, who was then CEO and a director, approved the recapitalization. In 2012, when the parties decided to sell the company, they discovered that the 2005 stock issuance was invalid. The company sought to fix the problem through Self-Help measures designed by company counsel. Implementation of the self-help plan required Kulikovsky’s signature as a director on certain corporate documents. He refused unless the parties agreed to dissolve the entity, which held two-thirds of the shares of CertiSign. Kulikovsky held a one-third interest in that entity and, if the entity were dissolved and the stock distributed, he would have had a 23 percent equity interest and potentially been able to ally with other stockholders against his former friends. The company refused. It then filed an action under Section 205 of the Delaware General Corporation Law to validate the 2005 recapitalization. Kulikovsky intervened and filed a counterclaim seeking a declaratory judgment validating over 1 million options as having been issued to him and validating that the company had assumed a debt obligation to his holding company of over $4 million. The court entered an order validating the 2005 recapitalization and thereafter the company claimed that it was entitled to damages for Kulikovsky’s failure as a director to sign certain corporate documents necessary to validate the 2005 stock issuance. The court stayed its order while the parties litigated the breach of fiduciary claim and Kulikovsky’s claim for the issuance of options and payment of the debt obligation. The court rejected Kulikovsky’s claims regarding the stock issuance and the debt obligation for a failure of proof but most interesting was the court’s findings regarding the company’s duty of loyalty claim.

Court Finds that Director’s Failure to Sign Corporate Documents Necessary to Validate the Company’s Capital Structure for Reasons Related to the Director’s Obtaining a Personal Advantage in Another Dispute Violated the Duty of Loyalty

The Court of Chancery relied on well-established Delaware precedent that “A public policy, existing through the years … demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation.,“ (citing to Guth v. Loft). The court held that Kulikovsky’s admitted refusal to sign the Self-Help documents to obtain leverage as a stockholder in his dispute over the entity which held the majority of the company’s shares did not justify his putting at risk fixing the company’s capital structure. The court found that “Kulikovsky was well aware that his refusal to sign the Self-Help documents perpetuated the defective constitution of the CertiSign board which, in turn, rendered every single board act over a period of several years invalid. By his defiance, Kulikovsky single-handedly and knowingly jeopardized CertiSign’s existence and operations in order to obtain leverage to advance his personal interests. This is the quintessential breach of the duty of loyalty.” As a remedy, the court awarded the company the costs including attorney fees leading up to and in connection with the Section 205 Action.

Lessons Learned

It is hornbook Delaware law that a stockholder can vote her shares as she pleases. In this case, however, the defendant attempted to justify his recalcitrance as a director of a Delaware corporation to gain advantage in his dispute as a stockholder with stockholders of a different entity (albeit the entity that held the majority of the shares of the company on whose board he sat). The director defendant’s testimony at trial that he withheld his consent to Self-Help documents that would have fixed the corporation’s capital structure and established a valid board solely to advance a personal interest is what led the court to find a breach of the duty of loyalty. However disappointed the director was by the actions of his former friends did not abrogate his responsibilities as a director. This case is a reminder that the scrupulous requirements of the duty of loyalty will not permit action or inaction by a director to the detriment of the corporation done solely to advance a personal interest.

Delaware Business Court Insider, June 27, 2018

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