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Chancery Appoints Custodian to Dislodge Board Deadlock

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March 1, 2017
Brett M. McCartney
Delaware Business Court Insider

Delaware law entrusts the management of a corporation to its board of directors. Not surprisingly, circumstances arise where a consensus among directors cannot be reached on major decisions impacting a company. In many cases, a board is composed of an odd number of directors, typically eliminating the potential for deadlock. However, where an even number of directors sit on a board, deadlocks can arise. In those situations, assuming certain statutory criteria is met, the Delaware Court of Chancery may appoint a custodian to act as a director and resolve the deadlock.

In Kleinberg v. Aharon, Delaware's Court of Chancery was confronted with a deadlocked board of six directors, a company teetering on the brink of collapse and a request for the court to appoint a custodian. After being satisfied that the conditions set forth in Section 226 of Delaware's General Corporation Law were met, the court rendered an opinion granting the request for a custodian to be appointed with limited powers to act as a director. This decision provides practitioners with a useful road map in considering claims under Section 226 while providing a cautionary tale for those drafting voting agreements or other corporate agreements with ineffective dispute resolution mechanisms. It's outcome also provides contrast to the highly publicized Delaware Supreme Court ruling in Shawe v. Elting.

In Kleinberg, the court was asked to resolve a dispute involving Applied Cleantech Inc., a Delaware corporation engaged in the sewage-processing technology business. The company was founded in 2007 by Refael Aharon, who was a director and CEO of the company since inception. Aharon found a venture capital firm, Saturn Partners, to invest $2.5 million and fund the company's attempt to commercialize its sewer-processing technology. Around the time of Saturn's investment, the company's principals entered into a voting agreement that contemplated a five-member board. The agreement gave Aharon the right to appoint one director to the company's board, an investing company that Aharon ostensibly controlled named SePage Ltd. the right to appoint two directors and Saturn the right to appoint two directors. Aharon appointed himself as a director and filled one of the two SePage seats with Baruch Dill. The other SePage director seat remained vacant. Saturn designated two of its partners as directors of the company.

Unfortunately for the company and its investors, attempts at commercialization were not successful. In 2013, Daniel Kleinberg and Tomer Herzog invested approximately $2.5 million in the company in exchange for approximately 35 percent of the company's equity. Additionally, the voting agreement was amended to provide for a board with six seats. The amended voting agreement granted both Kleinberg and Herzog seats on the board, while reducing Saturn's board seats from two to one. Ed Lafferty, a partner at Saturn, remained on the company's board, as did Aharon and Dill. The second SePage director seat remained vacant, meaning that the board was actively comprised of five directors.

Over time, Kleinberg and Herzog lost faith in Aharon's ability to effectively act as the company's CEO. Aharon resisted their attempts for the company to hire a CEO so that Aharon could focus his attention on developing the technology without the distraction of seeking to monetize his work. With the company rapidly losing money, a potential lifeline emerged in late 2015 when the company and Canadian Sewage Mining worked out the terms of a joint venture to manufacture and distribute sewage-processing machines in North America. The two companies would form a new entity called BioForm Manufacturing Inc., with the company licensing its technology to BioForm, which would manufacture the sewage-processing machines and the company would receive royalties from sales and 10 percent equity in BioForm. However, disputes between Aharon and representatives of BioForm over implementation of the joint venture ultimately lead to claims of breach from both sides.

Unhappy with BioForm's actions in implementing the joint venture, Aharon independently and without his other directors' knowledge, informed BioForm that they were in breach of the joint venture agreement. When Lafferty attempted to mediate the dispute between Aharon and BioForm, Aharon interpreted Lafferty's actions as siding with BioForm. Fearing that he may be ousted from the company he founded, Aharon appointed his brother-in-law, Boaz Cohen, as a SePage designated director, filling the company's board with six directors. This created an indisputable deadlock, as Kleinberg, Herzog and Lafferty were directionally at odds with Aharon, Dill and Cohen on how the Company should proceed with the BioForm deal, the future of Aharon as CEO and various other issues such as litigation the Company was directly or indirectly involved. Kleinberg and Herzog, along with Saturn, filed an action in the Court of Chancery seeking the appointment of a custodian.

Vice Chancellor J. Travis Laster engaged in a thoughtful analysis of Section 226 of the DGCL, noting that before the court can appoint a custodian three conditions must be satisfied. "First, the directors must be deadlocked; that is, they must be so divided respecting the management of the affairs of the corporation that the vote required for curative action by the board as a governing body cannot be obtained." Next, "the business of the corporation must either be suffering or threatened with irreparable injury because of the deadlock." Finally, "the shareholders must be unable by shareholder vote to terminate the division between the directors." On the first point, the court found that the deadlock as the board is split 3-3 on critical issues. The court found no merit in Aharon's arguments that the deadlock was manufactured and in bad faith, as the record demonstrated that the plaintiffs had legitimate disagreements with the direction of the company and Aharon's role. The court also found that the company had suffered substantial harm from the deadlock. The company's inability to resolve the BioForm situation, the board's failure to agree upon a direction and CEO for the company's future and the high likelihood of future insolvency should these circumstances remain unchanged satisfied the need to demonstrate injury under Section 226. Lastly, the court noted that the deadlock could not be broken by the stockholders because of the rights conferred in the voting agreement.

Taking everything into consideration, the court stated that it could craft relief across a broad spectrum. For instance, the court could decline to appoint a custodian and leave it to the parties to resolve the dispute. In this situation, the court noted that such a determination would be unjust. On the other hand, the court could appoint a custodian to liquidate or sell the company. However, because the company's affairs were in disarray, the court believed that only a fraction of the value of the company's technology would be recovered in a sale. Accordingly, the court appointed a custodian with limited powers to sit as a director. The court indicated that the custodian could help develop a new business plan that may attract investors. New investors would likely shake up the voting balance, eliminating the existing deadlock and making the need for a custodian temporary.

Delaware Business Court Insider | March 1, 2017

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