The Delaware Court of Chancery recently issued two important decisions addressing the interpretation and effects of stockholders' agreements. In Schroeder v. Buhannic,1the Court of Chancery refused to interpret a stockholders' agreement in a manner that would allow a corporation's common stockholders to remove the chief executive officer. In Southpaw Credit Opportunity Master Fund, L.P. v. Roma Restaurant Holdings, Inc.,2the Court of Chancery held that a corporation's purported restricted stock issuances were invalid, where the corporation failed to comply with provisions governing stock issuances in a stockholders' agreement to which the corporation was a party.
These two decisions are noteworthy statements of both the potential limitations and potency of stockholders' agreements. As often occurs, these decisions also both arose in the context of disputes between factions of stockholders over control of the company—an important reminder about the implications of these issues.
Schroeder v. Buhannic
In this case, two stockholders holding a majority of a corporation's common stock delivered a stockholder written consent attempting to remove the corporation's CEO both from his position as CEO and from his seat on the board of directors and to replace him with a new designee. After the corporation rejected this attempt, the stockholders brought a claim under Section 225 of the Delaware General Corporation Law (DGCL), which allows the Court of Chancery to decide disputes over director and officer elections and removals on a relatively rapid basis. A central issue in the litigation was a provision in a stockholders' agreement, which provided that the stockholder parties agreed to vote in a manner that would ensure, among other things, that the board of directors included "three (3) representatives designated by the holders of a majority of the Common Stock, one of whom shall be the Chief Executive Officer of the Company." The stockholders argued that this language should be read to mean that the board could only maintain in office a CEO whom a majority of the common stock supported as one of their designees—with the implication that they therefore could remove the CEO as well. The corporation, by contrast, contended that this provision merely requires that the subject stockholders must vote to ensure that the corporation's CEO, selected by the board of directors, is one of the three common designees.
Vice Chancellor Travis Laster of the Court of Chancery, in an 11-page order, agreed with the corporation and rejected the stockholders' argument. The court determined that although both interpretations were potentially reasonable, on balance, the corporation had the correct reading when the stockholders' agreement was examined as a whole. In particular, the court noted that provisions of the agreement governing the other board seats clearly provided certain classes or series with a number of designees and then limited, or put parameters around, who those designees could be. Importantly, the court also noted that even if the stockholders' agreement should contractually be read in the manner the common stockholders desired, such interpretation would invalidly conflict with Section 142(b) of the DGCL, which provides that, unless otherwise properly limited in a corporation's certificate of incorporation or bylaws, a corporation's officers are to be elected and replaced by the board of directors.
Southpaw Credit Opportunity Master Fund, L.P. v. Roma Restaurant Holdings, Inc.
This case arose in a dispute over control of the corporation's board of directors, also brought under Section 225 of the DGCL. Leading up to the dispute, a stockholder group owning a 48.8 percent stake in the company acquired additional shares in a secondary transaction and thereby took a majority stake. Immediately afterwards, the board of directors, which had intermittently considered adopting a new employee equity compensation plan over the preceding several months, adopted a plan and issued enough restricted stock under it to dilute the stockholder back down below a majority stake. The record reflected that the board had expressed concern over whether the diluted stockholder would try to change the board's composition. The diluted stockholder maintained that the incremental dilutive issuances were invalid and ultimately attempted in an action by written consent to remove and replace a majority of the board. The company contested that attempt in court, and another faction of stockholders representing the alleged "new" majority of stock—friendly to the prior board—attempted to reinstall the prior directors.
Vice Chancellor Tamika Montgomery-Reeves of the Court of Chancery, noting that the restricted stock issuances suffered from "multiple problems" in the board's process, concluded that the issuances were invalid. The court's specific analysis was that the board of directors had violated the company's stockholders' agreement, which contained a voluminous number of governance provisions and provided that all new stockholders must sign a joinder to the stockholders' agreement before the company could properly issue stock to them. The specified form of joinder, which had to be "substantially" agreed to, stated, among other things, that a new stockholder had reviewed the stockholders' agreement, understood the agreement, had an opportunity for counsel to review the agreement, and agreed to be bound by the terms of the agreement. Importantly, the stockholders' agreement provided that stock issued in violation of the joinder requirement was "null and void ab initio." The relevant restricted stock award agreements provided only that the stock would be "subject" to the stockholders' agreement and that the recipient stockholders would agree to execute all required instruments, but the recipients never executed joinders. Both parties in the litigation conceded that the stock issuances were flawed, but the company argued that the stock issuances were "voidable"—meaning that the board could ratify the stock issuances under common law and treat them as valid—whereas the diluted stockholder argued that the stock issuances were "void" and incapable of such a cure.
The court agreed with the stockholder, concluding that the issuances were void. The court relied on the "express" language of the agreement and the penalty it imposed, citing prior case law that it is the "court's job to enforce the clear terms of a contract." The court also relied on case law indicating that stock issuances undertaken in violation of statutory law and "governing instruments" are void. The court noted in a footnote that the defendants failed to contest that the stockholders' agreement rose to the level of a "governing instrument" and thus waived any such argument. Finally, the court noted that the outcome was equitable because the board had acted with entrenchment motives and had also engaged in gamesmanship in the litigation.
Takeaways
These new decisions highlight several key themes. First, the terms and the drafting of stockholders' agreements can be critical and should be carefully approached. In the Schroeder decision, the meaning that the common stockholders wanted to give the stockholders' agreement violated the boundaries of Delaware corporate law regarding the removal of CEOs. In the Southpaw decision, the company violated the express terms of the stockholders' agreement, resulting in invalid stock issuances, given the language of the agreement and the arguments before the court. We expect that the specific lessons from these cases will come up in practice. In addition, the decisions, consistent with many prior Delaware cases before them, highlight that technical requirements and considerations very often get tested in the context of disputes over control of the company. It is therefore important to approach stockholders' agreements and other similar issues carefully at the outset.
For more information about the decisions by the Delaware Court of Chancery or any related matter, please contact Amy Simmerman, Craig Sherman, or another member of the corporate governance or emerging companies practices at Wilson Sonsini.
