The Delaware Supreme Court issued an Order this week in OptimisCorp v. Waite that could have implications for VC-backed or other companies with so-called “block-holder” directors – or directors who are appointed by a stockholder with a large block of shares – in the context of corporate turmoil where management, the block-holder or factions of other block-holders are in disagreement over the strategic direction or operation of the business. In OptimisCorp, the board terminated the block-holder director who was also the CEO of the company and attempted to eliminate his right in the stockholder agreement to appoint a majority of the company’s board at a special board meeting called for this purpose. The CEO/director claimed that he was entitled to advance notice of the agenda for the meeting and that had he received the notice, he would have exercised his blocking rights and appointed new, friendly directors to the board in advance. Although the Court did not reach the merits of the CEO/director’s rights, as described below, it indicated in its Order that block-holder directors are not entitled to special rights as a director but are entitled to equal rights, including the right to receive advance notice of the agenda for the special meeting in which the board plans to oust the CEO/director so that he may exercise his rights to avert the coup.

OptimisCorp is a private, physical therapy software company based in California. Alan Morelli is the company’s CEO and initial stockholder with rights to appoint a majority of the company’s board. In October 2012, at a special meeting of the board, the board attempted to terminate Morelli and eliminate Morelli’s rights to appoint a majority of the board. Morelli claimed that had he received advance notice of the meeting agenda, he would have exercised his rights under the stockholders agreement to remove the dissident directors and appoint new directors and that the defendant directors breached their duties of loyalty by scheming to ambush him at the meeting. The director defendants, for their part, claimed that they believed that Morelli, who was being investigated for sexual harassment and accused of witness tampering among other things, was harming the company and that by trying to remove Morelli, they were not breaching their fiduciary duties of loyalty since their actions were being done for the benefit of the corporation. After a bungled board meeting in which the board allegedly removed Morelli and amended the stockholders agreement, Morelli filed a Section 225 motion to void the board actions and the Court of Chancery issued a status quo order to restore Morelli as CEO. In August 2015, the Court of Chancery issued a post-trial decision ruling in favor of the defendant directors finding, among other things, that Morelli failed to demonstrate that the director defendants breached their duties of loyalty in the alleged conspiracy and that the plaintiff suffered no damages in any event. On April 25, 2016, the Delaware Supreme Court affirmed the ruling but solely on the grounds that Morelli suffered no harm. The Court took issue with the Court of Chancery’s reasoning and, although it did not reach the merits of the block-holder issues, offered a number of key observations:

Key takeaways

• Advance notice of special meetings required. The trial court had characterized Morelli’s theory as a claim that he was a “super-director” and, as such, was entitled to advance notice of the meeting and could not be removed before he had a chance to exercise his blocking rights to remove and reappoint a board majority. Although the Supreme Court appeared to agree that Morelli should have received advance notice of the meeting, its reasoning was not based on whether Morelli had special rights as a block-holder director, but rather on the “core equity” principle that entitles directors to fair and non-misleading notice of the agenda for a special meeting. The Court strongly suggested that such notice is required for all directors, whether the director has a controlling interest or only a handful of shares, and noted that it would be inequitable for a board faction to confer and sandbag any fellow director regardless of his/her level of company control.

• Advance notice of regular meetings not required. The Court’s advance notice requirement appears to be confined to special meetings of the board and not to regular board meetings, with respect to which the Court has held that notice is not required under Delaware law. In Klaassen v. Allegro Dev. Corp., (Del. 2014), which similarly involved the termination of a CEO/director with blocking rights, the Court held that the corporation’s directors were not required to give the CEO advance notice that directors intended to consider his removal from his position as CEO at the board’s regular meeting because there is no default requirement that advance notice of agenda items be given at a regular meeting of the board.

• Deceptive practices by board factions are not justified by a subjective intent to benefit the corporation. The Court also discouraged board members from forming factions and developing “Pearl Harbor-like plans” to oust management — even in cases like this one where management’s behavior and policy direction were objectively flawed. The Court made clear that in affirming the trial court’s ruling, it was not endorsing the Court of Chancery’s view that a board faction may engage in deception toward other board members in failing to give notice of a special meeting if the faction subjectively believes that its intent is good for the corporation.

• Stockholders may exercise their bargained-for contractual rights. The Court noted that Delaware law authorizes stockholder agreements and the bargained-for rights of control that are contained in them. It then acknowledged that parties to stockholders agreements may exercise their contractual blocking rights in advance of a board meeting to remove those rights, including by appointing new board members. Therefore, VC funds and other block-holders should be aware of any restrictions on their ability to remove a CEO or director if a disagreement were to arise in the future, and may wish to consider these restrictions at the time of their investment in the company.

• Directors have a fiduciary duty to all stockholders, not special interests. The Court also clarified from a number of vantage points that a director has fiduciary duties to all stockholders, and not just to the person who appointed him. For example, the Court noted that a block-holder director is entitled to the same notice and procedural rights that an independent director would be entitled to under the law. The Court pointed out that if a board takes actions to the detriment of a VC fund or other block-holder by removing or eliminating the rights of that stockholder’s designee or by undermining the stockholder’s rights in the stockholders agreement, the board’s actions would be reviewed in light of each director’s fiduciary duties owed to all stockholders including to the harmed stockholder fund. Similarly, the Court noted that a director who is appointed by a block-holder in an effort by the block-holder to preserve his control would also owe fiduciary duties to all stockholders and that any arguably disloyal action done to please the block-holder who appointed him at the expense of the company and its stockholders will almost certainly draw close scrutiny and litigation.

• Need to understand technical requirements and conform stockholder rights. The decision emphasizes the need by VC funds and other block-holders with governance and other rights in a stockholders agreement to ensure that their bargained-for rights are consistent with, and not nullified by, the (lack of) notice or other technical requirements contained in the company’s charter or bylaws. Parties to stockholders agreements should review the company’s bylaws and charter to ensure that the provisions conform to the stockholders’ rights in the agreement or, at a minimum, require advance notice of any action that would adversely affect those rights. At the same time, VC funds and other block-holders should be aware that if a disagreement with management or another block-holder arises and there is a desire to remove a CEO or director, they must adhere to the technical notice and other requirements contained in the company’s governance documents and stockholders agreement with respect to that party.

See a copy of the Supreme Court’s Order.

See a copy of the Chancery Court ruling.

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