Court Upholds Stockholder's Share Ownership and Books-and-Records Request

by Morris James LLP
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Delaware Business Court Insider - July 26, 2017

Companies often defend against stockholder requests to inspect books and records by contending that the plaintiff stockholder lacks a proper purpose or that his or her stated purpose is not the real purpose. Less common is a contention that the stockholder lacks standing because his or her shares were canceled due to misconduct harmful to the company, a remedy provided for in a stockholder agreement. Such a claim raises issues under Section 202 of the Delaware General Corporation Law as to the enforceability of the remedy where the restrictions set forth in the stockholder agreement were not conspicuously noted on the share certificate. The recent case of Henry v. Phixios Holdings, C.A. No. 12504-VCMR (July 10), provides guidance on the requirements to enforce a restriction on the ownership or alienability of shares of a Delaware corporation when the restriction is not conspicuously noted on the share certificate. As the Chancery Court held, such a restriction is not enforceable except upon proof that the stockholder had actual knowledge prior to purchase of the shares or subsequently agreed or voted to approve the restriction, proof that Phixios failed to provide.

Background

This action began when Phixios fired plaintiff Jon Henry. Thereafter the plaintiff sought books and records both to value his shares in the private company and to investigate mismanagement. The suspicion of mismanagement was based on the chief operating officer's having used company funds for personal expenses. The company claimed that the plaintiff lost his shares and hence his standing to seek books and records because he violated a stockholder agreement which called for forfeiture of shares for engaging in conduct harmful to the company. Here Phixios claimed Henry was competing against the company. Henry denied such competition as well as any foreknowledge or subsequent assent to the stockholder agreement.

Phixios Failed to Inform Plaintiff of Forfeiture Provision

The company did not require written assent to the stockholder agreement when it issued Henry his shares. Although it claimed to have emailed him the stockholder agreement contemporaneous with the share issuance, Phixios could not produce the email even though it did produce other email to plaintiff dated the same day. Although months later the company did mail the stockholder agreement to plaintiff, it did not require him to click to acknowledge receipt and agreement to its terms. Henry's mere acknowledgement that he had received the agreement did not suffice to prove assent to the restrictions.

Court Finds Henry Stated a Proper Purpose

Phixios also defended the books-and-records requests by the more conventional assertion that Henry's actual purpose was to obtain documents to assist him in competing with Phixios. This argument failed for lack of proof. The company offered only hearsay testimony. The court also noted that the company failed to call as a witness at trial Henry's supervisor who Henry testified was fully aware of the activities that Phixios contended constituted unlawful competition. The court therefore accepted as valid Henry's stated purpose of wanting to value his shares including for estate planning purposes. Once the court found that plaintiff retained standing and had a proper purpose, it went on to determine that the documents he sought were necessary in light of his purpose. It denied, however, his request for attorney fees, because the court did not find facts to warrant departure from the American rule.

Lessons Learned

Section 202 of the DGCL protects a shareholder's investment from post-purchase restrictions that would devalue the shares. Delaware courts therefore have prevented boards or other stockholders from unilaterally imposing restrictions that impair the value of a stockholder's investment without the investor's foreknowledge or subsequent consent. The formalities required to impose a restriction on ownership or alienability of shares of a Delaware corporation are not limited to public companies. Where all the stockholders of a privately held company agree to be bound by restrictions in a stockholder agreement, they should make sure to document that all stockholders are made aware of and consent to the restrictions prior to purchase. In the absence of contemporaneous written documentation of consent, a company may find, as did Phixios, that the restrictions in a stockholder agreement on share ownership are not binding.

Delaware Business Court Insider | July 26, 2017

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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