California Court of Appeal Refuses to Permit an Action for Rescission of a Strategic Transaction, Holding That a Board Has No Duty Under California Law to Include a "Fiduciary Out"

by Sheppard Mullin Richter & Hampton LLP

In Monty v. Leis, 193 Cal. App. 4th 1367, 123 Cal. Rptr. 3d 641 (2011), the California Court of Appeal, Second District, affirmed the order of the California Superior Court, Santa Barbara County, denying a motion by shareholders of Pacific Capital Bancorp (“PCB”), a California corporation, for a preliminary injunction to enjoin or rescind a transaction by which Ford Financial Fund, L.P. (“Ford”) would acquire between 80 and 91 percent of PCB’s stock. The Court held that because the transaction closed while the motion was pending, the appeal of the preliminary injunction motion was moot, and that California law would not permit the shareholder plaintiffs to seek rescission of the transaction after it had been completed. The Court also rejected plaintiffs’ argument that the investment agreement constituted an improper defensive mechanism because it did not include a provision that allowed PCB to back out of the deal if a better offer was received. Instead, the Court held, there is no requirement under California law that the board of directors negotiate a “fiduciary out” before binding the company to particular strategic transaction. This decision, in which the Court declined to follow Delaware law, underscores the latitude given to a board of directors of a California corporation to cause the company to enter into a strategic transaction.

In the wake of the recent economic recession, PCB suffered losses in the real estate loan market that resulted in significant write-downs in the value of its assets. If the bank failed to improve its capital position by September 8, 2010, it risked being seized by federal regulators and liquidated. On April 29, 2010, PCB entered into an investment agreement (“Agreement”) with Ford pursuant to which Ford would provide $500 million in new capital to PCB and receive 225 million shares of common stock and 445,000 shares of convertible preferred stock. The Agreement allowed Ford to convert the preferred stock to 2.275 billion shares of common stock, leaving Ford with between 80 to 91 percent of PCB’s stock. The issuance of 2.275 billion shares of common stock would require an amendment of the articles of incorporation. PCB issued 225 million shares to Ford on the closing date, and such number of shares permitted Ford alone to approve the amendment to the articles of incorporation allowing issuance of the remaining common shares. NASDAQ rules required approval of shareholders without giving effect to the 225 million shares issued to Ford at the closing. However, because PCB was facing liquidation on September 8, 2010, the bank obtained a “financial viability” exemption from NASDAQ permitting it to proceed without such a vote.

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