Delaware Supreme Court affirms Court of Chancery’s decision to invalidate board actions tainted by inequitable deception

2 March 2021 Reed Smith Client Alerts

Home Perspectives Delaware Supreme Court affirms Court of Chancery’s decision to invalidate board actions tainted by inequitable deception

In Bäcker v. Palisades Growth Capital II, No. 156, 2020, 2021 WL 140921 (Del. Jan. 15, 2021), the Delaware Supreme Court recently affirmed the Court of Chancery’s decision to invalidate surprise resolutions taken at a regular board meeting, by which the defendant seized board control, concluding that duping a director into attending the regular board meeting under false pretenses in order to meet quorum requirements necessary for valid board action was inequitable under Delaware law.

Authors: Brian M. Rostocki Benjamin P. Chapple

Court of Chancery decision

In Palisades Growth Capital II, L.P. v. Backer, No. 2019-0931-JRS, 2020 WL 1503218 (Del. Ch. Mar. 26, 2020), the plaintiff, Palisades Growth Capital II, L.P., was a preferred shareholder of QLess, Inc. (the Company), that controlled one of the Company’s director seats through its share ownership. The plaintiff sued Alex Bäcker, who was the co-founder, majority common stockholder, and a board member of the Company. The plaintiff brought its claims under 8 Del. C. section 225 to resolve the composition of the Company’s board and sought, among other things, for the Court to exercise its equitable powers to invalidate certain actions taken at a contested regular board meeting.

By way of background, the defendant in Palisades was terminated as CEO, and it initially appeared that he would accept his termination without protest. The defendant also appeared, initially, to support the candidacy of his proposed replacement as CEO, and to support appointing the new CEO to the Company’s board. However, shortly thereafter, the defendant, together with his father, who also served as a director, took advantage of an unexpected independent director’s resignation on the eve of a regular board meeting. Specifically, the sudden resignation of the independent director on the eve of the board meeting gave the defendant and his father a board majority, enabling them to reverse the board’s course and reappoint the terminated defendant to his position as CEO. The third director, who was appointed by the preferred stockholders of the Company, was deceived as to this secret counter board agenda to reappoint the defendant to the CEO position and seize control of the board.

The Court of Chancery found that the defendant and his father had tricked the preferred director into attending the regular board meeting under the false pretenses that the board was going to appoint the replacement to the position of CEO and appoint the new CEO to the board. The Court of Chancery also found that, had the preferred director known the true plan, the preferred director could have chosen not to attend the board meeting, which, in turn, would have left less than a quorum of three directors necessary for valid board action under the company’s governing documents. In other words, the preferred director could have defeated a board quorum by not attending the meeting and prevented the defendant from reobtaining his CEO position.

The Court of Chancery’s decision invoked its broad equitable powers under Delaware law. The Court invalidated the surprise resolutions that were taken at the regular board meeting because the directors acted inequitably by pursuing a secret plan to usurp control of the board. The plaintiff’s appointee could have thwarted the directors actions by skipping the board meeting—thereby denying the board a quorum—had he been properly informed. The Court explained “[i]t is bedrock doctrine that this Court will not sanction inequitable action by corporate fiduciaries simply because the act is legally authorized.” The Court noted that, although the defendant’s actions were technically authorized in the Company’s governing documents, the defendant took affirmative action to mislead the other board members in order to get them to attend the regular board meeting. In short, the Court determined that if a director calls a meeting under false pretenses and then ambushes the board with self-serving resolutions, equitable relief may be warranted.

Delaware Supreme Court decision

The Delaware Supreme Court affirmed the Court of Chancery’s decision to invalidate the actions taken at the regular board meeting based on the inequitable sandbagging of the preferred director.

On appeal, the defendant-appellant argued, among other things, that the Court of Chancery erred by imposing an equitable notice requirement for a regular board meeting, as opposed to a special board meeting, which the defendant-appellant argued was contrary to Delaware precedent. The Supreme Court rejected this argument and ruled that the Court of Chancery’s finding of deception was not clearly erroneous. Specifically, the Supreme Court noted that the Court of Chancery did not impose an equitable notice requirement at a regular meeting of the board, where Delaware law does not require notice of an agenda. Instead, the “source of inequity” was the co-founder’s and his father’s “decision to secretly plan an ambush after feigning support for the planned governance items.”

Importantly, the Supreme Court’s decision applied the attendance-by-deception prohibition to a regular board meeting, which arose from prior Delaware decisions involving special meetings. The Supreme Court reasoned that, “regardless of the type of meeting or form of communications, Delaware law does not countenance deception designed to manufacture a quorum or otherwise induce director action.”

The defendant-appellant also argued on appeal that because the director continued to participate in the meeting after realizing the deception, his willing participation precluded invalidation or waived the ability to challenge the validity of the board actions. However, because the defendants had not raised the issue before the Court of Chancery in a timely manner before discovery closed and the trial was completed, the Supreme Court did not address the issue.

Key takeaways

Delaware courts have long recognized that “inequitable action does not become permissible simply because it is legally possible.” Under Delaware law, directors’ actions are “twice-tested” - first for legal authorization (such as under the Delaware General Corporation Law or a corporation’s governing documents), and second for equity.
As evidenced by the Supreme Court’s decision in Palisades, it is well established that Delaware courts can use their broad equitable powers to invalidate otherwise lawful board actions tainted by inequitable deception.
Delaware law does not require that board members receive notice of the agenda related to regular board meetings. In contrast, special board meetings often require notice, and Delaware courts have used false or misleadingly incomplete special meeting notices to invalidate inequitable board actions taken at such special meetings.

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