Action by Written Consent Challenged by Court

Lawyers often say that bad facts make bad law. Until the recent passage of the corporate statute for Massachusetts under Chapter 156D, corporate lawyers in Massachusetts would often shy away from incorporating in Massachusetts because of the various statutory limitations and the lack of case law to help interpret corporate conduct. One key issue, one seemingly resolved in the new 156D, was the requirement in the old law that all stockholders must sign a written consent. With clients and investors spread around the world, and often traveling, this requirement delayed many a closing and created other issues. The new statute provides an opt-in procedure for a charter provision to permit the majority to act by written consent in lieu of a meeting. While most practitioners still see this format as being inferior to that in Delaware - where this is the default from which you need to opt out – it is still a major improvement.

A recent decision by a Massachusetts Superior Court involving a renewable energy start-up called Current to Current Corporation (C2C) places this provision in doubt and creates ambiguity around the process of removing directors by written consent.

In Peak Ventures, Inc. v. Manfred Kuehnle et al, Mass. Sup. CV 07-3772 (Gants, J., Aug. 24, 2007), the controlling stockholder group (including the company’s founder, CEO and chairman) sought to remove independent directors from the Board after they accused the CEO, Mr. Kuehnle, of self-dealing and sought to remove him from the Board. The complaint alleges that he failed to disclose the company’s grave financial position to the Board and excluded them from the fundraising process, driving the company into insolvency and into deep debts. The plaintiffs (the other board members who were also minority investors and option holders) upon learning of the alleged wrongdoing, noticed a meeting to remove the CEO from office and to take other emergency action. The CEO asked to delay the meeting, while taking action by written consent to amend the bylaws to give the stockholders additional control over key corporate decisions and to remove the independent directors from the Board and appoint two new directors that plaintiffs claimed to be “loyal” to the CEO. The bylaws for the company followed the 156D statutory language to allow actions by less than unanimous written consent and expressly provided that a “[c]onsent signed under this Section has the effect of a vote at a meeting.”

With the action to take effect on seven days from the notice, the plaintiffs sought a TRO to prevent the effect of the consent action to restructure the Board. The Court agreed with them in part, ruling that removal of directors without a meeting is a special circumstance that requires a live stockholder meeting. Say what? The order does not cite any case law in support of this decision, nor is there any in the plaintiffs motion for TRO. The court held that the specific requirement for a meeting before a director is removed “overrides the more general authorization in 156D, s 7.04 for shareholder actions to be conducted without a meeting." The court reasoned that “this exception reflects the Legislature’s recognition that, when a director is to be removed, the reasons for such removal should be aired at a meeting, which may not occur if the majority of shareholders are permitted to act without such a meeting through a Consent.”

This decision is troubling for many reasons. Getting entrepreneurs to think about corporate governance issues and to bring on independent directors at an early stage is difficult enough. Decisions like Peak Ventures are only likely to scare founders away from bringing others into their decision-making process, leaving young companies without an experienced sounding board for their decisions. Considering that many venture investors will seek board representation and will ask to add industry experts as independents to the board, founding stockholders would be well-advised to increase the board size to still retain majority of the board. Here the board consisted of 5 directors; now it would seem that 7 or 9 may be the right number – making meetings harder to schedule and conduct.

For practitioners, this decision poses an interesting opinion issue. Since most startups don’t hold formal shareholder meetings and make most, if not all, decisions by written consent, the election of directors on which one relies for providing a corporate authorization representation and opinion could now be placed in doubt. In light of this decision, diligencing for opinion may now include a closer examination of written consents vs. meeting minutes.

Delaware court comments on "spring loaded" options

This has been an interesting month for stock option decisions. As mentioned in my prior post, a few weeks ago the Delaware Chancery court took a hard line against backdating option practices in Ryan v. Gifford (now available on the Chancery Court's website here).

Another decision issued on the same day (2/6/07)is In re Tyson Foods, an opinion written by Chancellor Chandler. The relevant part of this case is the discussion on "spring loaded" option grants issued by the Company to favor executives. Ok, so what are "spring loaded" options? The court explains that the are options granted right before a company makes an announcement that is expected to have a positive result on the stock price. The converse of this practice are "bullet dodging" grants, where the grants are timed to take place after the impact of an announcement that is anticipated to depress stock price, thereby giving the benefit of a lower strike price.

This theory of liability is interesting because it is different than straight backdating. As the court points out, backdating has the inherent problem of falsifying information about the grant itself. The date of issuance is false, as is the representation to stockholders that the option was granted at fair market value on its grant date. Spring loading, however, does not necessarily face the same ethical issues. As the court notes, a company may be justified in knowing issuing options that are in the money to executives, as a means to retention and providing performance incentives. The problem lies with disclosure.

The court notes that "[t]he touchstone of disloyalty or bad faith in a spring-loaded option remains deception, not simply the fact that they are (in every real sense) 'in the money' at the time of issue. A board of directors might, in an exercise of good faith business judgment, determine that in the money options are an appropriate form of executive compensation.... A company with a volatile share price, or one that expects that its most explosive growth is behind it, might wish to issue options with an exercise price below current market value in order to encourage a manager to work hard in the future while at the same time providing compensation with a greater present market value. One can imagine circumstances in which such a decision, were it made honestly and disclosed in good faith, would be within the rational exercise of business judgment...."

The interesting common thread between both decisions is the overtone relating to good faith/bad faith by directors. Some commentators have already noted that this arises from the Disney decision from 2006 where the Delaware Supreme Court elaborated on what some see as a new duty by the board, one of good faith. This analysis seems to allow for a private right of action under state law against directors, where theories under federal law for insider trading have not gotten much traction with the courts. (“To act in good faith, a director must act at all times with an honesty of purpose and in the best interests and welfare of the corporation.”)

The court also notes in dictum that a director may be absolved of liability if shareholders have expressly empowered the board of directors (or relevant committee) to use backdating, spring-loading, or bullet-dodging as part of employee compensation, and that such actions would not otherwise violate applicable law. It seems like this language could be useful in drafting future plans, although it begs the question as to what impact it would have under 409A, where you may still run into a problem for issuing options below fair market value.