Delaware Supreme Court Reprimands Directors for Deception, But Affirms Chancery Court in Klaassen V. Allegro, Hood, Pehl, Forlenza, Simpkins

Delaware Supreme Court Reprimands Directors for Deception, But Affirms Chancery Court in Klaassen v. Allegro, Hood, Pehl, Forlenza, Simpkins

The Delaware Supreme Court delivered a strong reprimand to the defendants in Klaassen v. Allegro, Hood, Pehl, Forlenza, Simpkins in an Opinion written by Justice Jack B. Jacobs on 14 March 2014. The Opinion found that "the Director-Defendants employed deceptive tactics" and that Delaware "courts do not approve the use of deception as a means by which to conduct a Delaware corporation's affairs, and nothing in this Opinion should be read to suggest otherwise".

However, the decision also affirmed the Court of Chancery ruling that denied injunctive relief to the plaintiff based on the equitable defenses of laches and acquiescence. The Opinion found that the deceptive actions taken by defendants, Raymond Hood, Michael Pehl, Robert Forlenza and Patrich Simpkins, were voidable, but not void. This distinction makes the deceptive acts subject to equitable defenses. The court also upheld the right of the plaintiff to remove Simpkins from the board and to elect a board representative of the common shareholders.

Details of the Case

Allegro is a software corporation that was growing and profitable prior to 2012. The company enjoyed high levels of customer regard, garnering industry awards for customer service and technology architecture. In 2012, the board of directors consisted of 5 members. Klaassen, CEO and founder of the company, represented common shareholders and held 70% of the stock. Directors Pehl, of North Bridge Growth Equity, and Forlenza, of Spring Lake Equity Partners, represented Series A Preferred shareholders, that held 30% of the stock. Directors Hood and Simpkins filled the remaining seats as independents.

Some of the directors had interests that conflicted with the company. Director Pehl was planning to raise a new fund with North Bridge and wanted a large profit to appease North Bridge investors. Pehl wanted to liquidate the company to increase returns for North Bridge, but could not obtain approval of the board and the common shareholders. Pehl then sought to gain control of the board, so North Bridge could force a buyout.

Director Hood was CEO of Qumu, a media software corporation. After six consecutive years of losses, Qumu was sold to Rimage in 2011. Hood misstated Qumu's revenue, forcing Rimage to restate its financial statements. Hood's contract was then set to terminate in November 2012. Hood had a strong motive to conspire with Pehl against the CEO and common shareholders. Pehl appealed to Hood to vote with him to gain control of the board, promising Hood the CEO position. Hood knew that he would receive lucrative compensation by voting with Pehl and Forlenza, and no compensation by voting against.

This arrangement was hidden from the company's CEO and Director, as well as the common shareholders. Each of the defendants admitted to holding a series of secret board meetings in 2012, where they made the decisions to change the composition of the board and to compensate Hood for his actions. These meetings violated mandatory bylaws requiring notice of meetings to be provided to all directors. In November 2012, the defendants voted to provide the Series A shareholders, North Bridge and Tudor Ventures, with complete control of the board.

From December 2012 to March 2013, the common shareholders entered into buyout negotiations with Series A shareholders, North Bridge and Tudor, represented by Pehl and Forlenza. However, the parties could not agree on price, and negotiations ceased by April 2013.

Shortly thereafter, the majority shareholder filed a lawsuit against directors Hood, Pehl, Forlenza, and Simpkins. The suit asserted that the four directors violated mandatory corporate bylaws and breached their fiduciary duties. In particular, the defendants admitted to the secret board meetings, as well as misrepresenting their intentions, which constituted a violation of a director's fiduciary duty of candor under Delaware corporate law. Further, Hood, Pehl, and Forlenza acted in their own self-interest against the interests of the corporation, which violated the fiduciary duty of loyalty. Finally, the election of Hood without due diligence or an evaluation process violated the fiduciary duty of care by directors Hood, Pehl, Forlenza and Simpkins. In the suit, the plaintiff cited precedents in settled Delaware law, in which litigants in the Adlerstein line of cases used similar logic successfully. The defendants cited the business judgment rule as justification for their deception.

The Chancery Court's opinion contained no decision on a corporate bylaw violation or a breach of fiduciary duties. The Court ruled that the plaintiff was barred from challenging the change in board control under the equitable defenses of laches and acquiescence. The Supreme Court affirmed the equitable defense of acquiescence, but did not rule on the equitable defense of laches. In denouncing the actions of defendants Hood, Pehl, Forlenza and Simpkins, the court stated that "Inequitable action does not become permissible simply because it is legally possible." While this judgment allows North Bridge and Tudor to control the board, it does not resolve the continuing dispute between Series A shareholders and common shareholders. Additional litigation remains probable.