MEMORANDUM OPINION

LAMB, Vice Chancellor

I. INTRODUCTION

This action arises out of the decision of the board of directors of Illinois Superconductor Corporation ("ISCO") to approve a financing transaction intended to infuse the company with needed capital. Plaintiff Jonathan Greenwald, an alleged stockholder of the company, filed this action derivatively on behalf of ISCO, contending that the board, for entrenchment purposes and in violation of its fiduciary duties to the corporation and its stockholders, chose a financing transaction which resulted in the substantial dilution of ISCO's stock and a sharp decline in its market value. Pending are defendants' motions to dismiss pursuant to Chancery Court Rules 23.1 and 12 (b)(6). For the following reasons, I will grant the motion made pursuant to Rule 23.1. Because I find it unnecessary to reach the Rule 12(b)(6) motion, it is denied without prejudice.

A. Factual History 1. The Defendants

Nominal defendant ISCO is a Delaware corporation with its principal offices in Mount Prospect, Illinois. ISCO is primarily engaged in the development and sale of filters used in cellular telephone base stations. ISCO is a publicly traded company whose stock is traded on NASDAQ. The individual defendants are eight current or former members of ISCO's board of directors: Leonard A. Batterson ("Batterson"), Michael J. Friduss ("Friduss"), Peter S. Fuss ("Fuss"), Edward W. Laves ("Laves"), Steven Lazarus ("Lazarus"), Tom L. Powers ("Powers"), Ora E. Smith ("Smith") and Paul G. Yovovich ("Yovovich").

Batterson, Friduss and Yovovich are former outside directors of the ISCO board, Batterson serving from February 1990 until his resignation in July 1997, Friduss serving from October 1996 until his resignation in July 1997, and Yovovich serving from October 1993 until his resignation in June 1997. All were directors at the time the board approved the financing challenged in the complaint. Friduss and Yovovich each own approximately 1000 shares of ISCO common stock.

Fuss, Powers and Lazarus have been outside directors of ISCO since June 1995, October 1996, and January 1992, respectively. Lazurus served as Chairman of the Board from August 1993 until July 1997. Powers owns 2,400 shares of ISCO common stock.

Smith has been a director of ISCO since October 1990, and served as President and Chief Executive Officer ("CEO") from October 1990 until July 1997. Since July 1997, Smith has served as Chairman of the Board. On July 1, 1997, Smith and ISCO entered into an Amended and Restated Employment Agreement, pursuant to which Smith is paid no less than $203,960 annually and which allows additional bonuses at the board's discretion. Smith also owns 69,000 shares of ISCO common stock.

Laves has been President, CEO and a director of ISCO since July 8, 1997. Laves was not a member of the board at the time the challenged financing was approved, but was a director at the time the board approved the draw down of additional tranches of funding from the financing.

2. The Search for Financing

ISCO was founded in 1989 by ARCH Development Corporation, an affiliate of the University of Chicago, to commercialize certain superconducting technologies. ISCO has recognized little revenue from sales and, since its inception in 1989, has accumulated operating losses in excess in $30 million. ISCO has traditionally funded its operations primarily through public and private equity financings, which have raised in excess of $40 million.

In early 1997, the ISCO board found itself in need of additional capital and began to solicit and review funding options. In May 1997, proposals were received from Wexford Capital ("Wexford") and Southbrook International Investments, Ltd. ("Southbrook"). The Wexford proposal contemplated the investment of $8 million into ISCO through the purchase of bonds with interest payable at the rate of 8% per year in cash, or additional debt, convertible to ISCO common stock at the price of $12 per share. The proposal also required Wexford's consent to any related party transactions and that Wexford be entitled to elect one member to the ISCO board.

The Southbrook proposal contemplated Southbrook's purchase of up to $15 million of specially issued ISCO preferred stock in tranches. The preferred stock issued under this proposal was to be convertible into ISCO common stock at a conversion price to be determined by a formula based on closing prices of ISCO common stock over defined periods prior to the date of issuance. Unlike the Wexford proposal, the Southbrook proposal did not involve a condition of board representation or the right to veto related party transactions.

After considering these two proposals, the board selected the Southbrook financing proposal and, in early June 1997, reached an agreement with Southbrook on the terms described above ("Financing Agreement" or "Agreement").

3. The Dissident Stockholder and the Alternative Financing Proposal

It is alleged that, at some unspecified time in "early" 1997, the ISCO board began receiving demands for changes in management and the board's composition from Sheldon Drobny ("Drobny"), a holder of more than 7% of ISCO's common stock. In particular, the complaint alleges that, on June 30, 1997, Drobny demanded the resignation of the company's directors (except Smith), President and CEO, and their replacement by persons selected by Drobny; and that, on July 10, 1997, Drobny asked the board to rescind ISCO's shareholder rights plan. The board rejected these demands.

The complaint also alleges that, on August 4, 1997, some months after approval of the financing at issue here, Dr. Semir Sirazi ("Sirazi") submitted a third financing proposal to the board. Under Sirazi's proposal, ISCO would receive in excess of $8 million in exchange for the issuance of 300,000 "units" of ISCO securities, each unit to consist of three shares of ISCO common stock and one warrant to purchase a share of ISCO common stock at a price of $11 per share. This proposal was contingent on the replacement of ISCO's board of directors and management as demanded by Drobny.

4. The Implementation of the Southbrook Financing Agreement

On June 6, 1997, ISCO drew down the first $3 million tranche of financing from Southbrook and issued to Southbrook 600 shares of convertible preferred stock in exchange therefor. As it was required to do under the terms of the Agreement, ISCO thereafter promptly filed a Registration Statement and Prospectus with the Securities and Exchange Commission covering the shares of ISCO common stock to be issued upon conversion of this preferred stock. The registration statement was amended on September 22, 1997 to cover additional shares.

On October 30, 1997, another tranche of financing was drawn down, consisting of $1.5 million from existing investors Southbrook, Westgate International L.P. and Brown Simpson Strategic Growth Fund L.P. and $3.5 million from new investor Elliott Associates, L.P. Thereafter, the registration statement was again amended to cover additional shares due to be issued upon conversion. As a result of the conversion of the preferred stock issued pursuant to the Financing Agreement, the total number of shares of ISCO common stock issued and outstanding increased from 5,050,987 in May 1997 to 12,556,773 in May 1998.

5. The Decline in Value of ISCO Common Stock

In May 1997, the ISCO common stock was trading at an average of approximately $12 per share. By November 14, 1997, the per share price had dropped to $5 and by March 31, 1998 to $1.50 per share. As of May 13, 1998, the per share price had increased slightly to $2.75.

6. The Filing of the Complaint

The complaint was filed on June 24, 1998. seeking "redress for the injury caused to the Company by breaches of fiduciary duties by certain current and former ISCO directors." (Pl.'s Opp'n Br. at 1.) More specifically, the complaint contends that the ISCO directors acted to entrench themselves, "select[ing] a particular financing source from several different otherwise equally attractive available sources, solely or primarily to avoid a change in the composition of the Board and a loss of control of the Company." Id.

Plaintiff alleges, generally, that in choosing this financing source, the board knew or should have known that the consequences of the conversion of the preferred stock to common stock would be harmful to the Company and its shareholders, in terms of both the significant dilution of the stock and the related decrease in its value. The complaint also alleges that the latter, while related to the increase in the amount of common shares of the company, is also a result of, as the complaint alleges, the fact that "on one or more occasions . . . Southbrook or agents acting on its behalf and at its direction sold short shares of ISCO common stock." (Compl. ¶ 30.) No further particulars of these "short sales" are alleged.

Plaintiff also alleges that the board breached its fiduciary duties in "materially misrepresent[ing] the terms under which the ISCO preferred stock could be converted to common stock," thus giving "the false impression that the Southbrook Deal would drive up the value of the stock when the exact opposite was the case." (Pl.'s Opp'n Br. at 8.) Plaintiff bases this allegation on a June 10, 1997 press release, which states:

The preferred stock is convertible into Illinois Superconductor Corporation common stock at current market prices, or under certain circumstances at a premium to prevailing market prices. The conversion price will be adjusted upward if the price of the company's common stock attains certain levels.

The complaint does not allege that this press statement does not accurately state the actual terms of the Financing Agreement.

II. DISCUSSION

Defendants' move to dismiss the complaint pursuant to Chancery Court Rule 12(b)(6), for failure to state a claim and Court of Chancery Rule 23.1, for failure to make pre-suit demand or show why demand is futile.

A. Standard

In considering a motion to dismiss under Rule 12(b)(6) for failure to state a claim, the Court is required to assume the truthfulness of all well-pleaded allegations in the complaint. See Grobow v. Perot, Del. Supr., 539 A.2d 180, 187 n. 6 (1988). Further, the plaintiff must be extended "the benefit of all reasonable inferences" that can be drawn from the complaint. In re USA Cafes, L.P. Litig., Del. Ch., 600 A.2d 43, 47 (1991). However, "neither inferences nor conclusions of fact unsupported by allegations of specfic facts upon which the inferences or conclusions rest are accepted as true." Grobow, Del. Supr., 539 A.2d at 187 n. 6.

In considering a motion to dismiss under Rule 23.1, for failure to make pre-suit demand or show why demand is futile, the Court is also limited to the allegations of the complaint. See Spiegel v. Buntrock, Del. Supr., 571 A.2d 767, 774 (1990); Pogostin v. Rice, Del. Supr., 480 A.2d 619, 622 (1984). In weighing the adequacy of the complaint under Rule 23.1, "only well-pleaded allegations of fact may be accepted as true; conclusory allegations of fact or law not supported by allegations of specific fact may not be taken as true. A trial court need not blindly accept as true all allegations, nor must it draw all inferences from them in plaintiffs' favor unless they are reasonable inferences." Grobow, Del. Supr., 539 A.2d at 187 (footnote omitted). The pleading requirements of Rule 23.1 are "an exception to the general notice pleading standard, " and a derivative plaintiffs pleading burden under this rule is "more onerous than that required to withstand a Rule 12(b)(6) motion to dismiss." Levine v. Smith, Del. Supr., 591 A.2d 194, 207-210 (1991).

B. Rule 23.1 Analysis

Rule 23.1 requires that in a derivative action brought by shareholders on behalf of a corporation, "[t]he complaint shall . . . allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority and the reasons for the plaintiffs failure to obtain the action or for not making the effort." Ch.Ct.R. 23.1. Demand under Rule 23.1 "is an objective burden which must be met in order for the shareholder to have capacity to sue on behalf of the corporation. The right to bring a derivative action does not come into existence until the plaintiff shareholder has made a demand on the corporation to institute such an action or until the shareholder has demonstrated that demand would be futile." Kaplan v. Peat, Marwick, Mitchell Co., Del. Supr., 540 A.2d 726, 730 (1988).

1. The Aronson Demand Futility Test

Plaintiff acknowledges that he did not make pre-suit demand on the ISCO board. Thus, he bears the burden of alleging with particularity why demand should be excused as futile. See Aronson v. Lewis, Del. Supr., 473 A.2d 805, 815 (1984). This burden is met where the stockholder-plaintiff pleads facts sufficient to demonstrate that: (1) a majority of the board of directors is interested in or lacks independence as to the challenged transaction, or (2) there exists reasonable doubt that the challenged transaction was a valid exercise of business judgment ("the Aronson test"). Id. at 814.

2. Prong One of Aronson

Plaintiff does not allege that the individual defendants: (1) had a personal financial interest in the Financing Agreement, (2) are not independent or (3) did not proceed with due care in selecting and approving the Agreement. Rather, in arguing that the first prong of the Aronson demand futility test is met, plaintiff relies solely on paper-thin allegations of entrenchment. Specifically, plaintiff argues that the directors chose to enter into the Financing Agreement, rather than pursue the Wexford Proposal, because Southbrook did not demand board representation or the power to veto related party transactions. The plaintiff also suggests, with the full benefit of hindsight, that the terms of the Financing Agreement created such a clear threat of dilution to the value of the ISCO shares, that the directors must have known and intended the resultant dilution and decrease in market value.

A plaintiff-shareholder may successfully plead pre-suit demand futility by alleging that "the `sole or primary purpose' of the challenged board action was to perpetuate the directors in control of the corporation." Green v. Phillips, Del. Ch., C.A. No. 14436, Jacobs, V.C., mem.op. at 9 (June 19, 1996). This standard was first set forth in Pogostin, where the Supreme Court of Delaware stated:

Where . . . allegations detail the manipulation of corporate machinery by directors for the sole or primary purpose of perpetuating themselves in office, the test of Aronson is met and demand is excused.

Del. Supr., 480 A.2d at 627. However, the mere allegation that directors have taken action to entrench themselves, without an allegation that the directors believed themselves vulnerable to removal from office, will not excuse demand. See Grobow, Del. Ch., 526 A.2d 914, 923 (1987), aff'd, Del. Supr., 539 A.2d 180 (1988). A successful claim of demand futility requires an allegation that an actual threat to the directors' positions on the board existed. See Bodkin v. Mercantile Stores Co., Inc., Del. Ch., C.A. No. 13770, Chandler, V.C., mem.op. at 8 (November 1, 1996).

Plaintiff attempts to meet this burden by reference to the demands and proposals of Drobny and Sirazi, who both requested that defendants step down and allow new directors to take their places. Initially, I note that the complaint contains no particularized allegations of fact that any actual threat to the directors' positions existed at the time they considered the two competing financing proposals and entered into the Financing Agreement. The first contact between Drobny or Sizari and the board of directors that is alleged with any particularity occurred after the board selected the Southbrook transaction and entered into the Agreement. Evidence of such post-transaction contact does not, of course, lend support to any inference of an entrenchment motive. Moreover, I note that Drobny is alleged to have owned only approximately 7% of the ISCO common stock at the time. That level of share ownership did not give him the power to remove the board, and he is not alleged to have been acting in concert with any other ISCO stockholder.

Plaintiff also argues that certain terms of the Wexford proposal (e.g. the requirement of board representation and the veto over related party transactions) may themselves be seen as posing a threat to the control of the board of directors. This argument fails for several reasons. Most obviously, the terms proposed by Wexford were merely proposals, not threats. It lay entirely within the control of the directors to accept the terms proposed by Wexford, to negotiate different terms, or to reject the Wexford proposal altogether. Moreover, the proposed terms on which plaintiff relies hardly posed a threat to the directors' control over the corporation. The board consisted of five persons. Adding a sixth would hardly have affected defendants' control. It is also noteworthy that three of the five directors who approved the Financing Agreement left the board the following month, suggesting a lack of entrenchment motivation. Similarly, I cannot infer on the basis of the well-pleaded facts in this complaint that the related party veto condition in the Wexford proposal was at all consequential to the directors in choosing between the Southbrook and Wexford proposals. There is nothing in the complaint to suggest either that the defendants contemplated such a transaction at the time they approved the Financing Agreement, or that the board had a history of such transactions.

Finally, I must reject plaintiffs contention that it is reasonable to infer from the allegedly disastrous consequences of the Financing Agreement that the decision to approve that agreement was driven by an entrenchment motivation. The linchpin of this argument is the allegation that "[t]he structure of the Financing Agreement's conversion formula and the absence of any prohibition against short selling by Southbrook provided Southbrook with the opportunity of risk free profit, while at the same time almost guaranteeing a massive drop in the Company's stock price." (Compl. ¶ 21.) Although it is possible that Southbrook and its associates profited through unspecified short selling activity and that this activity caused a decline in the market value of ISCO, the complaint contains no factual allegations from which I can reasonably infer that the individual defendants knew of, or should have foreseen, such a consequence of the Financing Agreement. Thus, I am unable and unwilling to infer from the well-pleaded facts of the complaint that the dilution resulting from the issuance of large numbers of shares of ISCO common stock and the related decline in the market value of that stock support an inference that the directors approved the Financing Agreement solely or primarily to entrench themselves in office. It is well settled that a plaintiff is entitled to only the reasonable inferences that can be drawn from the allegations of the complaint. See Grobow, Del. Supr., 539 A.2d at 187. However, it is both unreasonable and illogical to draw the inference suggested, based merely on plaintiffs unsupported, conclusory allegations, and I will not do so.

For these reasons, I do not find plaintiffs allegations sufficient to meet the first prong of the Aronson test for demand futility.

3. Prong Two of Aronson

Demand will also be excused as futile where the plaintiff shows that there exists reasonable doubt that the challenged transaction was a valid exercise of business judgment. See Aronson, Del. Supr., 473 A.2d 814-15. The business judgment rule is "a presumption that directors making a business decision, not involving self-interest, act on an informed basis, in good faith and in the honest belief that their actions are in the corporation's best interest." Grobow, Del. Supr., 539 A.2d at 187. Therefore, "a court will not substitute its judgment for that of the board if the latter's decision can be `attributed to any rational business purpose.'" Unocal Corp. v. Mesa Petroleum Co., Del. Supr., 493 A.2d 946, 954 (1985) (quoting Sinclair Oil Corp. v. Levien, Del. Supr., 280 A.2d 717, 720 (1971)).

In light of the business judgment presumption, the Court will not "assume that the transaction was a wrong to the corporation requiring corrective measures by the board." Pogostin, Del. Supr., 480 A.2d at 624. Instead, plaintiff is required to "plead particularized facts creating a reasonable doubt as to the `soundness' of the challenged transaction sufficient to rebut the presumption that the business judgment rule attaches to the transaction." Levine, Del. Supr., 591 A.2d at 206. Plaintiff faces a substantial burden, as the second prong of the Aronson test is "directed to extreme cases in which despite the appearance of independence and disinterest a decision is so extreme or curious as to itself raise a legitimate ground to justify further inquiry and judicial review." Kahn v. Tremont Corp., Del. Ch., C.A. No. 12339, Allen, C., mem.op. at 16 (April 21, 1994, rev. April 22, 1994).

Plaintiff contends that his substantive allegations of entrenchment are evidence of defendants' breach of their fiduciary duties to the company and its stockholders, and are sufficient to rebut the business judgment rule, thus excusing demand under Aronson. See Packer v. Yampol, Del. Ch., C.A. No. 8432, Jacobs, V.C., mem.op. at 37-45 (April 18, 1986). This contention must be rejected, as plaintiff has failed to meet the pleading requirements for a claim of entrenchment. See Green, Del. Ch., C.A. No. 14436, mem.op. at 9 (To plead a claim of entrenchment, a plaintiff "must allege facts sufficient to demonstrate that the `sole or primary purpose' of the challenged board action was to perpetuate the directors in control of the corporation.").

Further, while the complaint makes the conclusory allegation that the terms of the Financing Agreement were "guaranteed" to create a drop in the price of ISCO common stock, neither an after the fact evaluation of the Agreement nor the allegation that the Financing Agreement had adverse effects on the company's stock act to rebut the presumption of the business judgment rule. See In re The Walt Disney Co. Derivative Litig., Del. Ch., Cons. C.A. No. 15452, mem.op. at 32 (October 7, 1998) ("It is the essence of the business judgment rule that a court will not apply 20/20 hindsight to second guess a board's decision, except `in rare cases [where] a transaction may be so egregious on its face that board approval cannot meet the test of business judgment.'") (quoting Aronson, Del. Supr., 473 A.2d at 815).

As plaintiff has failed to meet either prong of the Aronson test, the complaint must be dismissed for failure to make pre-suit demand in accordance with Rule 23.1.

C. Rule 12(b)(6)

Defendant also moves to dismiss the complaint on the basis of Rule 12(b)(6), arguing that plaintiffs entrenchment and disclosure claims fail to state a claim upon which relief can be granted. Because the complaint must be dismissed for failure to satisfy the demand requirements of Rule 23.1, I find it unnecessary to address these issues at this juncture.

III. CONCLUSION

For the reasons stated herein, the complaint will be dismissed for failure to comply with the demand requirements of Rule 23.1. Defendants' motion to dismiss pursuant to Rule 12(b)(6) will be denied without prejudice. Counsel for the defendants are to prepare and submit an appropriate order within 10 days of the date hereof, on notice to the plaintiffs counsel.

_____________________________ Vice Chancellor