Opinion
C.A. No. 19042
Submitted: November 2, 2001
Decided: November 16, 2001
Martin P. Tully, Esquire, Donna Culver, Esquire, MORRIS, NICHOLS, ARSHT TUNNELL, Wilmington, Delaware; Yoseph J. Riemer, Esquire, KIRKLAND ELLIS, New York, New York, Attorneys for Plaintiffs David, McIlquham, Lee Wyatt, and Mark Wozniak, and Counterclaimant/Fourth-Party Plaintiff Mattress Holdings, International, Inc.
Arthur L. Dent, Esquire, Brian C. Ralston, Esquire, POTTER ANDERSON CORROON, Wilmington, Delaware; Ben C. Broocks, Esquire, H. Victor Thomas, Esquire, JACKSON WALKER, LLP, Houston, Texas, Attorneys for Defendant Gregory L. Feste.
MEMORANDUM OPINION I.
This is a Section 225 action brought to establish the validity of action taken by three of the four remaining directors of a Delaware corporation's seven person board to name three new directors to fill existing vacancies over the objection of. the fourth remaining director. The principal issue presented is whether or not a stockholders agreement vested the power to fill those three vacancies in the fourth director and the stockholders he claims to represent. The parties have cross-moved for summary judgment. For the reasons next discussed, I conclude that a trial is necessary to resolve that issue with the necessary degree of confidence.
II.
Malachi Mattress America, Inc. ("MMA"), a Delaware corporation, has approximately 30 shareholders. Mattress Holdings International, L.L.C. ("MHI"), the largest shareholder, is itself owned and controlled by Sealy Mattress, Inc. ("Sealy"), and, indirectly, by Sealy's parent company, Bain Capital, Inc. ("Bain"). David Mcllquham, Lee Wyatt, and Mark Wozniak ("MHI Directors") filed this action on August 7, 2001. Pursuant to 8 Del. C. § 225, they seek a determination by the court that David Campbell, Ken Sutherland, and Joseph M. Liebstack ("MHI Designees Elect") were validly appointed to serve as MMA directors at a July 30, 2001 meeting of the MMA board of directors.
MHIand MMA are parties to a series of agreements, dated as of June 1999, by which MHI bought from MMA a 49% block of MMA's common stock. The pertinent agreements include a stock purchase agreement by and between MMA and MHI dated June 22, 1999 ("Stock Purchase Agreement") and, as Exhibit A thereto, an amended and restated stockholders agreement by and between MMA, MHI, and the existing shareholders of MMA ("Existing Shareholders"), dated June 28, 1999 ("Stockholders Agreement").
In connection with the closing of the MHI/MMA transaction, MMA's directors — Feste, S. Chris Herndon and Mark D. Snelling — approved the expansion of the board from three to seven and filled the newly created vacancies by appointing one candidate designated by them and three by MHI. Thus, as of the date the MHI/MMA transaction closed, MHI had three director designees. The other four directors were chosen by the Existing Shareholders.
This situation remained unchanged until sometime in 2001 when, as a result of resignations, only the three MHI Directors and defendant Feste remained on the MMA board. This lawsuit arises out of the action of the three MHI Directors to appoint three new directors of their own choosing to fill the vacancies resulting from the resignations. They took this action over Feste's objection and notwithstanding his contention that only a majority in interest of the Existing Shareholders had the right to designate persons to fill those vacanciesZ Feste claims to represent a majority in interest of the Existing Shareholders and, thus, believes that he had the right to designate the replacement directors.
The source of controversy among the parties is found in Section 2(a) of the Stockholders Agreement. That section reflects an agreement among all stockholders to vote all securities of MMA over which they have voting power and to take all other necessary actions to implement a series of principles governing the size and composition of the MMA board of directors. Pertinent among these are the following:
[§ 2(a)(i)] [T]he authorized number of directors (x) shall initially be seven and (y) shall at all times hereafter be at least seven;
[§ 2(a)(ii)] [H]olders of record of a majority of the MHI Shares entitled to vote for directors of the Board will designate the number of directors which is proportionate to the number of voting securities held by MHI Investors; provided, that the MHI Investors shall initially designate three of the directors of the Board;
[§ 2(a)(iii)] [I]f any of [a series of defined financial shortfalls] shall occur, the authorized number of directors of the Board shall be increased to ten and the holders of a majority of the MHI Shares entitled to vote for directors shall be entitled to designate seven of the directors of the Board.
Section 2(a)(vi) of the Stockholders Agreement also defines the right to fill vacancies created by the resignation of any director-designees:
[I]n the event that any director designated hereunder for any reason ceases to serve as a member of the Board during such director's term of office, the resulting vacancy on the Board shall be filled by a director designated by the Stockholders referred to in clauses (ii), (iii) or (iv) above.
Except for these provisions, the Stockholders Agreement is silent on the subject of the election of directors or the filling of vacancies on the board.
MHI argues that Section 2, particularly Section 2(a)(ii), gives it the right to appoint three of the seven MMA directors but does not grant the Existing Shareholders the complementary right to designate the other four directors. Indeed, MHI's position is that the Stockholders Agreement does not address the question of how the other four directors are to be chosen at all. Thus, by reference to default principles of Delaware law, MHI insists that the Stockholders Agreement cannot be understood to limit its right to participate in the election of the four directors it does not have a contractual right to designate. In other words, MHI contends that the Stockholders Agreement guaranteed MHI the right to proportional representation on the board but did not limit its ability to vote its shares in the election of the directors it is not contractually empowered to designate.
By the same reasoning, MHI argues that its board designees had the power to act pursuant to Section 223 of the Delaware General Corporation Law ("DGCL")to fill vacancies occurring on the board of directors caused by the resignations of three of the four directors it was not entitled to designate. This is so, MHI argues, because nothing in the Stockholders Agreement vested in the Existing Shareholders (or anyone else) the power to designate replacement directors for those seats.
Feste responds that a basic precondition to his willingness to negotiate any deal with Sealy was that the Existing Stockholders would get control of the board of directors and would keep that control except in the circumstances defined in Sections 2(a)(iii) and 2(a)(iv). Feste testified in deposition as follows: "I made it very clear to [Sealy] that we were going to control the board or I never, ever, ever would have entered into that transaction with these people." Feste states that Sealy was only one of many potential investors who approached him during late 1998 about putting money into MMA: "It was an understanding that I would control the board or I'm not going to talk to Sealy. I'll go somewhere else." At his deposition, Feste also read the Stockholders Agreement to embody this understanding: "It says they have the right to control, implying that they don't have control until these things happen. . . . It does not say `only,' but it does say `acquire control.'"
Section 2(a)(iv) is similar to 2(a)(iii), discussed above, in that it grants MHI certain conditional rights to majority board representation in defined circumstances.
Fesre Dep. at 38.
Id. at 41. This assertion finds support in the testimony of the lawyer who negotiated the Stockholders Agreement on behalf of MMA. According to him, had MHI's attorneys communicated to him their interpretation that the Stockholders Agreement did not give the Existing Shareholders the right to designate four of the seven MMA directors, such communication "would have prompted further discussion." Noonan Dep. at 89.
Feste Dep. at 45.
Feste's lawyer, Michael J. Noonan ("Noonan"), also believed that Section 2(a)(ii) of the Stockholders Agreement gave the Existing Shareholders the complementary contractual right to designate the directors not designated by MHI. There is evidence that he communicated his understanding to Sealy in writing before the closing.
Feste also argues that the overall structure of the transaction and, in particular, the Stockholders Agreement, is consistent with the view that the Existing Shareholders were to have the right to designate a majority of the directors. For example, the Stockholders Agreement sets a number of "Restrictions on Transfer of Stockholders Shares, " among them a right of first refusal that gives MMA and any of the company's other stockholders the irrevocable right to purchase shares that are about to be offered for sale. Such provisions made it unlikely that MHI would acquire any of the Existing Shares unless Feste and the other Existing Shareholders intended that to happen.
This written communication took the form of draft minutes of the June 28, 1999 Board Meeting. Noonan prepared these minutes at the request of Sealy's lawyers and sent them to Sealy's attorney at Kirkland Ellis. One item addressed in these minutes relates to the size of the MMA board of directors. It states as follows:
The next matter to come before the Board was to increase the number of directors of the Board of Directors from three (3) to seven (7). In accordance with Section 2A(i)(ii) [sic] of the Stockholders Agreement, the Existing Shareholders shall have the right to designate four (4) of the directors of the Board and MHI Investors . . . shall have the right to designate three (3) directors of the Board.
The resolution that follows states:
RESOLVED that the number of directors of the Board of Directors is hereby increased from three (3) directors to seven (7) directors in accordance with Section 2(a) of the Shareholders Agreement.
The minutes then reflect the "election" of Gregory L. Feste, S. Christopher Herndon, Joseph Liepsack, and Paul F. Stork to serve in "the Existing Shareholders designated seats." Finally, the minutes reflect the unanimous "election" of Kenneth I. Walker, F. Lee Wyatt, and David Mcllquham to serve in the MHI Investors' designated seats." The final version of these minutes is signed by Feste, Herndon, and Snelling.
Jai Agrawal, a Kirkland Ehis attorney who worked on the deal, testified in deposition that he does not remember whether or not he saw the minutes. However, there is evidence that the minutes were delivered to him. Noonan has testified that "[the minutes] would have been hand-delivered to Ken Walker and Jai Agrawal on June 24th . . . as part of the kind of-what I considered post-execution resolutions." The minutes are also included as a line item on a "closing agenda" check list of necessary closing documents prepared by MHI's attorneys. Noonan further testified that these minutes were "on [Agrawal's] necessary-to-be-done, you know, before funding list" and that "[Agrawal] would have had to approve [the minutes] prior to [Sealy] delivering the stockholders agreement." Finally, copies of the minutes are found in the closing binders of deal documents prepared after the fact.
Agrawal Dep. at 28.
Noonan Dep. at 32.
Agrawal Dep. at 7.
Noonan Dep. at 46.
Agrawal Dep. at 70.
Agrawal, at his deposition, read the relevant provisions of the minutes as a clear expression of a misunderstanding by Feste of the Stockholders Agreement:
Q: Is there anything about these resolutions or minutes that strikes you as being actually or potentially inconsistent with the terms of the stockholders agreement that was signed in June of '99?
Agrawal: [The minutes say,] "the Existing Shareholders shall have the right to designate four of the directors of the Board and MHI Investors shall have the right to designate three directors of the Board." Under the stockholder agreement the existing shareholders do not have any right to designate board members. It says that MHI can designate what's proportionate to the number of voting securities held by MHI investors, provided that the MHI investors shall initially designate three of the directors. And it continues. So I don't know what that second sentence means. But the word "designate" I don't think is appropriate.
Id. at 15-16.
The testimony of Wyatt, who is the Vice President of Administration and Chief Financial Officer of Sealy, also raises an issue as to what Sealy or Bain thought Feste and his associates believed the Stockholders Agreement provided:
Q: Have you ever believed, at any point in history, that this agreement gave the non-MHI stockholders the right to designate or elect four board seats, while the board was seven?
Wyatt: I have never believed that this agreement gave them that right.
Q: Okay. Have you ever believed or suspected that Feste or anybody on his side thought that it did?
Wyatt: I believe that Greg Feste may have thought that it did.
Wyatt Dep. at 77-78.
In August of 1999, as part of a loan to MMA, Finova Mezzanine Capital Inc. ("Finova") received some 303,000 warrants for MMA stock. Finova did not become a party to the Stockholders Agreement and the shares to be issued upon exercise of the Finova warrants were not subject to the terms of that agreement. In July of 2001, MHI transferred a portion of its shares in MMA to MHI Co-Investors, LLC, an affihated company. In that same month, MHI and MHI Co-Investors bought a number of the Finova warrants and exercised them. With the addition of the warrant shares to those already owned, MHI and MHI Co-Investors now hold 50.53% of MMA's common stock.
Plaintiffs filed this Section 225 action on August 7, 2001, seeking a determination that the MHI Designees Elect were validly elected to the MMA board of directors at a July 30, 2001 meeting.
III.
A motion for summary judgment will be granted when there is no genuine issue as to any material fact and the moving party is entitled to judgment as a matter of law. I must accept all undisputed factual assertions made by either party as true and view the evidence in the light most favorable to the non-moving party. The party moving for summary judgment-both parties in this case-has the initial burden of establishing the absence of any genuine issue of material fact. The burden then shifts to the other party to submit evidence that such is not the case. Should either fail to show a material factual dispute, summary judgment may be granted in the other's favor. But, "if there is any reasonable hypothesis by which the opposing party may recover, or if there is a dispute as to a material fact or the inferences to be drawn therefrom," summary judgment will be denied. Finally, if "a more thorough development of the record would clarify the law or its application," the court may, in its discretion, deny summary judgment.
Ch. Ct. R. 56(c); Mentor Graphics Corp. v. Quickturn Design Systems, Inc., Del. Ch., C.A. No. 16584, mem. op. at 7. Jacobs V.C. (Oct. 9, 1998); see also Gilbert v. El Paso Co., Del. Supr., 575 A.2d 1131, 1142 (1990); Brown v. Ocean Drilling Exploration Co., Del. Supr., 403 A.2d 1114, 1115 (1979).
Mentor Graphics, mem. op. at 7 (citing Brown, 403 A.2d at 1115).
Scureman v. Judge, Del. Ch., 626 A.2d 5, 10 (1992).
Bershard v. Curtiss-Wright Corp., Del. Supr., 535 A.2d 840. 844 (1987) (quoting Vanaman v. Milford Memorial Hospital, Inc., Del. Supr., 272 A.2d 718, 720 (1970)).
In re Dairy Mart Convenience Stores, Inc., Del. Ch., Consol. C.A. No. 14713, 1999 Del. Ch. LEXIS 94, *38, Chandler, C. (May 24, 1999).
To understand the parties' arguments on these cross-motions for summary judgment, it is helpful to examine the basic elements of Delaware corporation law that provide the background to and the foundation of director designation provisions of the Stockholders Agreement. To begin with, I note that the MMA board is not classified. Therefore, all of its members serve one year terms and are expected to stand for election annually. Second, at the time the deal was struck, MMA had a single class of common stock, each share having one vote. Finally, because the MMA certificate of incorporation does not permit cumulative voting, the nominees for director receiving a plurality of the votes cast will be elected.
The application of these legal principles to the situation confronting the parties negotiating the Stockholders Agreement gave rise to certain issues. MHI presumably understood that, in the case of a closely held corporation like MMA, an acquisition of less than a majority of the common stock would not give it sufficient voting power to elect a single director on its own. Feste and the Existing Shareholders faced a different problem stemming from the fact that the ownership of the Existing Shares was fragmented among a number of smaller holders. Thus, in an election of directors in which all common shares had equal voting rights, the Existing Shareholders' power to elect directors would depend on them voting as a bloc. For example, the Existing Shareholders would lack the power to elect even a single director if more than 2% of their shares were not voted or if more than 1% of those shares were voted with MHI.
MHI's later acquisition and exercise of the Finova warrants reversed this situation. But as of the time the Stockholders Agreement was negotiated and executed, MHI should have realized the limited nature of the voting power it sought to acquire.
If more than 2% of the 51% owned by the Existing Shareholders failed to vote, then MHI's 49% vote would represent a plurality of the votes cast in the election and would be entitled to elect all seven of the directors. Similarly, if more than 1% of that 51% voted with MHI, the combined shares would represent an absolute majority of the voting power of the common stock and, therefore, would have the power to elect all seven of the directors.
Similar issues would have arisen from the potential application of Section 223 of the DGCL, which empowers "a majority of the directors then in office, although less than a quorum" to fill board vacancies. Both MHI and the Existing Shareholders had reason to be concerned that whatever power they had to elect directors be broad enough to include the right to designate directors to fill vacancies in their respective board representations.
Delaware corporation law allowed the parties to address these issues in several ways. For example, they could have provided for the issuance to MHI of a second class of MMA common stock giving it the same rights to board representation found in Section 2(a) of the Stockholders Agreement. Such a structure could easily have empowered a majority of the Existing Shareholders, as holders of the class of common stock having full voting power, to control the election of the directors not elected by MHI. Alternatively, the parties could have negotiated a Stockholders Agreement that both defined MHI's right to board representation and left the election or designation of the non-MHI directors to a majority of the Existing Stockholders. Indeed, this is what Feste argues happened in this case. Finally, the parties could have negotiated a Stockholders Agreement that only defined MHI's rights to board representation and left the election or designation of the balance of the directors to default principles of Delaware law. This is MHI's interpretation of the Stockholders Agreement.
8 Del. C. § 151 (a). Moreover, Section 223(a)(2) provides special rules in the event of a vacancy in a seat that is controlled by a class or series of stock, to ensure the continued representation of the holders of that class or series.
IV.
Section 2(a) of the Stockholders Agreement clearly manifests the parties' intention to contract around at least some aspects of these background rules. The issue is whether the Stockholders Agreement reflects an agreement to regulate fully the power of the stockholders to elect directors or, instead, is limited to the protection of MHI from the potential majority bloc voting power of the Existing Shareholders.
MHI argues that the only change to the background rules made by the Stockholders Agreement was to protect its position by giving it the right to proportional representation on the MMA board of directors. Thus, MHI was willing to take less than a majority of the board seats unless and until such time as certain financial milestones were not met, at which time it would get the right to control a majority of the board. MHI argues emphatically that this is the only protection afforded by Section 2(a) and that such protective provision does not imply any grant to the Existing Shareholders to elect or designate the other directors. Certainly, a surface reading of the contract, and Section 2(a)(ii) in particular, lends support to this interpretation.
Feste and the Existing Shareholders contend that the parties intended to reach a complete understanding about the composition of the MMA board of directors, including an agreement that a majority of the Existing Shareholders; would have the right to designate candidates for the board seats not designated by MHI. As a matter of contract analysis, the Existing Shareholders argue that the language and overall structure of Section 2(a) of the Stockholders Agreement impliedly gave to the Existing Shareholders as a separate voting bloc the power to designate the directors not designated by MHI. Alternatively, they argue that if the language and structure of the agreement will not bear such an interpretation, grounds exist to reform the contract to give them that right.
When dealing with a fully integrated, written contract, such as the Stockholders Agreement, this court will act with great caution before inferring or implying a term not literally expressed in the parties' agreement. Delaware law follows the generally recognized proposition that, absent grounds for reformation, "it is not the proper role of a court to rewrite or supply omitted provisions to a written agreement." At the same time, however, Delaware courts will "cautiously" supply a missing term to a written agreement "[i]n cases where obligations can be understood from the text of a written agreement but have nevertheless been omitted in the literal sense." In such a case, "a court's inquiry should focus on "what the parties likely would have done if they had considered the issue involved.'" In addition, such a case will require a factintensive inquiry and will turn "on issues of compelling fairness."
See Cincinnati SMSA Ltd. P'shp. v. Cincinnati Bell Cellular Sys. Co., Del. Supr., 708 A.2d 989, 992 (1998) (citing Gertrude L.Q. v. Stephen P.Q., Del. Supr., 466 A.2d 1213, 1217 (1983)).
Id.
Id. (quoting E.I. DuPont de Nemours Co. v. Pressman, Del. Supr., 679 A.2d 436, 443 (1996)).
Id. at 992.
It is also possible, in equity, to reform a contract, although reformation is an unusual remedy that requires a fact-intensive inquiry and depends on proof of the following by clear and convincing evidence:
Where an agreement as reduced to writing omits or contains terms or stipulations contrary to the common intention of the parties, the instrument will be corrected so as to make it conform to their real intent. The parties will be placed as they would have stood if the mistake had not occurred.
Moffett, Hodgkins Clarke Co. v. Rochester, 178 U.S. 373, 384 (1900).
A recent case from this court allows for reformation in circumstances that include unilateral mistake, one of the theories advanced by Feste to support his claim.
Fitzgerald v. Cantor, Del. Ch., C.A. No. 16297, 1998 Del. Ch. LEXIS 199, Steele, V.C. (Oct. 28, 1998).
V.
There is little question that I must deny Feste's motion for summary judgment. The language of the Shareholders Agreement and related documents do not plainly give Feste or the Existing Shareholders the rights he claims. On the contrary, a literal reading of the agreements more strongly supports MHI than Feste. Moreover, the background rule of one-vote-per-share operates against Feste and the Existing Shareholders because they must argue for the disenfranchisement of MHI's shares in the selection of the directors it otherwise is not entitled to designate. The law will not readily infer agreements to disenfranchise shares. As Vice Chancellor Strine recently wrote:
[O]ur courts rightly hesitate to construe a contract as disabling a majority of a corporate electorate from changing the board of directors unless that reading of the contract is certain and unambiguous. As Chancellor Allen noted in Rainbow Navigation, Inc. V. Yonge:
A shareholders agreement that is said to have the effect of depriving a majority of shareholders of power to elect directors at an annual meeting . . . is an unusual and potent document. . . . It is enough to note that an agreement, if it is to be given such an effect, must quite clearly intend to have it. A court ought not to resolve doubts in favor of disenfranchisement.
Rohe v. Reliance Training Network, Inc., Del. Ch., C.A. No. 17992, 2000 Del. Ch. LEXIS 108, Strine, V.C. (July 21, 2000) (quoting Rainbow Navigation, Inc. v. Yonge, Del. Ch., C.A. No. 9432, 1989 Del. Ch. LEXIS 41, Allen, C. (Apr. 24, 1989)).
Thus, Feste could only prevail on his motion for summary judgment if the record now before me were strong enough to establish conclusively either that I should imply in Section 2(a)(ii) a correlative power exercisable by a majority of the Existing Shareholders to designate directors or that grounds exist to reform the contract due to unilateral mistake. Suffice it to say that, based on the current record, I cannot conclude that Feste has carried this burden.
MHI's motion for summary judgment presents a much closer call, as it is quite possible to read Section 2(a) of the Stockholders Agreement as operating exclusively in MHI's favor. Nevertheless, after careful consideration, I am unable to determine conclusively that there are not material issues of fact relating to both (i) the proper construction of the Stockholders Agreement, and (ii) the claim of a unilateral mistake by Feste and his counsel. In these circumstances, I conclude that "a more thorough development of the record [might] clarify the law or its application."
See, e.g., In re IBP S'holders Litig. v. Tyson Foods, Inc., Del. Ch., C.A. No. 18373, 2001 Del. Ch. LEXIS 81, *101 Strine, V.C. (June 15, 2001) ("Where one of the parties, however, expresses its beliefs to the other side during the negotiation process or in the course of dealing after consummation, such expressions may be probative of the meaning that the parties attached to the contractual language in dispute.").
In re Dairy Mart Convenience Stores, Inc., Del. Ch., Consol. C.A. No. 14713, 1999 Del. Ch. LEXIS 94, *38, Chandler, C. (May 24, 1999).