Summary
In Orban, Chancellor Allen assumed that the entire fairness test would apply to a recapitalization and third party merger in which all of the consideration went to the preferred stockholders to satisfy their liquidation preference, leaving nothing for the common.
Summary of this case from In re Trados Inc. Shareholder Litig.Opinion
Civil Action No. 12820
Date Submitted: March 10, 1997
Date Decided: April 1, 1997
Joseph A. Rosenthal, Esquire, of ROSENTHAL, MONHAIT, GROSS GODDESS, P.A., Wilmington, Delaware; OF COUNSEL: LOWEY DANNENBERG BEMPORAD SELINGER, P.C., White Plains, New York; Attorneys for Plaintiffs.
Jesse A. Finkelstein, Esquire, of RICHARDS, LAYTON FINGER, Wilmington, Delaware; OF COUNSEL: Chaim T. Kiffel, Esquire, of KIRKLAND ELLIS, Chicago, Illinois; Terrence J. Galligan, Esquire and C. Mark Pickrell, Esquire, of KIRKLAND ELLIS, New York, New York; Attorneys for Defendants.
MEMORANDUM OPINION
This is a stockholders' suit brought by certain holders of common stock of Office Mart Holdings Corp. ("Office Mart"). The suit arises out of a series of transactions culminating in a June 23, 1992 stock-for-stock merger between Office Mart and a subsidiary of Staples, Inc. The first of the transactions was a November 15, 1991 recapitalization in which, in exchange for forgiveness of principal and interest of outstanding notes, Office Mart creditors accepted a package of securities including common stock warrants and a new Series C Preferred stock. The second step was board action of May 1992 facilitating the exercise of certain warrants held by the holders of preferred stock. The concluding transaction was the merger with Staples. In that merger, various classes of Office Mart preferred stock were entitled to liquidation preferences that together exceeded the value of the consideration paid. Thus, the Office Mart common stock received no consideration in the merger. The merger was an arm's-length transaction and it is not contended in this suit that the price paid by Staples was not a fair price or the best price reasonably available.
In summary, the claims made are now two. First, it is asserted that the Office Mart board breached its duty to the common stock by facilitating steps that enabled the holders of preferred stock to exercise warrants that enabled the preferred to overcome a practical power that the common held to impede the closing of the merger. This claim in essence asserts that the board, which was controlled by holders of preferred stock, exercised corporate power against the common and in favor of the preferred and, thus, breached a duty of loyalty to the common. Second, it is asserted that the merger agreement which provided for the payment of some $2 million to Office Mart, CEO, Stephen Westerfield, constituted a breach of loyalty and a waste.
An earlier version of the complaint which included claims of undisclosed merger negotiations survived a motion to dismiss on the stated ground that, in light of the then recent Delaware Supreme Court holdings in Cede Co. v. Technicolor, Inc., Del. Supr., 634 A.2d 345 (1993) and In re Tri-Star Pictures Litig., Del. Supr., 634 A.2d 319 (1993), the fact that it appeared that the plaintiff was not injured financially by the recapitalization or the merger — since given the circumstances the common stock turned out to be valueless in a liquidation or merger context — did not itself mean that the complaint did not state a claim upon which relief might be granted. See Orban v. Field, Del. Ch. C.A. No. 12820, Allen, C. (Dec. 30, 1993).
Extensive discovery has now occurred and an amended complaint, which no longer contains claims concerning undisclosed negotiations, has been filed. Defendants have moved for summary judgment.
For the reasons that follow, I conclude that no fact material to the appropriate legal analysis is in dispute and that defendants are entitled to judgment as a matter of law. With respect to the first claim, I conclude that there is no evidence upon which a fact finder could conclude that the board's actions (as explained below) in facilitating the exercise by holders of preferred stock of their legal rights to exercise warrants represented a disloyal act towards the common stock. Even assuming, as I do, that in facilitating the exercise of the warrants in these circumstances (where the warrants were used to overcome Mr. Orban's resistance to the merger) the board has a burden to establish either the reasonableness of its actions or its fairness, the record is, in my judgment, entirely consistent with that conclusion and wholly inconsistent with the opposite conclusion.
With respect to the second claim — waste or breach of loyalty arising from Westerfield's consideration — I conclude that the record again does not raise a triable issue. The board that approved these arrangements was dominated by preferred stock which was receiving less than its liquidation preference in the merger and if all of Westerfield's consideration arising from the merger had been redirected into merger consideration, it would have gone to the preferred, who still would have received less than the amount of their preference. Thus, in approving those payments to Westerfield those directors were fully entitled to the deference that the business judgment rule reflects. Nor were the payments such, when viewed in context, to even arguably raise the possibility of transgressing a "constructive fraud" or waste standard. Thus, this claim too will be dismissed with prejudice.
I. Relevant Facts
George Orban, the principal plaintiff in this action, founded Office Mart in 1987; served as its CEO until 1989; and as a director until March 1992. From 1987 to 1992, Office Mart developed and operated a chain of ten "WORKplace" office supply superstores in and around Tampa, Florida. The company was, however, never well capitalized. That fact became rather quickly apparent when the company sought to expand into the California market in 1988, from which it was forced to retreat.
Capital structure: Initially, the company was capitalized largely with equity in the form of voting preferred stock from institutional investors. Mr. Orban, who in this litigation, characterizes himself as a "venture capitalist," invested only approximately $15,000 in exchange for which he received all of the common stock. (Later other employees of the firm came to hold modest amounts of the common as well). The substantial capital; came in several tranches from financial institutions. 2,422,750 shares of Series A preferred stock were issued in 1987 to raise $2,950,000 in initial capital. In May 1988, an additional $17,084,080 was raised by the private placement of 6,833,632 shares of Series B preferred stock.
All classes of equity voted together. Mr. Orban was the largest holder of common stock, however, he held only 14.32% of the total voting power. Series A and Series B preferred stockholders held 22.59% and 63.18%, respectively, of the company's total voting rights. Both classes of preferred stock were convertible into common stock and entitled to vote on an as-converted basis, both had anti-dilution rights and possessed liquidation preferences payable in the event of a merger. The common stock, of course, had no such rights.
Mr. Orban's 1,417,500 shares of common stock, purchased for less than $15,000, together with the 74,724 shares of common stock held by the other plaintiffs to this action, constituted 96% of the company's common stock. In addition to common stock, Mr. Orban held 82,500 shares of Series A preferred stock through an investment vehicle, Orban Partners.
In the event of a liquidation or merger, Series A shareholders would receive the return of their original investment and Series B shareholders would be entitled to recover their original investment and 9% interest, compounded annually, before any distributions could be made to common stockholders.
Continuing need for long term capital: Relatively early on, by June 1989, Office Mart's board was forced to conclude that it either had to find additional capital to pursue an aggressive growth strategy, or had to sell the company. At that point, Mr. Orban resigned as CEO and Stephen Westerfield agreed to assume the duties of CEO. He had had no prior involvement with Office Mart. Mr. Westerfield began taking steps to address these issues. The investment banking firm of Donaldson Luikin Jenrette was hired to assist in these efforts, but no potential investors or acquirors were identified and the financial position of the company continued to worsen.
Mr. Westerfield, an experienced former president of Silo Company, entered into an employment agreement with Office Mart on May 2, 1989 which was unanimously approved by the Board, including Mr. Orban. Pursuant to the agreement, Mr. Westerfield was guaranteed a salary of not less than $175,000 and a bonus of $150,000 for his first year of employment. In each subsequent year, Mr. Westerfield's salary and bonus would increase by at least $10,000 and $15,000, respectively. Further, the agreement provided that if terminated without cause before April 30, 1994, Mr. Westerfield would receive the remaining payments owed to him under the employment contract. As will be discussed below, Mr. Westerfield salary for the two remaining years of his contract, subsequent to the merger, would have been $400,000 and $425,000. In addition to the severance pay provision, the agreement contained a two year non-compete clause.
Recognizing that it would be difficult for Office Mart to borrow necessary capital from commercial lenders, the company began to consider means to attract additional capital from the company's current investors. In April 1990, a group of Series B stockholders (including affiliates of Prudential Insurance, and Manufacturers Hanover Bank) provided the company with a $5.2 million line of credit in consideration of the issuance by the company of its 13% secured notes and warrants to acquire 40% of the company's fully diluted equity shares, exercisable at a price of $1.39 per share. The notes matured in three years (due on March 31, 1993) but could be prepaid at par plus accrued interest.
All of Office Mart's shareholders were offered an opportunity to participate in the debt placement, but Mr. Orban and certain other Series B shareholders decided not to do so.
Office Mart began to draw down its credit facility shortly after its establishment. The company had difficulty from the beginning in meeting the interest payments on the debt. In order to ameliorate this situation in January 1991, an agreement was reached with creditors pursuant to which the company's interest obligations were deferred, in consideration of the grant of additional common stock warrants. The warrants covered common stock equal to 1.75% of total equity for each quarter of interest deferred, for a maximum of up to 10.575% of total equity. Despite the credit facility and deferred interest agreement, Office Mart continued to have financial difficulties throughout 1991.
The recapitalization: On September 5, 1991, Mr. Westerfield recommended that a recapitalization plan be adopted in order to eliminate the debt burden on the company's balance sheet. During a telephone meeting on September 27, 1991, Mr. Westerfield expressed his opinion that the recapitalization was necessary for the company to continue as a going concern; the board approved a proposed recapitalization plan at that time. On November 14, 1991, the Board again unanimously voted on the terms of the recapitalization, authorizing the company's officers to effectuate the transaction on the following day. At that meeting. Mr. Westerfield informed the Board that "there was no significant activity" with respect to efforts that had been made to locate potential investors or buyers of the company.
The material elements of the recapitalization plan: First, a new senior, nonconvertible Series C Senior Cumulative Redeemable Preferred Stock was created. In exchange for 5.2 million shares of the Series C preferred stock and 2,136,976 new shares of common stock (equal to more than half of all then outstanding common stock and equal to 10% of the fully diluted equity of the company), the holders of the debt agreed to its cancellation and released the company from the repayment of the $5.2 million principal amount and $607,800 in accrued interest. Finally, the company reduced the exercise price on the warrants issued to the creditors in connection with the original extension of the $5.2 million credit, from $1.39 to $0.75 per share.
In the event of a liquidation or merger of the company, the new Series C preferred stock would entitle its owners to receive an initial preference of $7.5 million and a secondary preference of $1.5 million to be paid only after $12 million had been distributed to the A and B preferred stockholders. After the satisfaction of the secondary preference, the remaining proceeds would first go to the A and B preferred stockholders in order to meet their still unpaid liquidation preferences. The common stockholders would not receive any distributions until all of these preferences had been satisfied in full.
Mr. Orban voted in favor of the recapitalization as a member of the Board and, subsequently, in his capacity as a Series A preferred stockholder. Although the common stockholders never were asked to approve the recapitalization plan in a shareholders' vote, it went into effect on November 15, 1991.
This Court has determined that the common stockholders were not legally entitled to vote as a class on the recapitalization plan. See Orban, Mem. Op. at 19. The plan was approved by the Board and holders of Class A and B preferred stock which together constituted a majority of the total voting power of the company.
As a result of the recapitalization plan, the following changes in the company's capital structure were to be made. As to Mr. Orban, his combined ownership of common and preferred stock was diluted from 13.27% to 2.54%. As to the common stockholders as a group, since the total number of shares of common stock outstanding had been increased from 1,548,411 to 3,685,387 shares, the percentage of voting power held by the holders of the pre-recap common was reduced from 14% to less than 3%. As to the former creditors, the recapitalization was structured to provide them with a potential for 50% voting interest in the company, with the Series A and B preferred stockholders now capable of voting 10.54% and 36.92% of the equity respectively, and with the remainder 3% voted by the common stockholders.
This 50% ownership was to be divided with 10% in the form of common stock and 40% in the form of warrants.
Here is where things get a little complicated: As mentioned above, the Class A and B preferred stockholders, but not the common stockholders, had anti-dilution rights. These rights were triggered by the creation and issuance of the new Series C stock. In order to have the recapitalization comply with the anti-dilution provisions, it would be necessary to increase the total authorized shares to over 55 million. Since Office Mart had only 25 million authorized shares of which 10.7 million were outstanding, this would require an amendment to the corporate charter which would be a nuisance, but not a practical problem since the institutions owning the vast preponderance of the Series A and B preferred stock could control the vote of all classes of stock. Instead of this step, however, the Board decided to meet the anti-dilution obligation by proportionately reducing the number of shares of each class of stock outstanding. As part of this plan, the Board asked Mr. Orban to surrender certificates for 874,708 of his common stock shares to the company for cancellation. Mr. Orban, however, delayed in complying and later refused to surrender the requested stock certificates. Office Mart's Board took no immediate action to remedy this problem which only became significant many months later when Office Mart and Staples entered into a merger agreement.
Apparently, as will be discussed below, the Series A and B stockholders relied on the assurance that Mr. Orban would surrender this stock and did not take any action to enforce their anti-dilution rights at the time of the November recapitalization or immediately upon his refusal to surrender such shares.
Acquisition discussions: Office Depot: On December 18, 1991, shortly after the effectuation of the recapitalization, Mr. Westerfield reported to the Board continuing efforts to locate an investor. Office Depot was one of several companies mentioned as a potential investor, but no acquisition proposals had been offered yet. On January 30, 1992, Mr. Westerfield received from Office Depot a conditional offer to acquire Office Mart in a pooling of interest transaction for 548,000 shares of Office Depot's common stock, the value of which was approximately $30 million at that time. The offer was contingent upon Office Mart agreeing to a $2 million break-up fee, committing not to negotiate with other potential acquirors, and accepting the proposal by the next day. Determining that this proposal was unacceptable, the Office Mart Board rejected it. The Board directed management to continue negotiations with Office Depot and solicit offers from other companies in order to obtain a more favorable offer. When by February 17, 1992 no definitive offers had been received, the Board directed Mr. Westerfield to negotiate an improved Office Depot merger deal. Mr. Westerfield scheduled a meeting for February 26, but that meeting never occurred.
Acquisition discussions: Staples: The merger negotiations with Staples occurred quickly, beginning with discussions between Mr. Westerfield and the CEO of Staples, Thomas Steinberg, shortly after the February 17 Board meeting. Competitive concerns with Office Depot stimulated Staples' interest in Office Mart. On February 20, Steinberg told Mr. Westerfield that Staples was interested in acquiring Office Mart. Mr. Westerfield replied that a deal would have to be negotiated by February 22 due to his Board's request that he meet with Office Depot to finalize a transaction the following week. The deal was then quickly negotiated.
Apparently, Staples became interested in acquiring Office Mart as a defensive, strategic measure, aimed at preventing its competitor Office Depot from doing a deal with Office Mart which would strengthen its position in the Florida market. Staples had analyzed the company as a potential acquisition target during the previous year, but had concluded in September 1991 not to go forward with such a transaction.
The material terms of the February 22 letter agreement: Office Mart would be acquired by Staples in a stock for stock transaction, providing Office Mart shareholders with substantially greater consideration: 1,093,750 shares of Staples common stock, valued at $35 million as of February 21. Moreover, Staples agreed that $3 million of Office Mart's own funds, as of the date of the merger, would be used to satisfy pre-existing employment and other business obligations. The number of shares to be received by Office Mart shareholders would only be altered under one circumstance. If the value of Staples' stock dropped below $28 million on the effective date of the merger, Office Mart would have the right to terminate the agreement unless Staples provided sufficient additional shares of stock to make the total consideration $30 million.
As of February 22, the cumulative preferences of the Series A, B, and C preferred stock, equal to approximately $35,062,470, were greater than the merger consideration contemplated on that date.
As of January 30, 1992, Office Mart had approximately $6 million in cash.
The Staples proposal was for a merger qualifying as a tax free merger and for "pooling of interests" accounting treatment. In order to assure that the transaction qualified for pooling of interest treatment, Staples demanded a contract clause requiring that each class of Office Mart stock approve the transaction with a 90% vote.
On February 21 and 22, telephonic meetings were held by the Office Mart Board to discuss Staples' proposal. Mr. Orban was not involved in the discussions because he was in Europe at the time and could not be reached. The Board unanimously approved the proposed agreement The Board concluded, based on two years of searching for an acquiror, that the proposal was superior to a deal with Office Depot, and any other potential deals, in terms of the amount of consideration received, and had the additional benefit that it would likely result in fewer employee lay-offs than would alternatives. Mr. Orban was present at a February 25 meeting of the Board when it ratified all of the actions taken in entering into the letter agreement. The minutes from that meeting state that the Board "unanimously agreed that the merger with Staples was in the Company's best interests and that the terms were fair."
Three less central, but still significant elements of the merger were negotiated between the signing of the letter agreement and definitive merger agreement. First, and material to one of Mr. Orban's claims in this action, the record shows that Staples initiated the inclusion of a non-compete agreement by Mr. Westerfield of wider scope and greater duration than the non-compete clause in his employment agreement with Office Mart. Instead of relying on the pre-existing two year non-compete clause which only restricted Mr. Westerfield from working for discount office supply retailers, Staples requested a five year worldwide non-compete agreement covering electronics and computer businesses as well. After reviewing data concerning executive compensation and potential lost opportunities of Mr. Westerfield, the Office Mart Board approved a payment of $1.22 million to Mr. Westerfield in consideration for the non-compete. Mr. Stemberg has testified that he would have paid up to $2 million to Mr. Westerfield for a non-compete on these terms.
Of the five members on Office Mart's Board, three members voted to approve this payment: Mr. Field, Mr. McGoodwin, and Mr. Falvey. Mr. Westerfield did not participate in the Board vote or discussions due to his self-interest. Mr. Orban, who is now challenging this payment, abstained from the vote.
Second, Mr. Westerfield executed a Disclosure Letter dated February 24, which stated that of the $3 million of Office Mart funds that were available to be paid to cover certain negotiated obligations, at least $250,000 would be paid to employees, accrued investment banking fees would be paid, and the balance would be distributed as directed by the company. Subsequently, Office Mart's Board, with Mr. Orban abstaining, determined that the $3 million would be allocated as follows: $430,000 as bonuses to certain key employees to induce them to continue working after the merger, $525,000 to Donaldson Lufkin Jenrette for prior investment banking services, $825,000 to Mr. Westerfield for termination of his employment agreement, and $1.22 million to Mr. Westerfield for the non-compete.
Mr. Orban contends that the two payments to Mr. Westerfield were actually a bonus for negotiating the transaction with Staples. According to Mr. Orban, a $2.5 million bonus had been contemplated at some point in the negotiations, but was not included as part of the deal after it was contested by Mr. Orban.
Third, the parties had to agree upon a stock allocation date upon which to determine the proportionate distribution of the Staples shares to Office Mart stockholders. Due to the fact that the total consideration was of less value than the total preferred stock preferences, as of the date of the letter agreement, this issue was particularly important to the common stockholders. The common stockholders could only receive merger consideration if the value of the Staples shares exceeded $35,062,470 — the total amount of preferences to which the preferred were entitled — on the stock allocation date. The Board elected the date of May 29, the date of the signing of the definitive merger agreement. In hindsight, we know that the stock allocation date was inconsequential for the common stockholders because they would not have received merger proceeds on any of the possible stock allocation dates.
It appears that Mr. Orban abstained from the Board vote on this issue, but he cannot recollect which date he favored. There is some indication that Mr. Orban proposed the closing date of the merger but it was rejected by the Board because of practical considerations, such as the company's need to disclose the merger consideration price in shareholder consent forms to be executed prior to closing.
Dispute with Mr. Orban: In the interim between the letter agreement and the signing of the definitive merger agreement, Mr. Orban began to voice his objections to the deal in which the common stock would receive nothing. A dispute between the company and Mr. Orban, with regard to the pre-recapitalization stock certificates still held by Mr. Orban, provided him with a lever. As noted above, in order to assure pooling of interest accounting treatment, Staples conditioned its offer on the 90% approval of each class of Office Mart stock. The institutional investors who owned the preferred stock owned common stock or warrants sufficient to control a 90% vote, but because of the failure of the company to complete either the pro-rata reduction of outstanding shares or the increase in authorized stock necessary to fully satisfy the Series A and B anti-dilution rights, it was not clear that Mr. Orban did not still control more than 10% of the common stock. Thus, Staples became concerned that Mr. Orban could be able to vote more than 10% of the outstanding common stock against the merger since he had never returned the requested shares to the company for cancellation.
In fact, Mr. Orban would have held more than 10% of the common stock, regardless of whether he had returned the pre-recapitalization certificates, unless the Series C preferred stockholders exercised a portion of their warrants to purchase common stock. But either the pro rata reduction in outstanding shares or an amendment authorizing the issuance of more shares was necessary to fully allow for the satisfaction of the anti-dilution rights.
In order to remedy this problem, members of the Board met with Mr. Orban on March 19, 1992. Although the parties recollect the details of this meeting in slightly different fashions, it is clear that negotiations ensued in which Mr. Orban attempted to extract a payment of $4 million from the company in exchange for his agreement to support the merger. The Board, however, was unwilling to enter into serious negotiations with Mr. Orban regarding the allocation of the merger consideration. Shortly after this meeting, Mr. Orban resigned from the Board. Dilution of Mr. Orban's common stock interest: Instead of continuing negotiations with Mr. Orban, the Board removed the impediment to the closure of the transaction by facilitating the exercise of warrants to acquire common stock by the Series A and B stockholders.
It appears that Mr. Orban began the negotiations by requesting a payment of approximately $4 million, but the company was unwilling to consider a payment in that range, making a counter-offer of only $25,000.
Mr. Falvey resigned from the Board as well, leaving only three members of the Board when all subsequent actions were taken prior to the merger. The remaining directors were Mr. Field, Mr. McGoodwin, and Mr. Westerfield.
Several steps were required to effectuate this readjustment of proportionate ownership. First, the company's certificate of incorporation had to be amended to increase the authorized common stock from 25 to 56 million and preferred stock shares from 15 to 16.175 million. Second, to compensate for the issuance of additional shares, the Board adjusted the conversion ratio of the Series A and B and proportionately increase the number of warrants held by the holders of Series C preferred. Third, the Board proportionately reduced the exercise price of the warrants from $.75 to $.28726 in order to maintain the total exercise price of $6.4 million. Finally, the Board authorized the redemption of 2,089,714 shares held by Series C preferred stockholders, on a non-pro rata basis. In doing so, the company extended sufficient consideration to the Series C holders ($3,013,995) to enable them to exercise warrants to permit them, as a group, to hold more than 90% of Office Mart's outstanding common stock. The aggregate effect of these steps was to assure that Mr. Orban was entitled to vote less than 10% of the company's common stock.
To protect the right of Series C holders to exercise warrants sufficient to own 40% of the company in common stock, the company issued additional warrants entitling them to acquire 22,316,976 shares of common stock instead of only 8,547,906 shares.
Two of the Series C stockholders involved in the redemption and following warrant transaction were organizations which were affiliated with Mr. Field and Mr. McGoodwin. Mr. Field was Chairman of Prudential Equity Investments Corp., the general partner of Prudential Venture Partners II, a holder of Series C stock. Mr. McGoodwin was Senior vice President of Security Pacific Venture Capital Group which held Series C shares through its affiliate First Small Business Investment Company.
The Series C stockholders who participated in this transaction reduced the amount of consideration received by them after the merger by approximately $140,000 because their new 16,079,412 shares of common stock did not receive any merger proceeds. These stockholders were willing to accept this loss, however, having been informed by Mr. Field that the transaction was necessary to prevent Mr. Orban from attempting to block the merger. According to Mr. Orban, to further induce the organizations with director affiliations to participate in this transaction, the Board agreed to pay the organizations fees for the past services of Mr. Field and Mr. McGoodwin of $95,000 and $55,000 respectively. However, there is insufficient evidence that such payments were agreed to or made.
The merger: When Office Mart and Staples entered into the definitive merger agreement on May 29, 1992, the agreement received the approval of 90% of each class of outstanding stock. As of May 29, the stock valuation date, the 1,093,750 shares of Staples common stock were worth a total of $31,992,188. When the transaction closed on June 23, that amount was used to allocate the merger proceeds to be distributed to each class of Office Mart stock in accord with the preferences of the preferred stockholders.
The total value of the consideration had declined to $31,455,313 by June 23, 1992, when the transaction closed. Therefore, if the company had agreed to use that date, suggested by Mr. Orban, as the stock valuation date, it would not have benefitted the common stockholders.
10% of the merger consideration was placed in escrow to indemnify Staples and the company in the event that, as anticipated, Mr. Orban initiated a lawsuit to challenge the merger and prior transactions. The value of the 109,375 shares in escrow, which Mr. Orban claims he is entitled to receive as damages, has substantially increased since the merger.
Since the merger consideration was insufficient to satisfy all of the contractual preferences of Office Mart's preferred stockholders, Mr. Orban and the other common stockholders received no proceeds. It might be noted, however, that Mr. Orban would have received no proceeds from the merger even if the recapitalization and related transactions had never occurred.
Six months later, Mr. Orban filed this lawsuit challenging the fairness of the transactions which resulted in the dilution of his common stock interest in order to facilitate a merger in which only the preferred stockholders received consideration and challenging the payment of approximately $2 million to Mr. Westerfield.
II. Analysis
Plaintiffs contend that the Board breached its fiduciary duty of loyalty to the common stockholders by facilitating the exercise of legal rights of preferred stockholders in transactions aimed at eliminating the leverage of the common stockholders by diluting their ownership interest below 10% The basic theory of Mr. Orban's case is that although the common stock was practically under water (i.e., valueless in a liquidation context) as of the spring of 1992, when evaluating the merger consideration in relation to the preferred stock preferences, the pooling provision requiring a 90% approval vote of each class of stock gave Mr. Orban stock a certain value. That value was destroyed when the Board took actions to assist the preferred stockholders to exercise their warrants, diluting the plaintiffs' common stock interest below 10%.
There is no claim that the Board engaged in fraud or that the merger itself was not in the best interests of the corporation.
In response, defendants contend that the contested actions taken by the Board did not constitute any breach of fiduciary duty because they were legal and necessary to effectuate a merger in the best interest of the company. Further, defendants argue that the business judgment rule should apply to all of the challenged acts of the Board because the directors neither stood on both sides of the transactions nor received distinct personal benefits from such transactions. See, e.g., Cede Co. v. Technicolor, Inc., Del. Supr., 634 A.2d 345, 362 (1993); Aronson v. Lewis, Del. Supr., 473 A.2d 805, 812 (1984). According to defendants, all of the challenged acts of the Board were approved by a fully informed majority of disinterested directors and then ratified by an informed majority of the stockholders. Williams v. Geier, Del. Supr., 671 A.2d 1368 (1996).
Defendants stress that the fact that a director represents a large shareholder of the company is insufficient alone to find that a director was interested in the transaction. See Citron v. Fairchild Camera and Instrument Corp., Del. Supr., 569 A.2d 53, 65 (1989). Although this is true even where other shareholders are in potential conflict with the affiliated shareholder, it is inapplicable if there has been special treatment of the affiliated shareholders, as is alleged in this case. Id.
For purposes of this motion for summary judgment, I will assume that the business judgment rule is not applicable to the actions challenged by Mr. Orban' s breach of fiduciary duty claim. Unquestionably in this instance the board of directors exercised corporate power — most pointedly in authorizing a non-pro-rata redemption of preferred shares for the purpose of funding the exercise by holders of preferred stock of warrants to buy common stock. That act was directed against the common stock who found themselves with a certain leverage because of the requirements for pooling treatment. A board may certainly deploy corporate power against its own shareholders in some circumstances — the greater good justifying the action — but when it does, it should be required to demonstrate that it acted both in good faith and reasonably. See Phillips v. Insituform, Inc., Del. Ch., C.A. No. 9173, Allen, C. (Aug. 27, 1987); Unocal Corp. v. Mesa Petroleum Co., Del. Supr., 493 A.2d 946 (1985); see also Unitrin, Inc. v. American General Corp., Del. Supr., 651 A.2d 1361 (1995). The burden is upon defendants, the party moving for summary judgment, to show that their conduct was taken in good faith pursuit of valid ends and was reasonable in the circumstances.
While such a test is inevitably one that must be applied in the rich particularity of context, it is not inconsistent with summary adjudication where no material facts are in dispute or disputed facts may be assumed in favor of non-movant. In my opinion, the record established, satisfies the defendants' burden. See Celotex Corp. v. Catrett, 477 U.S. 317 (1986).
As a preliminary matter, it is important to note that there is no evidence, or even remaining allegation, that the November recapitalization was part of a scheme to deprive the common stockholders of consideration in the subsequent merger. The recapitalization was legally effectuated by the Board, validly altering the existing ownership structure of the company Certainly, when viewed as an isolated event, the recapitalization was fair, authorized appropriately, and if it were to be tested under a fairness test, it would satisfy that standard.
The recapitalization was approved by Mr. Orban as a director and ratified by a majority of Office Mart's shareholders. As was discussed above, this Court has already determined that Mr. Orban had no legal right to a class vote on the recapitalization. Ordinarily, the approval of disinterested directors and shareholder ratification would provide the recapitalization with the protection of the business judgment rule.
The subsequent conduct of the Board, while requiring a more involved analysis, was, in my opinion, fair as a matter of law as well.
Duty of loyalty: Dilution of Mr. Orban's common stock interest: Once Orban attempted to use a potential power to deprive the transaction of pooling treatment, the Board was inevitably forced to decide whether it would support the common stock's (Mr. Orban's) effort to extract value from the preferred position or whether it would seek to accomplish the negotiated transaction, which it believed to be the transaction at the highest available price.
Certainly in some circumstances a board may elect (subject to the corporation's answering in contract damages) to repudiate a contractual obligation where to do so provides a net benefit to the corporation. To do so may in some situations be socially efficient. See, e.g., Richard Craswell, Contract Remedies, Renegotiation, and the Theory of Efficient Breach, 61 S. CAL. L. REV. 629 (1988). But it would be bizarre to take this fact of legal life so far as to assert, as Mr. Orban must, that the Board had a duty to common stock to refrain from recognizing the corporation's legal obligations to its other classes of voting securities.
In economic terms, Mr. Orban's position does not represent an allocatively efficient transaction, the presence of which may make efficient breach socially desirable. Rather, it could be preferable to deny the preferred their full liquidation preference (or the fullest amount of it available) only on the assumption that, as a practical matter, Office Mart would not be required to repair the loss with damages.
To resolve this situation, the Board decided not to negotiate with Mr. Orban, but rather to effectuate the transaction as intended, respecting the preferential rights of the preferred stockholders. In my opinion, it cannot be said that the Board breached a duty of loyalty in making this decision. Whereas the preferred stockholders had existing legal preferences, the common stockholders had no legal right to a portion of the merger consideration under Delaware law or the corporate charter. The Staples' transaction appeared reasonably to be the best available transaction. Mr. Orban's threat to impede the realization of that transaction by the corporation was thwarted by legally permissible action that was measured and appropriate in the circumstances. See Unocal, supra.
Waste: Payments to Mr. Westerfield: Plaintiffs allege that both the non-compete and employment severance payments constitute a wrongful diversion of assets that could have otherwise been distributed as part of the merger consideration. Further, Mr. Orban argues that the directors who voted to approve these payments were indirectly interested since they represented holders of preferred stock who did get something out of the merger. Thus, he says the business judgment rule is inapplicable.
As a preliminary matter, although all facts are to be viewed in favor of the nonmoving party on a motion for summary judgment, I cannot accept Mr. Orban' s contention that these payments were approved by interested directors. A decision will fail to qualify for business judgment review only where the decision-maker lacks independence, which typically includes financial self-interest. Grobow v. Perot, Del. Supr., 539 A.2d 180, 187 (1988). There is no evidence of self-dealing by the Board with respect to either of the challenged payment decisions. Indeed, as noted at the outset of this opinion, the preferred stockholders received less than their liquidation preference. If the payments to Mr. Westerfield had been redirected to merger proceeds, they would have gone to the preferred. Thus, far from being conflicted with respect to this payment, they were in effect agreeing to payment from their own money.
As to the compensation for Mr. Westerfield to enter into a five year worldwide non-compete agreement, the amount of the payment was determined by three directors who were disinterested. As to the payment for the early termination of Mr. Westerfield's position as CEO of Office Mart, the terms of the payment were set in a pre-existing employment agreement which had been unanimously approved by a disinterested board which included Mr. Orban himself. Mr. Westerfield, the only director with a pecuniary self-interest, was not involved in the negotiation of either of these payments. The fact that Mr. Westerfield was one of three directors to approve the definitive merger agreement which effectuated these pre-determined payments is insufficient to deprive these decisions of the business judgment rule.
Where, as here, a payment decision has been approved by a majority of disinterested directors, it is entitled to the protection of the business judgment rule. See Tate Lyle PLC v. Staley Continental Inc., Del. Ch., C.A. No. 9813, Hartnett, V.C. (May 9, 1988) Slip Op. at 17. A payment protected by the business judgment rule will not be found to constitute an improper payment unless the challenging shareholder can prove that "no informed person could in good faith believe [the payments] to be advantageous to the corporation." Steiner v. Meyerson, Del. Ch., C.A. No. 13139, Allen, C. (July 19, 1995), Slip Op. at 11. Although a determination of whether a payment constitutes waste is an inherently factual inquiry which is difficult to determine on a summary judgment motion, there are some cases in which a "set of facts, if true, may be said as a matter of law not to constitute waste." Lewis v. Vogelstein, C.A. No. 14954, Allen, C. (March 7, 1997, revised March 11, 1997), Op. at 24. This is such a case.
It could be said that a majority of disinterested stockholders ratified these payments as well as a majority of disinterested directors. A majority of each class of shareholders voted to approve the merger with Staples after being fully informed as to how the $3 million of Office Mart cash was to be distributed at closing. This shareholder ratification further entitles the payments to business judgment protection.
No evidence has been presented suggesting that the payments to Mr. Westerfield were excessive. To the contrary, it appears from Mr. Steinberg's statements that the consideration granted to Mr. Westerfield for the non-compete was at the low end. The amount of consideration paid to Mr. Westerfield, in exchange for his waiver of two substantial contractual rights significantly affecting his short term future employment opportunities, surely does not satisfy the very narrow waste standard.
Rather than presenting evidence regarding the magnitude of the payments, Mr. Orban has advanced two main arguments concerning the propriety of the payments. First, Mr. Orban contends that these payments were really an improper bonus. This argument is premised upon the supposition that a disinterested board may not grant a reasonable bonus for work well done. There is some authority for the assertion that past services that give rise to no legal obligation cannot properly be the basis of any payment by a corporation. To do so would be a waste, these cases hold. This is a dubious principle in my opinion where the board is disinterested and the employee or officer continues to serve. See Zupnick v. Goizueta, Del. Ch., C.A. No. 14874, Jacobs, V.C. (Jan. 21, 1997).
In all events, the record here does not raise a triable issue as to whether this payment was a bonus for past services. There is no question but that Mr. Westerfield gave new consideration. Moreover, it is indisputable that Mr. Westerfield's employment contract provides for the granted severance payment in the event of early termination without cause.
Second, Mr. Orban contends that Mr. Westerfield is not entitled to a severance payment because he was not terminated without cause by the company. While it is true that Mr. Westerfield maintained a consulting and directorial relationship with Staples after the merger, he was stripped of his job as Chief Executive Officer of Office Mart on account of the merger. The merger resulted in this loss and it appears to be compensable under the executive's employment contract.
In my opinion, both the non-compete and severance payments to Mr. Westerfield were well within the Board s business judgment and could not be characterized as a waste. Therefore, defendants are entitled to summary judgment on Mr. Orban's claims relating to such payments.
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Based on the foregoing, defendants' motion for summary judgment is granted. IT IS SO ORDERED.