Recent Delaware Cases Address the Fiduciary Duties of Directors in the Face of Negotiated Contractual Terms to Redeem Stock

By Jim McMaster

The duties of corporate directors redeeming the shares of minority owners have always been uncertain.  However, when there is a written agreement that sets a redemption price, recent Delaware case law has now removed some of that uncertainty.

New Delaware Cases

In 2010, the Delaware Supreme Court held that Delaware Corporation Booz Allen Hamilton Inc. could buy the shares of two of its retired employees at a price set by its stock rights plan, even as its board negotiated a sale to the Carlyle Group at a much higher price.

The case, Nemec v. Shrader, involved two former high-level employee/directors who had retired after long terms of service.  Throughout their tenure they received annual grants of stock pursuant to an "Officer Rights Stock Plan."  Under that plan, Booz Allen had a right to redeem (call) the retired officers stock at book value.  Book value was approximately $120/share.

The Company negotiated to sell a part of its business at a price that translated to a total venture value of more than $700 per share.  Despite prior assurance to the retired shareholders that it would not do so, the Company exercised the call prior to the sale.  The retired shareholders then sued.

The Delaware Supreme Court held that the existence of the Officer Rights Stock Plan created a contract that negated the directors' fiduciary obligation to treat all shareholders equally.

Furthermore, the Court held there was no violation of the implied covenant of good faith because such a sale context could very well have been considered at the time the plaintiffs entered into the Officer Rights Stock Plan.

In the separate May 2010 case of Fletcher International Ltd. v. ION Geophysical Corp., a preferred shareholder claimed that an issuer had breached both its contractual and fiduciary duties in issuing a convertible promissory note that allegedly violated the terms of the preferred stock.  The Delaware Court of Chancery held that the rights of preferred shareholders "are primarily contractual in nature," and it agreed that the preferred shareholder's contractual rights had been violated.  It then held, however, that those contractual remedies supplant the application of fiduciary duties that would result in additional remedies.  Consequently, the court dismissed the fiduciary claims upon a motion for summary judgment.

Together this case and the Nemec case support the general proposition that shareholders of Delaware corporations can contractually forfeit their fiduciary duty protections, and more specifically, that a Delaware corporation can exercise contractual rights to purchase shareholders' shares, even in the face of negotiations to sell all, or a portion of, the company at a much higher valuation, without the directors violating their fiduciary duties.

Colorado Law

Colorado courts have not specifically addressed whether contractually set buyout terms or the terms of preferred stock supplant directors' fiduciary duties.

However, without addressing fiduciary duty issues, the Colorado Court of Appeals in Breniman v. Agric Consultants, Inc., did find that when there was a contractually provided redemption price for preferred stock, the redemption provision did not preclude the preferred shareholder from exercising appraisal rights and receiving a higher price.

Additionally, in the absence of contractual provisions, Colorado courts have made it clear that directors must disclose facts relevant to the value of a shareholder's stock when negotiating to purchase that stock.  In Van Schaack Holdings Ltd. v. Van Schaack, the Colorado Supreme Court held that corporate directors violated their fiduciary duties when they negotiated for the purchase of a minority shareholder's interest without informing her of ongoing negotiations to sell a large tract of land to be used in the development of Denver International Airport.

Similarly, in Thorne v. Bruder, the Colorado Court of Appeals held that a board's withholding of an appraisal, while negotiating with a shareholder to purchase her shares, was a violation of the board's fiduciary duties. 

While Colorado courts sometimes look to Delaware case law for guidance (see Pueblo Bancorporation v. Lindoe), the cases described above may signal that Colorado would take a more shareholder-tilted view than Delaware has taken in the face of specific contractual language regarding redemption.  However, until such a case is decided, Colorado law on whether a director's fiduciary duties to a corporation's shareholders can be contractually forfeited remains unsettled.

Despite this uncertainty, corporations can mitigate many problems by adopting well-thought-out shareholders' agreements.  Limited liability companies can do the same by including appropriate provisions in their operating agreement.  Express waivers may also be worth considering to ensure that the parties' intent is enforced.  We encourage business owners to work with counsel to address these issues now so that they don't become problematic at a future transition point.

If you have any questions about this Client Advisory, please contact a member of our Business and Corporate Practice Group.

©2010 Sherman & Howard                                                         September 1, 2010