Delaware Court Disallows Preferred Stock Class Vote Designed To Thwart Anticipated Proxy Contest

Applying enhanced scrutiny, Court determines that directors lacked "compelling justification" to deprive majority stockholders of their right to elect new directors

Since the 1988 decision of the Delaware Court of Chancery in Blasius Industries, Inc. v. Atlas Corp.,1 Delaware courts have zealously guarded the voting rights of stockholders, demanding that directors demonstrate a "compelling justification" for actions that impact a stockholder vote that "involves an election of directors or touches on matters of corporate control ...." Recently, in Johnston v. Pedersen,2 the Court of Chancery was asked to decide the outcome of a contested election of directors that hinged on the propriety of a class vote included in the terms of a new series of preferred stock. Applying a Blasius analysis, the Court concluded that the incumbent directors breached their duty of loyalty by granting a class vote designed to prevent holders of a majority of the outstanding voting power from electing a new board. On this basis, the Court took the extraordinary step of stripping the preferred stock of its class vote and installing the insurgent slate of directors.

Background

Xurex, Inc. was organized in 2005 as "an early-stage company engaged in the development and sale of protective coatings derived from nano-technology ... ." Xurex's founders raised $10 million of initial financing from outside investors through private placements that resulted in a capital structure of (1) 32,046,313 outstanding shares of common stock, and (2) 15,069,850 outstanding shares of Series A Preferred Stock. The Series A Preferred Stock carried one vote per share and "voted with the common stock on an as-converted basis." Following these financings, founders Bo Gimvang, the inventor of the technology, and Bob Bishop, an early CEO, retained majority control over Xurex's outstanding voting power.

Turmoil at Xurex

From the outset, Xurex struggled to bring its technology to market. In fact, just one company, DuraSeal Pipe Coatings Company, was able to develop a commercially viable use of Xurex's technology. As Xurex's only customer, DuraSeal accounted for "99% of [its] sales."

By 2009, Xurex stockholders were frustrated with the company's weak performance. Bishop eventually stepped down as CEO in favor of Bill Loven, who was identified by executive recruiter Rex Powers. Once in office, Loven found evidence that Gimvang and Bishop had "defrauded investors and misused company funds." Loven's vigorous pursuit of these claims triggered a series of contests for corporate control.

In the first contest, Gimvang and Bishop used their majority voting power to grant Powers a proxy to remove Loven and the rest of the Xurex board. Powers used this proxy to replace the sitting directors and elect himself...