«IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE ELDON KLAASSEN, ) ) Plaintiff and Counterclaim- ) Defendant, ) ) v. ) C.A. No. 8626-VCL ) ALLEGRO ...»
IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE
ELDON KLAASSEN, )
Plaintiff and Counterclaim- )
v. ) C.A. No. 8626-VCL
ALLEGRO DEVELOPMENT CORPORATION, )
RAYMOND HOOD, GEORGE PATRICH )
SIMPKINS, JR., MICHAEL PEHL, and ROBERT ) FORLENZA, ) ) Defendants and ) Counterclaimants. )
MEMORANDUM OPINIONDate Submitted: September 27, 2013 Date Decided: October 11, 2013 R. Judson Scaggs, Jr., Kevin M. Coen, Frank R. Martin, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; George Parker Young, Kelli Larsen Walter, HAYNES AND BOONE, LLP, Fort Worth, Texas; Attorneys for Plaintiff and Counterclaim-Defendant Eldon Klaassen.
Peter J. Walsh, Jr., Ryan T. Costa, POTTER ANDERSON & CORROON LLP, Wilmington, Delaware; Van H. Beckwith, Jonathan R. Mureen, Jordan H. Flournoy, BAKER BOTTS L.L.P., Dallas, Texas; Attorneys for Defendants/Counter-Plaintiffs Allegro Development Corporation, Raymond Hood, and George Patrich Simpkins, Jr.
Lisa A. Schmidt, Jacob A. Werrett, Adrian D. Boddie, RICHARD LAYTON & FINGER, P.A., Wilmington, Delaware; Robert B. Lovett, Karen Burhans, COOLEY LLP, Boston, Massachusetts; Attorneys for Defendants/Counter-Plaintiffs Michael Pehl and Robert Forlenza.
LASTER, Vice Chancellor.
Plaintiff Eldon Klaassen brought this action pursuant to Section 225 of the Delaware General Corporation Law (the ―DGCL‖) to obtain a determination that he remains CEO of Allegro Development Corporation (―Allegro‖ or the ―Company‖). He further contends that as the holder of virtually all of the Company‘s common stock, representing a majority of Allegro‘s outstanding voting power, he acted by written consent to remove two incumbent directors, fill the two resulting vacancies, and fill a preexisting vacancy. The defendants respond that the Allegro board of directors (the ―Board‖) properly removed Klaassen as CEO and replaced him with defendant Raymond Hood. They regard Klaassen‘s consent as ineffective such that Klaassen and the four individual defendants currently constitute the Board.
This post-trial decision holds that (i) Klaassen cannot challenge his removal as CEO, (ii) Klaassen continues to serve as a director, (iii) Klaassen validly removed defendant George Patrich Simpkins from the Board but did not validly remove Hood, (iv) Klaassen did not validly fill the vacancy created by Simpkins‘s removal, and (v) Klaassen validly filled a vacant directorship with non-party John Brown. To sum up, Hood is Allegro‘s CEO, and Klaassen, Hood, Brown, and defendants Michael Pehl and Robert Forlenza are its directors.
The following facts were proven at trial by a preponderance of the evidence. The parties commendably stipulated to a number of facts in the pre-trial order. Klaassen bore the burden of proof on his claims, and the defendants bore the burden of proof on their counterclaims and affirmative defenses.
A. Allegro And The Series A Transaction Allegro is a privately held Delaware corporation headquartered in Dallas, Texas.
The Company is a leading provider of software for energy trading and risk management (―ETRM‖). Klaassen founded the Company in 1984, and for over twenty years he operated it as an S corporation and owned nearly 100% of the stock.
In 2007, Klaassen solicited funds from outside investors to monetize a portion of his holdings. The best terms came from North Bridge Growth Equity 1, L.P. (―North Bridge‖), which proposed a total investment of $40 million in Allegro at a pre-money valuation of $130 million with North Bridge supplying at least $30 million of the capital.
Pursuant to a Stock Purchase Agreement dated December 20, 2007, North Bridge invested $30 million in return for shares of Series A Preferred Stock (the ―Series A Preferred‖). On January 18, 2008, Tudor Ventures III, L.P. (―Tudor‖) supplied the remaining $10 million, also in return for Series A Preferred. Under the terms of the deal, Allegro used the $40 million to repurchase common stock and options that Klaassen and certain other executives held. Klaassen received the bulk of the $40 million. Posttransaction, Klaassen continued to hold virtually all of Allegro‘s common stock, initially representing approximately 70% of the Company‘s fully diluted equity. North Bridge and Tudor (together, the ―Series A Investors‖) owned all of the Series A Preferred, initially representing approximately 30% of the Company‘s fully diluted equity.
As part of the Series A transaction, Allegro amended and restated its certificate of incorporation (JX 11, the ―Charter‖) and bylaws (JX 12, the ―Bylaws‖). Klaassen and the Series A Investors also entered into a Stockholders‘ Agreement dated as of December 20, 2007, to which Allegro was made a party. JX 10 (the ―Stockholders‘ Agreement‖).
These documents established a corporate governance structure in which Klaassen and the Series A Investors shared control at both the director and stockholder levels.
At the director level, Klaassen and the Series A Investors agreed on a Board of seven members and specified this number in the Bylaws. See JX 12 Art. II § 2. The Charter provided the holders of a majority of the Series A Preferred, voting together as a separate class, with the right to elect three directors (the ―Series A Directors‖). JX 11 § 3.3.1. The Charter provided holders of a majority of the common stock, voting together as a separate class, with the right to elect one director (the ―Common Director‖). Id. The holders of a majority of Allegro‘s outstanding voting power, with all shares voting together and on an as-converted basis, elect the remaining three directors (the ―Remaining Directors‖). Id.
Post-closing and at all times relevant to this case, Klaassen controlled a majority of Allegro‘s outstanding voting power through his ownership of the common stock, which nominally gave him the right to elect the Remaining Directors. Under the Stockholders‘ Agreement, however, Klaassen and the Series A Investors agreed to vote their shares to maintain the composition of the Board as follows: one Remaining Director seat would be filled by the CEO (the ―CEO Director‖), and the other two Remaining Directors seats would be filled by outsiders who were neither stockholders nor affiliated with any stockholder, such individuals to be designated by the CEO and approved by the Series A Investors (the ―Outside Directors‖). See JX 10 § 9.2(c)-(d).
For convenience, this decision refers to the Series A Directors and the Outside Directors collectively as the ―Non-Management Directors.‖ The term excludes the Common Director only because that seat remained vacant until June 2013, just before Klaassen filed this lawsuit.
As suggested by the absence of a Common Director, Klaassen and the Series A Investors never fully implemented the seven-director arrangement. Instead, the Board reached stasis at five directors. In 2012, when the events giving rise to this litigation took place, the Series A Investors had filled two of the Series A Director seats with Pehl, a managing director from North Bridge, and Forlenza, a managing director from Tudor.
Klaassen served as one of the Remaining Directors in the CEO Director seat. In his capacity as CEO, Klaassen had designated two Outside Directors, and the Series A Investors had approved both. As noted, Klaassen never elected the Common Director.
Although Klaassen considered it, he reasoned that the Series A Investors would respond by filling their additional Series A Director seat. Klaassen and the Series A Investors ended up sharing control over the Board essentially as planned, with neither Klaassen nor the Series A Directors designating a majority of the seats and the Outside Directors furnishing the swing votes.
At the stockholder level, Klaassen and the Series A Investors similarly shared control. In the Charter, Klaassen and the Series A Investors enjoyed the benefit of the same protective consent rights, such as the right to block (i) ‖any Liquidation Event or Deemed Liquidation Event,‖ (ii) any amendments to the Charter or Bylaws, (iii) the creation, authorization, or issuance of any additional class or series of capital stock, (iv) the issuance of any additional shares or any increase in the authorized number of shares of the common stock or Series A Preferred, or (v) any increase in the number of directors or change in the election procedure for the Board. JX 11 § 3.4. The Charter provided that ―so long as Eldon Klaassen is the record owner of at least 33% of the outstanding shares of capital stock‖ on a fully diluted basis, Allegro could not engage in any of these actions (plus others not referenced here), without both Klaassen‘s consent and the separate consent of the holders of a majority of the Series A Preferred. Id. In addition, as long as Klaassen held shares representing a majority of Allegro‘s outstanding voting power, he could control the outcome of any vote in which all of the shares voted together as a single class, without resort to his Charter-based consent right.
In negotiating the Series A transaction, the parties contemplated means by which the Series A Investors could exit from their investment. When they bought into the Company, the Series A Investors anticipated a five-year holding period. At trial, all of the witnesses, including Pehl and Forlenza, stressed that fact. To ensure that they had the ability to initiate an exit process, the Series A Investors bargained for the right to require Allegro to redeem their shares, subject to the limitations imposed by the DGCL and common law, at any time after December 20, 2012. The redemption price would be the greater of (i) the initial investment price of $40 million or (ii) ―Fair Market Value,‖ in each case plus accrued and unpaid dividends. See JX 11 §§ 6.1-6.2. The Charter defined ―Fair Market Value‖ as an amount determined in good faith by the Board and the holders of a majority of the Series A Preferred, but further provided that if a determination was not made within twenty days after receipt of a redemption notice, the amount would be determined by an investment banking firm chosen by the Series A Investors and reasonably acceptable to the Company. See id. § 6.5.
A more promising exit for the Series A Investors would be a sale. For that outcome, the Series A Investors bargained to receive an initial liquidation preference equal to two times their investment of $40 million, plus all accrued and unpaid dividends (the ―2x preference‖). Once the 2x preference was paid, all of the incremental value in any sale below $170 million would go to the common stock. At trial, the Series A Investors referred to this gap in their returns as the ―donut hole.‖ At deal prices above $170 million, the Series A Preferred resumed sharing in the incremental gains and would receive a somewhat greater than pro rata share of the upside, but with the common stock taking a progressively larger share as the valuation approached $390 million. At deal prices over $390 million, the Series A Preferred and the common stock would share the transaction value on a strictly pro rata basis. See id. § 2.1.
As part of the shared-control structure, the Series A Investors did not obtain sufficient power at the Board and stockholder levels to force a sale. As discussed, Board control was split. Likewise, at the stockholder level, Klaassen could exercise the voting power carried by his common stock, which represented a majority of the Company‘s outstanding voting power, or invoke his Charter-based consent right as long as he held at least 33% of the outstanding shares. The Series A Investors bargained for a drag-along right on Klaassen‘s shares in the Stockholders‘ Agreement, but Klaassen had a veto on that as well. As long as Klaassen owned at least 33% of the outstanding shares, the Series A Investors could not exercise their drag-along right for a transaction offering less than $390 million in aggregate consideration. JX 10 § 4.2(a). Klaassen‘s bundle of rights made him the gatekeeper for any exit by the Series A Investors at values below $390 million, unless the Series A Investors chose redemption.
B. The Decision To Terminate Klaassen On November 1, 2012, the Board removed Klaassen as CEO during a regular Board meeting and replaced him with Hood. The Non-Management Directors had spent August, September, and October of 2012 considering whether to terminate Klaassen, who should replace him as CEO, and how to go about doing it. The different individuals on the Board did not share a singular moment of clarity in which they collectively realized that Klaassen needed to go. Their dissatisfaction grew at different rates over time.
Indeed, the Series A Investors harbored concerns about Klaassen from the start and wanted him to broaden his management team immediately to include an outside professional executive. To that end, they bargained as a term of the Stockholders‘ Agreement for Allegro to hire Chris Larsen as COO to handle day-to-day operational tasks. In a pattern that would repeat itself with other senior executives, Larsen resigned after ten months on the job because he could not work with Klaassen.
A large measure of the Series A Directors‘ dissatisfaction with Klaassen stemmed from Allegro‘s failure to perform as anticipated. In the private placement memorandum (―PPM‖) circulated to potential investors in 2007, Allegro projected revenue of $61 million in 2008, $75 million in 2009, and $85 million in 2010. JX 4 at 11. Reality proved more sobering. In 2008, Allegro generated total revenue of approximately $46 million. By early 2009, the Series A Directors were worried about Allegro‘s underperformance and thought Klaassen needed to improve his operational skills. At the time, Klaassen had not yet designated any Outside Directors, and the Series A Directors encouraged him to identify individuals who might mentor him in his weaker areas.
conducting diligence, the Series A Investors approved him, and Simpkins joined the Board. He brought industry expertise in the ETRM sector and practical experience as a COO.
In December 2009, Klaassen designated Hood as the second Outside Director.