Stroud v. Grace

Justice MOORE

This appeal arises out of a series of disputes between Milliken Enterprises, Inc. ("Milliken"), a privately-held Delaware corporation, and certain shareholders, mostly members of the Stroud branch of the Milliken family (the "Strouds"). Plaintiffs brought individual and derivative claims against Milliken and its board of directors ("defendants"), alleging that the board breached its fiduciary duties by recommending certain charter amendments to its shareholders (the "Amendments"). The Strouds also contested the adequacy and accuracy of the disclosures the board made to the shareholders in the notice of meeting at which the proposed amendments were to be considered, and also challenged the validity of the amendments and a by-law ("By-law 3") which established the procedure for nominating candidates to Milliken's board of directors.

. . . Milliken is a privately-held Delaware corporation. It is one of the largest and most successful textile businesses in the world. Most of Milliken's 200 shareholders are direct descendants of its founder, Seth Milliken. The Milliken board has ten members. Four directors, Roger Milliken, Chief Executive Officer, Gerrish Milliken, a retired Vice President, Minot Milliken, Vice President, and Dr. Thomas Malone, President, are all members of the Milliken family or employees of the corporation. The remaining six directors are otherwise unaffiliated with the company. Roger, Gerrish, and Minot Milliken own or control, through various trusts, over 50% of Milliken's preferred and common shares.

The current controversy arose after the death in 1985 of Mrs. W.B. Dixon Stroud, Roger and Gerrish's sister. As a result of her death, certain Milliken shares were released from a trust under the control of Roger, Gerrish and Minot to the Strouds, who now own or control close to 17% of Milliken's shares.

Soon after Mrs. Stroud's death, Roger proposed that the Milliken shareholders enter into a General Option Agreement ("GOA"). The GOA gave the Milliken family and then Milliken itself, a right of first refusal to purchase any shares offered to unrelated persons. The GOA recited that it was intended to keep the company in private hands and to prevent the dissemination of confidential data. Almost 75% of Milliken's shareholders executed the GOA. Only the Strouds and a few others did not do so.

The Milliken board then proposed charter and by-law amendments which were recommended to the shareholders for their approval at the April 15, 1987 annual meeting. Milliken solicited proxies in connection with the proposed meeting. The Strouds sued in the Court of Chancery to enjoin the meeting. The Strouds complained, among other things, that the notice of the meeting and the proxy materials contained inadequate and misleading information. Stroud also challenged the proposed amendments claiming that they were intended to entrench the board. . . .

The board subsequently withdrew the 1987 amendments and replaced them with the present "Amendments." The most controversial aspects of the Amendments are charter Article Eleventh (c) and By-law 3. Article Eleventh (c) established a new method of qualifying directors for membership on Milliken's board. By-law 3 established the procedure for nominating board candidates. By-law 3 required the shareholders to submit a notice of their candidates to the board, specifying their qualifications under Article Eleventh (c), well in advance of the annual meeting. By-law 3 also empowered the board to disqualify a shareholder's nominee at any time even at the annual meeting.

The board considered the Amendments during meetings held on February 2, 1989, March 10, 1989 and March 11, 1989. The directors adopted the Amendments at their March 11, 1989 meeting which was attended by Milliken's counsel, nine of its ten directors, including five out of the six unaffiliated or outside directors. The board unanimously approved the Amendments and adopted a resolution recommending them to the shareholders for their adoption at Milliken's annual meeting scheduled for April 24, 1989.

On March 14, 1989, Milliken mailed notice of the 1989 annual meeting to its shareholders. Included with the notice was a copy of Milliken's current by-laws, the board resolution proposing the Amendments and Milliken's current Certificate of Incorporation. The notice was four pages long and included a number of recitals. It mentioned that the board had unanimously adopted the Amendments. Significantly, it also stated:

These amendments are proposed in lieu of all amendments previously proposed upon which the stockholders have not acted.

The notice did not explain the differences or similarities between the new Amendments and the previously withdrawn amendments. The notice stated that the board would not solicit proxies in connection with the scheduled 1989 meeting and cautioned:

Stockholders are encouraged to attend the meeting in person . . . . Pursuant to the corporation's by-laws, the chairman of the Board of the corporation, Roger Milliken, will preside at the meeting, and he and others will, among other things, endeavor to answer questions from stockholders concerning the matters to be voted upon, including the proposed amendments to the certificate of incorporation. . . .

Milliken held its annual meeting on April 24, 1989 in Wilmington, Delaware. Of its eligible voters, 93% personally attended the meeting, and 97.8% of the shares entitled to vote were present. Most of the Strouds and their Wilmington counsel also participated in the meeting.

. . . The Amendments were approved at the meeting by 78% of the shares entitled to vote.

After the meeting and vote, the Strouds again filed individual and derivative suits in the Court of Chancery against the defendants contesting the validity of the notice, the Amendments, and By-law 3. Plaintiffs argued that the board breached its duty of care and loyalty in approving and recommending the Amendments. They also argued that the Amendments were unfair to Milliken's shareholders by effectively entrenching Roger, Gerrish and Minot Milliken's control of the board.

The Strouds then moved for summary judgment. With one exception, the trial court sua sponte granted summary judgment in defendants' favor. . . . The Vice Chancellor granted summary judgment in favor of the Strouds by ruling that By-law 3 was unfair to Milliken's shareholders. . . .

The Vice Chancellor applied the presumption of the "traditional business judgment rule.". . . The trial court ultimately concluded that the board did not violate any fiduciary duties. . . .

The Strouds contend that this ruling "is contrary to Delaware law," and construes Unocal too narrowly. Plaintiffs correctly state that Unocal applies whenever a board "perceives a threat" to control and takes defensive measures in response to the threat. Citing to various sections of the record, including: (1) the board's supposed decision to pursue the GOA to respond to a generalized "threat" to the Milliken family's control; and (2) a provision in a subsequently revoked charter amendment identifying a threat to control, plaintiffs argue that the board was reacting to a threat when it approved the Amendments.

In our opinion this record does not justify application of Unocal and its progeny. The Strouds' analysis of Unocal is contrary to Delaware law.

Unocal reaffirmed the application of the business judgment rule in the context of a hostile battle for control of a Delaware corporation where board action is taken to the exclusion of, or in limitation upon, a valid stockholder vote. . . . Unocal recognized that directors are often faced with an "inherent conflict of interest" during contests for corporate control "because of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders. . . ." Unocal. . . . Unocal thus requires a reviewing court to apply an enhanced standard of review to determine whether the directors "had reasonable grounds for believing that a danger to corporate policy and effectiveness existed . . ." and that the board's response "was reasonable in relation to the threat posed.". . . If the board action meets the Unocal standard, it is accorded the protection of the business judgment rule. . . .

The scrutiny of Unocal is not limited to the adoption of a defensive measure during a hostile contest for control. In Moran v. Household International, Inc., . . . we held that Unocal also applied to a preemptive defensive measure where the corporation was not under immediate "attack.". . . Subsequent cases have reaffirmed the application of Unocal whenever a board takes defensive measures in reaction to a perceived "threat to corporate policy and effectiveness which touches upon issues of control." . . .

Inherent in all of the foregoing principles is a presumption that a board acted in the absence of an informed shareholder vote ratifying the challenged action. This significant distinction, in addition to the fact that Milliken faced no threat to corporate policy and effectiveness, or to the board's control, is fatal to plaintiffs' Unocal arguments.

Here, there is no evidence that the board adopted the Amendments as defensive measures. . . . . The Strouds' contention that the GOA was primarily designed as a takeover defense is untenable. That was a matter of private contract between the shareholders themselves and their company. All shareholders were free to accept the GOA or reject it. The plaintiffs chose the latter course. The shareholders of many privately-held corporations, like Milliken, enter into contracts, like the GOA, to preserve family ownership and give themselves a right of first refusal to purchase a company's shares. . . . The Strouds offer no material proof to support their claim that the board adopted Article Eleventh (c) to thwart a takeover. Any defensive effects of the GOA and the Amendments themselves were collateral at best.

Significantly, the record shows beyond peradventure that there was no threat to the board's control. Milliken was neither a takeover target, nor vulnerable to one. No Delaware court has applied Unocal in the absence of a danger to corporate policy and effectiveness, or as here, in the face of a valid shareholder vote ratifying the challenged board action. . . .

The record clearly indicates, and Stroud concedes, that over 50% of the outstanding shares of Milliken are under the direct control of Roger, Minot and Gerrish Milliken. These directors controlled the corporation in fact and law. . . . This obviates any threat contemplated by Unocal, and is buttressed by the further fact that at least 70% of Milliken's shareholders supported the GOA.

Thus, the Court of Chancery properly analyzed the board's decision to adopt and recommend the Amendments to the shareholders under the presumption of the business judgment rule. . . . Under such circumstances the burden is on the plaintiff to overcome the presumption of the rule. . . . Unfortunately, however, that does not end the matter. Since an overwhelming majority of Milliken's shareholders, even excluding those shares owned or controlled by Roger, Gerrish and Minot Milliken, approved the disputed Amendments at the 1989 annual meeting, standards governing the board's action leading to a fully informed stockholder vote have little relevance to the ultimate issue. Thus, our standard of review is linked to the validity of the shareholder vote.

In the absence of fraud, a fully informed shareholder vote in favor of even a "voidable" transaction ratified board action and places the burden of proof on the challenger. . . . The fact that controlling shareholders voted in favor of the transaction is irrelevant as long as they did not breach their fiduciary duties to the minority holders. . . There is no proof whatever of any such breach in this case. The burden, however, remains on those relying on the vote to show that all material facts relevant to the transaction were fully disclosed. . . .

Here, 78% of Milliken's shareholders adopted the disputed Amendments at the 1989 annual meeting. In the absence of proof by plaintiffs that the disclosures were misleading or inadequate, or that the actions of the board involved fraud, waste or other misconduct which were not ratified by unanimous vote of the stockholders, this ends the matter. . . .

. . . Due to the unique manner in which the trial court examined Strouds' disclosure claim, we must first address important legal questions implicating the relationship between the General Corporation Law and a director's common law fiduciary duties. . . .

Since there was no breach of any fiduciary duty in connection with the shareholder vote at the 1989 annual meeting, a fully informed majority of the shareholders adopted the Amendments and effectively ratified the board's action. This shifts the burden of proof to the Strouds to prove that the transaction was unfair. . . They have utterly failed in that regard. . . .

The Strouds' attack on the Amendments and the defendants' cross-appeal of the trial court's invalidation of By-law 3 both challenge the analytical framework employed by the Court of Chancery in resolving their respective claims. The choice of the applicable "test" to judge director action often determines the outcome of the case. . . .

A.

The Vice Chancellor, relying on Blasius Industries, Inc. v. Atlas Corp. . . . and Aprahamian v. HBO & Co., . . . examined the Amendments under an "intrinsic fairness" test. . . . While the trial court concluded that the board had not breached its fiduciary duty, it nonetheless stated that:

Because . . . the critical Charter and By-law amendments affect the Milliken shareholders' franchise, particularly their right to nominate directors, the validity of these amendments must be reviewed for their intrinsic fairness rather than considered pursuant to the business judgment rule.

That ruling put the burden on the board to demonstrate a compelling justification for its decision to adopt and recommend the Amendments under the test of "scrupulous fairness.". . .

The defendants contend that both Blasius and Aprahamian are distinguishable on their facts. They argue that a fairness review is only appropriate where the board breaches its fiduciary duty of loyalty to the corporation. They claim that the board did not act in its own self-interest, and the trial court should have considered the Amendments within the confines of the business judgment rule. The defendants alternatively argue that the Amendments could still withstand the exacting "intrinsic fairness" requirements.

The Strouds argue that these claims were properly decided under the rubric of Blasius and Aprahamian, when board action affects a shareholder vote. Stroud maintains that Blasius is applicable because the Amendments "directly impinge on the shareholder franchise."

The Vice Chancellor's reliance on Blasius implicates a question of law. We examine such questions de novo. . . . After considering the record, and in view of our conclusions earlier in this opinion, exculpating the defendants from a breach of fiduciary duty, we conclude that it was error to apply Blasius here.

B. In Schnell v. Chris-Craft Industries Inc., . . . this Court recognized that management may not inequitably manipulate corporate machinery to perpetuate "itself in office" and disenfranchise the shareholders. . . . The crux of Schnell is that:

Inequitable action does not become permissible simply because it is legally possible.

Schnell's broad holding spawned an entirely new line of Court of Chancery decisions. . . .

C. While we accept the basic legal tenets of Stahl and Blasius, certain principles emerge from those cases which are inextricably related to their specific facts. Almost all of the post-Schnell decisions involved situations where boards of directors deliberately employed various legal strategies either to frustrate or completely disenfranchise a shareholder vote. As Blasius recognized, in those circumstances, board action was intended to thwart free exercise of the franchise. There can be no dispute that such conduct violates Delaware law. . . .

The stringent standards of review imposed by Stahl and Blasius arise from questions of divided loyalty, and are well-settled. . . . After reviewing the record in this case, we conclude that a Blasius analysis in connection with the validity of the Amendments and By-laws was inappropriate.

D. Clearly, the Milliken board did not face any threat to its control. Roger, Gerrish and Minot Milliken effectively owned or controlled a majority interest in the corporation. Furthermore, most of the other shareholders had executed the GOA. Thus, it cannot be said that the "primary purpose" of the board's action was to interfere with or impede exercise of the shareholder franchise.

More fundamentally, the Vice Chancellor ruled, and we agree, that a fully-informed majority of Milliken's shareholders ratified the Amendments. Therefore, the factual predicate of unilateral board action intended to inequitably manipulate the corporate machinery is completely absent here. . . . Milliken's shareholders, unlike those in both Blasius and Aprahamian, had a full and fair opportunity to vote on the Amendments and did so. The result of the vote, ceding greater authority to the board, does not under the circumstances implicate Unocal or Blasius. . . .

VII.

The trial court rejected the Strouds' contention that Article Eleventh (c) of the Amendments was unfair to Milliken's shareholders. . . . We agree that even under the more exacting analysis employed by the trial court, the Amendments are valid. Article Eleventh (c) establishes the qualifications for board membership. It provides for three categories of directors including:

Category 1. Individuals who have had substantial experience in line (as distinct from staff) positions in the management of substantial business enterprises or substantial private institutions, who are not officers, employees or stockholders, whether of record or beneficially, of the corporation or any of its subsidiaries.

Category 2. Individuals who are beneficial stockholders of the corporation. For purposes of this Category 2, beneficial stockholders shall include beneficiaries of trusts which are record stockholders of the corporation.

Category 3. The chief executive officer the chief operating officer, and the president of the corporation, and any person who held any one or more of such offices. . . .

The contested article also provides:

A majority of the board of Directors shall, at all times . . . consist of persons qualified under (Article Eleventh) Category 1. At least 3 members of the Board of Directors shall, at all times . . . be persons qualified under Category 2. No more than 2 individuals qualified under Category 3 may serve as a director at the same time. For purposes of this paragraph (c), an individual qualified under both Category 2 and Category 3 shall be deemed to be qualified under Category 2 alone.

The Strouds contend that the tripartite director qualifications . . . are unreasonable and vague. Plaintiffs argue that the directors approved these provisions for the sole purpose of excluding all other people from Milliken's board except for Roger, Gerrish and Minot Milliken. The Strouds maintain that the amendment precludes them from ever serving as directors. . . .

A. Under our analysis, the burden falls on the Strouds to prove that the Amendments were not properly adopted or that their adoption was the product of fraud, manipulation or other inequitable conduct. Plaintiffs have not sustained that burden.

First, we disregard the Strouds' contention that the board unfairly "crafted" Article Eleventh to exclude all other candidates for office except Roger, Gerrish and Minot Milliken. We have already concluded that the shareholder vote ratified the Amendments, thus eliminating any possible taint on the board's decision. We will not revisit that proposition under the guise of the Strouds' scatter shot attack on the substance of the Amendments.

The Strouds challenge the validity of Article Eleventh (c) claiming that the category one qualifications are impermissibly vague. Plaintiffs focus on the language requiring category one directors to have "substantial experience in line . . . positions" in "substantial business enterprises" or "substantial private institutions." The Strouds claim that the term "substantial" is too indefinite because it is not defined in the corporate charter.

The trial court was troubled that the meaning of "substantial" could vary depending on how the board defined the term. . . . The Vice Chancellor nonetheless found that the board had the authority to define the term as long as they exercised their discretion fairly. The trial court found that Strouds could not prove that the board interpreted category one unfairly, and declined to rule that it was per se unreasonable. . . . We agree. . . .

VIII.

Finally, we turn to the defendants' cross-appeal regarding validity of Milliken's By-law 3. That provision establishes, in part, the procedure for nominating candidates to Milliken's board. By-law 3 initially requires all board candidates to meet the qualifications mandated in Article Eleventh (c). By-law 3, section (d), requires a shareholder proposing a board candidate to include in his or her notice of nomination:

The proposed nominee's name, the principal occupation or employment of each such nominee, the nominee's written consent to nomination and to serving as a director if elected, information establishing such nominee's fulfillment of any qualification requirements set forth in the Corporation's Certificate of incorporation, and such additional information with respect to such person as the Board of Directors may reasonably request.

. . . By-law 3 then mandates that the shareholder deliver a copy of his or her notice to Milliken's secretary:

Not less than fourteen (14) nor more than fifty (50) days prior to the date of the meeting for the election of directors; provided, however, that if less than twenty-one (21) days' notice of the date of the meeting is given to stockholders, notice by a stockholder to be timely must be delivered or mailed not later than the close of the seventh (7th) day following the day on which notice of the date of the meeting was mailed to stockholders.

The By-law does not place a time limitation on the board's right to nominate board candidates. Once received, the board is required to circulate the notice of nominations with the notice of the annual meeting, or if received after the notice is circulated, By-law 3 provides that board should separately send a notice of nominations "as soon as practicable."

The most controversial subsection of By-law 3 concerns the board's ability to determine a candidate's qualifications under Article Eleventh (c) at any time before the election up to and including the annual meeting. By-law 3 subsection (f) provides:

The Board of Directors, or if not feasible, the officer of the Corporation or other person presiding at the meeting of stockholders shall determine any questions concerning whether nominations have been made in accordance with the provisions of this By-law 3 and whether such person has met the qualification requirements, if any, set forth in the Corporation's Certificate of Incorporation. If such a determination is so made, the officer of the Corporation or other person presiding at the meeting of stockholders shall so declare to the meeting and shall declare that any such nomination shall be disregarded.

The trial court, applying Blasius, held that By-law 3 was "unreasonable and unfair, on its face.". . . The Vice Chancellor noted that By-law 3 precluded the shareholders from knowing exactly what information to include in their notice of nomination "because the category 1 criteria are not defined in Article Eleventh and are dependent on a determination by incumbent directors . . . ." The Vice Chancellor found that the board could effectively disenfranchise voters because subsection (f), when read in conjunction with the subsection limiting the shareholders' right to submit its notice of nomination not less than 14 days before the election, gave the directors the unfettered discretion to disqualify the shareholders' candidates without recourse. . . . The Vice Chancellor also noted that the same two subsections would effectively disenfranchise proxy voters whose candidates could hypothetically be disqualified at the annual meeting.. . .

The trial court's invalidation of By-law 3 by granting the Strouds' motion for summary judgment presents an issue of law for review. . . . After reviewing the entire record, we conclude that it was error to invalidate By-law 3.

Again, we observe that Blasius had no application here. Given the fully informed shareholder vote adopting Article Eleventh (c) at the 1989 annual meeting, there was no reason to apply Blasius. Plaintiffs utterly failed to prove that the By-laws were attributable to an improper corporate purpose.

The trial court ruled that Article Eleventh (c) was not unfair and did not unreasonably interfere with the shareholders' franchise. . . . . The Vice Chancellor refused to rule that the disputed article, which establishes the criteria for category one directors to include individuals having "substantial" experience in certain matters, was unfair "per se." Instead, the trial court held that the board was entitled to construe the meaning of "substantial" "if the determination (was) fairly made.". . . Parity of reasoning, therefore, required that By-law 3's reference to the Article Eleventh (c) qualifications likewise did not render it unreasonable per se. The board should have a reasonable opportunity to interpret this otherwise valid by-law in a fair and proper manner. . . .

There was no basis to invoke some hypothetical risk of harm rather than an examination of the board's proven, and entirely proper, conduct. . . . It is not an overstatement to suggest that every valid by-law is always susceptible to potential misuse. Without a showing of abuse in this case, we must reverse the trial court's decision and uphold the validity of By-law 3. The validity of corporate action under By-law 3 must await its actual use. . . .

Accordingly, the judgment of the Court of Chancery is AFFIRMED in part and REVERSED in part.