Recent Case Opens Possible Path to Increased Lawsuits Against Board Members - What You Should Know

Summary: Board members now must be even more careful when voting on transactions in which one or more of the directors has a “material financial interest.” A recent case has combined the longstanding conflict of interest challenges with the expedited process designed for questioning director elections. The result gives shareholders a faster way to raise conflict of interest claims as long as the transaction in question in some way involves the election or appointment of directors of a California corporation—or of a Delaware or other non-California corporation, where the election/appointment is held in California. 

Section 709 Expedited Process
Corporate boards usually take great care to follow statutory processes for corporate governance matters such as elections. Failure to adhere to deadlines, notice periods and other strict procedural requirements can lead to invalidation of the underlying election and related matters. Section 709 of the California Corporations Code (“Code”) provides an expedited process by which a corporate shareholder or other person denied the right to vote can challenge the validity of any election or appointment of a director of a California corporation or a director of a Delaware or other non-California corporation, where the election/appointment is held in California.

Previously, Section 709 had been used to examine electoral process issues such as adequacy of notice, presence of a quorum, or disputes over the right to vote.   In a recent case, the California Court of Appeals determined that a Section 709 action could be based on an alleged breach of fiduciary duty under Code Section 310, which governs corporate transactions in which one or more directors have a material financial interest. 

Case Facts: Morrical v. Rogers
The case, Morrical v. Rogers, Cal. Ct. App. Case No. A137011 (Oct. 10, 2013), involved an ongoing dispute between two brothers and their sister, the sole and equal shareholders and sole directors of a lucrative family business. The dispute escalated in February 2012, when the two brothers called a special joint meeting of the corporations’ boards of directors to consider several actions relating to a private equity firm’s proposed involvement in the business. Prior to calling the board meeting, the brothers and the private equity firm had entered into a number of agreements that provided, among other things, for substantial loans and other payments to the brothers from the firm.

After trying, but failing, to enjoin the board meeting, the sister brought an action against the private equity firm and its designated corporate directors under Section 709 of the Code. She asked the trial court to invalidate the election of the directors, stating that her brothers should be disqualified from voting under Section 310 because they had material financial interests in the transactions between the corporations and the private equity firm. She further asked the trial court for related relief, including setting aside all acts taken by the new directors subsequent to their election. After a seven-day trial, the trial court invalidated the election of the directors and set aside all corporate actions taken by such directors to “facilitate, implement or effectuate” the invalid election.

The California Court of Appeal reversed the trial court’s judgment due to the sister’s failure to include her two brothers in the action. However, the Court also held that allegations of breach of fiduciary duty and conflict of interest under Code Section 310 could serve as the basis of a challenge to the election of directors under the expedited process afforded by Code Section 709.  The Court specifically rejected the private equity firm’s claim that the expedited process of a hearing within five days of the filing of a complaint violated its due process rights to have the arguably more substantial Section 310 claims evaluated more thoroughly and stated its confidence that a “conscientious trial judge” could balance the need for expedition with the rights of the parties to have a fair hearing on the merits. 

Takeaway for Board Members
Until Morrical, defending an expedited Section 709 challenge would not have appeared too daunting for a corporate board, so long as the board followed the statutory processes for the election and appointment of directors.   However, this recent case has further increased the challenges and risks to corporate directors of California corporations by permitting complex substantive issues to be adjudicated in a process designed for procedural claims. In addition, due to the reach of Section 709, directors of Delaware and other non-California corporations also need to be aware of the increased risk, and should be mindful of where elections and appointments would be deemed to be held/made. 

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