Chancery Court Denies Motions for Summary Judgment in Case Brought by Minority Stockholders against Controlling Stockholders for Diversion of Equity as a Result of Breach of Duties

By Whitney Smith and Kevin Szu-Tu

In Fotta v. Morgan, C.A. No. 8230-VCG (Feb. 29, 2016), Vice Chancellor Glasscock denied cross motions for summary judgment and granted a motion to dismiss for failure to comply with Rule 23.1.  After determining that factual issues remained as to causes of action brought by certain stockholders of First Orion Corp. for waste, breach of fiduciary duty, and statutory claims, the Court of Chancery was unable to determine whether a significant creditor to nominal defendant First Orion Corp. used its control over the board of directors to divert equity to itself in breach of duties owed to the common stockholders.

Plaintiff, Keith Fotta (“Fotta”), founded First Orion Corp. (“First Orion”) in 2007 to develop and sell a mobile smartphone application that blocked telemarketers and reported unwanted callers to the Federal Trade Commission. In 2008 Charles D. Morgan, a defendant (“Morgan”), made an investment in First Orion preferred stock and was appointed to the First Orion board of directors.

In October 2009 First Orion sought to raise additional capital to fund its operations, and Morgan agreed to advance $400,000 dollars to First Orion in exchange for a warrant to buy 1.5 million shares of common stock at $1.50 per share. The agreement also included onerous terms if the advance was not repaid by January 2010 including irrevocable voting proxies for shares representing 72.8% of the outstanding capital stock of First Orion, and an additional share of preferred stock for each dollar advanced.

These terms eventually led to Morgan ousting Fotta and taking control of First Orion. Shortly after First Orion failed to repay the advance, Morgan voted his shares and Fotta’s proxies to remove Fotta as a director and officer of First Orion and to replace him with Jefferson Stalnaker, another defendant (“Stalnaker”).  As the two sole directors of First Orion, Morgan and Stalnaker declared a stock dividend for holders of preferred stock, which granted 73.9901 shares of common stock for every share of preferred stock.  The justification of the First Orion board of directors for declaring a dividend only for the preferred shares was to restructure the capital of First Orion to reflect stock ownership in proportion to each stockholder’s cash contribution to First Orion since inception.  This action resulted in an increase in Morgan’s ownership interest in First Orion from 15% to 72% while decreasing the common stockholders combined interests from 72.5% to 4.5%.  After being informed about the stock dividend, the Plaintiffs (common stockholders of First Orion) took no action to either approve or disapprove of the conduct of the defendants.

On January 17 2013, three years after the stock dividend, the plaintiffs sued Morgan, Stalnaker and the Charles D. Morgan Revocable Trust in Delaware Chancery Court. The plaintiffs brought claims for breach of fiduciary duty and waste as well as claims to void the stock dividend on statutory grounds.  Plaintiffs and defendants made cross motions for summary judgment.  In opposition to the plaintiffs’ equitable claims, the defendants raised the defenses of laches and acquiescence.  Defendants claimed that plaintiffs learned of the stock dividend in February 2010 and remained silent for three years and as a result acquiesced to the stock dividend which bars plaintiffs’ legal and equitable claims. The Court noted that the defendants made no assertions regarding their view of Plaintiffs’ knowledge of the stock dividend and how their inaction at the time led them to believe that the stock dividend had been approved.  The defendants focused on the plaintiffs’ knowledge following the stock dividend.  The Court further noted that a more developed record of the facts is needed and denied the defendants’ motion for summary judgment based on acquiescence.

Defendants also asserted that laches bars plaintiffs’ request for equitable relief due to unreasonable delay in asserting a claim with respect to the stock dividend. The Court found that the plaintiffs had sufficient information to bring a claim challenging the stock dividend as a result of their receipt of a letter from the president of First Orion describing the actions taken to approve the stock dividend and failed to assert a sufficient reason for the delay.  The Court found that a more developed record was needed to determine the extent to which the defendants suffered some prejudice as a result of the plaintiffs’ delay, to what extent prejudice should be disregarded as a result of defendants’ breaches of duty, and to what extent plaintiffs’ should have known that their delay was causing prejudice, and denied defendants’ motion for summary judgement for laches.

Despite the differing tests, the Court made a point to note that the laches and acquiescence defenses are often conflated and misunderstood. The Court did provide guidance on differentiating the two.  First, timing is important.  The relevant time frame for a laches defense is after the alleged breach, when the plaintiff is finally informed of the wrong and any subsequent inaction thereafter.  Conversely, on an acquiescence defense, the relevant time frame is at the time of alleged breach.  Secondly, the analysis for laches focuses on the plaintiff’s actions, while the acquiescence analysis looks both to the plaintiff’s and the defendant’s actions.  Under laches the Court looks first to whether the plaintiff had knowledge of a potential claim.  After determining the plaintiff had knowledge, the Court looks to balance the length of delay with the prejudice caused to the defendant.   For an acquiescence analysis, the Court will look to the plaintiff’s understanding of the alleged breach at the time it occurred, the plaintiff’s action or inaction at that moment, and finally the defendants’ understanding of the plaintiff’s knowledge and actions.

While not able to dispose of the bulk of the claims on summary judgment due to the existence of factual issues, the Court did dismiss, for failure to make a demand on the board of directors, two derivative claims based on a separate allegedly wrongful act – the grant of stock options to Stalnaker in 2011, which the plaintiffs alleged amounted to waste of corporate assets. The derivative claims were added to the plaintiffs’ second amended complaint after the composition of First Orion’s board of directors had changed.  In general, when claims are already properly before a court, Rule 23.1 does not require a plaintiff to reevaluate compliance with the rule due to a change in the composition of the board before filing an amended complaint. However, where the composition of a board changes after the complaint is filed, and then a plaintiff amends the complaint to challenge a transaction that is not “already in litigation,” the plaintiff may be required to make a demand on the board as then constituted regarding the new claim, or plead facts demonstrating demand futility.  Vice Chancellor Glasscock ruled that the 2010 stock dividend and the grant of options to Stalnaker nearly two years later were distinct transactions necessitating compliance with Rule 23.1 to add the new derivative claims to the amended complaint. Since the plaintiffs did not make, or plead facts excusing, a demand on the board as constituted at the time of their amended complaint, the Court granted the defendants’ motion to dismiss.

Fotta V. Morgan C.A. No. 8230-VCG (Feb. 29, 2016)

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