Court of Chancery Denies Motion To Dismiss Claim Alleging Breach of Fiduciary Duty Involving Option Grants to Directors and Voting Agreement

By: Cartwright Bibee and Ernest Simons

In Williams v. Ji, C.A. No. 12729-VCMR (Del. Ch. June 28, 2017), the Delaware Court of Chancery denied Defendants’ motion to dismiss, holding that the option and warrant grants and voting agreements in question were subject to entire fairness and that the Defendant directors had not carried their burden at that stage. The Defendants also moved to stay in favor of an earlier filed case in the Court, but the motion was denied as moot because the earlier filed case had settled.

The action arose out of an alleged scheme in which the directors of Sorrento Therapeutics, Inc., a Delaware corporation (“Sorrento”), granted themselves options and warrants (the “Grants”) for the stock of five subsidiaries over which Sorrento had voting control. The board also adopted or amended the certificates of incorporation of the five subsidiaries to allow for the issuance of stock to facilitate the Grants and transferred valuable assets and opportunities to the subsidiaries. The stockholders never approved of the Grants and related transactions, though Sorrento did disclose the plan in its 2015 form 10-K (which was later amended, after the deadline for director nominations, to disclose that all of the Sorrento directors were recipients of the Grants). Sorrento’s shares are publicly traded on the Nasdaq Capital Market. The Plaintiff, a stockholder of Sorrento, alleged a breach of fiduciary duties in that the Grants were a part of a scheme to siphon assets from Sorrento for the benefit of the directors.

Contemporaneously, Sorrento entered into private placements with four investors to raise $150 million in exchange for approximately 45% of its common stock (the “Private Placement(s)”). One of the Private Placement investors, Yuhan Corporation, signed a voting agreement (the “Yuhan Voting Agreement”), as a condition to the closing of the Private Placement, under which Yuhan was required to vote its common shares as directed by the Sorrento board. The Private Placements closed on the record date for the annual meeting of stockholders, allegedly so that the Private Placement investors could vote for the incumbent board. Yuhan invested $10 million in Sorrento, and its shares constitute 2.75% of the outstanding Sorrento common shares. The Plaintiff challenged the Yuhan Voting Agreement as a breach of fiduciary duties, claiming it to be illegal managerial vote buying designed both to disenfranchise the Sorrento stockholders in the director election and to further entrench the board of directors.

The Court found Plaintiff’s claims regarding both the Grants and the Yuhan Voting Agreement to be ripe. As the Grants had been made and the Yuhan Voting Agreement had been executed, whether or not they constitute a breach of fiduciary duties could be determined on a record developed from evidence currently available at the time. The Defendants argued that the precise value of the Grants remained speculative. However, the Court found such argument to be properly directed to the merits of Plaintiff’s claim, not to ripeness. Similarly, even though the Yuhan Voting Agreement had not yet dictated the outcome of any specific vote, the Court found that it could determine whether the board’s decision to enter the agreement constituted a breach of fiduciary duties.

The Defendants argued that the Plaintiff’s challenge to the Grants did not state a claim for breach of fiduciary duty as compensating directors for their service to a subsidiary is permissible and that the business judgment rule should apply. Citing Valeant Pharm. Int’l v. Jerney, 921 A.2d 732 (Del. Ch. 2007), the Court found that self-interested compensation decisions made without independent protections are subject to the entire fairness review like any other interested transaction.

Under Delaware law, to prove entire fairness, a defendant must prove both fair dealing and fair price. The Court held that Plaintiff’s complaint adequately alleged both an unfair process and unfair prices for the Grants. As to process, Plaintiff alleged that no one other than the interested directors ever independently approved the Grants. Further, the Court took issue with the timing of the Grants and ancillary transactions, and the Grants were not disclosed as non-executive directors’ compensation, but rather as related-party transactions. The Court found that these allegations gave rise to at least a reasonably conceivable inference of unfair process. As to price, taking the Plaintiff’s allegations of value as true, the value of the compensation was large enough to sufficiently plead that the Grants were excessive. The Court held that to accept the Defendants’ argument that the Grants were fair compensation for additional services to the subsidiaries would improperly draw an inference in Defendants’ favor. As such, the Defendants were not able to prove that the Grants to the directors were entirely fair to Sorrento.

Finally, the Defendants argued that the Plaintiff’s challenge to the Yuhan Voting Agreement failed to state a claim. Under Delaware law, a vote-buying agreement is not considered to be illegal per se unless the purpose is to defraud or in some way disenfranchise other stockholders. However, management may not use corporate assets to buy votes unless it can be demonstrated that management’s vote-buying activity does not have a deleterious effect on the corporation. Here, the Court reasoned that Sorrento’s directors made the Yuhan Voting Agreement a condition of the Private Placements, and thus, used corporate assets to buy the votes. As such, the Defendants must prove that the Yuhan Voting Agreement is intrinsically fair and not designed to disenfranchise the Sorrento stockholders. Taking reasonable inferences in Plaintiff’s favor, the Court found that the complaint adequately alleged a disenfranchisement purpose, thus shifting to the Defendants the burden of proving that the agreement was intrinsically fair, which the Defendants did not do through their motion to dismiss.

Williams v. Ji, et al., memorandum opinion 170628

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