Delaware Court Upholds CEO Removal and Determines Board Composition

In Klaassen v. Allegro Development Corporation, 2013 WL 5739680 (Del. Ch. Oct. 11, 2013), Eldon Klaassen, the former CEO of Allegro Development Corporation (“Allegro”), brought an action under Section 225 of the Delaware General Corporation Law, requesting that the Court of Chancery declare that he: (1) was still the CEO of Allegro, (2) had validly removed two of Allegro’s directors and appointed their replacements, and (3) had validly filled a preexisting director vacancy. Klaassen claimed that his removal as CEO of Allegro by the board of directors (the “Board”) was void. If he was indeed still CEO, he had the power to remove directors and appoint new ones under Allegro’s governing documents. In a post-trial opinion, the Court of Chancery found that Klaassen was barred from challenging his removal as CEO by the equitable doctrines of laches and acquiescence. Regarding his changes to the Board, the Court of Chancery determined that Klaassen did succeed in removing one director and filling the preexisting vacancy on the Allegro Board, but that he did not remove the second director and new CEO, nor validly appoint a replacement for the removed director.

Klaassen, founder and nearly 100% stockholder of Allegro, sought outside investment in Allegro and obtained it from two outside investors (the “Series A Investors”) in exchange for shares of Series A Preferred Stock of Allegro (the “Series A Preferred”). The parties agreed to a corporate governance structure where Klaassen and the Series A Investors shared control at both the director and stockholder levels of Allegro. In an amended certificate of incorporation, Klaassen and the Series A Investors agreed to a seven-member board. The holders of the Series A Preferred would elect three directors, the holders of the common stock (a majority of which was held by Klaassen) would elect one director (the “Common Director”), and the holders of a majority of Allegro’s outstanding voting power (also held by Klaassen) would elect the remaining three directors (the “Remaining Directors”). In a separate Stockholders’ Agreement, Klaassen and the Series A Investors agreed that one Remaining Director seat would be occupied by the CEO, and that the other two Remaining Directors seats would be occupied by outsiders designated by the CEO and approved by the Series A Investors (the “Outside Directors”).

On November 1, 2012, the Board removed Klaassen as CEO during a regular Board meeting, and replaced him with Raymond Hood (then serving as an Outside Director), because of operational and managerial failures. The Board chose not to give Klaassen advance notice that they were removing him as CEO, although the Outside Directors had warned Klaassen that his position was in jeopardy. Instead, the Outside Directors procured the attendance of Allegro’s CFO and general counsel through the admitted “ruse” of telling Klaassen that their attendance was necessary to discuss redemption of the Series A Preferred. After his removal, Klaassen seemed to accept his termination (even if he was displeased by it). Then, on June 5, 2013, seven months after his termination, Klaassen for the first time asserted that he was still CEO and, in his purported capacity as CEO, claimed that he was removing the two Outside Directors (Hood and George Simpkins) from the Board without cause and filling the vacant Common Director seat with non-party John Brown.

In the Court of Chancery, Klaassen argued that because a majority of the directors breached their duties of loyalty and good faith in removing him as CEO, the removal was void. As support, he claimed that the Outside Directors (1) improperly “tricked” him by concealing the purpose of the meeting at which he was terminated, thereby preventing him from taking preemptive action, (2) bribed Hood with the offer of a CEO position, and (3) threatened Klaassen’s removal only to convince Klaassen to buy them out at a higher price.

Disagreeing, the Court of Chancery held that because Klaassen was attempting to use equitable principles to invalidate the Board’s actions—even if Klaassen succeeded on these equitable theories—his removal was only potentially voidable, not void. That is, because Klaassen never contended that the Board violated a mandatory bylaw, he was relying on equity and thus his claims were subject to equitable defenses.

The Court of Chancery held that Klaassen was barred from challenging his removal as CEO under the equitable doctrines of laches and acquiescence. Laches applied because Klaassen had understood the material facts surrounding his removal and obtained legal advice about his rights, but still waited seven months to assert any claims. In the meantime, the new management had made many changes, such that the company would be thrown into chaos if Klaassen returned. In addition, acquiescence applied because, even though Klaassen did eventually express displeasure over his removal, his overall conduct had made it reasonable for the Board to believe that he accepted Hood’s installation as CEO. Accordingly, the Court found Klaassen could not contest his removal as CEO.

Next, the Court turned to Klaassen’s alleged Board changes. Klaassen had served as the CEO Director until his termination as CEO. The defendants urged that upon Klaassen’s termination, he was no longer qualified to be the CEO Director and was not qualified to be an Outside Director, and hence had become the Common Director. The Court rejected this claim and held that Klaassen continued as a Remaining Director and that the Common Director seat had remained vacant until Klaassen validly filled the seat with Brown. The Court noted that the result could have been different had the qualifications for the various Board seats appeared in a clear, self-executing provision of the certificate of incorporation. However, because the qualifications appeared in the Stockholders’ Agreement, Klaassen’s cessation to satisfy the qualifications could not affect his continuing status as a director.

Regarding Klaassen’s attempt to remove Hood and Simpkins, the Court held that the Stockholders’ Agreement limited Klaassen’s ability to remove Outside Directors. However, the Court held that Klaassen retained the right under that agreement to remove without cause directors whom he had originally been entitled to designate, but whom he was no longer entitled to designate. The Court held that Klaassen was the person originally entitled to designate Simpkins as an Outside Director and hence retained the power to remove him even after Klaassen’s removal as CEO. However, the Court held that Hood had ceased to be an Outside Director and instead filled the CEO Director seat, and thus that Klaassen could not remove him without cause. Finally, the Court found that although Klaassen had validly removed Simpkins from the Board, he had not validly replaced him because the Stockholders’ Agreement required that Outside Director seats be filled by nominees designated by the CEO and approved by the Series A Directors. Because Klaassen was no longer the CEO when he attempted to alter the composition of the Board, neither of his nominees validly became a director.

An expedited appeal of the decision has been filed with the Delaware Supreme Court. Oral argument is scheduled for December 2013.