On January 4, 2024, the Delaware Court of Chancery issued an opinion in Ashish Chordia, et al. v. Edward Lee, et al., concluding that an interim CEO acted on behalf of the company when terminating two of its non-executive-officer employees, who were also founders of the acquired company. The court held that because the interim CEO was acting for the company when terminating the two non-executive-officer founders/employees, he was bound by—and breached—the company’s “reasonable efforts” obligation to ensure the viability of the rights contained in the relevant stockholders’ agreement. Accordingly, the court held that the breach excused certain conditions provided elsewhere in the stockholders’ agreement, and so certain rights of the non-executive-officer founders of the company remained intact.
For context, the issue at hand centered on the relationship formed when LG Electronics (“LGE”) acquired a majority interest in the tech start-up Alphonso Inc. (“Alphonso”), which developed automatic content recognition (“ACR”) technology. LGE purchased the majority interest because, as a smart TV brand, it sought to invest in ACR technology. When negotiating the deal, LGE sought to acquire control over Alphonso by way of a majority interest. The founders of Alphonso, on the other hand, had concerns with this level of control, particularly as to LGE being able to terminate Alphonso’s founders, including the CEO. LGE assured the Alphonso founders that such power would be a “nuclear option” to be used only if management were “running the company into the ground.”
Ultimately, in exchange for the majority interest, the Alphonso founders received cash and liquidity rights, which were outlined in a stockholders’ agreement and included, among other things, certain liquidity rights, a director-designation right, and corresponding veto rights. The liquidity rights were protected by the Alphonso founders’ right to designate three members of Alphonso’s board of directors. That designation right, however, would be conditioned on at least one Alphonso founder remaining at Alphonso as either an officer or an employee. The stockholders’ agreement also permitted the board to possess hiring and firing rights as to Alphonso’s executive officers. This right did not extend to non-executive-officer employees. Rather, only Alphonso could terminate such individuals. The agreement also required Alphonso to use “reasonable efforts” to ensure that the rights outlined in the stockholders’ agreement remained effective and to the Alphonso founders’ benefit.
The relationship between the parties started off well, but soon tensions arose. Among other things, there were disputes over Alphonso’s failure to use the proper chain of command; controversies over branding and the hiring of a new president; and concerns about data privacy and compliance, depletion of the stock option pool, transfer pricing for ad inventory, and a general environment of conflict and unprofessional behavior. Tensions also stemmed from the differences in objectives: LGE had more long-term goals relating to the integration of ACR technology into its smart TVs, whereas the Alphonso founders focused on getting to an initial public offering.
Yet Alphonso thrived, and LGE sought to obtain more control to move Alphonso in the direction LGE wanted. Namely, LGE began attempting to gain more strategic flexibility, which evolved into a plan to terminate all the Alphonso founders so that LGE could avoid its obligations to the founders as stipulated in the stockholders’ agreement. LGE intended to accomplish this by using the board to terminate the founders pursuant to Section 10.5 of the stockholders’ agreement, which allowed the board to terminate “executive officers” and employees compensated $500,000 or more per year. However, two founders did not fit in either of these categories. Thus, to remove those two individuals, the termination would have to come from Alphonso itself. Once all the terminations were completed, there would be no more director-designation right to hamper LGE’s control and LGE would be free to end the stockholders’ agreement.
In December 2022, LGE’s plan came to fruition. The board approved a resolution to terminate certain executive officers, and LGE hired an interim CEO to enable Alphonso to complete the termination of the two non-executive-officer founders/employees. LGE thereafter executed written consents to remove the three directors designated by Alphonso.
In response, the plaintiffs, which consisted of all the Alphonso founders as well as other invested parties, brought an action under 8 Del. C. § 225 to seek a determination of the board’s proper composition. Specifically, they sought an order stating that the written consent to remove the three Alphonso-designated directors was invalid and that each remained a member of the board. After a trial and posttrial arguments, the court’s opinion followed.
The court concluded that the consent to remove the Alphonso-designated directors was invalid. Holding that the case ultimately turned on a “simple breach of contract,” the court explained that Alphonso was bound by the “reasonable efforts” obligation of the stockholders’ agreement. The court’s analysis began and ended with said “reasonable efforts” obligation. The court analyzed various terms in the “reasonable efforts” provision to determine the extent of what it meant for Alphonso to take reasonable steps to protect the rights of the Alphonso founders. The court explained that while “the requirement to take ‘all reasonable steps’ does not ‘mean everything possible under the sun[,]’ it does include certain basic requirements.” For example, “actively torpedoing a condition” was obvious evidence of a breach, but “even the failure to take actions a party is contractually obligated to use its efforts to take can give rise to a breach.”
The court determined that the unrefuted evidence demonstrated that the board appointed the interim CEO merely “as a warm body to do the dirty work that it could not.” The interim CEO himself admitted he had no basis for the terminations “other than blindly following” LGE’s direction. The court found that the interim CEO not only “gave little or no regard to Alphonso’s obligation to take ‘all reasonable steps’ to ensure that [the non-executive-officer founders] enjoy the benefit of the rights granted to them in the [s]tockholders’ [a]greement,” but he appeared “never even to have considered whether Alphonso had obligations to [the non-executive-officer founders] before terminating them.”
The court further noted that, by way of the interim CEO, “Alphonso not only failed to take ‘all reasonable steps[,]’” but the “overwhelming weight of the evidence … compel[ed] the conclusion that Alphonso took no steps and made no efforts to maintain [the terminated non-executive-officer founders’] bargained-for right. Worse than taking no steps to ensure the right, Alphonso triggered the [director-d]esignation condition and deprived them of the right entirely.” What’s more, the court determined Alphonso had no reasonable grounds to terminate the non-executive-officer founders in the way that it did, nor did it take any steps or make any attempts to resolve the issues with the non-executive-officer founders.
Accordingly, the court held that the nonperformance of Alphonso’s “reasonable efforts” obligation by way of the interim CEO resulted in the nonoccurrence of the director-designation condition that at least one Alphonso founder remain at Alphonso as either an officer or an employee. The court held that the nonperformance constituted a breach of the stockholders’ agreement such that the director-designation condition was excused. It followed that the written consent to remove the three members of the board of directors designated by Alphonso was invalid.
This ruling emphasizes that companies cannot manipulate their contractual relationships to manufacture a controlling position within that relationship. Such manipulation is particularly ineffective where the parties have implemented a “reasonable efforts” obligation for one party to protect itself within the agreement that binds the parties. In such instances, one party’s efforts to send a “warm body” to do its bidding could be seen as “torpedoing” that obligation. Rather, where there is a “reasonable efforts” obligation at play, parties should ensure that they (1) have reasonable grounds for undertaking any action that may counteract the “reasonable efforts” obligation and (2) only undertake such action after attempting to otherwise resolve the underlying conflict with the other party.