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Klaassen v. Allegro Development Corporation

Court of Chancery of Delaware

October 11, 2013

ELDON KLAASSEN, Plaintiff and Counterclaim-Defendant,
v.
ALLEGRO DEVELOPMENT CORPORATION, RAYMOND HOOD, GEORGE PATRICH SIMPKINS, JR., MICHAEL PEHL, and ROBERT FORLENZA, Defendants and Counterclaimants.

Submitted: September 27, 2013

R. Judson Scaggs, Jr., Kevin M. Coen, Frank R. Martin, MORRIS, NICHOLS, ARSHT & TUNNELL LLP, Wilmington, Delaware; George Parker Young, Kelli Larsen Walter, HAYNES AND BOONE, LLP, Fort Worth, Texas; Attorneys for Plaintiff and Counterclaim-Defendant Eldon Klaassen.

Peter J. Walsh, Jr., Ryan T. Costa, POTTER ANDERSON & CORROON LLP, Wilmington, Delaware; Van H. Beckwith, Jonathan R. Mureen, Jordan H. Flournoy, BAKER BOTTS L.L.P., Dallas, Texas; Attorneys for Defendants/Counter-Plaintiffs Allegro Development Corporation, Raymond Hood, and George Patrick Simpkins, Jr.

Lisa A. Schmidt, Jacob A. Werrett, Adrian D. Boddie, RICHARD LAYTON & FINGER, P.A., Wilmington, Delaware; Robert B. Lovett, Karen Burhans, COOLEY LLP, Boston, Massachusetts; Attorneys for Defendants/Counter-Plaintiffs Michael Pehl and Robert Forlenza.

MEMORANDUM OPINION

LASTER, Vice Chancellor.

Plaintiff Eldon Klaassen brought this action pursuant to Section 225 of the Delaware General Corporation Law (the "DGCL") to obtain a determination that he remains CEO of Allegro Development Corporation ("Allegro" or the "Company"). He further contends that as the holder of virtually all of the Company's common stock, representing a majority of Allegro's outstanding voting power, he acted by written consent to remove two incumbent directors, fill the two resulting vacancies, and fill a preexisting vacancy. The defendants respond that the Allegro board of directors (the "Board") properly removed Klaassen as CEO and replaced him with defendant Raymond Hood. They regard Klaassen's consent as ineffective such that Klaassen and the four individual defendants currently constitute the Board.

This post-trial decision holds that (i) Klaassen cannot challenge his removal as CEO, (ii) Klaassen continues to serve as a director, (iii) Klaassen validly removed defendant George Patrich Simpkins from the Board but did not validly remove Hood, (iv) Klaassen did not validly fill the vacancy created by Simpkins's removal, and (v) Klaassen validly filled a vacant directorship with non-party John Brown. To sum up, Hood is Allegro's CEO, and Klaassen, Hood, Brown, and defendants Michael Pehl and Robert Forlenza are its directors.

I. FACTUAL BACKGROUND

The following facts were proven at trial by a preponderance of the evidence. The parties commendably stipulated to a number of facts in the pre-trial order. Klaassen bore the burden of proof on his claims, and the defendants bore the burden of proof on their counterclaims and affirmative defenses.

A. Allegro And The Series A Transaction

Allegro is a privately held Delaware corporation headquartered in Dallas, Texas. The Company is a leading provider of software for energy trading and risk management ("ETRM"). Klaassen founded the Company in 1984, and for over twenty years he operated it as an S corporation and owned nearly 100% of the stock.

In 2007, Klaassen solicited funds from outside investors to monetize a portion of his holdings. The best terms came from North Bridge Growth Equity 1, L.P. ("North Bridge"), which proposed a total investment of $40 million in Allegro at a pre-money valuation of $130 million with North Bridge supplying at least $30 million of the capital. Pursuant to a Stock Purchase Agreement dated December 20, 2007, North Bridge invested $30 million in return for shares of Series A Preferred Stock (the "Series A Preferred"). On January 18, 2008, Tudor Ventures III, L.P. ("Tudor") supplied the remaining $10 million, also in return for Series A Preferred. Under the terms of the deal, Allegro used the $40 million to repurchase common stock and options that Klaassen and certain other executives held. Klaassen received the bulk of the $40 million. Post-transaction, Klaassen continued to hold virtually all of Allegro's common stock, initially representing approximately 70% of the Company's fully diluted equity. North Bridge and Tudor (together, the "Series A Investors") owned all of the Series A Preferred, initially representing approximately 30% of the Company's fully diluted equity.

As part of the Series A transaction, Allegro amended and restated its certificate of incorporation (JX 11, the "Charter") and bylaws (JX 12, the "Bylaws"). Klaassen and the Series A Investors also entered into a Stockholders' Agreement dated as of December 20, 2007, to which Allegro was made a party. JX 10 (the "Stockholders' Agreement"). These documents established a corporate governance structure in which Klaassen and the Series A Investors shared control at both the director and stockholder levels.

At the director level, Klaassen and the Series A Investors agreed on a Board of seven members and specified this number in the Bylaws. See JX 12 Art. II § 2. The Charter provided the holders of a majority of the Series A Preferred, voting together as a separate class, with the right to elect three directors (the "Series A Directors"). JX 11 § 3.3.1. The Charter provided holders of a majority of the common stock, voting together as a separate class, with the right to elect one director (the "Common Director"). Id. The holders of a majority of Allegro's outstanding voting power, with all shares voting together and on an as-converted basis, elect the remaining three directors (the "Remaining Directors"). Id.

Post-closing and at all times relevant to this case, Klaassen controlled a majority of Allegro's outstanding voting power through his ownership of the common stock, which nominally gave him the right to elect the Remaining Directors. Under the Stockholders' Agreement, however, Klaassen and the Series A Investors agreed to vote their shares to maintain the composition of the Board as follows: one Remaining Director seat would be filled by the CEO (the "CEO Director"), and the other two Remaining Directors seats would be filled by outsiders who were neither stockholders nor affiliated with any stockholder, such individuals to be designated by the CEO and approved by the Series A Investors (the "Outside Directors"). See JX 10 § 9.2(c)-(d). For convenience, this decision refers to the Series A Directors and the Outside Directors collectively as the "Non-Management Directors." The term excludes the Common Director only because that seat remained vacant until June 2013, just before Klaassen filed this lawsuit.

As suggested by the absence of a Common Director, Klaassen and the Series A Investors never fully implemented the seven-director arrangement. Instead, the Board reached stasis at five directors. In 2012, when the events giving rise to this litigation took place, the Series A Investors had filled two of the Series A Director seats with Pehl, a managing director from North Bridge, and Forlenza, a managing director from Tudor. Klaassen served as one of the Remaining Directors in the CEO Director seat. In his capacity as CEO, Klaassen had designated two Outside Directors, and the Series A Investors had approved both. As noted, Klaassen never elected the Common Director. Although Klaassen considered it, he reasoned that the Series A Investors would respond by filling their additional Series A Director seat. Klaassen and the Series A Investors ended up sharing control over the Board essentially as planned, with neither Klaassen nor the Series A Directors designating a majority of the seats and the Outside Directors furnishing the swing votes.

At the stockholder level, Klaassen and the Series A Investors similarly shared control. In the Charter, Klaassen and the Series A Investors enjoyed the benefit of the same protective consent rights, such as the right to block (i) "any Liquidation Event or Deemed Liquidation Event, " (ii) any amendments to the Charter or Bylaws, (iii) the creation, authorization, or issuance of any additional class or series of capital stock, (iv) the issuance of any additional shares or any increase in the authorized number of shares of the common stock or Series A Preferred, or (v) any increase in the number of directors or change in the election procedure for the Board. JX 11 § 3.4. The Charter provided that "so long as Eldon Klaassen is the record owner of at least 33% of the outstanding shares of capital stock" on a fully diluted basis, Allegro could not engage in any of these actions (plus others not referenced here), without both Klaassen's consent and the separate consent of the holders of a majority of the Series A Preferred. Id. In addition, as long as Klaassen held shares representing a majority of Allegro's outstanding voting power, he could control the outcome of any vote in which all of the shares voted together as a single class, without resort to his Charter-based consent right.

In negotiating the Series A transaction, the parties contemplated means by which the Series A Investors could exit from their investment. When they bought into the Company, the Series A Investors anticipated a five-year holding period. At trial, all of the witnesses, including Pehl and Forlenza, stressed that fact. To ensure that they had the ability to initiate an exit process, the Series A Investors bargained for the right to require Allegro to redeem their shares, subject to the limitations imposed by the DGCL and common law, at any time after December 20, 2012. The redemption price would be the greater of (i) the initial investment price of $40 million or (ii) "Fair Market Value, " in each case plus accrued and unpaid dividends. See JX 11 §§ 6.1-6.2. The Charter defined "Fair Market Value" as an amount determined in good faith by the Board and the holders of a majority of the Series A Preferred, but further provided that if a determination was not made within twenty days after receipt of a redemption notice, the amount would be determined by an investment banking firm chosen by the Series A Investors and reasonably acceptable to the Company. See id. § 6.5.

A more promising exit for the Series A Investors would be a sale. For that outcome, the Series A Investors bargained to receive an initial liquidation preference equal to two times their investment of $40 million, plus all accrued and unpaid dividends (the "2x preference"). Once the 2x preference was paid, all of the incremental value in any sale below $170 million would go to the common stock. At trial, the Series A Investors referred to this gap in their returns as the "donut hole." At deal prices above $170 million, the Series A Preferred resumed sharing in the incremental gains and would receive a somewhat greater than pro rata share of the upside, but with the common stock taking a progressively larger share as the valuation approached $390 million. At deal prices over $390 million, the Series A Preferred and the common stock would share the transaction value on a strictly pro rata basis. See id. § 2.1.

As part of the shared-control structure, the Series A Investors did not obtain sufficient power at the Board and stockholder levels to force a sale. As discussed, Board control was split. Likewise, at the stockholder level, Klaassen could exercise the voting power carried by his common stock, which represented a majority of the Company's outstanding voting power, or invoke his Charter-based consent right as long as he held at least 33% of the outstanding shares. The Series A Investors bargained for a drag-along right on Klaassen's shares in the Stockholders' Agreement, but Klaassen had a veto on that as well. As long as Klaassen owned at least 33% of the outstanding shares, the Series A Investors could not exercise their drag-along right for a transaction offering less than $390 million in aggregate consideration. JX 10 § 4.2(a). Klaassen's bundle of rights made him the gatekeeper for any exit by the Series A Investors at values below $390 million, unless the Series A Investors chose redemption.

B. The Decision To Terminate Klaassen

On November 1, 2012, the Board removed Klaassen as CEO during a regular Board meeting and replaced him with Hood. The Non-Management Directors had spent August, September, and October of 2012 considering whether to terminate Klaassen, who should replace him as CEO, and how to go about doing it. The different individuals on the Board did not share a singular moment of clarity in which they collectively realized that Klaassen needed to go. Their dissatisfaction grew at different rates over time. Indeed, the Series A Investors harbored concerns about Klaassen from the start and wanted him to broaden his management team immediately to include an outside professional executive. To that end, they bargained as a term of the Stockholders' Agreement for Allegro to hire Chris Larsen as COO to handle day-to-day operational tasks. In a pattern that would repeat itself with other senior executives, Larsen resigned after ten months on the job because he could not work with Klaassen.

A large measure of the Series A Directors' dissatisfaction with Klaassen stemmed from Allegro's failure to perform as anticipated. In the private placement memorandum ("PPM") circulated to potential investors in 2007, Allegro projected revenue of $61 million in 2008, $75 million in 2009, and $85 million in 2010. JX4 at 11. Reality proved more sobering. In 2008, Allegro generated total revenue of approximately $46 million. By early 2009, the Series A Directors were worried about Allegro's under performance and thought Klaassen needed to improve his operational skills. At the time, Klaassen had not yet designated any Outside Directors, and the Series A Directors encouraged him to identify individuals who might mentor him in his weaker areas.

In June 2009, Klaassen designated Simpkins as an Outside Director. After conducting diligence, the Series A Investors approved him, and Simpkins joined the Board. He brought industry expertise in the ETRM sector and practical experience as a COO.

In December 2009, Klaassen designated Hood as the second Outside Director. After conducting diligence, the Series A Investors approved him, and Hood joined the Board in January 2010. Simpkins and Hood knew each other, having served at SensorLogic, Inc. as COO and CEO, respectively. It was Simpkins who recommended Hood to Klaassen. Hood brought his extensive experience as a CEO managing companies that ranged from pre-revenue startups to publicly traded corporations.

When Hood joined the Board, Klaassen's relationship with the Series A Directors was already strained. Although 2008 had been bad, 2009 was worse. Instead of the $75 million projected in the PPM, Allegro generated revenue of just $37.5 million and missed its budget by 30%. The Great Recession undoubtedly factored into the Company's struggles, but it was becoming clear that Klaassen's management style also contributed. To grow a business, a CEO must succeed across multiple dimensions, including assembling and retaining a talented executive team, empowering them to succeed, setting appropriate budgetary goals and implementing processes to achieve those goals, and communicating with the Board. Klaassen struggled in each of these areas. In particular, the Series A Directors were frustrated by what they perceived to be Klaassen's persistent inability to provide the Board with accurate information. In the weeks and even days before the end of a quarter, Klaassen would give the Board updates that led the directors to expect good quarterly results. Then, after the quarter closed, he would deliver the bad news that the Company actually had missed its target. The Series A Directors understood the software business and were prepared to accept some volatility, but Klaassen seemed unable to get a handle on how the business was doing.

This pattern continued during 2010, and by October, the Series A Directors were ready to consider a CEO change. The Outside Directors, however, believed that Klaassen should be given more time. Hood explained to the Series A Directors that Klaassen seemed "very engaged in the 'go to market' process" and with the specific planning tools that Hood had suggested. JX 82. Hood thought Klaassen was "taking a long view" and had "plenty of fight in him." Id. Hood recommended that the Series A Directors "find ways to be supportive and make it work." Id. The Series A Directors were persuaded, and Hood told Klaassen that he had gotten him more time as CEO.

For a while, Klaassen justified the Outside Directors' confidence. In November 2010, Klaassen presented to the Board the go-to-market strategy that he had worked on with Hood. Although Allegro again missed its budget for the year, and the Company's revenue of under $35 million amounted to less than half the PPM figure of $85 million, Hood was pleased with Klaassen's progress and told him so. For 2011, Hood and the other Non-Management Directors worked with Klaassen to set a lower, more achievable budget that would create positive energy in the organization. Allegro actually achieved its revenue budget during each of the first three quarters of 2011. While Klaassen continued to have difficulties recruiting and working with senior executives, there were signs of improvement.

Then came the fourth quarter of 2011, which was "ugly." JX 150. Klaassen described the quarter as "a disaster, " JX 145, and he had no explanation other than that a couple of big deals slipped. JX 138. They did more than just slip, because the first quarter of 2012 was similarly bad. In a contemporaneous email, Klaassen tried to reassure Pehl that "[w]e can do better than this." JX 164.

C. The Year Of Redemption

Going into 2012, everyone on the Board understood that the Series A Investors' redemption right would ripen on December 20 and could be exercised at any time after that point. Prudently, the directors began planning for that eventuality.

At a Board meeting on April 19, 2012, redemption was a central topic of discussion. Hood offered to act as an intermediary between Klaassen and the Series A Investors. He also asked for authorization to hire independent counsel to express a view on the Company's redemption obligations. Allegro, through Klaassen, had obtained advice on the redemption mechanics from Gibson Dunn & Crutcher LLP, and the Series A Directors were receiving advice from Cooley LLP. Hood proposed to hire a third firm to express an independent view. The Board approved, and Hood hired Baker Botts LLP.

The documentation surrounding the retention of Baker Botts was not as clear as it could have been, and the parties disputed at trial whom Baker Botts represented. The Baker Botts engagement letter referred to a "special committee" of independent directors as its client, but the Board never created a special committee. Baker Botts prepared its advice with the understanding that it would be provided to the full Board, leading Klaassen to argue that the full Board was Baker Botts's client. Baker Botts later advised the Non-Management Directors on issues surrounding Klaassen's removal, and Klaassen feels betrayed by the firm. Having considered the conflicting evidence and testimony, I find that Hood retained Baker Botts as counsel to the Outside Directors. Hood and Simpkins were Baker Botts's clients. Klaassen was never a client of Baker Botts.

At Hood's request, Baker Botts prepared and circulated a memorandum that addressed the redemption right. The memorandum made clear, and all of the directors understood, that the Series A Investors could not immediately force a full redemption if the Company did not have legally available funds, nor could the Series A Investors effectively convert their Series A shares into a debt claim against the Company. But the memorandum also explained, and the directors understood, that if Allegro could not finance a complete redemption, then the Board would have to determine regularly the amount of funds that Allegro could use for redemption and deploy those funds to buy back shares of Series A Preferred. Compliance with this obligation would constrain the Company's ability to reinvest in its business and grow. The threat posed by redemption therefore depended significantly on (i) the amount the Company would have to pay and (ii) whether the Company had sufficient funds legally available to redeem the Series A Preferred in full.

The Board's next regular meeting was scheduled for July 19, 2012. During the weeks before the meeting, Hood explored various alternatives with Klaassen and the Series A Investors. Hood believed that the most logical solution was a third party sale. Unfortunately, the value of the Company in 2012 had fallen well below its 2007 pre-money valuation of $130 million. In any sale in that range, the Series A Investors would receive their 2x preference off the top, with the balance going to Klaassen and the other common stockholders. At the time, the 2x preference inclusive of dividends amounted to approximately $92 million and would consume the vast majority, if not all, of the proceeds in any transaction. Klaassen made it clear that he would not sell. Both as the holder of a majority of the outstanding voting power and under the Charter and the Stockholders' Agreement, Klaassen had blocking rights.

Another path was a recapitalization. One possibility was an external recapitalization in which the Company would take on debt or bring in a new investor and repurchase the Series A Preferred. A second possibility was an internal recapitalization that would reallocate the equity stakes of the Series A Preferred and the common stock to reflect the Company's lower valuation. The latter would have negative implications for Klaassen's control and would not result in a Series A exit, so the parties spent most of their time on the former.

In advance of the July 19, 2012, meeting, Klaassen proposed to have Allegro repurchase the Series A Preferred for $60 million, consisting of $40 million in cash and $20 million in subordinated debt. To support his offer, Klaassen obtained a valuation of the Series A Preferred from CBIZ Valuation Group, LLC, which placed the value of the Series A Preferred at between $39 and $47 million, including accrued dividends. Klaassen argued that his $60 million offer was generous in light of the CBIZ valuation and represented more than the Series A Preferred could expect to receive in a redemption.

The Series A Investors regarded the CBIZ valuation as unreliable. They did not identify specific problems with the CBIZ methodologies, nor did they obtain a valuation of their own. They rather seem to have viewed CBIZ valuations as generally slapdash and superficial because boards often use them when pricing stock options, an exercise traditionally approached with less rigor than other valuation tasks. The Series A Investors took the position that what they might receive in redemption was irrelevant to what they wanted in a negotiated resolution. They demanded $92 million for their shares.[1]

As the July 19 meeting approached, another event raised the tensions between Klaassen and the Non-Management Directors. Just four days before the end of the quarter, Klaassen fired Brett Friedman, Allegro's Senior Vice President of Sales. Klaassen had no plan for a replacement, and the timing of the termination dismayed the Non-Management Directors. Although they did not oppose the termination itself, they had asked Klaassen to have a succession strategy and to wait until after the end of the quarter so as not to interfere with pending deals. The Non-Management Directors asked for an explanation, but Klaassen simply said Friedman had been insubordinate. Simpkins and Hood were particularly troubled by how Klaassen handled the firing. Simpkins "felt like [Klaassen] had completely missed my coaching about having communication with the board and having faith in the board, and I was extremely surprised and very disappointed." Tr. 916. Hood saw a recurring pattern in which Klaassen could not work with new executives: "There was no leadership team being built, and the Company was going sideways .... We had the same exact executive team we had five years earlier." Tr. 744, 747.

On July 10, 2012, Hood asked Baker Botts to be prepared to discuss the mechanics for CEO termination at the July 19 meeting. In an email two days later, he explained his reasons for wanting to broach the subject:

Eldon and his management team have had 4 years to get the Company moving and, for all intents and purposes, it is in stasis. His recent firing of the head of sales a few days before the Company posted its best sales quarter ever kind of spooked me ... . It makes me wonder what a year delay [of redemption] does. ... I think the [Series A] investors are pretty clear about how ugly things could get, but I think Eldon has rose-colored glasses on. Introducing some hard headed realism about the cost and damage that a fight or delay [of redemption] could cause might push the parties to compromise. That's my hope.[2]

Hood knew that Klaassen and the Series A were "very unhappy" with each other. Tr. 744-45. He felt that if he could "get them to just settle up and pay off each other, " then he would have "done [his] job as an independent [director], " the shareholders would be "happy, " and he could "happily walk away." Tr. 745.

D. The July 19 Meeting

During the Board meeting on July 19, 2012, the Board covered a full agenda of Company business. When it came time to discuss redemption, Baker Borts presented its analysis. Klaassen responded that the redemption right did not concern him. He also stated that before he would agree to a third-party sale, it would need to be a transaction that generated $100 million for him personally. Simpkins was struck by Klaassen's obsession with his own interests and his failure to consider other important corporate constituencies, such as the Company's employees.

The Non-Management Directors regularly met in executive session for a portion of each Board meeting, and on July 19 they discussed Klaassen's performance as CEO. Forlenza sensed for the first time that the Outside Directors had become frustrated with Klaassen, and he began to think that terminating Klaassen might be a viable option.

After the meeting ended, the Outside Directors asked Klaassen to remain for a private discussion. Hood told Klaassen that how he handled Friedman's termination seemed to be part of a recurring theme. Hood also encouraged him to compromise with the Series A Investors rather than put the Company in a position where its cash would be drained off to fund a periodic redemption requirement. Simpkins backed Hood. Klaassen reiterated that he was not concerned about redemption and contended that he could ignore it and "stonewall" the Series A Investors. Tr. 808 (Hood); Tr. 919 (Simpkins). The Outside Directors disagreed, and Hood pointed out that the Board could fire Klaassen: "[A]ll it takes if they have two [votes] is either me [Hood] or him [Simpkins] to vote with them, and you're out of here as CEO." Tr. 809 (Hood); accord Tr. 675-76 (Hood); Tr. 918-20 (Simpkins).

E. Klaassen Consults With Counsel About The Termination Risk.

After meeting with the Outside Directors, Klaassen barreled into the office of Chris Ducanes, Allegro's General Counsel. Klaassen "looked very concerned and agitated" and asked if the Board could remove him as CEO. Tr. 881-84 (Ducanes). Ducanes told Klaassen that he "didn't have an employment contract and that he could be removed by the board." Id. Klaassen asked Ducanes to get a second opinion, so Ducanes contacted Gibson Dunn. In August, Gibson Dunn confirmed that there was no limitation on the Board's ability to terminate Klaassen as CEO.

F. The July 31 Meeting

At Hood's suggestion, the directors convened again on July 31, 2012. Simpkins participated by telephone, and the other directors attended in person. Although styled as a special meeting of the Board, the session was really an opportunity for Klaassen and the Series A Investors to discuss various alternatives and potentially negotiate a deal. The Series A Investors lowered their demand to $80 million, and they proposed selling Allegro as an alternative. Klaassen reiterated that he would not approve a sale and again offered $60 million.

To support the reasonableness of his $60 million offer, Klaassen gave a PowerPoint presentation designed to show that the value of Allegro as a whole did not support a higher figure. To prove his point, Klaassen detailed the Company's poor performance during the life of the Series A investment. Most strikingly, Klaassen presented a slide that compared Allegro's performance to its two nearest competitors. According to the slide, Allegro's ...


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