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MM Companies, Inc. v. Liquid Audio, Inc.

Supreme Court of Delaware
813 A.2d 1118 (2003)
ELI5:

Rule of Law:

When a board of directors takes a defensive action for the primary purpose of interfering with the effective exercise of the shareholder franchise in a contested election, the board has the burden of demonstrating a compelling justification for its action, and this standard is applied within the Unocal framework.


Facts:

  • MM Companies, Inc. ('MM') sought to gain influence over Liquid Audio, Inc. ('Liquid Audio') and made an unsuccessful acquisition offer.
  • Liquid Audio had a five-member, staggered board of directors, with two Class III director seats up for election at the upcoming annual meeting.
  • MM announced its intention to nominate two of its own candidates for the available director seats, initiating a proxy contest.
  • As the annual meeting approached, it became apparent that MM's two nominees would win the election.
  • Just before the scheduled shareholder meeting, the incumbent Liquid Audio board amended the company's bylaws to expand the board's size from five to seven members.
  • The board then immediately appointed two new directors, James Somes and Judith Frank, to fill the newly created vacancies, ensuring incumbents would maintain a majority even after the election of MM's nominees.

Procedural Posture:

  • MM Companies, Inc. sued Liquid Audio, Inc. and its directors in the Delaware Court of Chancery, seeking to invalidate the board's expansion.
  • Following a trial, the Court of Chancery ruled in favor of the Director Defendants, holding that the board's action was a reasonable defensive measure under the Unocal standard and did not trigger the compelling justification standard from Blasius.
  • The Court of Chancery entered a final judgment for the defendants.
  • MM Companies, Inc., as appellant, appealed the final judgment to the Supreme Court of Delaware.

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Issue:

Does a board of directors' defensive action, taken for the primary purpose of interfering with the effectiveness of a shareholder vote in a contested director election, violate the board's fiduciary duties if the board cannot demonstrate a compelling justification for the action?


Opinions:

Majority - Holland, Justice

Yes. A defensive board action taken for the primary purpose of interfering with a shareholder vote is a violation of fiduciary duties unless the board can show a compelling justification. The court found that the Unocal standard for reviewing defensive measures must incorporate the Blasius 'compelling justification' standard when the board's primary purpose is to impede the shareholder franchise. The trial court correctly identified that the Liquid Audio board's 'primary reason' for expanding the board was to diminish the influence of MM's nominees and foreclose the possibility of a deadlock or MM gaining control. Because this action was a defensive measure designed to interfere with the stockholders' voting rights in a contested election, the board was required to demonstrate a compelling justification. The board failed to provide such a justification; its desire to dilute the influence of shareholder-elected directors was deemed an 'inequitable purpose' that compromised corporate democracy. Therefore, the board's action was invalid.



Analysis:

This decision clarifies the relationship between the Unocal and Blasius standards of review in Delaware corporate law. It establishes that Blasius is not a separate, standalone test but is integrated into the Unocal framework's proportionality prong when a defensive measure's primary purpose is to interfere with shareholder voting rights. This holding significantly raises the legal hurdle for incumbent boards that take actions to entrench themselves during a proxy contest, even if those actions do not completely preclude a shareholder victory. The ruling reinforces the judiciary's role in protecting the shareholder franchise as the fundamental basis for director legitimacy.

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