Settlement Agreement Violates Preferred Stockholder Consent Rights

By: Jill B. Louis and Pouya D. Ahmadi

In PWP Xerion Holdings III LLC v. Red Leaf Resources Inc., C.A. No. 2017-0235-JTL (Del. Ch. Oct. 23, 2019), the Delaware Court of Chancery (the “Court”) granted Xerion Holdings III LLC’s (“Xerion”) motion for partial summary judgement on a breach of contract claim, holding that the Red Leaf Resources, Inc. (“Red Leaf” or the “Company”) breached Xerion’s contractual right to consent as the holder of a majority of the shares of the Company’s Series A preferred stock.

Red Leaf is a Delaware corporation in the business of developing technology to extract oil from shale. Xerion is a hedge fund that acquired Series A preferred stock in the Company.

Before the dispute arose, Red Leaf had participated in a joint venture agreement with Total E&P USA Oil Shale, LLC (“Total Sub”) intended to develop a specific technology suitable for extracting oil from shale. Total Sub became a stockholder of Red Leaf and, as a part of its investment into the joint venture, obtained the right to designate a member of the Company’s board of directors.

The dispute at hand arose out of Total Sub’s intent to exit the joint venture. To facilitate an exit from the joint venture, Total Sub proposed a settlement, under which it would pay Red Leaf $85 million and return its equity interests in the Company.

Xerion, however, in connection with its investment into Red Leaf, had previously bargained for certain consent rights in the certificate of designations governing the Series A preferred stock. The rights relevant to the matter at issue included the right to consent to (i) any transaction “with or for the benefit of any director or officer (or their respective affiliates),” (ii) any change of “the business or business plan” of the Company, and (iii) any purchase or redemption of an equity interest in the Company.

The Company’s board was advised by the Company’s general counsel and outside counsel that consent was required to authorize the settlement transaction and Red Leaf and Total Sub initially asked for Xerion’s consent to the proposed settlement. After Xerion declined to consent, however, the Company and Total Sub proceeded with a modified settlement, restructured in an attempt to avoid violating the consent requirement by providing that the Total Sub equity redemption would not occur unless Xerion’s consent was received. The Company’s outside counsel delivered a non-reasoned opinion that the settlement did not violate any provision of the certificate of designations for the Series A preferred stock. Subsequently, the Company’s board authorized the modified settlement without obtaining prior consent from Xerion. The end of the joint venture also created the need for the Company to refocus its business plan on extracting oil from a different location and using different technology and change in business plan was approved by the board as well.

Following implementation of the settlement, Xerion brought an action against the Company claiming that in authorizing and executing the settlement agreement, Company breached Xerion’s consent rights because the transaction (i) benefited an affiliate of a director of the Company, (ii) caused a material change in the Company’s business plan, and (iii) resulted in the purchase or redemption of an equity interest in the Company.

First, the Court analyzed whether the authorization and execution of the settlement violated Xerion’s right to consent to any transaction benefitting an affiliate of a director of the Company. Citing dictionary definitions of the term “affiliate” and its usage under Section 203 of the General Corporation Law of the State of Delaware and under Rule 144 of the Securities Act of 1933, the Court held that the director appointed by Total Sub to the Company, who was also an officer of Total Sub, was in fact an “affiliate” of that company. Accordingly, the Court found that Xerion’s right to consent was breached.

Likewise, the Court held that refocusing the business from one technology to a similar but not identical technology required Xerion’s consent, as it was a material change to the Company’s business plan.

The Court next examined whether the settlement agreement as modified to include Xerion’s consent as a condition to the transfer of the equity interests back to Total Sub constituted a transaction that resulted in the purchase or redemption of an equity interest in the Company. Rejecting Xerion’s attempt to utilize the step transaction doctrine, the Court found that the step transaction doctrine was inapplicable because the settlement agreement was a single transaction, not a series of nominal ones. Furthermore, the Court found that Xerion’s right to consent was not violated in this instance because no purchase or redemption of equity took place under the settlement without such consent.

Finally, the Company attempted to defend its actions with the assertion that the board of directors of the Company acted in accordance with its fiduciary duties and in good faith while approving the settlement; thus, the Company should not be held liable. This defense was not accepted by the Court which noted that Xerion had asserted a breach of contract claim against the Company, not a claim for breach of fiduciary duty.