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Chancery Court Explains Expansive Scope Allowable in Section 225 Suits; Applies Res Judicata to Bar Claims Not Pursued in Prior Section 225 Case

By Francis G. X. Pileggi, Esq.

In Levinhar v. MDG Medical, Inc., No. 4301-VCS (Del. Ch., Nov. 24, 2009), read opinion here, the Delaware Court of Chancery explains the expansive scope of claims allowable in a summary proceeding pursuant to Section 225 of the Delaware General Corporation Law (DGCL). Section 225 proceedings are summary in nature and are designed primarily to address the proper composition of a board. Typically, such actions address, for example, whether a particular director is a proper board member or was properly elected or removed. In this case, the penalty imposed by the Court for not including related claims in a prior Section 225 suit was to bar those claims in the present suit based on the doctrine of res judicata.

Section 225 Suits Must Now Include Related Claims to Avoid Later Bar of Res Judicata

This opinion includes an important explanation of the policy reasons behind res judicata, and the elements that must be established for its application. However, more importantly, this opinion is must reading for anyone who would file suit in Delaware based on DGCL Section 225. This is so because the Court's opinion in this case "serves notice" loud and clear to all who may have considered Section 225 suits to be limited by the nature of a Section 225 action as a summary proceeding, to the specific issue of proper board composition only. Whether or not one was laboring under that misconception, this opinion removes any doubt that failure to raise related issues creates the risk that those related issues may be barred by res judicata in later suits.

Companion Case Alternative

After providing copious citations to precedential Delaware decisions, the Court explains that an alternative to including related claims that are part of the same operative facts or transaction that forms the basis of the Section 225 dispute, one has the alternative of filing a contemporaneous companion case and then asking the Court to consolidate the companion case with the Section 225 case. See, e.g., footnotes 47 to 52 and accompanying text. The reasoning used by the Court includes the following: "Although Section 225 actions are summary proceedings, claims that bear on the appropriate composition of the board of directors many be brought in connection with a Section 225 action." Slip op. at 28. Moreover, the Court added that:  "... it is common in Section 225 cases for this court to address the consequences that stockholder voting agreements have on the outcome of director elections or removal efforts." Id. at 29.

Related Valuation Issues

The Court did not bar, and did allow to proceed, an appraisal claim that was also pursued in this matter. In footnote 54 (that is almost 2 pages long), the Court describes the differences between the valuation method in a claim for damages resulting from the breach of a stockholders' agreement, that may subject a stockholder in a closely-held company to a marketability discount, and the separate standard applied in an appraisal case in which Delaware law does not ordinarily apply either marketability or minority discounts. See, e.g., Cavalier Oil Corp. v. Harnett, 564 A.2d 1137, 1144-45 (Del. 1989). Compare Shannon Pratt, The Lawyers' Business Valuation Handbook: Understanding Financial Statements, Appraisal Reports, and Expert Testimony, 208-211 (2000). [As an aside, I was asked to write a Foreword for the updated edition of this treatise by Shannon Pratt.]

Full post as published by Delaware Corporate and Commercial Litigation Blog on November 27, 2009 (boomark / email).