Fletcher v. ION: Delaware Builds on String of Cases Regarding Duties to Preferred Stockholders

Following a line of recent cases addressing fiduciary duties owed to preferred stockholders (including, e.g., Nemec v. Shrader, In re Trados S’holders Litig. and LC Capital Master Fund, Ltd. (QuadraMed) v. James), the Delaware chancery court confirmed in Fletcher International, Ltd. v. ION Geophysical Corporation, et al that a preferred shareholder may not maintain both contractual and fiduciary duty claims arising out of the same set of facts unless the fiduciary duty claims are based on duties and rights not provided for by contract.

The controversy in Fletcher centered on language in the Certificates of Rights and Preferences (the “Certificates”) for ION’s Series D Preferred Stock. Specifically, the Certificates required the consent of a majority of the Series D holders, voting separately as a single class, to permit any subsidiary of ION to issue or sell any security of such subsidiary. When a subsidiary of ION issued convertible promissory notes without the consent of the Series D holders, the sole Series D holder sued alleging breach of contract and breach of the board’s fiduciary disclosure obligations with respect to the issuance of the notes and obtaining the Series D consent.

Relying on Delaware and federal law, the court first found that the convertible notes were securities of the ION subsidiary, even though the notes converted into ION’s common stock. The court reasoned that the convertible notes were more like an investment in the subsidiary and not a purely commercial or consumer instrument. For example, the notes were fully transferable, convertible into equity and subject to investment risk. Analogizing the notes to an option contract that was issued by the subsidiary to acquire shares of its parent, the court determined that the notes were in fact securities of the subsidiary.

Having found the notes to be securities of the subsidiary, the court logically concluded that the failure to obtain the Series D consent was a clear breach of the Series D contractual rights set forth in the Certificates. However, beginning with the premise that the rights of preferred stockholders are primarily contractual in nature, the court held that the preferred holders could not bring an overlapping breach of fiduciary claim. Since the alleged fiduciary breach in Fletcher was squarely addressed by the contractual relationship between ION and the Series D holder, the fiduciary duty claim was superfluous. In fact, in this case, the fiduciary duty claim could not exist independently of the breach of contract claim. If ION had correctly determined that the convertible notes were not securities of its subsidiary, then there would have been no contractual duty to obtain consent, let alone a fiduciary duty to make any disclosures regarding the issuance of the notes.

Although the court confirmed that directors may owe preferred stockholders traditional fiduciary duties, the court concluded that rights arising out of the corporation’s governing documents do not give rise to fiduciary duties because such rights are purely contractual in nature.