Joseph Adlerstein (“Adlerstein”) was Chairman and CEO of SpectruMedix Corporation (“SMC”), a Delaware corporation engaged in the manufacture and sale of instruments to the genetics and pharmaceutical industries. Adlerstein founded SMC and controlled 73.27% of the voting power.
Adlerstein sued SMC and three individuals who claimed to be the current directors: Steven N. Wertheimer (“Wertheimer”), Judy K. Mencher (“Mencher”), and Ilan Reich (“Reich”). He contested a series of actions taken at or in conjunction with a purported board meeting held on July 9, 2001.
First, a board majority (consisting of Wertheimer and Mencher) voted to issue to the I. Reich Family Limited Partnership (“RLP”), an entity affiliated with Reich, a sufficient number of shares of a new class of supervoting preferred stock to convey to RLP a majority of the voting power in SMC stock.
Second, the same majority voted to remove Adlerstein for cause as CEO, to remove him as Chairman of the board, and to appoint Reich to serve as CEO and Chairman.
Third, immediately after the board meeting, RLP executed and delivered to SMC a written consent in lieu of the stockholders’ meeting purporting to remove Adlerstein as a director.
When the dust settled, the board consisted of Wertheimer, Mencher, and Reich. RLP had replaced Adlerstein as holder of the majority voting control, and Reich had replaced Adlerstein as Chairman and CEO.
Adlerstein argued that the board meeting was not properly convened and all actions taken at or in conjunction with that meeting were null and void. He also claimed that even if the meeting was properly convened, the actions taken by Wertheimer and Mencher constituted breaches of their fiduciary duties owed to him in his capacity as a director and controlling stockholder.
The meeting on July 9, 2001, resulted from a series of financial and operational crises that had plagued SMC under Adlerstein’s management. In 1997, SMC raised $4.67 million through an IPO. It experienced substantial net losses over the next several years, “burning” through all of the IPO proceeds and additional sums from time to time advanced by Adlerstein and others. In March 2001, an employee filed a sexual harassment claim against Adlerstein.
In April 2001, Wertheimer and Mencher suggested retention of a consultant to help reduce expenses and to improve SMC’s manufacturing process. Adlerstein impeded the consultant’s restructuring actions, which had been welcomed by Wertheimer, Mencher, and senior employees. By July 2, 2001, the consultant, Wertheimer, and Mencher concluded that Adlerstein was the “central problem” and had to be removed from any “operating influence.” At that time, SMC was insolvent, its auditor was refusing to issue its opinion letter necessary to file SMC’s annual report with the SEC, Adlerstein was not communicating with creditors, and vendors were refusing deliveries unless paid in cash.
During June 2001, Wertheimer had several discussions with Reich regarding possible investment and management involvement. These discussions were not disclosed to Adlerstein. By early July, a plan was devised through which RLP would invest $1 million, Reich would assume the active management of SMC, and RLP would receive preferred shares carrying voting control.
On July 5, 2001, Wertheimer and Adlerstein had a telephone conversation regarding SMC’s deteriorating financial condition, a pending arbitration proceeding, and the audit opinion letter status. Wertheimer claimed that during this conversation Adlerstein called for a July 9, 2001 board meeting to address these pending issues. Adlerstein maintained that he simply agreed to meet with Wertheimer on that date to discuss the pending arbitration proceeding.
Wertheimer and Mencher attended the meeting with documents to conclude the proposed transactions with Reich. Adlerstein stated that he was not interested in the Reich proposal and was not in a position to provide needed operating funds. He said nothing else. Wertheimer and Mencher then voted on the Reich proposal, as well as the question of removing Adlerstein for cause, consisting of his mismanagement, misrepresentations regarding SMC’s financial condition, and sexual harassment in violation of his employment agreement. By a two out of three vote, the Reich proposal was approved and Adlerstein was removed. The court concluded that the meeting on July 9, 2001, constituted a board meeting and that it had been properly called by Adlerstein during his telephone conversation on July 5, 2001, with Wertheimer. It noted that under SMC’s bylaws, special meetings of the board could be called upon two days’ notice by the President, that verbal notice was sufficient and that no prior distribution of an agenda was required. It acknowledged the financial and operating exigencies that mandated quick action, the good faith belief of Wertheimer and Mencher that adoption of the Reich proposal, and removal of Adlerstein were necessary to save the company, as well as their fear that advance notice would cause Adlerstein to kill the deal. Nevertheless, it concluded that failure to disclose the Reich proposal before the meeting invalidated the board’s approval.
According to the court, Adlerstein’s status as either a director or stockholder, individually and in and of itself, was insufficient to find such a breach, in the absence of some special bylaw or contractual right to prior notice of proposed board actions. However, when a director is also the controlling stockholder, such a breach may occur where, as in this case, a board’s decision to withhold prior notice effectively prevents a director/controlling stockholder from exercising his or her contractual right to block other directors’ schemes. In such cases, non-disclosure violates a basic duty to conduct directors’ affairs according to a minimum standard of fairness. In this case, it deprived Adlerstein of the opportunity to exercise his then existing voting control to remove either one or both of Wertheimer or Mencher by a written consent, which would have prevented a vote approving the Reich proposal that he opposed.
The Adlerstein case underscores the care that must be exercised by directors in dealings among themselves, particularly where one is also the controlling stockholder. Plotting directors may outwit themselves through action constituting a breach of a fiduciary duty to a director/controlling stockholder, resulting in nullification of the action, even where exigent circumstances suggest it to be appropriate. We recommend and encourage directors to seek experienced counsel in all internal disputes.