Early test of Delaware ‘loser pays’ bylaws looms in Biolase dispute

July 8, 2014

(Reuters) – On Monday, a Delaware shareholder firm issued a press release urging shareholders of the dental laser company Biolase to get in touch if they’re concerned about allegations that board members leaked corporate financials, among other supposed shenanigans. You know what that means: Class action firms are circling the beleaguered company, looking for a reason to file a shareholder derivative suit accusing Biolase’s board of breaching its duties.

Meanwhile, Biolase’s former chairman and CEO — ousted in June after months of fighting in Delaware courts to keep his job — has sent a demand for books and records to the company’s board. Deposed CEO Federico Pignatelli claims that his fellow Biolase directors are working for their own interests, not for shareholders. Represented by Baker Marquart, he’s spoiling to keep litigating against the directors who tossed him out.

That’s a risky proposition for Pignatelli and for Delaware shareholders. At the same June 26 meeting at which the board got rid of Pignatelli, Biolase became one of the first public companies in Delaware to adopt a “loser pays’ fee-shifting bylaw.

As you probably recall, the Delaware Supreme Court ruled in May that state corporate law permits companies to shift the cost of defending shareholder suits to investors whose cases fail. The Biolase “loser pays” bylaw is a variation on that theme: It’s not directed at all shareholders who sue the board, but only at current or former directors (or anyone acting at their behest) who assert unauthorized claims against the board.

The bylaw was obviously enacted with Pignatelli in mind. Under its terms, if Pignatelli sues his fellow Biolase directors and loses, he’s on the hook for their defense costs. More significantly for the Delaware shareholder bar, if Pignatelli challenges the validity of the Biolase fee-shifting bylaw and loses, more public corporations will be emboldened to enact loser pays provisions. That would be bad news for Delaware shareholders who count on enforcing their rights through litigation.

Pignatelli is positioning himself as a champion of shareholder rights, since he holds an almost 5 percent stake in Biolase. (Oracle Partners has more than 16 percent.) As such, his lawyer Ryan Baker told me Tuesday, he will “absolutely” challenge the fee-shifting provision if he decides to sue the board.

“The harm to shareholders is substantial” from bylaws discouraging directors from holding their colleagues accountable, said Baker, adding that he has heard “an upwelling of concern” from shareholder lawyers after news spread of the Biolase amendment. “Mr. Pignatelli takes these issues very seriously,” Baker said. (“While I dispute the legality and enforceability of these amendments, they are clearly designed to chill actions taken to protect all shareholders and hold the board accountable for misconduct,” Pignatelli said in a statement announcing his books and records demand.)

Plaintiffs’ lawyer Craig Springer of Andrews & Springer, whose firm is also considering a books and records demand on Biolase, said that Pignatelli’s overlapping roles as a shareholder and a director should color the Delaware Chancery Court’s view of Biolase’s fee-shifting bylaw. Springer’s reasoning: Even though the provision is restricted to current and former directors, it affects Pignatelli as a major shareholder as well. (Springer also said that after his firm’s press release went out Monday, he has talked to a couple of Biolase shareholders but hasn’t signed anyone as a client yet.)

Biolase, on the other hand, will have a good argument that the board adopted a narrowly tailored fee-shifting provision in the hope of avoiding additional litigation expenses after the bitter fight to oust Pignatelli. That litigation concluded in June, when the Delaware Supreme Court affirmed Vice-Chancellor John Noble‘s ruling on the composition of the Biolase board.

The backstory, as Noble tells it in his May 21 decision, is yet another saga of corporate intrigue and ego, but the short version is that Biolase needed a capital infusion. Oracle Partners, which invests exclusively in healthcare companies, was interested but deeply concerned about corporate governance under Pignatelli’s leadership. The chairman and CEO claimed in talks with Oracle that he was willing to step down in favor of an experienced CEO candidate. He engineered the resignation of two board members and their replacement with two others acceptable to Oracle. But when the new directors called for his resignation as CEO, Pignatelli attempted to reinstate the two board members who had resigned in order to block the new directors from ejecting him.

Oracle sued for a declaration that the new directors were in and the old ones were out. Noble ruled that the board properly consisted of four uncontested directors (including Pignatelli) and one of the new board members. When the Delaware Supreme Court upheld the ruling, the reconstituted board promptly voted Pignatelli out as CEO and chairman.

So you can see why Pignatelli’s fellow directors wanted to discourage more litigation with the ex-CEO and adopted a fee-shifting provision to avert it. The Delaware Supreme Court ruling that sanctioned loser pays provisions last May said they can be valid even when they’re enacted in anticipation of litigation, as Biolase’s bylaw clearly was, but that the validity depends on the circumstances.

If, as Pignatelli lawyer Baker predicts, Biolase ends up as a test vehicle for loser pays provisions, Delaware judges will have a lot to think about when they weigh the case.

I left a message with Biolase’s general counsel, Michael Carroll of CorpGen Counsel, and with Oracle lawyer Steven Cohen of Kane Kessler but didn’t hear back. Ropes & Gray, which represents the independent Biolase directors, declined comment.

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