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IBS Financial Corporation v. Seidman & Associates, L.L.C.

136 F.3d 940 (3rd Cir. 1998)

CORPORATIONS; DIRECTORS; FIDUCIARY DUTY—A corporation cannot amend its by-laws to reduce its number of directors the purpose of frustrating disgruntled shareholders from gaining a board seat, even if the plain language of the by-laws permit it to try to do so.

The board of directors of a corporation amended company by-laws to reduce the size of the board from seven members to six. As a consequence, only one seat would come up for election at the next annual meeting. One of the stated reasons for reducing the size of the board was to hinder efforts of disgruntled shareholders to establish a presence on the board. Since there was no New Jersey case law on point, the District Court looked to the abundance of Delaware case law and found that board actions taken to impede the effectiveness of a shareholder vote can be sustained only upon a showing of compelling justification. Even though a board may think a dissident shareholder plan is bad for the company, the determination should be made by all the shareholders and not the board. The District Court found that the board acted only to impede the shareholder vote and minimize the potential success of any impending proxy solicitation. Since the corporation did not offer any compelling justification for its actions, the District Court invalidated the seat elimination as a violation of the duty of loyalty owed by the board to the shareholders.

Since neither the parties nor the courts were able to find New Jersey cases on point, the Third Circuit held that the District Court properly considered Delaware law. Although the corporation argued that preventing a group of disgruntled shareholders from acquiring a seat on the board was not its primary motivation in eliminating a board seat, the Third Circuit upheld the finding that the other stated reasons were merely pretextual. The company also argued that the District Court improperly characterized the situation as a challenge for control of the company. The Third Circuit agreed with the lower court that even though the unhappy shareholders could not gain outright control of the company by seeking only one board seat, the attempt to gain the seat was a first step towards attempting to gain control. Therefore, the cases relied on were the proper ones. Based on those cases, the Third Circuit agreed with the District Court that there needed to be a compelling justification in order for the board to interfere with shareholder rights. Since the board failed to show a compelling justification, the Third Circuit upheld the finding that the size of the board was reduced primarily to frustrate shareholders and that the eliminated seat had to be reinstated.


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