Liquid Audio, Inc., a Delaware corporation in the digital music business, faced dissatisfaction from a significant stockholder, MM Companies, Inc. MM launched a proxy contest to elect two nominees to Liquid Audio's board at the upcoming annual meeting. In response, the incumbent board adopted several measures, the most controversial of which was expanding the board from five to seven directors and immediately appointing two new directors aligned with management. The timing and effect of those appointments meant that even if MM's two nominees won, the insurgents would remain a minority and the electoral impact of stockholder voting would be materially diluted. The board justified its actions as necessary to add expertise and ensure business stability while it explored strategic alternatives. MM sued in the Delaware Court of Chancery, challenging the board's actions as an improper entrenchment and as an interference with the shareholder franchise. The Court of Chancery largely upheld the board's conduct under Unocal's enhanced scrutiny. MM appealed. The Delaware Supreme Court affirmed in part and reversed in part, sustaining some defensive measures but invalidating the mid-contest board expansion and appointments.
When directors act during a proxy contest to expand the board and appoint new directors, thereby diluting the effectiveness of an imminent shareholder vote, what standard of review applies, and does such action violate the directors' fiduciary duties?
Director defensive measures are reviewed under Unocal enhanced scrutiny: the board must show (1) reasonable grounds for believing a threat to corporate policy and effectiveness exists, based on good faith and reasonable investigation, and (2) that the response is reasonable and proportionate to the threat (i.e., not coercive or preclusive and falling within a range of reasonableness). Where board action has the primary purpose of interfering with or impeding the exercise of the shareholder franchise, Blasius applies as a specific, more exacting application of enhanced scrutiny, requiring the board to demonstrate a compelling justification for its action. Schnell's principle also applies: inequitable action does not become permissible simply because it is legally possible under the DGCL or corporate instruments.
Actions taken in the midst of a proxy contest that primarily interfere with the shareholder franchise must satisfy Blasius's compelling justification requirement in addition to Unocal. Liquid Audio's mid-contest expansion of the board and appointment of two directors lacked a compelling justification and therefore violated fiduciary duties. Other challenged measures that did not primarily impede the vote were properly analyzed under Unocal and sustained.
The Court first confirmed that Unocal's enhanced scrutiny governs director action taken in a defensive posture against a perceived threat to corporate policy and effectiveness—here, the insurgent proxy contest. But because the specific measure at issue—the mid-contest expansion of the board and filling of the new seats—had the primary purpose and clear effect of diluting the outcome of an imminent shareholder vote, the Blasius doctrine was implicated. The Court emphasized that Blasius is not a wholly separate test displacing Unocal; rather, it is a specialized application of enhanced scrutiny where the stockholder franchise is directly at stake. Applying Unocal, the Court accepted that the board perceived a threat from MM's campaign and had undertaken some good-faith investigation into strategic options. It also recognized that certain defensive or strategic steps (e.g., forming committees, retaining advisors, pursuing alternatives) can be reasonable, non-coercive responses that fall within a range of reasonableness. However, the board's decision to increase its size mid-contest and immediately appoint two directors was functionally coercive as to the vote because it diluted the stockholders' ability to effect change through the ballot. Under Blasius, such an action can be sustained only upon a showing of a compelling justification—something more than a generalized desire for continuity, additional expertise, or board stability. The record showed the timing and context were aimed at thwarting the insurgents' electoral prospects; there was no exigency requiring action before the stockholders voted, and less intrusive alternatives existed (e.g., waiting until after the election to add directors). The Court reiterated that corporate statutes granting boards authority to change board size or fill vacancies cannot be used inequitably to impede stockholder voting, invoking Schnell's admonition that formality does not sanitize inequity. Consequently, the board expansion and appointments were invalidated. By contrast, other measures not primarily directed at frustrating the stockholder vote and that were proportionate were upheld under Unocal.
Liquid Audio is a leading modern articulation of how Unocal and Blasius interact. It cautions boards that while they retain broad statutory powers, those powers cannot be wielded to undermine the stockholder vote. The case protects the franchise by requiring a compelling justification when actions primarily impede an election, yet leaves room for reasonable, proportionate defensive measures. For law students, it is essential for understanding enhanced scrutiny, the limits of board authority during proxy contests, and the doctrinal synthesis that guides judicial review of entrenchment-related conduct.
MM Companies v. Liquid Audio reinforces Delaware's consistent protection of the shareholder franchise while providing a practical roadmap for reviewing board conduct in the heat of a proxy fight. By clarifying that Blasius functions within Unocal's enhanced scrutiny when voting rights are at stake, the Court both preserves doctrinal coherence and underscores the extraordinary burden directors face when their actions primarily impede stockholder choice.