Usefulness of Preliminary Injunction in a Shareholder Dispute

In the world of shareholder disputes, which can be complex even for experienced attorneys, a preliminary injunction or TRO is sometimes the only way to prevent serious and irreversible harm to a party’s interest.

The recent case of Z Capital Partners v. Kornsteinet al, shows how a preliminary injunction can make an enormous difference in changing the course of litigation. In this action, Z Capital, the largest shareholder in Affinity Gaming, brought a law suit against the directors of the company, accusing them of breaching the company’s operating agreement by, on the occasion of converting the company from an LLC to a corporation, passing new articles of incorporation that, among other things, authorized the directors to issue new shares of preferred stock and also to formulate a ‘poison pill’ provision that would have effectively diluted the ownership interest of Z Capital by 85% if it so much tried to acquire even one more share of the corporation.

As the directors had already authorized themselves to issue new shares, and Z Capital was now effectively blocked from protecting its interests by acquiring any more equity in the company, they had little recourse but to file an action against the directors, as well as ask for a preliminary injunction to ensure that its interests were protected during the litigation.

The Nevada state court that heard this case used the traditional four-part test to determine whether or not the injunction should be granted. First, it considered whether or not Z Capital was likely to succeed on the merits of its claims. After examining the Operating Agreement and, more specifically, the section dealing with Corporate Conversion, the court agreed that Z Capital was likely able to show that the acts of the directors had adversely and disproportionately affected their ownership interests and voting rights in Affinity Gaming, which was a violation of the Operating Agreement.

Interestingly, the Nevada court did not spend a great deal of time examining the other three elements of the test. In terms of irreparable harm, it merely noted that a breach of the Operating Agreement was probably not something that could be remedied at law, and then moved on to the third and fourth elements, that it also quickly worked through, noting only that the balancing of the harms and public interest both weighed in favor of Z Capital without any explanation. While the public interest element is perhaps relatively unimportant in this case between two private entities whose dispute only affects the public interest in a peripheral manner, there is a significant harm to enjoining the directors from being able to issue more securities for their company, especially as Affinity Gaming had just recently emerged from bankruptcy. That is not to say that this harm to the directors outweighs the harm to Z Capital, and it very well may not, but it is somewhat striking that this issue was not addressed.

Finally, the court required Z Capital to post a $100,000 bond as a condition of the injunction, which seems to indicate that the court was at least aware of the possibility of a wrongfully-granted injunction causing at least some level of harm to the directors, making the court’s quick rejection of any such harms while doing the preliminary injunction analysis more jarring.

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