A highly anticipated recent Delaware Chancery Court decision highlights the need for venture capital, private equity, sovereign wealth and other financial investors and their designees on the boards of portfolio companies to be pro-actively attentive to conflicts of interest in connection with a potential sale or other strategic transaction.
Several weeks ago, in In re Trados Inc. Shareholder Litigation, the Delaware Chancery Court (Vice Chancellor Laster) held that a sale transaction was “entirely fair” to the common shareholders of Trados even though (1) the preferred shareholders, made up of venture capital firms, and (2) management, by virtue of a board-approved management incentive plan, received all of the merger consideration, while the common shareholders received nothing. The court reached this ruling even as it also found that the Trados directors failed to follow a fair process in connection with the merger transaction.
The court held as it did solely because it found that the board made an acceptable decision to sell the company when it did, and that the common shares had no value and therefore their receipt of no merger consideration was “fair.” Despite an ultimately favorable outcome, the 114-page decision followed a lengthy (eight-year) court battle, including extensive discovery and a five-day trial, and presents a cautionary tale for financial investors and their board designees as they consider potential sales or other strategic transactions that impact shareholders.
The majority of the board of Trados, a desktop translation company, was made up of venture firm-appointed designees. A class action shareholder suit was brought against Trados and its board after the common shareholders received no consideration from SDL plc.’s 2005 acquisition of Trados for $60 million in cash and stock (the “Merger”). The suit alleged, among other things, that the Trados’ directors (whose funds principally held preferred stock) breached their fiduciary duty in approving the Merger and had a duty to continue to operate Trados on a stand-alone basis in order to maximize the value of the corporation for the benefit of the common stockholders.
The court’s decision focused in detail upon the conflicts of interest facing the venture-appointed board members. The court found that those directors had divided loyalties since their respective venture firms, which held preferred stock, had different incentives from the common shareholders with respect to whether and on what terms to sell the company, in regard to both (1) returns on preferred vs. common equity, and (2) the optimal timing for a sale or other liquidity event. In that regard, the court noted that, as a general matter, venture firms with limited fund lifetimes often have exit strategies that may run counter to the desire of other shareholders to hold their stock for the longer term. The court also noted that other directors — who were senior executives of Trados — stood to gain personally from the Merger by virtue of the board-approved management incentive plan, which ultimately resulted in the payment of $7.8 million. $52.2 million of the $60 million in proceeds were paid to the preferred shareholders (as a result of their $57.9 million outstanding liquidation preference), while the common shareholders received nothing.
A venture firm-appointed director’s divided loyalty between what is best for her venture firm versus what may be best for minority shareholders in and of itself does not invalidate a transaction or create liability for breach of the fiduciary duty of loyalty. That said, however, where the majority of a board considering a transaction is not disinterested and independent, the transaction is subject to a much higher degree of scrutiny than the generally applied business judgment rule. In such cases, a Delaware court must apply the “entire fairness” standard.
This more exacting standard has two aspects: fair dealing and fair price. The fairness test is not a bifurcated one; rather the court must examine the fairness issue “as a whole.” In addition, under the “entire fairness” standard, the burden of proof falls upon the board members to defend their decision. The Merger in Trados was held to be “entirely fair” only because the court was convinced that (1) the directors elected to sell the company at an acceptable time, and (2) common shareholders received a fair price for their stock, which, in this case, happened to be zero. However, the court devotes many pages in its decision to a detailed review of the conflicts of interest of each of the conflicted board members, and the court had much to say about the lack of “fair dealing.”
At its core, the court’s criticism of the lack of fair dealing was rooted in the Trados board’s failure to pro-actively recognize and address the inherent conflicts of interests a majority of the directors faced as they initiated and approved the Merger. In sum, the evidence indicated that little or no consideration was given to the best interests of the common shareholders. The Merger itself was initiated based on the desire of the venture firms for an exit, without taking into account the perspectives of minority shareholders with a more long-term view. Put simply, the directors did not consider whether continuing to operate the company for another year or more would lead to a return for the common shareholders down the road.
Then, the Merger consideration was structured so that all of it went to the preferred shares and to management. The court was very critical of the board’s decision-making process in that it failed to address the inherent conflicts between the interests of the preferred shareholders and the interests of the common shareholders. Among other things, the court was critical of the failure to establish a “special committee” made up of independent directors to represent the interests of the common shareholders. Further, no independent fairness opinion was obtained. The defendants also gave no consideration to whether the Merger should have been conditioned upon approval by a majority of disinterested common shareholders.
The Trados court noted that in conducting an “entire fairness” analysis, a court should recognize that an unfair process can “infect the price,” which could warrant liability. Therefore, venture firms should take no comfort from the fact that the Trados court, addressing in the particular circumstances before it, found that the unfair process did not infect an otherwise fair price. Rather, the guidance Trados reinforces is this: to best avoid liability or a successful challenge to a transaction, venture firms and their board representatives should act early and carefully to ensure that any conflicts of interests inherent in a potential transaction are recognized and adequately addressed. For example:
Much of the law and practice regarding boards of directors has developed in the context of public companies. Today, it is widely believed in that setting that a combination of independent committees, appropriate fairness opinions and majority disinterested shareholder votes will insulate a transaction from scrutiny. Unfortunately, these “standard” approaches are often not practical in the venture-backed private company setting. But it is still possible to tailor an approach that addresses conflicts in a manner that will reduce the likelihood that they will end up in protracted shareholder litigation.
Trados is a cautionary tale that a board can make the “right” decision, but then spend eight years defending it. Boards can mitigate that risk by focusing on conflicts when they begin to think about strategic alternatives, and then designing a process (participants, advisors, incentive plans) that minimizes their impact.
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This article was originally published by Bingham McCutchen LLP.