In In re Trados Inc. Shareholders Litig., C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013), the Delaware Court of Chancery held that a venture-backed board’s approval of a merger in which the company’s common stockholders received nothing was entirely fair despite the merger having been approved as part of an unfair process in which the interests of the company’s preferred stockholders were favored over the interests of the common stockholders. The court reluctantly reached the conclusion that the board’s actions survived scrutiny under the exacting entire fairness standard of review after finding that: (1) the value of the common stock was nothing at the time of the merger, and (2) the entire fairness standard is not a bifurcated test as between fair price and fair process, the two components of an entire fairness analysis. Thus, in the court’s view, it could find that the board’s approval of the merger was entirely fair even if the VC-backed board’s process was unfair. In principle, the Delaware courts have consistently held that the entire fairness test is not a bifurcated analysis. However, in practice, the Delaware courts have consistently found against defendants in cases reviewed under the entire fairness standard where there has been unfair dealing because an unfair process usually results in an unfair price. Although the court found the directors committed no breach of fiduciary duty under the entire fairness standard, the court noted, in dicta, that the company’s venture capital investors could have averted or mitigated fiduciary issues in connection with a merger in which the interests of the common and preferred were not aligned.
This action arose from the July 2005 acquisition of TRADOS Inc. (Trados) by SDL plc (SDL) for $60 million in cash and stock. The preferred stockholders received $52.2 million as partial payment of their liquidation preference, which was triggered by the merger, and management received $7.8 million as part of a management incentive plan (the MIP). The common stockholders did not receive any merger consideration. Without the MIP, the common stockholders would have received $2.1 million in the merger. The merger constituted the culmination of a process initiated in 2004 by four venture capital firms, which held Trados preferred stock and designated five of seven members of the Trados board. Trados had initially obtained venture capital funding in 2000, from Wachovia Capital Partners (Wachovia) and Hg Capital LLP (Hg), and Wachovia and Hg each obtained the right to designate a director. Subsequent preferred stock investors included Sequoia Capital (Sequoia), which designated two directors, and Invision AG (“Invision” and, collectively, with Wachovia, Sequoia and HG, the “VC Investors”), which also designated a director.
Although Trados increased revenue year-over-year, the company struggled financially. By 2004, the VC Investors were no longer willing to fund Trados and began to demand an exit strategy. To this end, the Trados board approved the MIP, which compensated management for achieving a sale even if the transaction yielded nothing for the common stock. As the company’s financial picture improved, Trados management actively solicited offers for the company. SDL emerged from the sales process as the only merger partner offering the possibility of a near-term exit for the VC Investors. On June 15, 2006, the Trados board approved a merger with SDL which triggered the preferred stockholders’ contractual liquidation preference and provided no value to the holders of Trados common stock. At the time of the board’s approval of the merger, five of seven Trados directors were designees of VC Investors and the remaining two directors were members of Trados management who reaped the benefits of the MIP and post-closing employment agreements with SDL.
Plaintiff, a common stockholder, subsequently brought this action for breach of fiduciary duty and for an appraisal of his common stock. The plaintiff contended that the Trados board should not have approved a merger because it had a fiduciary obligation to continue operating Trados on a stand-alone basis to maximize the value of the corporation for the ultimate benefit of the common stock. Plaintiff’s fiduciary claims survived a motion to dismiss, and this decision followed a five-day trial in which defendants bore the burden of proving that their actions were entirely fair because the court found that six of the seven Trados directors were not disinterested and independent.
In reviewing the plaintiff’s fiduciary claims, the court focused on the two elements of an entire fairness analysis: fair dealing and fair price. As to fair dealing, the court found that the Trados board dealt unfairly with the holders of common stock when negotiating and structuring the merger. Indeed, the court found that there was “no contemporaneous evidence suggesting that the directors set out to deal with the common stockholders in a procedurally fair manner.” According to the court, the MIP skewed the negotiation and structure of the merger in a manner adverse to the common stockholders. But for the MIP, the personal financial interests of the two management directors would have been aligned with the interests of the other common stockholders because the directors owned common stock, an incentive to evaluate critically the merger. The court also found that the board’s failure to obtain a fairness opinion or to seek the advice of an investment banker to present the alternatives available to Trados constituted strong evidence of unfair dealing.
However, in contrast to the evidence on fair dealing, which decidedly favored the plaintiff, the court found that the evidence on fair price supported defendants. Specifically, the court determined that, at the time the Trados board approved the merger, Trados common stock had no economic value, and Trados did not have a realistic chance of generating a return for the holders of its common stock. Thus, the court found that the Trados directors had no duty to continue to operate the fledgling company independently to generate value for the common stock. Because the test for entire fairness is not a bifurcated one as between fair dealing and price, the defendants’ evidence on price fairness was ultimately persuasive to the court’s unitary fairness determination. Thus, the approval of a merger in which the holders of common stock received no consideration did not constitute a breach of fiduciary duty under the specific facts of this case. The court also found that the appraised value of the common stock for purposes of the appraisal proceeding was likewise zero.
Lessons from Trados: Draft a Better Exit Strategy
Use a Drag-Along Right or Forced-Sale Provision
In Trados, the court noted that the VC Investors did not “attempt to incorporate any mechanism for side-stepping fiduciary duties (such as a drag-along right if the VC funds sold their shares). . . .” Drag-along rights are frequently found in voting or stockholders’ agreements for venture-backed companies and typically grant a specified percentage of the company’s voting power, the right to force the company’s remaining stockholders (who have previously consented to the drag-along provision) to participate in the sale of the company. The drag-along right typically would require the drag-along stockholders to vote in favor of a transaction that requires stockholder approval or sell their shares in a stock sale. If the trigger for the drag-along right is based solely on a vote of a specified percentage of the corporation’s voting power, as opposed to being predicated on both board and stockholder approval, and the board takes no action in connection with the subsequent forced-sale, then the board should not be exposed to liability for breach of fiduciary duty.
However, even if the drag-along provision requires board action to trigger forced participation in the sale of the company, the existence of a drag-along right should still mitigate (or even completely end-run) subsequent fiduciary duty issues at the board level. In Trados, the court held that a board does not owe fiduciary duties to preferred stockholders with respect to the exercise of rights which are specifically addressed by contract. Rather, the board only owes holders of preferred stock fiduciary duties when it takes action on matters where the rights of the common and preferred stock exist on equal footing because the preferred failed to negotiate for preferred or special rights. Thus, for example, in a case where the board must allocate merger consideration between the holders of common stock and preferred stock and the rights of the preferred are not addressed by contract, a preferred stockholder may maintain a breach of fiduciary duty action.
Using a Contract to Render Fiduciary Claims Superfluous
By contrast, if the preferred stock designation provides some discretion for the board in allocating merger consideration, but clarifies that the discretion is to be exercised in good faith, the rights of the preferred may be limited to challenging bad faith actions of the board. This principle is not unique to preferred stock; it applies to other holders of contract rights against the corporation, including holders of common stock to whom the board owes fiduciary duties. Thus, disputes relating to the exercise of a contractual right by common stockholders should be treated as a breach of contract claim, not a fiduciary claim, if the rights and obligations at issue are expressly addressed by contract. In this specific context, any fiduciary duty claims arising out of the same facts that underlie the contract obligations generally should be foreclosed as superfluous.
For example, in the recent 2013 decision in Blaustein v. Lord Baltimore Capital Corp., the Delaware Court of Chancery held that plaintiff, a stockholder of Lord Baltimore Capital Corp. (Lord Baltimore), could not bring a fiduciary claim against the directors of Lord Baltimore for breach of fiduciary duty arising from the board’s decision to forego the repurchase of her shares of common stock pursuant to an optional repurchase provision in a stockholders’ agreement. Blaustein v. Lord Baltimore Capital Corp., C.A. No. 6685-VCN (Del. Ch. Apr. 30, 2013). Section 7(d) of the stockholders’ agreement at issue provided that: “the Company may repurchase Shares upon terms and conditions agreeable to the Company and the Shareholder [.]” (emphasis added). Plaintiff alleged that the Lord Baltimore board breached its fiduciary duties by voting to reject a repurchase proposal she submitted for the company’s consideration. The court disagreed and held that the board’ decision whether to repurchase plaintiff’s shares was not limited by fiduciary duties absent gross abuse of discretion or inequitable conduct because the stockholders’ agreement addressed the matter at issue. In other words, the Lord Baltimore board could just say no to plaintiff’s repurchase proposal irrespective of its reasons because the stockholders’ agreement did not provide plaintiff with a right to compel the company to repurchase her shares and required the terms of any repurchase to be agreeable to the company. According to the court, any fiduciary duty claims arising out of the same facts that underlie contract obligations are generally foreclosed as superfluous. Indeed, the Court of Chancery held that Lord Baltimore did not even have an obligation to accept a “reasonable” repurchase proposal from plaintiff under the implied covenant of good faith and fair dealing. However, the court did note that the specification of a redemption price in the stockholders’ agreement or the elimination of all board discretion on the matter would have facilitated its conclusion to dispense with plaintiff’s fiduciary claims.
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Directors of Delaware corporations owe fiduciary duties to the corporation’s equity holders. Unlike the fiduciary duties of managers of an alternative investment vehicle, such as a Delaware limited liability company, the fiduciary duties of directors of Delaware corporations cannot be eliminated or modified by contract. However, VC and other investors in privately held corporations may use contractual provisions to side-step the fiduciary duty issues that typically arise when exiting the investment becomes imperative.