The Annual Survey Working Group reports annually on the decisions we believe are the most significant to private equity and venture capital practitioners.2 The decisions selected for this year’s Annual Survey are the following:
1. Huff Energy Fund, L.P. v. Gershen (shareholders’ agreements and fiduciary duties in the context of dissolution following an asset sale)
2. Calesa Associates, L.P. v. American Capital, Ltd. (determining when a minority investor is a “controlling stockholder”)
3. Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund (finding of control group liability for portfolio company pension plan obligations)
4. In re ISN Software Corp. Appraisal Litigation (statutory appraisal of a privately held corporation)
5. Frederick HSU Living Trust v. ODN Holding Corp. (fiduciary and statutory obligations in connection with preferred stock redemption rights)
1. HUFF ENERGY FUND, L.P. V. GERSHEN (SHAREHOLDERS’ AGREEMENTS AND FIDUCIARY DUTIES IN THE CONTEXT OF DISSOLUTION FOLLOWING AN ASSET SALE)
In this case,3 the Delaware Court of Chancery granted the defendants’ motion to dismiss a complaint brought by The Huff Energy Fund, L.P. (“Huff Energy”), the owner of approximately 40 percent of the outstanding common stock of Longview Energy Company (“Longview”), that challenged the decision of Longview’s board of directors and stockholders to dissolve Longview following a sale of a significant portion of its assets.4 The complaint alleged that Longview and certain members of its board breached a shareholders’ agreement entered into in connection with Huff Energy’s investment in Longview (the “Shareholders’ Agreement”),5 and also that the Longview board breached its fiduciary duties by adopting a plan of dissolution without exploring more favorable alternatives in violation of Revlon6 and as an unreasonable response to a perceived threat in violation of Unocal.7 In coming to its conclusion, the court held that the Shareholders’ Agreement, which required unanimous board approval of certain actions, did not prevent Longview from adopting a plan of dissolution by a majority vote of the board.8 In addition, the court held that neither Revlon nor Unocal applied to the board’s approval of Longview’s dissolution,9 and, even if Revlon or Unocal did apply, the approval of the transaction by a fully informed, uncoerced, and disinterested stockholder majority would shift the standard of review to business judgement under Corwin.10
Longview, a Delaware corporation with its principal place of business in Dallas, Texas, was engaged in the exploration and production of oil and gas.11 In 2006, Huff Energy purchased 20 percent of Longview’s outstanding common stock and entered into the Shareholders’ Agreement with Longview.12 Over the next four years, Huff Energy increased its investment in Longview to approximately 40 percent.13 Beginning in 2008, Longview began to pursue a potential liquidity event.14 After declining a prospective asset sale in 2010 and failing to consummate a merger in 2011, Longview retained Parker Whaling, an investment bank specializing in the oil and gas industry, to assist in the process.15 In April 2014, after three years of being unable to find a merger partner for Longview, Parker Whaling found a buyer for its California oil and gas properties and related assets, which generated approximately 90 percent of Longview’s operating revenue (the “California Assets”).16 In September 2014, Longview circulated to the board an agreement for the sale of the California Assets for $43.1 million.17 Concerned about the tax implications of distributing the sale proceeds as a dividend, Huff Energy’s board representative suggested that Longview adopt and distribute the proceeds according to a plan of dissolution.18 In October 2014, oil prices collapsed, which caused the buyer to withdraw from the transaction.19
On May 14, 2015, Longview proposed a new transaction in which Longview would sell the California Assets to White Knight Production, LLC for $28 million and subsequently adopt a plan of dissolution.20 On May 18, 2015, the board met to approve the transaction and the associated proxy statement to be distributed to stockholders to solicit the required stockholder approval.21 During this meeting, Huff Energy first learned that Longview would not be making a distribution to stockholders and would instead retain all net proceeds in light of Longview’s contingent liabilities.22 Although the Longview board proceeded to approve the transaction and the distribution of the proxy statement to stockholders, Huff Energy’s board representative abstained.23 On June 5, 2015, Huff Energy wrote a letter to the Longview board requesting that it rescind its request for approval of the plan of dissolution because Longview’s “withholding of the net proceeds negated any tax burden associated with a distribution” and because of the harmful effects it would have on stockholders, including the elimination of the transferability of shares.24 On June 8, 2015, the board denied Huff Energy’s request and, on June 11, 2015, Longview’s stockholders approved the transaction.25 Huff Energy thereafter commenced an action alleging, among other claims, that Longview breached the Shareholders’ Agreement and the director defendants breached their fiduciary duties by adopting the plan of dissolution.26
With respect to the breach of contract claims, Huff Energy argued that Longview violated section 10(b)(iii) of the Shareholders’ Agreement, which required unanimous board approval of “any action or omission that would have a material adverse effect on the rights of any [Longview shareholder], as set forth in” the Shareholders’ Agreement.27 The court rejected Huff Energy’s argument that the Shareholders’ Agreement “set forth” a right of transferability in its right of first offer, and that the board’s adoption of the plan of dissolution had a material adverse effect on this right.28 The court reasoned that the term “set forth” could not reasonably be construed to mean “referenced” in the Shareholders’ Agreement; rather, its only reasonable meaning could be “created by” the Shareholders’ Agreement.29 The court held that, because the Shareholders’ Agreement did not create Huff Energy’s right of transferability in its shares, Longview’s adoption of the plan of dissolution did not violate section 10(b)(iii) of the Shareholders’ Agreement.30
Huff Energy also argued that Longview violated a covenant in the Shareholders’ Agreement, requiring that Longview “shall continue to exist and shall remain in good standing under the laws of its state of incorporation and under the laws of any state in which [it] conducts business.”31 The court rejected Huff Energy’s argument that by approving the dissolution Longview breached the covenant.32 The court noted that a merger in certain forms would have the same effect as a plan of dissolution (i.e., Longview would cease to exist), yet the Shareholders’ Agreement explicitly provided for a merger to be approved by a two-thirds board vote.33 As a result, the court held that, because dissolution was not listed under the Shareholders’ Agreement’s supermajority provisions, it would be reasonable to allow the Longview board to adopt a plan of dissolution by a majority vote.34
Regarding the breach of fiduciary duty claims against the director defendants, the court similarly rejected each of Huff Energy’s arguments.35 First, Huff Energy argued that the director defendants adopted the plan of dissolution to advance their own interests at the expense of Huff Energy and Longview’s other stockholders.36 In particular, Huff Energy alleged that certain directors were motivated by their desire to receive significant severance payments.37 The court rejected this argument, stating that “the possibility of receiving change-in-control benefits pursuant to pre-existing employment agreements does not create a disqualifying interest as a matter of law.”38 The court noted that, in any event, these severance payments were triggered, not by the plan of dissolution, but rather by the preceding asset sale, which was not challenged by Huff Energy.39 The court also rejected Huff Energy’s argument that a majority of the Longview board acted under a disqualifying conflict of interest by virtue of the fact that they formerly and currently served together as directors on other boards, or as a result of the alleged animosity of one of the directors toward Huff Energy.40 The court noted that personal and outside business relationships, without more, are insufficient to raise a reasonable doubt of a director’s ability to exercise independent business judgment.41
Second, Huff Energy argued that the dissolution of Longview was a “final stage” transaction, which should have been subject to Revlon enhanced scrutiny.42 The court held that the plan of dissolution did not constitute such a final stage transaction because, following the approval of the plan of dissolution, Longview was to continue to exist for at least three more years while its affairs were wound up, during which time the directors would maintain control over Longview’s non-California assets and continue to owe fiduciary duties to the stockholders.43
Third, Huff Energy argued that the board’s adoption of the plan of dissolution constituted an unreasonable defense under Unocal’s enhanced scrutiny test.44 The court disagreed and noted that the “omnipresent specter” of director entrenchment is not present where a corporation is winding up its affairs in preparation for its liquidation.45 In dicta, the court stated that, even if Huff Energy had pled facts subjecting the transaction to enhanced scrutiny, the Longview stockholders’ approval “cleansed” the transaction, thereby reinstating the business judgment rule.46 The court rejected Huff Energy’s argument that the stockholder vote was not fully informed due to Longview’s failure to disclose in the proxy statement that Huff Energy’s board representative had abstained from the vote and the reasons for his abstention.47 The court reasoned that, because the board’s vote did not require unanimity, the disclosure was immaterial to Longview stockholders in making their decision to approve the transaction.48
The decision in this case demonstrates the difficulty a party to a shareholders’ agreement might experience in challenging board or stockholder action in circumstances in which the shareholders’ agreement does not clearly and unambiguously support its veto rights. In particular, the case suggests that matters subject to a party’s veto rights should be specifically enumerated among the matters subject to supermajority vote requirements (rather than being left to more general standards). This case also reinforces a number of other recent Delaware cases that demonstrate the difficulty in bringing fiduciary duty claims in situations in which the challenged board action has been approved by the corporation’s stockholders.
2. CALESA ASSOCIATES, L.P. V. AMERICAN CAPITAL, LTD. (DETERMINING WHEN A MINORITY INVESTOR IS A “CONTROLLING STOCKHOLDER”)
In this case,49 the Delaware Court of Chancery denied a private equity investor’s motion to dismiss a breach of fiduciary duty claim challenging a complex transaction between the company and the private equity investor. Although the private equity investor owned only 26 percent of the company at the time of the transaction, the court concluded that it could be a controlling stockholder because of its control and influence over a majority of the board.
Halt Medical, Inc. (“Halt”) is a Delaware corporation that supports and markets a procedure to treat fibroid tumors in women.51 In June 2007, American Capital, Ltd. and its affiliates (“ACAS”)52 invested $8.9 million in Halt. Under the terms of the investment, ACAS was granted two of Halt’s five board seats and a right to block any subsequent pari passu investments in Halt.53
Halt needed additional funds, and in June 2011, ACAS offered to provide $5 million in exchange for a 50 percent interest in Halt.54 Halt’s board of directors declined the offer and instead entered into a short-term loan agreement with a third party secured by Halt’s intellectual property.55 Subsequently, ACAS purchased the short-term note.56 By the fall of 2011, Halt again needed additional funds.57 The board negotiated a potential deal for a $35 million investment at a 15 percent interest rate, subject to ACAS’s waiver of its blocking rights.58 However, ACAS exercised its blocking rights and, as an alternative, offered to loan Halt an additional $20 million at a 22 percent interest rate, with the right to add one director and appoint an additional independent director.59 Halt accepted ACAS’s offer.60
By the fall of 2013, Halt owed ACAS $50 million under a note due at the end of 2013.61 Despite indications that ACAS would extend the note, in September 2013, ACAS demanded repayment in full by December 31, 2013.62 In October 2013, ACAS loaned Halt an additional $3 million to help it operate through the end of 2013 in return for Halt agreeing to a supermajority vote requirement for any Chapter 11 proceeding.63
With the pressure from the impending due date of the $50 million note and its inability to secure financing elsewhere, Halt met with ACAS representatives to negotiate a deal that would allow Halt to be sold to a third party.64 The final agreement provided that ACAS would loan Halt up to $73 million, ACAS’ ownership would increase from 26 percent to almost 66 percent,65 ACAS would get a blanket first priority security interest, the prior outstanding warrants would be cancelled, and a new management incentive plan would be created (allegedly for the benefit of the Halt CEO/director).66 Finally, the transaction documents provided that if Halt was not sold within one year of the transaction, subordinated debt owned by minority stockholders would be converted to equity and preferred stock owned by minority stockholders would be cancelled.67 The minority stockholders received copies of the transaction documents by e-mail and were instructed to sign and return them by the next day.
The plaintiffs in this action are minority stockholders of Halt.68 The plaintiffs alleged breaches of fiduciary duty, aiding and abetting breaches of fiduciary duty, and violations of section 228 of the Delaware General Corporation Law (“DGCL”) against ACAS and certain members of the board.69 The plaintiffs’ key contention was that the defendants breached their duty of loyalty by forcing Halt to enter into a deal that diluted the minority stockholders to ACAS’ advantage.70 The defendants’ motion to dismiss was denied.71
Breach of Fiduciary Duty. The court first addressed whether the entire fairness standard of review applied because ACAS was a controlling stockholder on both sides of the transaction, and because a majority of the board was interested or lacked independence from a conflicted party.72 Even though ACAS only owned 26 percent of Halt prior to the transaction, the court noted that a stockholder is a controlling stockholder (and hence owes fiduciary duties to other stockholders) if the stockholder owns a majority interest or exercises actual control over the business and affairs of the corporation.73
The court started its analysis with the fact that ACAS’ contractual rights allegedly gave it the ability to control the Halt board by virtue of the ability to block other transactions.74 However, the court determined that the exercise of contractual rights was not sufficient, by itself, to demonstrate control.75 The court next turned to analysis of the individual Halt board members to determine if a majority of the directors were under the actual control and influence of ACAS.76
Because there were seven directors at the time of the transaction, the court focused only on whether four directors (a majority) were beholden to ACAS.77 Simply appointing a director, without more, does not establish actual domination.78 One director, who was an officer of ACAS and who negotiated the transaction on behalf of ACAS, clearly lacked independence.79 Another director, who served on both the ACAS board and the Halt board, also lacked independence.80 A third director who served as president and CEO of another ACAS portfolio company was determined by the court to be conflicted. The court relied on a disclosure in the information statement that stated this director had interests different than the interests of Halt’s stockholders.81 Finally, the court found a fourth director, Halt’s CEO, also to be beholden to ACAS.82
In addition to concluding that the claims against ACAS survived, the court concluded that for the same reasons, plaintiffs’ claims of breach of loyalty against the director defendants also survived.83
Aiding and Abetting a Breach of Fiduciary Duty. In the alternative, the plaintiffs argued that ACAS aided and abetted the director defendants’ breach of fiduciary duty.84 The court noted that if ACAS is ultimately found to be a controlling stockholder, this claim would fail for lack of a defendant who is not a fiduciary.85 However, because that determination would not be made until the record was further developed, the court reserved determination for a later state of the proceedings.86
Miscellaneous Claims. With respect to the claim challenging the validity of the written stockholder consent obtained in lieu of a meeting pursuant to section 228 of the DGCL, the court noted that Delaware law requires strict compliance.87 The court declined to dismiss this claim because several exhibits to the consent form provided to the stockholders were either incomplete, missing, or in draft form.88
Making the determination whether a holder of less than a majority of stock is a controlling stockholder is a fact-intensive inquiry. While part of the analysis, the percentage of ownership is not determinative because the court will look to multiple factors (for example, the stockholder’s contractual protections) and will evaluate the board’s independence on a director-by-director basis. This determination can have a significant effect on the outcome of the case because the board’s actions will no longer receive the benefit of the business judgement rule. Instead, the court will review the transaction under the entire fairness standard. The benefit of anticipating this possible review standard is that counsel can help set up a process that will be easier to withstand judicial scrutiny. The process might entail creating a special committee of disinterested and independent directors to negotiate the transaction on behalf of the unaffiliated stockholders and/or subjecting the approval of the transaction to a non-waivable majority-of-the-minority vote.
3. SUN CAPITAL PARTNERS III, LP V. NEW ENGLAND TEAMSTERS & TRUCKING INDUSTRY PENSION FUND (FINDING OF CONTROL GROUP LIABILITY FOR PORTFOLIO COMPANY PENSION PLAN OBLIGATIONS)
In this case,89 the United States District Court for the District of Massachusetts found that two private equity funds under common management were liable to a multiemployer pension plan for $4.5 million in withdrawal liability incurred by one of the funds’ bankrupt portfolio companies despite the fact that neither fund had the 80 percent ownership interest in the portfolio company required to establish a controlled group between itself and the portfolio company under the Employee Retirement Income Security Act of 1974 (“ERISA”).90 Using the “investment plus” test articulated by the United States Court of Appeals for the First Circuit in a 2013 decision,91 the district court found that the funds were not merely passive investors in the portfolio company but rather they together constituted an active “trade or business.”92 Furthermore, despite the fact that the two funds were separate legal entities with different investors and disparate portfolio company investments, the district court found that the two funds’ coordinated efforts vis a vis the portfolio company created a notional partnership between the funds under federal common law.93 Together, these findings led the district court to aggregate the funds’ ownership stakes in the portfolio company, thereby establishing the existence of a controlled group under ERISA and causing the funds to be jointly and severally liable for the funding shortfall in the portfolio company’s multiemployer pension plan.94
In 2006, two private equity funds (each, a “Fund,” and together, the “Funds”) controlled by Sun Capital Advisors (“Sun Capital”) formed a limited liability company (the “LLC”) in which one Fund held a 70 percent ownership interest and the other Fund held a 30 percent ownership interest.95 The LLC, through a wholly owned subsidiary holding company, acquired all of the stock (the “Acquisition”) of Scott Brass, Inc., a metal coil manufacturer (“Scott Brass”).96 As is customary in the private equity industry, Sun Capital took an active role in the management of Scott Brass, appointing a majority of the Scott Brass board of directors through Sun Capital–affiliated management companies.97 In addition, Scott Brass paid management fees to Sun Capital for advisory services, payments that were used to offset the fees that the Funds would have otherwise owed to their general partners.98
At the time of the Acquisition, Scott Brass was a member of the New England Teamsters & Trucking Industry Pension Fund (the “Pension Fund”), a multiemployer pension plan regulated by ERISA.99 Historically, labor unions have established multiemployer pension plans by way of collective bargaining agreements amongst multiple employers in a particular industry, pooling retirement contributions and benefits and sharing investment risk for the contributing employers’ unionized workforce as a result.100 When a participating member of a multiemployer pension plan stops contributing to the plan (either as a result of bankruptcy or otherwise), ERISA determines that company’s “withdrawal liability,” which is its share of any unfunded vested benefits under the plan.101 By statute, ERISA imposes the calculated withdrawal liability jointly and severally on each “trade or business” that is under “common control” with the withdrawing employer.102
Due to a decline in copper prices, in 2008, Scott Brass filed for bankruptcy, withdrawing from the pension fund as a result.103 At the time of its withdrawal from the pension fund, Scott Brass incurred approximately $4.5 million in withdrawal liability under ERISA.104 The pension fund demanded payment of this liability from the Funds, claiming that the Funds were in an active “trade or business” and had effectively formed a partnership that was under “common control” with Scott Brass.105 As a result, the pension fund concluded that the Funds were jointly and severally liable for the withdrawal liability of Scott Brass under ERISA.106
The Funds sued the pension fund in the United States District Court for the District of Massachusetts, seeking a declaratory judgment that the Funds were not liable for the withdrawal liability of Scott Brass.107 The district court granted summary judgment to the Funds, finding that the Funds were not “trades or businesses” and, accordingly, they could not be held liable for the withdrawal liability of Scott Brass under ERISA.108
The pension fund appealed to the United States Court of Appeals for the First Circuit, which reversed the district court’s decision.109 In rendering its decision, the court of appeals endorsed a position taken in an earlier 2007 administrative decision, holding that the existence of a “trade or business” can arise from a mere investment for profit plus some additional factors that suggest that the investment is not merely passive.110 Despite not providing any specific guidance regarding the contours of the “investment plus” test, the court of appeals nonetheless found that one of the Funds was a “trade or business” under the “investment plus” test.111 The court remanded the case to the district court in order for it to determine whether the other Fund was also a “trade or business” and to determine whether the Funds were under common control with Scott Brass, such that the entities would be considered a single employer for the purposes of determining their withdrawal liability under ERISA.112
On remand, the district court ruled that both Funds were “trades or businesses” under the “investment plus” test, finding that the Funds were more than mere passive investors in Scott Brass because they received economic benefits related to their investment that an ordinary investor would not normally derive.113 Specifically, the district court focused on the management fees that the Funds’ general partners were entitled to and the fact that these fees could be reduced or eliminated entirely by offsetting them against fees that were paid directly by the Funds’ portfolio companies (such as Scott Brass) to the general partners.114 Similarly, if there were no such fees to offset, they could be carried forward as potential future offsets.115 By virtue of the Funds’ coordinated activities and the Funds’ hands-on involvement with their investment in Scott Brass, the Funds were deemed to be under common control with Scott Brass.116 As a result, the Funds’ ownership interests in Scott Brass were aggregated to satisfy the statutory 80 percent ownership requirement for joint and several withdrawal liability under ERISA.117
In determining the issue of common control, ERISA looks to Internal Revenue Code (the “Code”) regulations.118 The Code provides that two or more trades or businesses are under common control if they are members of a “parent-subsidiary” group, which occurs when a parent entity owns 80 percent or more of a subsidiary entity either directly or through a chain of entities.119 The district court stressed that a finding of common control functions to effectively pierce the corporate veil and disregard formal business structures in situations where a single employer might attempt to avoid its withdrawal liability under ERISA.120 In the view of the district court, the Funds’ ownership of Scott Brass, via the intermediate holding company and limited liability company, was not split 70-30.121 Rather, Scott Brass was owned 100 percent by a notional partnership that had been formed by the Funds.122 In its ruling, the district court found that the Funds had established a “partnership in fact” under federal law, despite the facts that (i) each Fund was a separate legal entity; (ii) the Funds filed separate income tax returns, maintained separate bank accounts, and issued separate reports to a largely disparate set of limited partners; (iii) the Funds invested in largely non-overlapping portfolio companies, suggesting that they were not structured to invest in parallel; and (iv) the Funds’ operating agreements expressly disclaimed any intent to form a partnership or joint venture with respect to co-investment activities of the Funds.123
The courts’ decisions in Sun Capital cast doubt on the efficacy of oft-used investment structures designed to facilitate active investor involvement in the management of portfolio companies while also avoiding the liabilities of portfolio companies from being ascribed to their investors. Under the Sun Capital decisions, an investment fund may be considered an “active trade or business” under ERISA even if the fund does not receive direct economic benefits from its portfolio company investments.124 Furthermore, an investment fund that individually owns less than 80 percent of a portfolio company may still be subject to ERISA withdrawal liability if a court determines that a partnership-in-fact exists among the fund and other affiliated funds whose aggregate holdings exceed the 80 percent ownership threshold prescribed by ERISA.125 Although the court of appeals’ decision is only binding in the First Circuit and the district court’s decision is only binding in Massachusetts, the holdings in Sun Capital may nonetheless be persuasive authority in courts outside of these jurisdictions. Furthermore, although Sun Capital only addressed the issue of multiemployer plan liabilities under ERISA, it is an open question whether the reasoning of the district court could be extended to liabilities under other types of employee benefit plans.
4. IN RE ISN SOFTWARE CORP. APPRAISAL LITIGATION (STATUTORY APPRAISAL OF A PRIVATELY HELD CORPORATION)
In this post-trial appraisal decision,126 the Delaware Court of Chancery held that the fair value of ISN Software Corp. (“ISN”), a privately held company, was $98,783 per share at the time its controlling stockholder cashed out some, but not all, of the stock held by the minority stockholders. The fair value assigned by the court represented a 257 percent increase to the $38,317 per share merger consideration paid by the controlling stockholder in the underlying cash-out transaction.127 In determining fair value, the court relied exclusively on a discounted cash flow (“DCF”) analysis because the controller’s valuation method was unreliable, and neither historical sales of stock nor evaluations of comparable companies and transactions provided reliable indicators of fair value given that ISN was a privately held company whose stock was essentially illiquid.128
ISN, a privately held Delaware corporation and a provider of subscription-based online database services, had experienced substantial growth in the years leading up to the merger, serving a variety of industries across more than seventy countries.129 ISN was controlled by its majority stockholder, Bill Addy.130
On January 9, 2013, ISN merged with a wholly owned subsidiary, with ISN continuing as the surviving corporation (the “Merger”).131 Stockholder approval was obtained pursuant to DGCL section 228 by the written consent of Bill Addy and ISN’s CEO, who at that time owned 65.3 percent and 4.9 percent of the company’s stock, respectively.132 The Merger cashed out holders of less than 500 shares (which included petitioner Polaris) for $38,317 per share, while providing that shares held by owners of 500 or more shares (which included petitioner Ad-Venture) remained unchanged and outstanding.133 Bill Addy determined the cash-out merger consideration, without the assistance of a financial advisor, using a valuation created by a third party in 2011, which Addy purportedly adjusted based on his expectations for the company.134
Both Polaris and Ad-Venture submitted demands for appraisal after receipt of the company’s notice of action by written consent and notice of appraisal rights, and they subsequently filed appraisal petitions pursuant to section 262 of the DGCL.135 In February 2016, the court held a five-day trial featuring a battle of financial experts.136 The court issued its post-trial opinion in August 2016.
The court preliminarily acknowledged that while it has broad discretion in an appraisal proceeding to consider all relevant factors when determining fair value and the discretion to use the valuation methods it deems appropriate, it must limit its valuation to the firm’s value as a going concern and exclude the speculative elements of value that may arise from the accomplishment or expectation of the merger.137 Each of the three parties, petitioners Polaris and Ad-Venture, and respondent ISN, proffered experts who opined on the fair value using various valuation methods.138 ISN’s expert opined that the fair value of ISN was $29,360 per share (i.e., less than the cash-out merger price), while Polaris’s and Ad-Venture’s experts testified that ISN was worth $230,000 and $222,414 per share, respectively.139 The court decided to rely exclusively on the DCF method, finding other valuation methods to be unreliable for a number of reasons.140 First, the court held that the “guideline public companies” approach was not a reliable method of valuation because ISN had no public competitors and its “alleged industry include[d] various and divergent software platforms.”141 Second, the court concluded that the direct capitalization of cash flow method (“DCCF”)—which assumes that a company will grow in perpetuity at a long-term growth rate—was not a reliable indicator of ISN’s fair value, explaining that the DCCF method is an appropriate valuation tool only when a company “has reached a steady state” or when “no other feasible valuation methods exist,” neither of which was true in ISN’s case.142 Third, the court held that two prior transactions involving the sale of ISN’s stock were unreliable indicators of fair value because ISN was a privately held company with illiquid stock and the evidence at trial indicated that the prior sales were effectuated for liquidity reasons and therefore were not necessarily designed to maximize the sales price.143 Moreover, the court explained that the two past sales of stock were neither shopped to multiple buyers nor priced using complete and accurate information, and each of the prior transactions included incompatible forms of consideration, such as financial options and land, which were difficult to value.144 These factors, according to the court, made the past-transactions analysis an unreliable method of valuation.145
Finding the DCF method to be the only appropriate valuation method but finding each of the experts’ DCF models lacking in certain respects, the court conducted its own DCF analysis deriving various factors from the three experts’ DCF models.146 Observing that each of the three experts utilized a different projection period in their analysis, the court explained that the reliability of a DCF valuation depends on the accuracy of its future cash flow projections and the length of the period used to project those future cash flows.147 With that principle in mind, the court selected the standard five-year projection period used by ISN’s expert instead of the longer projection periods used by the petitioners’ experts, explaining that “projections out more than a few years owe more to hope than reason.”148 Starting with ISN’s DCF model, the court adjusted several inputs and assumptions by, among other things, removing a cash-flow adjustment for incremental working capital because ISN historically operated with a negative working capital balance, and using a cost of equity based solely on the capital asset pricing model and equal to ISN’s weighted average cost of capital because the company did not have long-term debt at the time of the Merger.149 The court then determined that the fair value of ISN’s shares at the time of the Merger was $98,783 per share.150
The court also held that both Polaris and Ad-Venture were entitled to statutory interest.151 The court noted that shortly after Polaris filed its appraisal petition, ISN and Polaris entered into a stipulation under section 262(h) of the DGCL pursuant to which ISN pre-paid $25,000 per share plus interest, thus tolling the running of interest with respect to that amount.152 With respect to the balance, because Polaris was deprived of its stock on the date of the Merger, January 9, 2013, it was entitled to interest from that date.153 The court explained that Ad-Venture was in a slightly different position because the Merger did not technically convert Ad-Venture’s stock.154 Instead, interest would run from the date Ad-Venture perfected its appraisal rights by delivery of its appraisal demand, which was several weeks after the date of the Merger.155
The decision in this case provides financial experts and legal advisors with helpful insight into the Court of Chancery’s approach to valuing private companies in a statutory appraisal proceeding. The Court of Chancery is likely to rely heavily, if not exclusively, on the DCF method of valuation when calculating the fair value of a company whose stock does not trade publicly and for which there are no comparable companies and transactions that can serve as reliable indicators of fair value. The opinion also highlights the perils of using a merger to cash out only specified minority holders (for example, holders of less than a fixed number of shares or non-accredited holders) where unreliable methods are used to determine the merger consideration and where holders whose shares would remain unchanged can use the merger as an opportunity to cash out of their otherwise illiquid position.
5. FREDERICK HSU LIVING TRUST V. ODN HOLDING CORP. (FIDUCIARY AND STATUTORY OBLIGATIONS IN CONNECTION WITH PREFERRED STOCK REDEMPTION RIGHTS)
In this case,156 the Delaware Court of Chancery held on a motion to dismiss that it was reasonably conceivable that a corporation’s controlling stockholder, directors, and officers breached their fiduciary duties of loyalty by engaging in a de facto liquidation of the corporation to maximize the redemption value of the controller’s preferred stock.157 In so holding, the court clarified that “the fiduciary principle does not protect special preferences or rights” of preferred stockholders, but rather requires “that decision makers focus on promoting the value of the undifferentiated equity in the aggregate” by focusing on the maximization of a corporation’s value over the long term, even in the presence of a redemption right.158
In 2008, affiliates of Oak Hill Capital Partners (“Oak Hill”) invested $150 million in preferred stock of ODN Holding Corporation (“ODN”).159 The preferred stock carried a mandatory redemption right exercisable by Oak Hill in February 2013 “out of funds legally available.”160 If ODN did not have legally available funds, ODN was required to raise funds for additional redemptions as “determined by [ODN]’s Board of Directors in good faith and consistent with its fiduciary duties.”161 As part of its investment, Oak Hill appointed two of its partners to ODN’s board.162 In 2009, Oak Hill purchased a block of ODN common stock, giving it voting control of ODN and an additional board designee.163
In mid-2011, ODN began stockpiling cash for the redemption.164 In January 2012, ODN sold two of its four business lines for $15.4 million, despite having acquired only a part of those businesses for $46.5 million in 2007.165 In May 2012, ODN’s compensation committee approved bonuses for certain ODN officers, which were contingent on the redemption of $75 million of Oak Hill’s preferred stock.166 In August 2012, the board formed a special committee, consisting of two outside directors, to negotiate the terms of the upcoming redemption of Oak Hill’s preferred stock.167 The special committee tasked the officers who were party to the bonus agreements with determining how much cash ODN required to operate.168 The officers concluded that ODN needed $10 million to continue operating, freeing $40 million for the redemption.169
However, Oak Hill recommended that ODN make a partial payment of $45 million.170 In exchange, Oak Hill agreed to defer further redemption payments, subject to a unilateral right to cancel the deferral.171 In response, ODN revised its estimate of the amount of cash that ODN required to operate to $2 million, and the special committee and ODN board approved a $45 million redemption.172
In May 2014, ODN sold the business line constituting its main source of revenue.173 On June 4, 2014, the ODN board re-established the special committee to oversee another redemption of Oak Hill’s preferred stock and to recommend ODN’s restructuring.174 As a result, the board approved a sale of the “crown jewel” of ODN’s sole remaining business line for $600,000, over $16 million less than what ODN had paid to acquire the business in 2010.175 Thereafter, the special committee and the board approved a $40 million redemption of Oak Hill’s preferred stock, which triggered the officers’ bonus payments.176 In 2015, ODN’s revenues fell to $11 million from $141 million just four years prior, representing a 92 percent decline.177
Plaintiff, an ODN common stockholder, filed suit on March 15, 2016.178 Defendants moved to dismiss plaintiff’s complaint in its entirety.179
Plaintiff alleged, inter alia, that the redemptions violated section 160 of the DGCL (requiring that redemptions not impair capital) and the common law (prohibiting redemptions that render a corporation insolvent); that the board, certain officers, and Oak Hill breached their fiduciary duties; that Oak Hill aided and abetted the board’s breach; and that Oak Hill and certain officers were unjustly enriched.180
The court dismissed plaintiff’s statutory and common law claims regarding the redemptions.181 Specifically, the court found that the ODN board was not required to treat the preferred stock as a current liability for purposes of calculating surplus under section 160 of the DGCL, as claimed by plaintiff, because preferred stock is equity, not debt.182 Furthermore, the court found that because the redemptions did not render ODN balance-sheet insolvent, unable to pay its bills when due, or without sufficient resources to operate for the foreseeable future, the redemptions did not violate the common law.183
Next, the court held that plaintiff stated a claim that all but one of the ODN directors violated their duties of loyalty by stockpiling cash, selling off businesses, and using the proceeds to redeem the preferred stock.184 The court explained that the ODN board owed a fiduciary duty to “the stockholders in the aggregate in their capacity as residual claimants, which means the undifferentiated equity as a collective, without regard to any special rights.”185 Furthermore, the court held that “the fiduciary relationship requires that the directors act prudently, loyally, and in good faith to maximize the value of the corporation over the long-term for the benefit of the providers of presumptively permanent equity capital.”186 Specifically, here “the fact that a corporation is bound by its valid contractual obligations does not mean that a board does not owe fiduciary duties when considering how to handle those contractual obligations.”187
The court found that entire fairness was the applicable standard of review because, based on the pleadings, a majority of the board was neither disinterested nor independent.188 First, the court found that the Oak Hill designees were not independent or disinterested because they owed fiduciary duties to both ODN and Oak Hill, and when Oak Hill sought to exercise its redemption right, their interests conflicted.189 Next, the court found the CEO director to be interested because she was employed at ODN (which was controlled by Oak Hill) and stood to benefit from the redemptions pursuant to her bonus agreement.190 Finally, the court found that ODN’s outside directors were interested in and/or lacked independence with respect to the redemption because they furthered Oak Hill’s interests by approving the bonus agreements for ODN’s officers, failing to effectively negotiate with Oak Hill, recommending the redemption on Oak Hill’s terms, and causing the sale of ODN’s crown jewel.191
In applying the entire fairness standard, the court held that the complaint supported a reasonable inference that the price was unfair because ODN divested its assets at substantial discounts.192 The court also held that the complaint supported a reasonable inference that the process was unfair, citing both the board’s use of bonus agreements to incentivize ODN’s officers to favor divestitures and the forced timing of the divestitures themselves, which contributed to the low prices obtained in the sales.193 Therefore, the court found at the pleading stage that it was reasonably conceivable that by stockpiling funds through divestitures instead of managing ODN with a view toward long-term value generation, the directors engaged in unfair transactions in breach of their duties of loyalty to the undifferentiated equity.194
The court also held that plaintiff stated a claim that ODN’s officers breached their fiduciary duties by, inter alia, adjusting their estimate of ODN’s necessary cash for operations to fund Oak Hill’s redemption and generating a business plan that resulted in the sale of ODN’s crown jewel.195 Next, the court held that plaintiff stated claims that Oak Hill breached its fiduciary duties as a controller and aided and abetted the board’s breach by causing ODN to engage in divestitures to stockpile cash to fund the redemption of Oak Hill’s preferred stock.196 Finally, the court held that plaintiff stated a claim that Oak Hill and the officers who received bonuses in connection with the redemptions were unjustly enriched in the transactions.197 Accordingly, the court denied defendants’ motion to dismiss plaintiff’s fiduciary duty, aiding, and abetting and unjust enrichment claims but granted the motion with respect to plaintiff’s statutory and common law claims.198
Mandatory redemption provisions are not uncommon.199 This case impacts the value of mandatory redemption provisions as an exit method because, according to the court, issuers will be under neither a contractual nor an equitable obligation to deviate from growth-oriented business plans or liquidate assets in order to fund redemption obligations, and indeed such actions may constitute a breach of the board’s duty to maximize long-term value for the benefit of the common stockholders.200
For venture-capital-backed corporations, the court’s decision indicates that directors owe fiduciary duties to the undifferentiated equity holders to maximize the company’s value over the long term even in the presence of a redemption right.201 Indeed, the court recognized that “a board of directors may choose to breach [a contractual obligation] if the benefits . . . exceed the costs.”202 Therefore, a board should not treat a preferred stockholder who has exercised a redemption right as “a creditor with an enforceable lien on the corporation’s assets.”203
For venture capital and private equity firms, the decision provides guidance to ensure that redemption rights remain a favorable exit option. In its analysis, the court noted that the preferred stock did not pay a cumulative dividend, which would have had the effect of steadily increasing the liquidation preference and redemption price, and thus reducing the prospect that the corporation would generate value for the undifferentiated equity over the long term. The court indicated that in such a case the common stock may be “functionally worthless” if the company could never realistically generate a sufficient return to pay off the preferred stock and yield value for the common stockholders.204 Firms might consider coupling a mandatory redemption right with a cumulative dividend provision to avoid the circumvention of their redemption rights or structuring their investments using a pure debt structure.205
1. Thomas A. Mullen of Potter Anderson & Corroon LLP and Lisa R. Stark of K&L Gates LLP cochair the Working Group and the Jurisprudence Subcommittee. Contributors of written summaries in this year’s survey, in addition to Mr. Mullen and Ms. Stark, are Lisa Murison from Edmunds, Matthew Brodsky from Stradling Yocca Carlson & Rauth, Scott R. Bleier of Morse Barnes-Brown Pendleton, S. Scott Parel and Sacha Jamal from Sidley Austin LLP, Taylor Bartholomew of K&L Gates LLP, and Christopher G. Browne of Potter Anderson & Corroon LLP.
2. To be included in the survey, cases must meet the following criteria: (a) the decision must address either a preferred stock financing or a change in control of a company that had previously issued preferred stock; (b) the court must (i) interpret preferred stock terms, (ii) interpret a statute pertaining to a preferred stock financing, (iii) address a breach of fiduciary duty claim brought in the context of a transaction described in (a) above; or (c) the decision must involve a company that has been funded primarily by private investors.
3. Huff Energy Fund L.P. v. Gershen, C.A. No. 1116-VCS, 2016 WL 5462958 (Del. Ch. 2016) [hereinafter Huff Energy].
4. Id. at *1–2.
5. Id. at *1.
6. Revlon v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 174 (Del. 1986).
7. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).
8. Huff Energy, 2016 WL 5462958, at *8–11.
9. Id. at *14–15.
10. Id. at *11–16 (citing Corwin v. KKR Fin. Holdings LLC, 125 A.3d 304 (Del. 2015)).
11. Id. at *1–2.
12. Id. at *2.
13. Id. at *3.
19. Id. at *4.
24. Id. at *4–5.
25. Id. at *1, *5.
26. Id. at *6.
27. Id. at *8.
29. Id. at *9.
32. Id. at *10.
35. Id. at *11–16.
36. Id. at *11.
40. Id. at *12.
42. Id. at *13.
44. Id. at *14.
46. Id. at *15.
49. Calesa Assocs., L.P. v. Am. Capital, Ltd., C.A. No. 10557-VCG, 2016 WL 770251 (Del. Ch. Feb. 29, 2016).
50. Because this case is decided on a motion to dismiss, facts (and reasonable inferences) pled by the plaintiffs are accepted as true. See id. at *8. If this case goes to trial, the facts could turn out to be different.
51. Id. at *1.
52. For ease of discussion, the distinction between the private equity firm and its affiliates is ignored.
53. Id. at *3.
54. Id. at *1.
55. Id. at *4.
64. Id. at *5.
65. Id. at *6–7.
66. Id. at *5.
68. Id. at *2.
69. Id. at *1.
70. See id.
71. Id. at *15.
72. Id. at *9.
73. Id. at *10.
77. Id. at *11.
81. Id. at *12.
84. Id. at *13.
87. Id. at *14.
89. Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 172 F. Supp. 3d 447 (D. Mass. 2016) [hereinafter Sun Capital III].
90. See generally id.
91. Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129, 143 (1st Cir. 2013) [hereinafter Sun Capital II].
92. Sun Capital III, 172 F. Supp. 3d at 466.
93. Id. at 462–66.
94. Id. at 467.
95. Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 903 F. Supp. 2d 107, 111 (D. Mass. 2012) [hereinafter Sun Capital I], aff’d in part, vacated in part, rev’d in part, 724 F.3d 129 (1st Cir. 2013).
97. Id. at 117.
98. See Sun Capital II, 724 F.3d at 143; Sun Capital III, 172 F. Supp. 3d at 454.
99. Sun Capital I, 903 F. Supp. 2d at 111–12.
100. See PENSION BENEFIT GUAR. CORP., MULTIEMPLOYER PENSION PLANS: REPORT TO CONGRESS REQUIRED BY THE PENSION PROTECTION ACT OF 2006, at 1 (2013).
101. Sun Capital I, 903 F. Supp. 2d at 109.
102. Id. at 113.
103. Id. at 111.
107. Id. at 112.
108. Id. at 118.
109. Sun Capital II, 724 F.3d at 148–49.
110. Id. at 141.
112. Id. at 148–49.
113. Sun Capital III, 172 F. Supp. 3d at 457–58.
114. See id. at 454–58.
116. Id. at 466.
117. See id. at 467.
118. See id. at 458–59.
119. Id. at 458.
120. See id. at 458–59.
121. See id. at 462–66.
122. See id.
124. See id. at 457–58.
125. See id. at 462–66.
126. In re ISN Software Corp. Appraisal Litig., C.A. No. 8388-VCG, 2016 WL 4275388 (Del. Ch. Aug. 11, 2016).
127. See id. at *2–3.
128. Id. at *1.
131. Id. at *2.
133. Id. at *2 n.15.
134. Id. at *2.
136. Id. at *3.
139. Id. at *3–4.
141. Id. at *4.
143. Id. at *4–5.
145. Id. at *5.
146. Id. at *5–6.
147. Id. at *5.
149. Id. at *6.
150. Id. at *7.
152. Id. at *3, *7.
153. Id. at *7.
155. Id. at *2, *7.
156. Frederick Hsu Living Trust v. ODN Holding Corp., C.A. No. 12108-VCL, 2017 WL 1437308 (Del. Ch. Apr. 14, 2017, corrected Apr. 24, 2017).
157. See id. at *1.
158. Id. at *22.
160. Id. at *3.
161. Id. at *4.
163. Id. at *5.
166. Id. at *6.
170. Id. at *7.
175. Id. at *9.
178. Id. at *10.
181. Id. at *12.
183. Id. at *15.
185. Id. at *17.
186. Id. at *18.
187. Id. at *24.
188. Id. at *27.
189. Id. at *27–29.
190. Id. at *30.
191. Id. at *31–33.
192. Id. at *35.
193. Id. at *36.
194. See id. at *35–36.
195. Id. at *39.
196. Id. at *40–42.
197. Id. at *42–43.
198. Id. at *44.
199. See William W. Bratton & Michael L. Wachter, A Theory of Preferred Stock, 161 U. PA. L. REV. 1815, 1865 n.200 (2013) (noting that in an “EDGAR-based survey of recent preferred issues, 14% of the registered issues had mandatory redemption provisions and 36% of the unregistered issues had mandatory redemption provisions”).
200. See Frederick Hsu Living Trust, 2017 WL 1437308, at *1, *24–25.
201. See id. at *35.
202. Id. at *24.
203. Id. at *32.
204. See id. at *35–36.
205. See id. at *35 (“The Preferred Stock was effectively trapped capital, and [ODN] could have used that capital for the benefit of the residual claimants.”).