Six months ago, Delaware Vice Chancellor Laster issued a post-trial opinion in In re Trados Inc. Shareholder Litigation, 73 A.3d 17 (Del. Ch. Aug. 16, 2013), which sparked a great deal of interest. In Trados the court held that management directors, the directors appointed by the venture capital (VC) investors, and one ostensibly independent director with strong ties to another VC were personally interested in a merger transaction that triggered payments on the preferred stock to VC investors while paying common stockholders nothing. Moreover, the court found the board had wrongfully considered only the interests of the preferred stockholders, to the exclusion of common stockholders, and failed to institute any procedural safeguards for common shareholders in approving the merger. These facts combined to require application of the entire fairness standard of review. Even though the court found the board’s process was procedurally unfair, it nevertheless found the transaction satisfied the entire fairness standard based on price alone.
On these facts, Trados appeared to expand the application of the entire fairness standard of review in a typical VC start-up transaction, while simultaneously relaxing that application of that review. The Trados opinion was seen as presenting challenges and opportunities for both plaintiffs and defendants in Delaware merger-and-acquisition litigation. As a result, Trados sparked numerous articles and significant debate among both the plaintiff and defense bars. Now, six months later, it appears that Vice Chancellor Laster’s opinion in Trados has had little application in subsequent opinions and has left many to wonder about the future of Delaware’s entire fairness standard.
The Factual Background
Trados, Inc., founded in 1984, began several rounds of VC financing through the issuance of preferred stock in 2000. The VC investors were issued convertible preferred shares with what has become “standard features of VC preferred stock:” (1) a liquidation preference payable upon a change-of-control transaction; (2) voting rights identical to common shares on an as-converted basis; (3) certain other customary VC control rights, including the veto right over change-in-control transactions; and (4) certain of the VC investors received the power to designate representatives to the Trados board. As a result of these features, the VC investors collectively controlled a majority of the voting power on an as-converted basis and held the power to elect the majority of the board.
In the years leading up to the merger, the company showed the ability to generate revenue but could not achieve meaningful profitability. Thus, by 2004, Trados was “neither a complete failure nor a stunning success.” Consequently, the VC directors updated the partners at their respective VC firms throughout this period and advised them that although an exit was achievable, they were not likely to see significant returns on their investments.
Against this background, in July 2004 the board hired a new chief executive officer (CEO). The board also approved a management incentive plan that gave senior executives, including the newly appointed CEO, an incentive to pursue a sale of Trados by offering management an increasing percentage of the total sales proceeds as the sales price increased—even if the ultimate sale paid nothing to common shareholders. Also in 2004, the board rejected an initial $40 million acquisition proposal from SDL plc, which it considered too low, because it was well below the VC investors’ liquidation preference at that time.
The new CEO advised the board that the company had two options: Either Trados and its VC investors could invest additional capital (either debt or equity) to reposition its core business for growth in the enterprise sector, or the company could focus on a potential sale or merger transaction as an exit strategy for the VCs. Although additional investment in Trados as a stand-alone enterprise may have permitted the company to generate a modest return, it did not appear to offer a realistic opportunity for the “stunning success” sought by VC investors that would provide meaningful returns for both them and common shareholders. Thus, the board focused on an exit strategy for the VCs. However, as noted by Vice Chancellor Laster, because VC investors in “sales often exit as preferred shareholders with liquidation preferences that must be paid in full before common shareholders receive any payout, common shareholders may receive little (if any) payout. At the same time, the sale eliminates any ‘option value’ (upside potential) of the common stock.”
Ultimately, in June 2005, Trados agreed to be acquired by SDL for $60 million in cash. Owing to the terms of the management incentive plan, the first $7.8 million of proceeds went to the management directors and other employees. The remaining $52.2 million went to the VC investors to satisfy their total combined liquidation preference of the preferred stock of $57.9 million. Without the management incentive plan payments to management, the common stockholders would have been entitled to $2.1 million in proceeds but instead received nothing. The merger agreement was approved by the required percentages of the preferred stock and the common stock, with the VC investors owning enough of the preferred stock to approve the merger on their own.
The plaintiff, a common stockholder, initially brought an action for appraisal of his shares but later brought a second action alleging a breach of the fiduciary duty of loyalty as a result of discovery during the appraisal action. The plaintiff alleged that the board ignored the interests of the common stock by focusing entirely on achieving an exit that would benefit the preferred stockholders, despite the fact that the company could have continued to operate profitably as a stand-alone entity and thereby generate value for common shareholders.
The Two Core Holdings
A majority of the board was interested in the outcome of the merger. At the time of the merger with SDL, the board consisted of seven directors, including two management directors, three VC-appointed directors, and two ostensibly outside directors. The court pointed out that “[t]here is nothing inherently pernicious” in the typical VC structure employed by many start-up businesses. Yet, following extensive discussion, it found that the three VC directors acted as “fiduciaries for VC funds that received disparate consideration in the Merger in the form of a liquidation preference.” Therefore, each of the VC directors “faced the dual fiduciary problem” or conflict inherent in conflicting fiduciary duties. Trados, 73 A.3d (citing Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983)). Similarly, the court found the two management directors received material personal benefits in the merger that likewise rendered them “interested in the decision to approve the [m]erger.” Id. at 45.Perhaps most notably, the court went on to review the independence and disinterestedness of the purportedly independent directors. After a discussion of the “web of interrelationships that characterizes the Silicon Valley startup community,” id. at 54, Vice Chancellor Laster found that one of the two ostensibly independent directors was likewise interested in the outcome of the merger by virtue of his business relationships with two of the VC directors and his beneficial ownership of preferred stock of Trados. Thus, the court found that six of the seven directors were interested in the merger, which required application of the “entire fairness” standard to the evaluation of the merger and the directors’ actions.
The entire fairness standard applied to the merger. Because a majority of the board was interested in the merger, the court applied “[e]ntire fairness, Delaware’s most onerous standard” for reviewing the transaction. The Trados court explained that once entire fairness applies, the defendants must establish “to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.” Id. at 44 (quoting Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1163 (Del. 1995)) (emphasis in original, internal quotation marks omitted in original).The court found that the defendants failed to establish that the merger was the product of fair dealing. Specifically, the court found that the board failed to recognize its inherent conflicts, consider the interests of the common shareholders, or implement any procedural protections whatsoever for common shareholders. Nevertheless, based on extensive expert testimony, the court ruled that the transaction ultimately passed review for entire fairness based on fair price alone, finding the common stock had zero value before the merger and that is exactly what the common shareholders received in the merger.
Vice Chancellor Laster explained that fair dealing “embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained,” while fair price “relates to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.” Id. at 56 (quoting Weinberger, 457 A.2d at 711). The court went on to conduct a holistic analysis stating “the test for fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must be examined as a whole since the question is one of entire fairness.” Id.
Thus, in the guise of a holistic analysis of entire fairness, the Tradoscourt became the first Delaware court to find a transaction unfair because of the process by which it was negotiated, yet still hold that it satisfied the entire fairness standard based on price alone—even though the merger provided no value whatsoever to common shareholders.
Entire Fairness after Trados
The Trados opinion prompted immediate responses from practitioners, both from the plaintiff and defense bars. It raised concerns for VC investors that a typical VC start-up structure could subject VC investors to litigation and liability under the entire fairness standard of review. Likewise, for common shareholders, it generated concern that the entire fairness standard had been significantly weakened, where a merger with no procedural safeguards for common shareholders whatsoever can be approved on price alone—even where the entire sales price is divided between management and VC investors, leaving nothing for common shareholders.
In the six months following the issuance of Trados, Vice Chancellor Laster’s opinion has not yet demonstrated significant impact. Indeed, the opinion has been cited in only one published opinion, Pfeiffer v. Leedle, No. C.A. 7831-VCP (Del. Ch. Nov. 8, 2013), and only with respect to a general statement regarding the business judgment rule, and has been mentioned in passing in only two scholarly journals. See Brian Broughman & Jesse M. Fried, “Carrots and Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups,” 98 Cornell L. Rev. 1319, 1346 n.86 (2013); Michelle N. Harner, “A More Realistic Approach to Directors’ Duties,” 15 Transactions 15, 17 n.8 (2013). Moreover, since the issuance of Trados, eight published Delaware opinions have discussed the entire fairness standard, none of which cited Trados. So far the Trados opinion has not had the impact some predicted, leaving investors and their counsel to wonder whether this decision will have a significant influence on Delaware transactional litigation or whether it is one more example of the age old adage that “bad facts can make bad law.”