Recent decision by Delaware Superior Court where investor loses claim for liquidation preference. Case involves a multi-step merger where the conceptual timing of conversion of preferred to common (and loss of preference) and the merger was complicated. Very fact-specific but worth a read for anyone drafting complex charters.
Interesting new decision by the Delaware Chancery Court in a case involving Amazon. Amazon obtained antidilution rights with preferred stock in Basis and when followon rounds were issued above their price (by $.03), Amazon claimed that the Board acted with self-interest to circumvent their antidilution rights. Amazon argued that the Board breached their duties of care and loyalty by getting a higher price, thereby causing less dilution to all shareholders, other than Amazon that had this special right. While acknowledging that they were novel, the court rejected Amazon’s arguments. The take-away from this case seems that if a follow-on round is close in price to the last round, it may be a good idea to document how and why that price was reached, at least in the case where the company is not on the best of terms with the shareholderthat may complain.
An April decision by the Connecticut Supreme Court rejects a claim by minority stockholders of Latex Foam International against the majority stockholders for doing a down round favoring the majority. The May v. Coffey decision can be found here.
The case was brought by a former COO of Latex Foam after the company did a down round led by the majority shareholders in which the COO did not participate. (The case footnotes that the COO held stock as part of his executive comp and was partially bought out — after the company and he had arbitration over the shares. It looks like the Company did not buy him entirely at the time, so he remained a shareholder and thus could bring this lawsuit. This seems like obvious 20-20 hindsight here, but this case is a good reminder of how closely-held companies should always try to entirely buy out former employees when they leave the company. In my opinion, leaving loose ends like this is always asking for trouble.)
The plaintiffs brought claims against the majority stockholders, the Board and the officers of Latex Foam, alleging breach of fiduciary duty and unjust enrichment. The trial court dismissed the plaintiffs’ case because they found the claims to be derivative (i.e. they apply to the whole corporation, and not just plaintiff) and needed to have been brought by the corporation, as opposed to the plaintiff. The Supreme Court agreed and wrote a pretty lengthy decision explaining its reasoning. The following are a few interesting nuggets from the case:
a stock offering at below market value does not result in a separate and distinct harm to individual shareholders. Existing shareholders suffer an indirect injury, a reduction in the value of their existing shares, which is derived from the unreasonably low offering price of the new shares.
the court rejects the notion that the claims are “direct” because the majority shareholders are the ones who benefited from the offering. The court reasoned that this result should be no different than where a third party (such as in a public offering) would have purchased the shares in the new offering.
the court emphasizes throughout the decision that this case is based on Connecticut law, not Delaware. The court expressly disagrees with a number of technical points raised by other cases (from the 2nd circuit and from Delaware) cited by the plaintiffs. “It is Connecticut law, not Delaware law, that controls our resolution of this case….As we explained in part I of this opinion, under Connecticut law, …we fail to see how the company’s receipt of less than fair value for its new shares of stock becomes a separate and distinct harm to individual shareholders merely because a controlling shareholder, rather than an independent third party, acquires the offsetting benefits.”
Finally, it is important to note that this case is about standing. Nowhere does the Court actually address whether the down round would have been an actual breach of fiduciary duty. However, this decision certainly sets a nice barrier to these types of claims, since they must be brought by the corporation, which retains significant discretion over bringing the claims in the first place.
The facts here definitely favored the defendants. It looks like the plaintiffs were given the right to participate in the new round on the same terms as the other investors, and therefore could have avoided the dilution that resulted. This is a reminder that in these circumstances – and we are probably going to be seeing a lot more down rounds in the near future – it may be prudent to make the offering to everyone, even if they don’t have preemptive rights or rights of first refusal.
A series of recent decisions dismissing copyright claims allow Veoh Networks and its investors to breathe a short sigh of relief. The first decision last August, in a case brought by adult site IO Group, ruled that Veoh was entitled to the safe harbor under the DMCA and was not infringing. In December, in a different case brought by Universal Music, the court again sided with Veoh, finding that is was entitled to the safe harbor even though, technically, its streaming process did result in some “copying” within the meaning of the Copyright statute.
Most recently, in early February, a sharply worded decision by the Central District of California dismissed Universal Music’s claims against Veoh investors (Shelter Capital, Spark Capital and Torrante) for contributory and vicarious copyright infringement. UMG Recordings v. Veoh Networks Inc., 2009 WL 334022 (C.D.Cal). (The investors were added as defendants a year after the initial action against Veoh was filed). This decision is potentially significant because it shows a court’s unwillingness to pierce the corporate veil and go after deeper pockets in the copyright context – something that many investors have feared since the 2004 Napster case against Hummer Winblad – and presents a bit of a roadmap on how future claims may be constructed (and how to hedge against them).
After the Napster fallout and the lawsuits against Bertelsmann and Hummer Winblad resulting from their investment in Napster, many investors grew fearful that an investment in a user generated content (UGC) based business, such as Youtube or Veoh, could expose them to “aiding and abetting” claims for copyright infringement. In fact, it quickly became market for many investors to expand the scope of their indemnification agreements to demand that their portfolio companies indemnify the investors as shareholders, and not just the investor directors who served on the boards of these companies. Three years later, these concerns are finally coming to roost, albeit in a different economic, social and technological marketplace.
Per the roadman in Bertelsmann, the plaintiffs in Veoh alleged that the investors “controlled” Veoh by holding three of five board seats, providing all of their operational capital and making decisions all of the Company’s major decisions, including those relating to its content offerings. Assuming all that to be true, the court rejected the claims on the ground that they could not state a claim. The following are some nuggets from the decision:
> Membership on a Board of Directors necessarily and inherently entails making almost all these [operational] decisions. “To allow for derivative copyright liability merely because of such membership could invite expansion of potential shareholder liability for corporate conduct, without meaningful limitation.”
> There is no common law duty for investors (even ones who collectively control the Board) “to remove copyrighted content,” in light of the DMCA.
> The court extensively distinguished the Bertelsmann decision, thereby limiting its future application, on a number of specific facts absent here. Most importantly, in that case the investors proceeded to invest and control Napster after the liability issues had been going on for two years and then did not stop the conduct after taking over. Therefore, prospective investors in a company where a copyright lawsuit is actually pending would be well advised to consider whether the indemnification agreement (which they are probably ultimately paying for) is going to serve its ultimate purpose.
> The court dismissed the vicarious liability claim – which requires a defendant to have a direct financial interest in the infringing conduct – by holding that a “profit from their investments through the sale of Veoh to a potential acquiring company or through a public offering… is too far removed from the alleged infringement to be considered a “direct” financial interest.” This should be compared against potential direct benefits mentioned by the court, such as where investors may receive fees paid by customers or advertisers, or even a dividend or distribution from those revenues. Therefore, investors considering a recapitalization or an early distribution of profits should consider this issue as part of their analysis.
Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or RestructuringFebruary 20, 2009
A recent decision by the Delaware Supreme Court, Gantler v. Stephens, C.A. No. 2392 (Del. January 27, 2009) (available here) provides new guidance for directors and officers on their fiduciary duties arising in connection with a possible corporate sale or restructuring. In Gantler, the Court held that directors and officers of an Ohio bank (the “Bank”) could be found to have breached their fiduciary duty by rejecting an opportunity to sell the Bank and instead pursuing a recapitalization that favored the insiders. The case was brought by a former director (Gantler) and minority shareholders of First Niles Financial, Inc. (“First Niles”), the Bank’s holding company.
In short, the historical position under Delaware corporate law has been that certain conflicts of interest of insiders (such as trying to keep one’s employment or directorship) are inherent and unavoidable, and if properly disclosed, would not result in a higher level of scrutiny from courts over board decisions. Gantler holds that this is not always true, and that specific facts can alter that position.
Specifically, where directors and/or officers are — or with 20/20 hindsight, may be argued to be — motivated to prefer one particular transaction over another, even if the motivation is reasonable and disclosed to shareholders, extreme care should be taken to ensure that the board evaluation and deliberation process is balanced and well-documented. Failure to do so may prevent a board from being entitled to the business judgment rule and subject the directors and officers to a stricter standard that the actions meet the “entire fairness” test under Delaware law.
After a strong acquisition market, in August 2004, the First Niles board agreed to put the Bank up for sale and hired investment bankers to pursue the opportunity. Shortly thereafter, the managing officers of First Niles (and the Bank), several of whom were also directors, advocated that the Bank abandon the process and privatize the company by delisting from the NASDAQ SmallCap Market. The Bank received offers from three strategic purchasers, each considered by the bankers to be within the recommended range. Two offers made clear that the purchaser would terminate the incumbent First Niles board upon closing. In the months that followed, management did not respond to the bidders’ due diligence requests and delayed the process (resulting in the withdrawal of one bid, which was not disclosed to the board until after the fact) and continued to discuss the privatization proposal. In March 2005, notwithstanding a favorable opinion from the bankers as to one of the offers, the board voted 4 to 1 to reject the offer, with Gantler being the only dissenting vote, and turned its attention to the privatization plan.
In April 2005, management presented to the board its privatization proposal, which would reclassify the First Niles common stock held by holders of 300 or fewer shares into a new class of Series A Preferred Stock that would pay higher dividends and have the same liquidation preference as the common stock, but that would not have voting rights except in the event of a proposed sale of the company. In December 2005, the proposal was approved 3 to 1 by the Board, with Gantler again being the only dissenting vote. Shortly thereafter, Gantler was replaced on the Board by an officer of the company. The following June, the newly-composed First Niles Board unanimously approved a charter amendment to effect the reclassification and proceeded with the proxy solicitation process for shareholder approval. The proxy statement did disclose that the directors and officers had a conflict of interest with respect to the reclassification and the alternative transactions that the board had considered, including a business combination that was turned down.
Following shareholder approval of the charter amendment, the plaintiffs brought suit in the Delaware Chancery Court alleging, among other things, that the board violated its various fiduciary duties by sabotaging due diligence and abandoning the sales process in favor of their own incumbency. In March 2008, the Chancery Court dismissed the case for failure to state a claim and the parties appealed.
In reversing the Chancery Court’s dismissal, the Supreme Court clarified several issues of Delaware corporate law, including the following:
§ Higher Scrutiny for Transactions with Potential Conflict of Interest. The Court agreed with the defendants that the Board’s duty in this case should be analyzed under the more favorable business judgment rule, as opposed to the “enhanced scrutiny” standard under Unocal.
However, the Court did hold that the business judgment presumption could be rebutted in this case because reasonable inferences of self interest could be drawn from the defendant directors’ and officers’ lack of cooperation with the due diligence requests and sabotaging of the bid process. In its analysis, the Court highlighted the specific conflicts arising from a sale of the Bank for each of the directors — the potential loss of employment for the Chairman/CEO; and the loss of the Bank as a key client for businesses operated by two different directors. It is also interesting to note that the Court relied on the disclosure in the proxy statement of the potential for conflict of interest as an admission that the conflict did in fact exist.
There can be little question that the extreme facts of this case heavily influenced the Court’s decision to rebut the presumption of good faith by the board, and that the outcome may have been different if the some of the “sabotaging” activity was not present and if the board deliberations regarding the sale proposals were more extensive. The Court specifically noted that after only one bidder remained and the bankers opined that the bidder may continue to improve their offer, the board did not discuss the offer at one meeting and rejected in another, “without discussion or deliberation.”
If directors or officers do have personal financial interests that diverge from the interests of other shareholders, a board should now be prepared for a higher standard of review of their actions. That said, Gantler should not be read to require a board to reach any particular decision (e.g. sell, recapitalize, etc.), but only that the process to reach that decision is fair and informed. Therefore, to the extent that certain opportunities can later be reasonably argued to have been more preferable for certain (minority) shareholders, boards should be advised to more carefully evaluate those opportunities and to document why they may not have been in the best interests of all shareholders.
Where a potential conflict does exist, boards should be advised to consider the appointment of an independent committee for the M&A process, where such committee would have the authority to engage its own advisors and independent legal counsel. Another approach may be to engage multiple investment banking advisors to provide a board with a comparative analysis of the opportunities. Finally, extreme care should be take to distribute all studies, reports and materials in advance of board meetings, to have substantive discussions on those issues at the meetings and properly memorialize in the minutes to evidence that the board fulfilled its duty of care (which it would seem was not met in Gantler).
§ Fiduciary Duty of Officers equal to that of Directors. As an issue of first impression, the Court held that officers of a Delaware corporation have the same fiduciary duties as directors. While this position has been implied, the Supreme Court has now explicitly held that officers owe fiduciary duties of care and loyalty that are the same as those of directors of Delaware corporations.
§ Shareholder Ratification Limited. The Court also disagreed with the Chancery Court’s finding that the shareholder approval of the privatization plan, as submitted by the First Niles board and described in the proxy, “ratified” the prior actions of the board, absolving them of liability. To clarify this area of the law, the Court imposed a number of specific limitations on this doctrine.
First, shareholder ratification is effective only where a “fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become more legally effective.” Therefore, where a shareholder vote is otherwise required – such as for the approval of a charter amendment or a merger – the shareholder vote does not carry any ratifying effect of the preceding board action.
Second, the only director action that can be ratified is that which shareholders are specifically asked to approve. For example, the ultimate approval of a merger by shareholders does not mean that shareholders have also ratified all related director actions, such as defensive measures that may have been taken in the context of that transaction.
Third, the effect of shareholder ratification does not extinguish all claims in respect of the ratified director action, but rather subjects the challenged action to business judgment review (as opposed to the entire fairness test). Therefore, companies should not assume that a valid shareholder vote would sanitize the prior actions of a board in connection with any particular corporate decision or transaction.