Delaware case on liquidation preference

January 23, 2012

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.


Post by Fred Wilson on post-deal integration

February 1, 2011

Interesting post by PEHUB on Fred Wilson’s thoughts on post-deal integration:

“The other critical piece of an integration plan is what happens to the key people. Do they stay with the business? Do they stay with the buyer but focus on something new? Do they parachute out at the signing of the transaction?

I believe the buyer needs to keep the key people in an acquisition. Otherwise, why are you buying the company? So letting the key people parachute out at the signing seems like a really bad idea. That said, the buyer also needs to recognize that great entrepreneurs will not be happy in a big company for long. So most M&A deals include a one or two year stay package for the founder/founding team. That makes sense. That gives the buyer time to put a new team in place before the founding team leaves.

Generally speaking, I think it is a good idea for the key people to stay with the business post acquisition. This provides continuity and comfort in a tumultuous time for the company. However, I have seen situations where the key people went to other parts of the organization and provided value. Dick Costolo left Feedburner post acquisition by Google and focused on other key issues inside Google. Dave Morgan left TACODA and focused on strategic issues for AOL post the TACODA acquisition. This can work if there is a strong management team left in the acquired business post transaction.

Another key issue is how to manage conflicts between the acquired company and existing efforts inside the buyer’s organization. This happened in Yahoo’s acquisition of Delcious. Yahoo had a competing effort underway and they left it in place after acquiring Delicious. This resulted in a number of difficult product decisions and competing resources and a host of other issues. I think it was one of many reasons Delicious did not fare well under Yahoo’s ownership. You have the most leverage before you sign the Purchase Agreement so if you want the buyer to kill off competing projects, get that agreeed to before you sell. You may not be able to get it done after you sell.

These are some of the big issues you will face in an integration. There are plenty more. But this is a blog post and I like to keep them reasonably short. Take this part of the deal negotiation very seriously. Many entrepreneurs focus on the price and terms and don’t worry too much about what happens post closing. But then they regret it because they have to work in a bad situation for two years and worse they witness the company and team they built withering away inside the buyer’s organization and are powerless to do anything about it. It is a faustian bargain in many ways. But you don’t have to let it be that way. Get the integration plan right and you can have your cake and eat it too.”

Recent Delaware case on redemption rights – Part Deux

February 1, 2011

Several years ago, I wrote about a few cases covering redemption rights.  My original post is here.

One of the cases involving Thoughtworks and SV Investment (aka Schroeders) is back for another look.  A copy of the opinion can be found here.

This decision refutes the popular urban myth that the term “surplus” means the same thing as “funds legally available” – these terms are the litmus test of whether a corporation has the capacity, and therefore the obligation, to redeem its shares at any particular time.

The court defines the term “funds legally available” as follows:  it contemplates “funds” (in the sense of cash) that are “available” (in the sense of on hand or readily accessible through sales or borrowing) and can be deployed “legally” for redemptions without violating DGCL Section 160 or other statutory or common law restrictions, including the requirement that the corporation be able to continue as a going concern and not be rendered insolvent by the distribution.

Here, the investors claimed that the company was obligated to continue redeeming their shares because it had “funds legally available”, per the terms of the company’s charter.  Despite the fact that an expert found that the company had $67-128 million in “surplus”, the court ruled that the company did not have the “funds legally available” and therefore was not obligated to make the $66,900 redemption payment.   The court reasoned that there was a substantial risk that the redemption would the company insolvent, which meant that the funds were not “legally available”, notwithstanding that there was “surplus” as found by the experts.

Thoughtworks’ redemption provision contained two limitations on the obligation “to redeem for cash.” Redemption could only be “out of any funds legally available therefor.”  The provision also excludes funds “designated by the Board of Directors as necessary to fund the working capital requirements of the Corporation for the fiscal year of the Redemption Date.”  To the extent that redemption cannot be effected, the charter requires pro-rata payments to the investors until they are paid out in full.  The charter also provides  that “[f]or the purpose of determining whether funds are legally available for redemption . . . , the Corporation shall value its assets at the highest amount permissible under applicable law”.

The board sought legal and financial advice with respect to the company’s redemption obligations per the charter.  The opinion quotes an interesting part of the memo provided to the board by the financial advisors:

“In declaring the amount of legally available funds for redemption, the Board must (a) not declare an amount that exceeds the corporation’s surplus as determined by the Board at the time of the redemption, (b) reassess its initial determination of surplus if the Board determines that a redemption based on that determination of surplus would impair the Company’s ability to continue as a going concern, thereby eroding the value of any assets (such as work in process and accounts receivable) that have materially lower values in liquidation than as part of a going concern, such that the value assumptions underlying the initial computation of surplus are no longer sustainable and the long term health of the Company is jeopardized, (c) exercise its affirmative duty to avoid decisions that trigger insolvency, (d) redeem for cash, (e) apply the amount declared pro rata to the Redeemed Stock, and (f) recognize the right of the Preferred Shareholders to a continuous remedy if the amount declared is not sufficient to satisfy in full the redemption obligation under the Charter.”

The court provides a succinct synthesis of the Delaware statutory law regarding redemption:

  • Section 160 of the DGCL authorizes a Delaware corporation to redeem its shares, subject to statutory restrictions.  In general, a corporation may redeem its own shares where the redemption does not result in the impairment of capital.
  • A repurchase impairs capital if the funds used in the repurchase exceed the amount of the corporation’s ‘surplus,’ defined by 8 Del. C. § 154 to mean the excess of net assets over the par value of the corporation’s issued stock.” Klang v. Smith’s Food & Drug Ctrs., Inc., 702 A.2d 150, 153 (Del. 1997).
  • Net assets means the amount by which total assets exceed total liabilities.” 8 Del. C. § 154.
  • Under Section 160(a)(1), therefore, unless a corporation redeems shares and will retire them and reduce its capital, “a corporation may use only its surplus for the purchase of shares of its own capital stock.” In re Int’l Radiator Co., 92 A. 255, 256 (Del. Ch. 1914).

The court goes on to distinguish the term “surplus” from “funds legally available” and provides a helpful history on the etymology of these terms.  “A corporation easily could have “funds” and yet find that they were not “legally available.”  A corporation also could lack “funds,” yet have the legal capacity to pay dividends or make redemptions because it had a large surplus.  Funds required to be withheld for taxes (e.g. payroll withholdings) and other statutory payment obligations are not to be considered as part of available funds.

Finally, the court provides a nice comparison of debt (including convertible debt)  and  equity, from the standpoint of redemption rights and investor protective provisions (see pp. 29-32).  This summary may be a useful read when negotiating term sheets (or explaining the difference to clients).


Amazon loses case on antidilution clause

July 18, 2009

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.

Minnesota Federal Court Decision on M&A Indemnity

April 27, 2009

A recent decision by the Minnesota Federal District Court involves claims for breach of reps of warranties and indemnification by a buyer of a ready-to-eat food manufacturing business.  The decision can be found on Westlaw 2009 WL 1086474.  

The case involved the failure by the seller to disclose to the buyer that one of their biggest customers, Exxon, threatened to pull the business, only thereafter working out the relationship with the seller.  The Merger Agreement specifically required seller to rep that since the most recent financials, there has not been any “material adverse effect” in the business relationship with any customer, and no customer has threatened to reduce or terminate the business.  After the closing, Exxon terminated the contract and the buyer sued, looking to recover against the escrow.

This is a garden variety case of this sort, but interesting for the following reasons:

  • the elements for a plain vanilla (i.e. non-UCC Article 2) breach of warranty claim under Minnesota law are: (1) existence of a warranty; (2) breach; (3) causation leading to damages and (4) reliance on the warranty. 


  • The court found that the complaints raised by Exxon before the closing (even though they were ultimately worked out) fell within the broad definition of a “material adverse change” in the Merger Agreement.  Therefore, even though the issues appeared to have been resolved, the strict language of the reps required the customer complaints to have been disclosed.

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April 27, 2009

Connecticut Supreme Court rejects minority stockholder claim over down round

April 25, 2009

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.




VC Investors Prevail In Dismissal of Copyright Infringement Claims involving Veoh Networks

February 24, 2009

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.

First Circuit Court Surprises Media Lawyers with Controversial Decision in Libel Case

February 23, 2009

A recent decision by the 1st Circuit against Staples, Inc. surprised many media lawyers by holding that truth is not an absolute defense to a libel claim. It held that a truthful statement may give rise to a cause of action by a private-figure plaintiff if it was made maliciously. The decision departs from decades worth of jurisprudence establishing truth as an absolute defense to a defamation claim.

No doubt the extreme facts in this case drove the Court’s outcome. The case was brought by a former Staples employee who was terminated for “cause” submitting false expense reports. The termination took place after an extensive internal investigation that uncovered the fraud. After the termination, a manager issued an email to 1,500 Staples employees stating that the employee had been terminated for abusing the travel & expense policy. (The court’s commentary seems to suggest that the fact that employee was mentioned by name in this en masse email is what they thought a jury could consider to be malicious. Although the court held that there was no question that the statement in the email was true, it nonetheless allowed a libel claim to stand based on a 1902 law (G.L.c.231, sec. 92) that provides that truth is a justification for libel “unless malice is actually proved.”


It is important to note, however, that this decision does not mean that Staples loses on this claim. The 1st Circuit remanded the case back to the US District Court for trial where a jury may still find that the manager’s email did not constitute malice.

Another interesting part of the decision deals with stock options. As part of the for “cause” termination, the employee’s vested stock options were terminated per the terms of the option plans. The agreements provided that whether or not termination is for cause would be “as determined by Staples, which determination shall be conclusive.” Finding no prior Mass. law on this issue, the 1st Circuit held it will not second guess the Company’s termination decision unless it finds that it was “arbitrary, capricious, or made in bad faith,” which in this case was based extensive internal investigation and therefore was allowed to stand.

In this market where layoffs are looming in just about every industry, this case underscores the importance of proper procedure (and tact) in handling terminations. Based on this decision, employers should be additionally cautious when handling any announcements internal or external and discussions regarding anyone being terminated, as well as in the context of giving references or referrals. And while not all employers have Staples’ budget to conduct internal investigations to find “cause”, any determination of such a finding should be well documented.

Delaware Supreme Court Provides New Guidance for Directors and Officers Evaluating a Corporate Sale or Restructuring

February 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.