ANNUAL SURVEY OF JUDICIAL DEVELOPMENTS PERTAINING TO VENTURE CAPITAL

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1 ANNUAL SURVEY OF JUDICIAL DEVELOPMENTS PERTAINING TO VENTURE CAPITAL 1. FLETCHER INTERNATIONAL, LTD. V. ION (DAMAGES AWARD FOR BREACH OF BLOCKING RIGHT) By: Mary Beth Kerrigan 1 I. Summary. In Fletcher International, Ltd. v. ION Geophysical Corp., C.A. No CS (Del. Ch. Dec. 4, 2013), the Delaware Court of Chancery determined the amount of damages owed to the plaintiff, Fletcher International, Ltd. ( Fletcher ), a preferred stockholder of the defendant, ION Geophysical Corporation ( ION ), for ION s breach of Fletcher s blocking right over convertible debt issuances by an ION subsidiary. The Court awarded Fletcher only $300,000 out of a requested $78 million in damages. The damages award represented the Court s estimate of the value that Fletcher could have extracted from ION had it actually sought Fletcher s consent to the convertible debt issuance as required by the preferred stock designation governing Fletcher s investment. II. Background. In 2005, Fletcher invested $30 million in ION by purchasing preferred stock that granted Fletcher a blocking right over the issuance of convertible debt instruments by ION subsidiaries. In 2009, ION faced severe financial distress and potential bankruptcy. To avert a bankruptcy and obtain some liquidity, ION formed a joint venture with BGP Inc. ( BGP ), a Chinese stateowned enterprise. As part of this joint venture, ION received $40 million in bridge financing from the Bank of China. In connection with the bridge financing, ION s subsidiary, ION International S.àr.l ( S.àr.l ), issued a $10 million convertible note to the Bank of China without obtaining Fletcher s consent as required by the preferred stock designation governing Fletcher s investment. ION had an existing credit facility with several other investors, and the Bank of China provided its bridge financing by becoming a party to the existing loan facility. As part of the much larger overall BGP transaction, BGP contributed between $195 and $245 million to ION. Fletcher did not possess a blocking right over the greater BGP transaction: Fletcher s consent right related solely to the $10 million convertible note issuance by S.àr.l to the Bank of China in connection with the $40 million bridge financing. The existing lenders unanimously approved the BGP transaction and received a fee in exchange for their consent equal to 25 basis points in excess of the amount of the loan 1 Mary Beth Kerrigan, Esquire is a partner with the law firm of Morse, Barnes-Brown & Pendleton, P.C. in Waltham, Massachusetts.

2 outstanding. The BGP transaction reduced ION s overall debt from over $240 million to only $106 million, all of which was in the form of a term loan under a new credit facility with China Merchants Bank. The market viewed the joint venture positively, and ION s stock price increased by 47% following public announcement of the joint venture. Notwithstanding the positive impact of the joint venture, Fletcher brought a complaint against ION in the Delaware Court of Chancery: (i) claiming that its right to consent to the issuance of the $10 million convertible note had been violated; (ii) seeking an injunction of the BGP transaction; and (iii) seeking an award of damages, arguing in part that the additional debt incurred would decrease the value of its preferred stock. In March 2010, the Court of Chancery issued a decision, finding that Fletcher had a reasonable likelihood of success with respect to its claim that ION had violated its blocking right, but that the balance of the equities weighed against granting injunctive relief. Instead, the Court determined damages would adequately remedy the breach. In its decision, the Court cited three reasons for refusing to grant injunctive relief: (i) an injunction may have prevented the transaction with BGP from occurring which would have resulted in ION defaulting on its obligations to its existing lenders; (ii) Fletcher was unlikely to suffer irreparable harm in the absence of the injunction since damages could be determined; and (iii) Fletcher had delayed pursing a remedy for ION s breach of its blocking right. In a May 2010 decision, the Court of Chancery found ION had violated Fletcher s right to consent to the issuance of the convertible debt security by S.àr.l and ordered a trial to determine Fletcher s damages. Subsequently, Fletcher filed for bankruptcy and its bankruptcy trustee sought to change its damages theory on the eve of the much-delayed damages trial. In this December 2013, post-trial decision, the Court determined the amount of Fletcher s damages for ION s breach of its consent right. III. Analysis. The Court requested that both parties present evidence on the amount of consideration Fletcher would have been able to extract from ION had ION requested Fletcher s consent and been required to bargain with Fletcher to obtain its approval to the convertible note issuance. Fletcher argued that it would have received $78 million in improvements to the terms of its preferred stock, including an increase in its dividend rate from 250 to 350 basis points, a decrease in its conversion price from $4.45 to $2.80 and a restatement of Fletcher s redemption right without a minimum price provision. Fletcher valued these changes at almost $78 million almost double the size of the transaction to which Fletcher should have been asked to consent. Fletcher further took the position that it would have been willing to refuse to give its consent even if the refusal resulted in ION filing for bankruptcy. The Court found Fletcher s position unrealistic for a number of reasons. First, the Court noted that BGP and the existing lenders 2

3 would have been involved in any negotiations with Fletcher because their consent was required for any changes to Fletcher s dividend rights, and that BGP and the existing lenders would not have agreed to a significant consent fee for Fletcher given their superior bargaining position. The Court also took into consideration the fact that the BGP transaction benefited Fletcher by averting the bankruptcy of ION. Indeed, Fletcher s investment in ION made up almost twothirds of Fletcher s investment portfolio, and an ION bankruptcy would have likely caused Fletcher to become insolvent. Finally, the Court noted that ION and BGP could have structured the BGP transaction to avoid triggering Fletcher s consent right altogether. For the reasons discussed above, the Court found that Fletcher would not have been able to negotiate for significant changes to its preferred stock terms in exchange for its consent to the BGP transaction. To determine the true damages to Fletcher, the Court looked at the consent fees that the existing lenders had received in connection with their consent to the BGP transaction and prior transactions. The Court concluded that Fletcher would not have been able to extract a consent fee from ION which was significantly larger than any consent fee the existing lenders had been previously able to obtain. On that basis, the Court awarded Fletcher damages in the amount of $300,000, which was equal to a consent fee of 75 basis points over the amount of the $40 million financing transaction Fletcher had the contractual right to approve. IV. Conclusion. This case serves as an important reminder for practitioners on how damages may be imposed by a Delaware court if a party violates another party s contractual consent right and fundamentally calls into question the meaning of blocking rights, suggesting that if a contract remedy is appropriate, that may be the remedy (in lieu of equitable relief). While the Court in the Fletcher decision analyzed the issue in the context of a blocking right over the issuance of a security, following Fletcher, preferred stockholders may not in fact enjoy the benefits of what they previously understood to be blocking rights in various situations, including, for example, the sale of a company. One possible solution would be for the parties to contractually agree from the outset in the preferred stock purchase agreement that monetary damages would be an inadequate remedy for breaches of the blocking rights. The Delaware Court of Chancery has held that contractual stipulations as to irreparable harm alone suffice to establish that element for the purpose of issuing preliminary injunctive relief in appropriate cases. A stipulation in the preferred stock designation that any breach of the consent rights will render the underlying transaction void might also have some utility depending on the circumstances. How a court will view such provisions in this context remains to be seen. 3

4 2. KLAASSEN V. ALLEGRO (ENFORCEABILITY OF STOCKHOLDERS AGREEMENTS) By: Lisa R. Stark 2 I. Summary. In Klaassen v. Allegro Development Corp., C.A. No VCL (Del. Ch. Oct. 11, 2013), the Delaware Court of Chancery held that where a director of a corporation serving in a seat subject to a director qualification ceases to meet the qualification, the director remains on the board in the seat subject to the qualification in the absence of a self-executing charter provision which explicitly cuts the director s term short upon failure to meet the qualification. The Court also confirmed that the election or removal of a director by a majority stockholder is invalid if the action conflicts with a voting restriction contained in a stockholders agreement to which the stockholder is a signatory even if the voting restriction would be invalid as a charter or bylaw provision under the General Corporation Law of the State of Delaware (the DGCL ). Finally, the Court confirmed the invalidity of a bylaw or charter provision purporting to limit the governance rights of all stockholders by reference to a stockholders agreement to which not all stockholders were signatories. II. Background. This Section 225 action arose from the ouster of Eldon Klaassen, the founder, majority stockholder and former CEO of Allegro Development Corp. ( Allegro ), a privately-held Delaware corporation. In 2007, Allegro secured financing from North Bridge Growth Equity I L.P. ( North Bridge ) and Tudor Ventures III, L.P. ( Tudor and, together with North Bridge, the Series A Investors ) in the amount of $40 million. In return, the Series A Investors received Allegro Series A preferred stock, which represented approximately 30% of Allegro s voting power. In connection with the Series A investment, Allegro amended its certificate of incorporation (the Certificate ) and bylaws. The Certificate provided: (1) the holders of a majority of the common stock, voting as a separate class, with the right to elect one director (the Common Director ), (2) the holders of Allegro s outstanding Series A preferred stock, voting as a separate class, with the right to elect three directors (the Series A Directors ), and (3) the holders of a majority of Allegro s outstanding voting power, voting together as a single class, with the right to elect the remaining three directors (the Remaining Directors ). Allegro s stockholders entered into a governance agreement (the Stockholders Agreement ), requiring them to vote their shares to fill the Remaining Directors seats with: (1) Allegro s current CEO 2 Lisa R. Stark, Esquire is a partner with the law firm of Berger Harris LLP, in Wilmington, Delaware. 4

5 (the CEO Director ), and (2) two unaffiliated individuals to be designated by the CEO and approved by the Series A Directors (the Outside Directors ). Immediately prior to the actions at issue, the Common Director seat and one Series A Director seat were vacant. Klaassen occupied the CEO Director seat, and defendants Hood and Simpkins occupied the Outside Director seats. By 2012, the Series A Investors had become extremely dissatisfied with Allegro s and Klaassen s performance. The Series A Directors and Outside Directors removed Klaassen as CEO at a regularly scheduled board meeting. At the November 2012 board meeting, the board elected Hood as Allegro s new CEO. Seven months later, Klaassen purported to: (1) remove by written consent (the June 2013 Consent ) defendants Hood and Simpkins from their Outside Director seats, and (2) fill the resulting vacancies with non-parties Stritzinger and Velidi. Klaassen also purported to fill the Common Director seat with non-party Brown. III. Analysis. In this action filed by Klaassen, the Court determined the validity of (1) the removal of Klaassen as CEO, and (2) the June 2013 Consent. As to the first issue, Klaassen argued that his removal as CEO was void because he did not receive advance notice that his removal would be considered at the November 2012 board meeting. The notice of the meeting undisputedly complied with the DGCL and Allegro s organizational documents. However, Klaassen argued that, despite technical compliance with Delaware law, his removal was void as an equitable matter because he also was a majority stockholder and could have preempted his removal as an officer by changing the board s composition prior to the meeting. While there were some prior Chancery Court rulings arguably supporting Klaassen s contentions as to the notice issue, the Court held that the equitable defenses of laches and acquiescence applied to bar Klaassen s claim. Klaassen failed to contest his ouster for seven months and took numerous actions that conceded the validity of his termination. Klaassen subsequently appealed this part of the decision and the Delaware Supreme Court confirmed the Chancery Court s decision. Klaassen v. Allegro, C.A. No. 58, 2013 (Del. Mar ). The parties disputed the validly of all actions taken by the June 2013 Consent. First, the parties disputed whether the Common Director seat was vacant and could be filled with Brown. Defendants argued that Klaassen ceased to be the CEO Director and became the Common Director when the board terminated him as CEO. Under this theory, Klaassen could not have filled the Common Director seat with Brown since Klaassen himself occupied the Common Director seat. According to the Court, only a self-executing charter provision may validly cut a director s term short when the director serving in a seat subject to a director qualification ceases to meet such qualification. Here, Klaassen occupied a seat subject to a director qualification set forth in a stockholders agreement. Accordingly, Klaassen continued to hold the seat even 5

6 though he no longer met the qualification. Since Klaassen held the CEO Director seat, not the Common Director seat, Klaassen validly filled the Common Director seat with Brown. Second, the parties disputed the validity of Klaassen s removal of the two Outside Directors under Allegro s bylaws and the Stockholders Agreement. Allegro s bylaws provided that stockholders could not remove directors without cause unless such removal complied with the Stockholders Agreement. Section 9.4 of the Stockholders Agreement prohibited the parties thereto from voting to remove the Outside Directors without cause unless: (1) such removal was directed or approved by the affirmative vote of the person or persons entitled to designate the director, or (2) the designation rights of the person originally entitled to designate the director had ceased. Section 9.2 of the Stockholders Agreement further provided that Allegro s CEO designated the two Outside Directors with the approval of the Series A Directors. In reviewing the parties claims, the Court began by noting that, under Section 141(k) of the DGCL, any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors with two exceptions not applicable here. Thus, the bylaw provision arguably conflicted with the DGCL by limiting the ability of the stockholders to remove directors without cause. To avoid the conflict, the Court read the bylaw as limiting only the rights of stockholders who are parties to the Stockholders Agreement to remove directors without complying with that agreement. The Court found that Klaassen s removal of Simpkins complied with clause (2) of Section 9.4 of the Stockholders Agreement because Klaassen designated Simpkins to the board as CEO and could remove Simpkins because Klaassen was no longer the CEO. Klaassen had also designated Hood as an Outside Director and could have removed Hood under the same rationale as Simpkins except that the Stockholders Agreement separately required Klaassen to use his voting power to elect Allegro s current CEO as a director. Because Hood was Allegro s current CEO, Klaassen could not vote to remove him as a director. Accordingly, Hood continued as a director notwithstanding the June 2013 Consent. Third, the parties disputed the effectiveness of Klaassen s attempt to fill the vacancy created by the removal of Simpkins. The Court first noted that Allegro s bylaws conflicted with Delaware law by providing that vacancies on the board could only be filled as provided for in the Stockholders Agreement. According to the Court, the bylaw provision could not prevent stockholders (other than the parties to the Stockholders Agreement) from exercising their common law right to fill board vacancies. However, Klaassen agreed to fill vacancies in the Outside Director seats with persons designated by the CEO and approved by the Series A Directors when he became a party to the Stockholders Agreement. Neither Hood nor the Series A Directors approved Simpkins replacement. Therefore, Klaassen failed to validly fill the vacancy created by Simpkins removal. 6

7 IV. Conclusion/Practice Point. Klaassen shows both the utility and the limitations of stockholders agreements as tools to circumvent Delaware law restrictions on permissible governance provisions for certificates of incorporations and bylaws of Delaware corporations. The case also shows how the certificate of incorporation may be used to address some of the limitations on the utility of stockholders agreements under Delaware law. V. Other. The Court also addressed whether the board of directors of a Delaware corporation is required to give a director of the corporation special notice that his or her removal as an officer of the corporation will be voted on at a regular board meeting under the theory that, with advance notice, the director could change the board s composition and avoid being removed as an officer. The Court held that the director was not entitled to special advance notice of a regular board meeting even if his removal as an officer would be considered at the board meeting. In contrast, the DGCL requires advance notice to directors of the purposes for which a special board meeting has been called. Thus, Klaassen provides a clear path forward for the removal of a director from an officer position at a regular board meeting without their prior knowledge. 3. IN RE NINE SYSTEMS CORP. STOCKHOLDERS LITIG. (EQUITY DILUTION CLAIMS AGAINST ALLEGED CONTROL GROUP OF PRIVATE EQUITY INVESTORS) By: Jay G. Cohen 3 I. Summary. In In Re Nine Systems Corp. Stockholders Litig., Consol. C.A. No VCN (Del. Ch. Feb. 28, 2013), the Delaware Court of Chancery considered plaintiffs claims that several private equity firms unfairly diluted them in connection with a recapitalization effected by Nine Systems Corporation ( NSC ) in 2002, four years prior to the 2006 acquisition of NSC by Akamai Technologies, Inc. (the Akamai Merger ). Unfair dilution claims typically are derivative. Accordingly, former stockholders of a company acquired in a cash-out merger lose standing to pursue dilution claims under the continuous ownership requirement for bringing derivative claims under Chancery Court Rule However, in this case, the Court considered whether plaintiffs could bring their claims of unfair dilution as direct claims for breach of fiduciary duty under the theory that the three private equity firms, which owned over a majority of NSC s outstanding voting power, acted in concert as a control group to expropriate value from NSC s 3 Jay G. Cohen, Esquire is a partner with Duane Morris LLP in Baltimore, Maryland. 7

8 minority stockholders. Ultimately, the Court concluded that the record supported a reasonable inference that the private equity firms acted as a control group and therefore denied defendants motion for summary judgment. The Court also found that certain plaintiffs did not have standing to pursue their claims because they were debt (not equity) holders at the time of the recapitalization. Finally, the Court found that it could not determine on the present motion whether the equitable doctrine of laches barred certain stockholders from pursuing their equity dilution claims. II. Background. The Plaintiffs are former stockholders of NSC. Some of the plaintiffs purchased NSC common stock in the spring of In 2001, other plaintiffs purchased NSC debt instruments, which were later converted into NSC common stock. Yet another group of plaintiffs purchased NSC debt instruments that were converted into Series A Preferred Stock of NSC in The plaintiffs contend that NSC s three largest shareholders defendants Wren Holdings, LLC ( Wren ), Javva Partners, LLC ( Javva ), and Catalyst Investors, L.P. ( Catalyst and, collectively, with Wren and Javva, the PE Firms ) conspired in 2002 to recapitalize NSC in a matter that unfairly diluted plaintiffs by increasing defendants ownership interest in NSC from approximately 54% to at least 85% (the Recapitalization ). Under the Recapitalization, NSC issued two new series of preferred stock: Series A Preferred Stock and Series B Preferred Stock. Holders of NSC s existing convertible secured debt were issued Series A Preferred Stock in exchange for their debt instruments. NSC also issued Series B Preferred Stock to Wren and Javva in exchange for cash, which NSC desperately needed. NSC asked certain plaintiffs to consent to the conversion of their debt into equity, and informed them that the Recapitalization would reduce their proportionate interests in the company, but failed to disclose that the PE Firms benefited from the dilution and that the PE Firms would be providing the new money. These convertible debt holders eventually consented to the Recapitalization and exchanged their notes and warrants for Series A Preferred Stock. Around the same time, the NSC board approved a one-for-twenty reverse stock split of the common stock. Immediately following the reverse stock split, defendants issued themselves additional shares of Series B Preferred Stock. The defendants approved the foregoing transactions by written consent of the board and stockholders through their control of the board and the stockholder vote. After consummation of all of the Recapitalization transactions in October 2002, defendants possessed a collective ownership interest in NSC of between 85% to 90%. Defendants alerted plaintiffs that the Recapitalization had been completed. Defendants subsequent communication with plaintiffs occurred four years later in connection with NSC s solicitation of their vote on the Akamai Merger. This communication engendered an unhappy 8

9 response from the minority stockholders, including plaintiffs, who finally understood from the solicitation materials the extent to which their holdings in NSC had been diluted by virtue of the Recapitalization. The Akamai Merger closed on December 13, In this action, the plaintiffs claimed that the PE Firms breached their fiduciary duties by unfairly diluting their equity and voting power. Defendants brought a motion for summary judgment on plaintiffs dilution claims. The major issues raised included the following: (1) whether the PE Firms acted as a control group under Gentile, such that plaintiffs had standing to pursue their dilution claims, (2) whether defendants even owed fiduciary duties to certain plaintiffs who held only convertible debt and warrants at the time of the approval of the Recapitalization, and (3) whether the equitable doctrine of laches barred some of the plaintiffs from pursuing their claims. III. Analysis. Control Group. The plaintiffs argued that the PE Firms constituted a control group through their collective ownership of more than 50 percent of NSC s equity and their ability to control a board majority. The Court noted that two or more minority stockholders may collectively constitute a control group if they are connected in some legally significant way, for example, by contract, common ownership, agreement, or some other arrangement to work together toward a shared goal. The Court further noted that proving the existence of a control group is not an easy task, made more complicated because of the fact-intensive nature of the inquiry. However, the Court stated that a plaintiff must only support a reasonable inference that a control group exists and that plaintiffs had met this burden. Specifically, the Court noted that the PE Firms together held a voting majority in NSC both at the stockholder and board level which the investors used to accomplish the Recapitalization. In addition, the record suggested that the PE Firms developed details of the Recapitalization in advance of NSC board meetings and excluded NSC s independent director (who had voiced some objections) from these discussions. Further, the Court noted that while Catalyst did not purchase shares in the Recapitalization and therefore did not gain from the diminution of the minority stockholders interests, the PE Firms collectively enjoyed a substantial increase in their holdings at the expense of the minority stockholders. Breach of Fiduciary Duties. Defendants argued that the Court should dismiss claims brought by plaintiffs who were not stockholders at the time the board approved the Recapitalization. Plaintiffs argued that defendants owed them fiduciary duties because they had an agreement to purchase shares of common stock by virtue of convertible debt instruments and/or warrants to purchase common stock. The Court rejected plaintiffs argument because claims for breach of fiduciary duties must be based on an actual, existing fiduciary relationship at the time of the alleged breach of fiduciary duty. 9

10 Laches. Finally, the Court considered, but denied defendants motion for summary judgment on the issue of whether one of the plaintiff s claims (as well as his affiliates claims) were barred under the equitable doctrine of laches because he had received some form of notice from the defendants about the dilution and had shared the information with his affiliates. Under the doctrine of laches, if the disclosure adequately put this plaintiff and his affiliates on notice of the dilution and the surrounding circumstances, then their claims were time-barred for failure to bring an action to recover losses within three years from the disclosure. Here, the Court could not determine on a motion for summary judgment whether the disclosures adequately put the stockholder on notice of the dilution and thus denied defendants motion. IV. Conclusion. In this decision, the Delaware Court of Chancery concluded that a control group comprised of private equity firms may be the functional equivalent of a controlling stockholder for the purpose of permitting plaintiffs to bring a direct claim for equity dilution. The Court found that plaintiffs had met their burden of creating an inference that a control group existed based on a minimal showing that the private equity firms that controlled the board may have acted in a similar manner without necessarily having committed themselves to acting in concert. This case suggests that private equity firms may want to take reasonable steps when serving on boards of portfolio companies to ensure that they are not creating the appearance of acting in concert with other firms invested in the company. V. Other. The Court reaffirmed established Delaware law that holders of a company s debt or warrants are not stockholders and are owed no fiduciary duties. A claim for breach of fiduciary duties must be based on an actual, existing fiduciary relationship between a plaintiff and defendant at the time of the alleged breach. 4. IN RE TRADOS INC. SHAREHOLDER LITIG. (FIDUCIARY CONSIDERATIONS IN THE ALLOCATION OF MERGER CONSIDERATION BETWEEN COMMON AND PREFERRED STOCKHOLDERS) By: Daniel R. Sieck 4 I. Summary. In the post-trial decision, In Re Trados Inc. Shareholder Litig., C.A. No VCL (Del. Ch. Aug. 16, 2013), the Delaware Court of Chancery found that the sale of Trados Incorporated ( Trados ) to SDL plc ( SDL ) through a cash-out merger was entirely fair to the Trados 4 Daniel R. Sieck, Esquire is associated with McLane in Woburn, Massachusetts. 10

11 common stockholders although the common stockholders received nothing, and all transaction consideration was paid to fund a management incentive plan ( MIP ) and to satisfy the preferred stockholders liquidation preference. Specifically, the Court determined that: (1) the entire fairness standard of review applied to this challenge to the directors decision-making process because a majority of the members of the board were conflicted with respect to the transaction; (2) the board did not satisfy the fair process prong of the entire fairness test because it failed to consider the interests of the common stockholders; and (3) the payment of zero merger consideration to the common stockholders satisfied the fair price prong of the entire fairness standard because the common stock had no economic value at the time of the merger. Because the entire fairness standard requires a unitary fairness determination, the Court could find the directors conduct entirely fair despite an unfair process. II. Background. Trados, a translation software company founded in 1984, had enjoyed more than a decade of growth before seeking venture capital ( VC ) financing in 2000 in anticipation of an IPO. Like many technology startups, Trados obtained multiple rounds of VC financing, issued several series of preferred stock, and had several VC designees sitting on its board of directors. By 2004 however, the company s revenues were in decline and, prior to the 2005 merger with SDL, Trados needed an injection of capital. With its VC investors unwilling to invest more cash in the business, Trados sought to improve its business prospects by hiring new management, including a new CEO and CFO, and obtaining venture debt. Although the company s revenues began improving under the new management team, its VC investors and their board designees, were dissatisfied with the company s prospects for growth and desired liquidity for their investments. In pursuit of that liquidity, the Trados board adopted the MIP in December 2004 to incentivize management to pursue a strategic exit. In July of 2005, Trados closed a cash-out merger with SDL in which Trados received $60 million in cash and stock. The first 13 percent of the merger consideration, or $7.8 million, went to senior management under the MIP. The holders of Trados preferred stock received the remaining $52.2 in partial satisfaction of their $57.9 million liquidation preference. The holders of common stock received nothing; although they would have received $2.1 million from the transaction if the MIP had not been in place. The plaintiff, a holder of Trados common stock, alleged that the Trados board pushed the SDL deal through at the expense of the common stockholders because the VC directors had given up on the long-term prospects of the company in favor of an immediate exit and liquidity for their funds. The plaintiff claimed that in doing so, the directors breached their fiduciary duties to the common stockholders. Specifically, the plaintiff argued that, in pursuing the SDL transaction, the defendant directors ignored Trados s improving revenues and did not consider whether continuing to operate the company for another year or more would have led to a return for the common stockholders. With respect to the standard of review, the plaintiff argued that 11

12 the transaction must be reviewed under the stringent entire fairness standard of review because a majority of the Trados directors were interested in the transaction or otherwise aligned with the preferred stockholders. III. Analysis. As a threshold question, the Court examined whether the Trados directors were interested in, or otherwise conflicted with respect to, the transaction. At the time of the transaction, the Trados board was comprised of (1) two members of the company s management, (2) three VC designees, who were also employed by their respective VC firms, and (3) two outside directors, who were not currently employed by the VC firms that designated them to the Trados board. The Court concluded that six of the seven directors were not disinterested and independent: (1) the management directors were conflicted because they stood to receive financial benefits from the sale of the company under the MIP that the other common stockholders would not share; (2) the VC designees were conflicted because they had competing fiduciary obligations to their firms; and (3) one of the outside directors was conflicted due to his lengthy business relationship with the VC firm that appointed him. In determining that the outside director was conflicted, the Court focused on the director s prior business relationship with the VC firm that appointed him to the Trados board, which involved investing with the firm. The director also served as an executive for some of the VC firm s other portfolio companies. The Court believed that these activities created a sense of owingness on the part of the outside director vis à vis the VC firm which appointed him to the Trados board. Having found that a majority of the directors were conflicted, the Court reviewed the transaction under Delaware s most stringent standard of review, the entire fairness standard. Under this standard, because the merger was not approved by a majority of the minority of disinterested stockholders or a committee of independent directors, the defendant directors had the burden to prove that the transaction was entirely fair. The Court was critical of the sales process under the first prong of the test. The Court found that the transaction was not a product of fair dealing because the Trados directors initiated the process to achieve an exit for the preferred stockholders, adopted the MIP to facilitate that exit, did not understand that their role was to maximize value for the common stockholders and failed to demonstrate that they had considered the interests of the common stockholders in arriving at their decision to sell. In reaching this conclusion, the Court highlighted the board s failure to apply procedural safeguards such as: (1) establishing a special committee comprised of independent directors to represent the interests of the common stockholders; (2) conditioning the merger on approval by the disinterested common stockholders; (3) obtaining a fairness opinion; or (4) funding the MIP out of the proceeds received by the preferred stockholders. Despite its findings of an unfair process, the Court concluded that the directors satisfied the entire fairness test because the price SDL paid for the common stock was fair, and a fair price was enough to overcome the procedural defects. In reaching this conclusion, the Court noted 12

13 that the two prongs of the entire fairness test are initially considered separately, but ultimately analyzed together in a unitary determination of fairness. The Court noted that for Trados to generate a return for the common stockholders, it would have needed to finance its operations with outside funding. However, there was no realistic path for Trados to obtain outside funds. In light of that determination, the Court concluded that Trados would not have been able to grow at a rate that would have yielded any value for the common stockholders. Accordingly, the plaintiff could not recover on his breach of fiduciary duty claims because no (i.e., zero) consideration amounted to a fair price for the common stock, which allowed the directors to satisfy the entire fairness test when both factors (fair price and fair dealing) were analyzed together as part of the unitary fairness determination. IV. Conclusion/Practice Point. While the defendant directors avoided liability in Trados, it took them nearly eight years to justify their actions through protracted litigation. VC-backed startup companies, which often operate in environments similar to those of Trados (i.e. directors designated by VC investors, questions of board independence, management incentives and transactions that divide the interests of preferred and common stockholders), should not take comfort in the fact that the Trados directors prevailed under the particular circumstances before the Court. Rather, to best avoid Trados-like scrutiny, VC firms and their board designees should recognize conflicts of interest lurking in a potential transaction and carefully address those conflicts by applying procedural safeguards that protect the common stockholders. While no single safeguard is per se required, when board members are conflicted by dual fiduciary obligations or other biases in favor of preferred stockholders, boards are advised to convene a special committee of directors independent from the preferred stockholders, require a fairness opinion from a first tier investment bank engaged by the special committee, require a vote of a majority of the stockholders unaffiliated with the holders of the preferred stock, or take other steps to objectively determine that the transaction consideration is consistent with the common stockholder s reasonable long-term value expectations. V. Other. Also of interest was the Court s differentiation between the fiduciary duties owed to common stockholders and those owed to preferred stockholders. The Court adopted the position advanced in earlier Delaware case law that the rights of preferred stockholders are contractual in nature, and a board does not owe fiduciary duties to preferred stockholders on the basis of those contractual rights. Preferred stockholders are only owed fiduciary protection when the right at issue is not a special contractual right, but instead a right shared with the common stockholders. The Court noted that when faced with a discretionary judgment, it will generally be the duty of the board to prefer the interests of the common stockholders, the ultimate beneficiaries of the firm s residual value, provided that the board can otherwise abide by the terms of its contractual 13

14 agreement with the preferred stockholders. This concept appeared here because the Trados preferred stockholders did not contract for a special right to force a sale of the company and without a contractual sale right, the interests of the preferred stockholders should have been subordinate to those of the common stockholders. The Court also implied that the inclusion of a drag-along provision or similar sale right may have alleviated this problem for the preferred stockholders and their board designees. 5. IN RE WAYPORT, INC. LITIG. (DISCLOSURE DUTIES IN THE CONTEXT OF AN INSIDER S DIRECT PURCHASE OF COMPANY STOCK) By: Amy L. Simmerman and Ryan J. Greecher 5 I. Summary. In the post-trial opinion in In re Wayport, Inc. Litig., 76 A.3d 296 (Del. Ch. 2013), the Delaware Court of Chancery held that the question whether an insider owes a fiduciary duty of disclosure in connection with private stock sales is decided under the special facts doctrine. Under the special facts doctrine, a director or other fiduciary has a fiduciary duty to disclose information in the context of a private stock sale [or purchase] only when a director is possessed of special knowledge of future plans or secret resources and deliberately misleads a stockholder who is ignorant of them. This decision arose from the sale of stock by a founder and former CEO of a venturebacked company to the company s preferred stockholders. The preferred stockholders had designees on the company s board and access to insider information. The founder alleged that the preferred stockholders breached a fiduciary duty of disclosure and committed common law fraud by failing to share insider information with him that was relevant to the value of his stock at the time of the stock sales in question. Although the Court found that disclosure was not required under the special facts doctrine in this case, the Court found one of the defendants liable for common law fraud. II. Background. Brett Stewart cofounded Wayport, Inc. ( Wayport ) and served as its CEO until In the late 1990s, Trellis Partners Opportunity Fund, L.P. ( Trellis ) and New Enterprise Associates ( NEA ) invested in Wayport preferred stock. The preferred stock designations and stockholders agreement granted Trellis and NEA the right to designate directors, the right to receive company financial information and rights of first refusal (a ROFR ) over Stewart s stock sales. Wayport also possessed a ROFR over stock sales by Stewart. After the technology 5 Amy L. Simmerman, Esquire is Of Counsel and Ryan J. Greecher, Esquire, is an Associate with Wilson Sonsini Goodrich & Rosati, P.C. in Wilmington, Delaware. 14

15 bubble burst, Wayport replaced Stewart as CEO, and Stewart ceased to play an active role in Wayport. In 2005, the new executive team began exploring corporate alternatives, including a sale or license of certain of Wayport s patents via a patent auction. Stewart had some early involvement in Wayport s patent review process because he was listed as an inventor of some of the patents. Around the same time, an outside party, Millennium Technology Value Partners, L.P. ( Millennium ), contacted Stewart and other cofounders of Wayport who would ultimately join Stewart as plaintiffs in the Wayport litigation about purchasing some of their stock in Wayport. Stewart and the other stockholders decided to sell some of their shares and ultimately presented the sale to Trellis, NEA and Wayport in light of their ROFRs. In March 2006, with a Wayport officer s assistance as intermediary, the plaintiffs sold over 500,000 shares to Millennium. Several months later, in December 2006, and shortly before Wayport commenced a patent auction; Stewart notified Wayport, Trellis and NEA that he and the same group of stockholders were interested in selling a second tranche of stock to Millennium. This time, Trellis, NEA and some of Wayport s directors decided to waive the ROFRs only if they could purchase some of plaintiffs shares while permitting some shares to be sold to Millennium. During the negotiations that followed, Stewart requested a representation that the buyers did not possess material information about the value of Wayport unavailable to him. Stewart did not know about the pending patent auction, but knew that Trellis and NEA had superior access to information about the value of Wayport by virtue of their board designees. A managing partner of Trellis (but not Trellis s designee on Wayport s board) responded to Stewart s concerns, by e- mail, on behalf of Trellis as follows: We are not aware of any bluebirds of happiness in the Wayport world right now and have graciously offered to [represent] that. But what happens if Google walks in in 30 days and says we d like to buy [Wayport]. [sic] The way the [representation] is worded, you would come to us and say foul you should have told me. Stewart responded by stating, [i]f you know of a Google deal in play, perhaps you ought to refrain from this transaction, or arrange for us to be on a level information playing field. At the time of the bluebirds , Wayport had actually received several bids for its patents. In late June 2007, Stewart and the other sellers closed the sale of the second tranche of stock to NEA and Trellis (with the directors who had initially expressed interest in purchasing shares choosing not to participate). The stock purchase agreement between Trellis and plaintiffs ultimately excluded any representations about information. About nine days later, Wayport closed on a $9.5 million patent sale to Cisco. The sale constituted a major achievement for Wayport, delivering cash representing 77% of its year-end operating income. 15

16 Shortly after the closing of the second stock sale and the patent sale to Cisco, Wayport served as intermediary in a sale of a third tranche of Stewart s stock to NEA and Trellis. Plaintiffs were not informed about the patent sale to Cisco during the negotiations for the sale of their stock. This third sale of stock closed in September Days after the third sale, Stewart requested Wayport s audited financials, which contained a brief reference to the patent sale. About a year later, AT&T acquired Wayport for $328 million in cash. Wayport stockholders received almost three times more for each share of Wayport stock in the merger than plaintiffs received from NEA and Trellis. Stewart and his co-plaintiffs then filed the instant litigation, asserting, among other things, claims of breach of fiduciary duty and fraud against Wayport, NEA, Trellis and certain members of Wayport s management and board. The plaintiffs contended that they would not have sold their shares to Trellis and NEA had they known about the patent sale because the patent sale revealed that their stock was potentially much more valuable than they understood at the time of the sale of the third tranche of stock. Rather, they would have remained stockholders of Wayport as of the merger date and received the more valuable merger consideration. III. Analysis. The Court held that Delaware law applies the special facts doctrine to evaluate disclosure claims in the context of direct purchases or sales of stock by corporate insiders (importantly, as distinguished from purchases or sales through public markets, where the doctrine would not apply). Under the special facts doctrine, an affirmative disclosure obligation only exists when a fiduciary both is possessed of special knowledge of future plans or secret resources and deliberately misleads a stockholder who is ignorant of them. The Court emphasized that the facts about which the fiduciary has special knowledge must relate to a substantial event or transaction to trigger disclosure obligations in this context. If the special facts doctrine applies, a fiduciary s failure to disclose material information is evaluated within the framework of common law fraud. The Court applied the special facts doctrine and determined that the patent sale to Cisco, while material, did not rise to the level of a special fact because it did not substantially affect[] the value of Wayport stock and did not necessarily imply anything about the market value of the remaining patents. Accordingly, even though NEA and Trellis possessed material information (the patent sale) when buying the third tranche of Stewart s stock, the Court entered judgment in defendants favor on the fiduciary duty claims. For the same reasons, judgment also was entered in favor of the officer of Wayport who facilitated the stock sales. The Court came to a different conclusion with respect to the plaintiffs fraud claim, which required the plaintiffs to prove (1) a false representation, (2) defendants knowledge or belief in the representation s falsity or reckless indifference to its truth, (3) defendants intent to 16

17 induce action, (4) plaintiffs reasonable reliance on the representation, and (5) causally related damages. According to the Court, once the Cisco sale occurred and Trellis learned of it, the no bluebirds representation became materially misleading, and Trellis had a duty to speak. Instead, Trellis remained silent. For purposes of fraud, the decision to remain silent placed Trellis in the same position as if Trellis knowingly made a false representation in the first instance. The Court also found that plaintiffs established the remaining elements of a fraud claim: (1) the no bluebirds statement was intended to induce Stewart to sell stock to Trellis without Stewart being suspicious of information asymmetries; (2) it was reasonable for Stewart to rely on the statement because a Trellis partner was a director; and (3) Stewart would not have sold to Trellis without the no bluebirds statement and, if he had learned of the patent sale, would not have sold in the third tranche for so low a price. Accordingly, the Court awarded damages calculated as the difference between the price at which plaintiffs shares were sold in the third tranche and the price the plaintiffs would have received for those shares in the AT&T merger if they had still owned them. IV. Conclusion. Wayport clarifies that Delaware applies the special facts doctrine to disclosure claims involving private sales of company stock between corporate insiders and stockholders. The case also provides a word of warning to venture capital and private equity firms who engage in private trades of stock of portfolio companies on whose boards one or more of their managers also serve as a director. The Court of Chancery seemingly imputed Trellis s designee s knowledge about the Cisco transaction to Trellis and treated Trellis as a constructive insider with concomitant fiduciary duties in a scenario where it was not clear that Trellis would otherwise be a fiduciary vis à vis plaintiffs. 6. GREAT HILL EQUITY PARTNERS IV, LP V. SIG GROWTH EQUITY FUND I, LLLP (SURVIVING CORPORATION TO A MERGER ACQUIRES ATTORNEY-CLIENT PRIVILEGE OF CONSTITUENT CORPORATIONS) By: Robert A. Friedel 6 I. Summary. In Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, 80 A.3d 155 (Del. Ch. 2013), the Delaware Court of Chancery addressed the question of whether the former stockholders and representatives of a target corporation retained the attorney-client privilege in respect of pre-merger communications with legal counsel following a reverse triangular merger, or, whether the privilege passed to the corporation surviving the merger as a wholly owned subsidiary of the buyer. The Court found that the attorney-client privilege of the constituent 6 Mr. Friedel, Esquire is a partner at Pepper Hamilton LLP in Philadelphia, PA. 17