In this Opinion, the Court of Chancery denied, in large part, defendants’ motion to dismiss plaintiffs’ claims challenging several allegedly self-interested and dilutive transactions.
Plaintiffs, Joseph A. Carsanaro, the founder of Bloodhound Technologies, Inc. (“Bloodhound” or the “Company”), and the four original employees he brought on to help build the Company, formed Bloodhound in 1997 to create web-based software applications allowing healthcare providers to monitor claims for fraud. In 1999 and early 2000, the Company conducted two rounds of venture capital financing in which defendants North Carolina Bioscience Fund, LLC (“NC Bioscience”) and Wakefield Group III LLC (the “Wakefield Fund”) purchased Series A and Series B Preferred Stock of the Company.
According to plaintiffs, after the two rounds of financing, NC Bioscience and the Wakefield Fund maneuvered to oust Carsonaro as CEO, President and Chairman, and to gain control of the board. First, they convinced the board that replacing Carsonaro with a new CEO with additional Healthcare domain experience would make the Company more marketable to potential acquirors. A new CEO was hired and was later given a seat on the board. Then, in an apparent attempt to attract a like-minded venture capitalist, the investors convinced the board that Bloodhound should raise one last round of financing in the form of a new Series C convertible preferred stock. Carsonaro assisted in negotiations with the venture capital firm of defendant Allen S. Moseley and the two eventually agreed on terms. However, in December 2000, before the negotiations were final, Carsanaro was asked to resign as a director, officer and employee of the Company. Plaintiff Samir Abed, one of the original employees, upset by the forced resignation of Carsonaro, was also asked to resign from the board. The directors approved the Series C financing, but on terms different from those negotiated when Carsanaro was involved in the discussions. Under the new terms, in addition to the Moseley-affiliated entities (the “Moseley Funds”), the Wakefield Fund and NC Bioscience also participated. To the extent the Wakefield Fund and NC Bioscience were able to maintain their equity stake by participating, the dilution from the down round was suffered principally by the common stock.
The directors thereafter approved a sale of a new Series D Preferred Stock. Members of the board or their affiliated funds purchased the overwhelming majority of the Series D Preferred. They did not contact outside investors or determine whether more favorable terms were available to the Company.
In July 2002, the directors proceeded with yet another round of financing. Again, rather than contacting third parties or canvassing the market, the directors negotiated with themselves. The Moseley Funds proposed to purchase up to 30,000,000 shares of the Series E Preferred Stock. To keep the conversion rights of the Series E Preferred equivalent, the Bloodhound directors approved a 10-for-1 reverse split (the “Reverse Split”) of the Company’s outstanding common stock and filed an amended and restated charter authorizing the Series E Preferred (the “Series E Charter”). Although Bloodhound did file the certificate of amendment effecting the Reverse Split, the Series E Charter did not adjust the conversion prices of the Series A, B or C Preferred to account for the Reverse Split. The Series E Charter therefore made the conversion rights for those shares ten times more valuable. Bloodhound entered into separate agreements with the holders of Series D and Series E Preferred to protect them from the dilution. According to plaintiffs, the dilution from the failure to adjust the conversion prices fell squarely on the common stock.
On April 27, 2011 Bloodhound was acquired by Verisk Health Inc. for $82.5 million in total consideration. The Bloodhound board contemporaneously approved a management incentive plan (the “MIP”) that granted management awards totaling $15 million, which represented 18.87% of the merger consideration. Plaintiffs claim that when learning of the Merger, they were shocked to discover, for the first time, that as a result of the several rounds of financing and the failure to adjust the preferred stock conversion prices in connection with the Reverse Split, the aggregate ownership interest of all common stockholders had been diluted to 2.18% and that plaintiffs collectively held less than 1%. They then filed this suit challenging the dilutive transactions, the allocation of $15 million in merger proceeds to management, and the fairness of the merger.
The Court first addressed the personal jurisdiction argument asserted on behalf of certain of the Moseley Funds and the Wakefield Fund. Those defendants argued that they were not Delaware entities and did not have operations in Delaware, and therefore that the Court lacked in personam jurisdiction over them. The Court explained that determining whether it can exercise personal jurisdiction over non-resident defendants involves a two-step inquiry: 1) whether Delaware’s long-arm statute, 10 Del. C. § 3104(c), is applicable, and, if so, 2) whether subjecting the nonresident defendants to the Court’s jurisdiction would violate due process. Subsection (1) of the long-arm statute provides that the Court may exercise personal jurisdiction over a defendant who transacts business in the state. The Court explained that, under the statute, a single transaction will be sufficient to confer jurisdiction where a plaintiff’s claim is based on that particular transaction. The Court stated that making a corporate filing with the Secretary of State constitutes a transaction of business within Delaware for purposes of Section 3104(c)(1). The Court held that because each of the challenged transactions required defendants to submit one or more corporate filings with the Secretary of State, the first requirement of an act within Delaware was satisfied.
As for the second prong, the Court held that the complaint satisfied due process on the legal principle that one conspirator’s acts are attributable to the other conspirators. If the purposeful act or acts of one conspirator are of a nature and quality that would subject the actor to the jurisdiction of the court, all of the conspirators are subject to the jurisdiction of the court. The Complaint alleged that the funds participated in the conspiracy to secure the vast bulk of Bloodhound’s value, and are deemed to have known of both the conspiracy and the filings in Delaware because the knowledge of their board representatives is imputed to them. Therefore, the Court determined it could exercise personal jurisdiction.
The Court then addressed plaintiffs’ claims. First, with regard to plaintiffs’ claim that the directors of Bloodhound breached their fiduciary duty in approving the Series D Financing, the Court found that plaintiffs overcame the business judgment rule’s presumption of loyalty by alleging facts supporting a reasonable inference that there were not enough independent and disinterested individuals among the directors making the decision to comprise a board majority. Because of the directors’ dual statuses as fiduciaries for both Bloodhound as well as the entities purchasing the Series D Preferred, the directors could not be deemed independent with respect to the Series D Financing. The Court reached the same conclusion with respect to plaintiffs’ claim challenging the fairness of the Series E Financing.
Plaintiffs also claimed that the adoption of the Reverse Split and the Series E Charter violated Section 242 of the Delaware General Corporation Law (the “DGCL”). Under Section 242(b)(1), a corporation with capital stock can amend its charter through a process in which the board first approves and recommends the amendments to stockholders, then obtains the approval of the stockholders. Section 242(b)(1) also provides that a certificate setting forth the amendment and certifying that such amendment has been duly adopted only becomes effective when it is filed with the Secretary of State. The amendment that Bloodhound filed with the Secretary of State differed from what was approved by the board and stockholders in that the filed amendment did not adjust the conversion prices of the Series A, B or C Preferred. The Court explained that the amendment filed with the state must be identical to that approved by the board and stockholders. Because it was not, the Court found that plaintiffs asserted a claim that Bloodhound did not comply with the statutory requirement.
The complaint also alleged a statutory violation on the theory that the Reverse Split was not actually approved by a majority of the common stockholders. Defendants purported to act by written consent under Section 228 of the DGCL and argued that the written consent of plaintiff Abed provided the necessary votes to conduct the Reverse Split. However, plaintiffs argued that the form of consent provided to Abed did not set forth the actions to be taken by the board, as is required under Section 228. Although the form of consent incorporated by reference the Series E Charter and the certificate of amendment for the Reverse Split, neither was attached or otherwise provided to Abed. The Court explained that, because Section 228 permits immediate action by the board, without prior notice to minority stockholders, the statute involves great potential for mischief and its requirements must be strictly complied with if any semblance of corporate order is to be maintained. It held that plaintiffs therefore stated a claim that the Reverse Split violated Section 228.
Defendants argued that plaintiffs’ request for declarations that the Reverse Split and Series E Charter were null and void could not be maintained in light of Section 124 of the DGCL which limits the categories of individuals who may challenge a corporate act as ultra vires. The Court explained that, viewed in its historical and statutory context, Section 124 solely addresses disputes over a corporation’s capacity or power to act, and does not address disputes over whether corporate actors properly authorized the corporation to exercise its capacity or power.
The Court also found that the complaint stated a claim against the Bloodhound directors for breach of fiduciary duty in approving the Merger and the MIP. The Court noted that the complaint did not suggest why defendants would have had a reason to sell Bloodhound if the Merger were not the optimal wealth-maximizing strategy. Therefore, based on the facts pled, it seemed likely to the Court that the total consideration obtained in the Merger would not be subject to legitimate challenge, and that the case would instead turn on (i) whether it was fair to allocate 18.87% of the consideration to management through the MIP and (ii) whether any of the preferred stock was wrongfully issued or wrongfully granted additional conversion rights, such that amounts paid to the holders of those shares otherwise would have been available to holders of common stock.
The defendants sought dismissal of plaintiffs’ claims relating to the Merger on the theory that the preferred stockholders could have acted together to take 100% of the value of the Company by exercising their redemption rights. According to defendants, the preferred investors had a contractual right under the certificate of incorporation to force the Company to redeem their preferred shares at any time after the fifth anniversary of the issuance of the Series E preferred stock, a date that had passed more than three years before the Merger. The defendants therefore argued that they could not be held liable in connection with the Merger, in which the common stockholders received at least something, because defendants had a contractual right to take the entirety of the consideration offered in the transaction. The Court rejected this argument, stating that a redemption right does not give the holder the absolute, unfettered ability to force the corporation to redeem shares under any circumstances. Section 160 of the DGCL places restrictions on the ability of a Delaware corporation to redeem its shares. The Court noted Section 160(a)(1), which provides that 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.
Finally, the Court addressed plaintiffs’ standing to assert a direct, as opposed to a derivative, challenge to the Series D and E Financings and the MIP. With respect to the Series D and E Financings, the Court noted that in some instances a dilutive stock issuance can have the dual aspect of injuring both the corporation and the stockholders and, in such instances, a plaintiff may choose to sue individually. The Court concluded that plaintiffs had standing to assert the claims directly “because each financing challenged in the complaint was a self-interested transaction implicating the duty of loyalty and raising an inference of expropriation.”
Finally, the Court similarly noted that a claim alleging diversion of merger consideration may be either direct or derivative, and determined that plaintiffs’ challenge to the MIP, which asserted that plaintiffs were deprived of a material portion of the merger consideration, stated an individual right to sue.
The full opinion is available here.