This morning, Delaware Chancery Court Vice Chancellor Laster issued his highly anticipated, post-trial decision in In re Trados Incorporated Shareholder Litigation, C.A. No. 1512-VC (August 16, 2013), where the directors who either held preferred stock or were nominees of private equity firms that held preferred stock, sold the company for an amount that resulted in the common holders receiving zero proceeds. This case was a consolidated breach of the fiduciary duty of loyalty case and appraisal case. In the Court’s 114-page decision, it finds that, despite a flawed process, the Company’s directors satisfied the entire fairness standard because the company was worth less than the merger consideration obtained. The decision states that:
In light of this reality, the directors breached no duty to the common stock by agreeing to a Merger in which the common stock received nothing. The common stock had no economic value before the Merger, and the common stockholder received in the Merger the substantial equivalent in value of what they had before.
The Court also awarded the plaintiff nothing on their appraisal claim. Here is a copy of the opinion in case you are interested. Below is some background on the case and thoughts on best practices when conducting a sale process.
As quick background, in Trados, a former common stockholder of a company brought a class action for breach of fiduciary duty arising out of a sale of the company that triggered a multimillion dollar liquidation preference of preferred stockholders while giving nothing to the common stockholders. According to the plaintiff, the transaction was undertaken at the behest of certain preferred stockholders that desired a transaction that would trigger their large liquidation preference and allow them to exit their investment in Trados. In denying the defendants’ motion to dismiss, from the plaintiff’s contention that the company’s financial condition appeared to be improving, the Court found that it was “reasonable to infer that the common stockholders would have been able to receive some consideration for their Trados shares at some point in the future had the merger not occurred.” The Court further found that the former common stockholder made a plausible argument that the directors breached their fiduciary duties in approving the sale transaction because at least a majority of the directors had an ownership or employment relationship with an entity that owned Trados preferred stock and were thus incapable of exercising independent and disinterested business judgment. Accordingly, in 2009, the Court denied the defendants’ motion to dismiss. In doing do, the Court noted that, “in circumstances where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.” The Court made other broad statements that subsequently caused great angst like the following: “generally it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stock—as the good faith judgment of the board sees them to be—to the interests created by the special rights, preferences, etc., of preferred stock, where there is a conflict.” This earlier decision generated a great deal of attention, with some people worrying that directors will face personal liability if the common stockholders do not receive a substantive portion of the sale proceeds, even if it would come at the expense of the proceeds contractually owed to the preferred.
Best Practices at the Level of Process
Private equity and venture-backed company can sometimes find themselves in the difficult situation where the timing of the major investors’ need for liquidity (due to such investors’ investment time horizon) does not align with the company’s ability to obtain an optimal liquidity event (either in time or value). Trados does not signal a shift in the law but rather is a reminder to run a proper sale process. Directors designated by venture capital, private equity and other preferred stockholders should be on heightened alert and should consider taking certain additional precautions when considering a transaction where the common stockholders (or any other subsection of capital stock) would otherwise be entitled to none of the proceeds from a sale of a portfolio company because of the triggering liquidation preferences. Such precautions may include:
Run a proper sale process: It is important to pursue multiple sale avenues, to thoroughly evaluate the risks and consider alternatives, and most importantly, to document the process. One of the alternatives to consider is the option not to sell the company at that point in time.
Create an independent special committee of the board: For a transaction that is not a distressed or forced sale, it may be advisable for the board to create a special committee comprised of independent directors to evaluate (i) generally, whether a sale of the company is in the best interests of the company’s stockholders, (ii) the timing of such a sale, and (iii) how the proceeds from a sale of the company should be allocated among the various constituencies.
Obtain a fairness opinion or third party valuation: In order to support a board’s exercise of its duty of care, the board or special committee should consider obtaining an independent opinion on the fairness of the consideration received by the stockholders in the transaction. This can come from an official fairness opinion or from a third party valuation, which could simply be another offer.
If the board runs a proper sale process and documents it, then the board is under no obligation to allocate the proceeds from the transaction to the commons unless there is something left over after the preferred stockholders’ liquidation preference has been satisfied.