By the Annual Survey Working Group of the Jurisprudence Subcommittee, Private Equity and Venture Capital Committee, ABA Business Law Section*
The Annual Survey Working Group reports annually on the decisions that we believe are the most significant to private equity and venture capital practitioners.1 The decisions selected for this year’s Annual Survey are the following:
In Reith v. Lichtenstein,2 the Delaware Court of Chancery refused to dismiss plaintiff ’s breach of fiduciary duty claims, finding it reasonably conceivable that a 35.62 percent stockholder was a controller that owed fiduciary duties to the corporation’s other stockholders based on the size of the controller’s equity ownership, its board representation, its management services agreement with the company, and its affiliation with senior company executives. Based on this finding, the court concluded that the entire fairness standard of review applied to its review of a preferred stock financing between the company and the controller and the issuance of equity grants to controller-affiliated board members. The court also refused to dismiss certain breach of fiduciary duty claims against the independent directors of the board for their knowing approval of equity issuances in violation of the terms of the company’s existing equity incentive plan, and it held that plaintiff adequately pled disclosure claims for misstatements and omissions in the proxy statement disclosing the proposed amendments to the equity incentive plan.
Steel Partners Holdings, L.P. (“Steel Holdings”) became a stockholder of Steel Connect, Inc. (“Steel Connect”) in 2011 and owned 14.9 percent of Steel Connect’s stock by September 28, 2012.3 Steel Holdings and Steel Connect subsequently entered into an agreement, whereby Steel Holdings acquired the right to nominate two designees for election to Steel Connect’s board and the right to purchase additional equity in Steel Connect.4 By December 14, 2016, Steel Holdings owned 35.62 percent of Steel Connect’s stock.5 Over this time period, affiliates of Steel Holdings also entered into a management services agreement with Steel Connect, and certain individuals affiliated with Steel Holdings became senior executives of Steel Connect.6
In 2017, Steel Connect considered strategic transactions to utilize Steel Connect’s net operating loss carryforwards (“NOLs”) and determined to acquire IWCO, a third-party company, which would permit it to utilize the NOLs.7 Steel Connect’s board, in considering sources of financing for the acquisition, appointed a special committee of independent directors (the “Special Committee”) to consider obtaining financing from Steel Holdings.8 The Special Committee retained legal and financial advisors and considered “a proposed $35 million capital raise through the issuance of convertible preferred stock” to Steel Holdings.9 On December 15, 2017, Steel Connect’s board approved (i) the acquisition of IWCO and the preferred stock financing with Steel Holdings (which had been previously approved by the Special Committee), (ii) the appointment of two new directors affiliated with Steel Holdings, and (iii) the issuance of equity grants to the two new directors and the current chairman.10 The equity issuances were granted to the two new directors for their “current and future services to Steel Connect,” which included their service as the “de facto investment bankers” in connection with Steel Connect’s acquisition of IWCO.11 The equity issuances, in conjunction with the convertible preferred stock issued to Steel Holdings, raised Steel Holdings’ total equity ownership of Steel Connect to 52.3 percent.12
The equity issuances required Steel Connect to seek stockholder approval of an amendment to Steel Connect’s Incentive Award Plan adopted in 2010 (the “2010 Plan”).13 The proxy statement issued to the stockholders contained affirmative misrepresentations and omissions regarding the 2010 Plan and failed to describe why the amendments were necessary.14 Plaintiff challenged the preferred stock and equity issuances to affiliates of Steel Holdings as pretextual because those transactions allowed Steel Holdings to acquire majority voting control of Steel Connect for “inadequate consideration.”15 Plaintiff further alleged that the defendant directors breached their fiduciary duty of disclosure in connection with the proxy solicitation for stockholder approval of the amendments to the 2010 Plan.16
The court first considered whether Steel Holdings was a controlling stockholder.17 Under Kahn v. Lynch Communication Systems, Inc.,18 the court noted that Steel Holdings, as a holder of less than 50 percent of the voting stock of Steel Connect before the transaction, could only be considered a controller to the extent it exhibited “actual control” over Steel Connect.19 The court, following the Delaware Supreme Court’s guidance in Olenik v. Lodzinksi,20 evaluated Steel Holdings’ status as a controller at the time “when substantive economic negotiations took place that fixed the field of play for the eventual transaction price,” which the court determined was at the formation of the Special Committee rather than the board’s approval of the transaction.21 In conducting its evaluation of actual control, the court focused on Steel Holdings’ substantial ownership of Steel Connect’s equity and its influence over Steel Connect’s board and management, and found that it was reasonably conceivable that Steel Holdings was a controller.22 The court further explained that, even conducting the analysis at the later date put forth by the defendants, it was reasonably conceivable that Steel Holdings was a controller because its affiliated members played an influential role in arranging and approving the IWCO transaction, and a majority of the board would not have been disinterested and independent with respect to the IWCO acquisition.23
Having found that it was reasonably conceivable that Steel Holdings was a controller, the court next considered whether plaintiff ’s claims were direct or derivative under Tooley v. Donaldson, Lufkin & Jenrette, Inc.,24 and whether the “dual” direct and derivative exception from Gentile v. Rossette25 applied.26 Noting that corporate overpayment claims are normally “exclusively” derivative, the court further held that the Gentile exception did not apply, relying on the court’s prior decision in Klein v. H.I.G Capital, L.L.C.,27 which held that minority dilution through the issuance of a different kind of equity was not the type of harm contemplated by Gentile because the common stockholders retained the same percentage of common stock as they did before the transaction.28 With respect to the equity issuances, the court noted that the issuances failed to satisfy the Gentile test because there was no “exchange” of shares for assets, as the grants were for “current and future services to the Company.”29 Thus, all of plaintiff ’s claims were derivative, and the court dismissed plaintiff ’s direct claims.30
Because the claims were all derivative, the court then analyzed whether demand had been excused under Aronson v. Lewis31 for the preferred stock and equity issuances.32 The court noted that the defendant conceded that three of the directors were not disinterested and independent given their ties to Steel Holdings, and the court dismissed the conclusory challenges by plaintiff regarding the independence and disinterestedness of the Special Committee members.33 In analyzing the independence and disinterestedness of the seventh board member, the court held that such director was not disinterested and independent, relying on (i) the longstanding ties of the director to Steel Holdings, (ii) disclosures by Steel Connect that such director was “affiliated with Steel Holdings” and may face conflicts of interests, (iii) that such director was not independent under NASDAQ rules, and (iv) that the director’s “principal occupation” was working for an entity affiliated with Steel Holdings.34 Thus, the court found that demand was excused for the derivative breach of fiduciary claims pertaining to the preferred stock and equity issuances.35 In addition, with respect to demand excusal for the equity issuances, the court explained that pleading a knowing violation of a stock incentive plan would be enough, on its own, to excuse demand for such claim under Aronson.36
The court then considered whether plaintiff had adequately pled non-exculpated claims against the Special Committee members under section 102(b)(7) of the General Corporation Law of the State of Delaware,37 which exculpates directors for monetary damages for breaches of the fiduciary duty of care, but not the duty of loyalty.38 The court dismissed the claims against the Special Committee members for their role in approving the preferred stock issuance, noting that such members were independent and did not receive a unique benefit from the transaction, there were no allegations of bad faith, and there were no facts to sustain a claim for waste.39 However, the court refused to dismiss the breach of fiduciary duty claims against the Special Committee members for their role in approving the equity issuances, noting that the knowing approval of equity issuances in violation of the unambiguous terms of the 2010 Plan could constitute a breach of the duty of loyalty.40
Following the above determinations, the court then evaluated the plaintiff ’s derivative claims under Court of Chancery Rule 12(b)(6).41 The court first determined that plaintiff had adequately pled the existence of a controlling stockholder who stood on both sides of the transaction and received a non-ratable benefit. The court then determined that the conversion price for the preferred stock could have been “set too low particularly in light of the expected price bump” from the IWCO transaction, that the non-Special Committee defendants had breached their fiduciary duties in connection with such issuance, and that the entire fairness standard of review should govern the claim.42 Using the same reasoning, the court found that plaintiff adequately pled that all members of Steel Connect’s board breached their fiduciary duties in connection with the equity issuances and that the entire fairness standard of review also applied to that claim.43 The court further determined that plaintiff ’s unjust enrichment claims had been adequately pled, but dismissed the claims as they pertained to some defendants as inapplicable.44 The court also held that the plaintiff had adequately pled the existence of a disclosure violation by Steel Connect’s board for the failure to disclose all of the material information related to the amendments to the 2010 Plan and for affirmative misrepresentations regarding the existing equity issuance limits set forth in the 2010 Plan.45
Reith confirms that the Delaware courts will stringently review a “stealth” transfer of majority voting control, especially when such transfer of control goes to a substantial minority equity owner of a corporation that also exerts significant influence over the corporation’s board and management. In this case, the board of directors correctly formed a special committee of independent directors to address the conflicts raised by the source of financing for the transaction, but it was unclear what role the special committee’s advisors played in its evaluation of the transaction. This decision also serves as a cautionary tale for a board of directors in considering potential actions involving a corporation’s equity incentive plan, as demand will be excused when a plaintiff can demonstrate that the board of directors “knowingly” violated the terms of the incentive plan in approving the equity issuances. The decision further highlights that a board of directors should be aware of past disclosures in connection with a corporation’s equity incentive plan and ensure that any disclosures or amendments to the incentive plan comport with, or make affirmative correction to, prior statements.
In Obasi Investment Ltd. v. Tibet Pharmaceuticals, Inc.,46 the Third Circuit ruled that non-voting board observers were not persons performing similar functions as directors and thus were not proper defendants in a claim under section 11 of the Securities Act of 1933, as amended (the “Securities Act”).
In 2010, Tibet Pharmaceuticals, Inc. (“Tibet”) initiated a public offering in order to raise capital for its operations.47 Tibet granted its placement agent for the offering the right to name two non-voting board observers to Tibet’s board of directors.48 These observers served for a finite period of time based on the success of the public offering.49 The registration statement identified the board observers and noted that while they did not have voting rights, they may “significantly influence the outcome of matters submitted to the Board of Directors for approval.”50
Following the closing of the public offering, the plaintiffs sued Tibet, the placement agent, and several other defendants, including the two board observers, for violations of section 11 of the Securities Act, among other claims.51 Section 11 of the Securities Act imposes liability for misstatements and omissions in registration statements on “‘every person who, with his consent, is named in the registration statement as being or about to become a director, person performing similar functions, or partner.’”52
Although the district court noted that the observers did not have voting rights, because of the influence that the observers could have on the board of directors, the court determined that a jury was best suited to decide whether the board observers performed similar functions as directors.53 An interlocutory appeal to the U.S. Court of Appeals for the Third Circuit followed.54
Given the strict liability nature of liability under section 11 of the Securities Act, the Third Circuit observed that section 11 was purposely drafted to apply to a narrow set of potential defendants.55 The court concluded that reference to “directors” in section 11 referred to the technical position of a director as someone who had the “formal power to direct and manage a corporation.”56
Based on the registration statement, the Third Circuit found that the board observers did not perform similar functions to directors. In particular, the court noted that, unlike directors, the observers could not vote, were not necessarily aligned with the interests of the stockholders, and were not subject to removal or replacement by the stockholders.57 The court concluded that the ability for a person to exercise influence on the board did not make a person a “quasi-director.”58
The dissent concurred with the majority on the fact that section 11 liability should be construed narrowly and should be based only on the registration statement, but argued that the question of whether observers performed functions similar to directors was a question of fact for a jury.59 Additionally, the dissent concluded that several factors—the potential for substantial influence on the directors, the compensation paid similar to directors, and the access to information given to directors—weighed in favor of finding that the observers had similar functions to directors.60
For private equity, venture capital, and other firms that are accustomed to appointing board observers, the Third Circuit’s opinion is welcome news. Although the opinion applies narrowly to the question of liability under section 11 of the Securities Act, it is easy to extrapolate arguments from this opinion as to why board observers should not be held to the same fiduciary and other standards as directors in other contexts.
In Palisades Growth Capital II, L.P. v. Bäcker,61 the Delaware Court of Chancery held that actions taken at a board meeting were invalid as a matter of equity because a director used trickery and deceit to convene a board meeting and to secure the presence of other board members at the meeting, with the goal of reinstating himself as CEO and seizing control of the board.
Under the certificate of incorporation of QLess, Inc. (the “QLess Charter”), Alex Bäcker (“Bäcker”), cofounder and former CEO of QLess, Inc. (“QLess”), controlled two common director seats on the QLess board of directors (the “Board”) through his ownership of a majority of QLess’s common stock.62 Palisades Growth Capital II, L.P. (“Palisades”), as majority owner of QLess’s Series A Preferred Stock, and Altos Hybrid 2 L.P. (“Altos”), as majority owner of QLess’s Series A-1 Preferred Stock, were each entitled to elect one director to the Board.63 Bäcker and the investors made further provisions for appointing directors pursuant to a voting agreement, whereby the parties agreed to appoint one jointly designated independent director to the fifth director seat. If Bäcker were terminated as CEO, the voting agreement further required the parties to create a new CEO director seat to be filled with Bäcker’s replacement.64
The Board removed Bäcker as QLess’s CEO in June 2019.65 The Board hired Kevin Grauman (“Grauman”) as the new CEO.66 At the time of Bäcker’s removal, all five Board seats were filled.67 Bäcker and his father served as the two common directors, Jeff Anderson (“Anderson”) served as the Series A director, and Hodong Nam (“Nam”) served as the Series A-1 director. Ivan Markman occupied the independent director seat.68 Nam subsequently resigned from the Series A-1 director seat, and Altos determined to fill the vacancy with Paul D’Addario (“D’Addario”).69 Even though the QLess Charter granted the Series A-1 preferred stockholders the exclusive right to fill a vacancy in the Series A-1 director seat, QLess counsel erroneously advised Altos that the Board was required to fill the vacancy.70 Relying on this misinformation, Altos took no further action to elect D’Addario.71
At Bäcker’s request, the Board arranged for a telephonic meeting to be held in order to formally appoint D’Addario and Grauman to the Board.72 Leading up to the Board meeting, the anticipated meeting participants exchanged various correspondence regarding the meeting agenda and proposed resolutions for the Board’s consideration, each contemplating that the Board would confirm Grauman’s position as the CEO director.73 Bäcker did not object to this agenda item and, at various times, affirmatively suggested he was supportive of Bäcker’s role as the CEO director. Markman unexpectedly resigned from the independent director seat the day before the Board meeting, creating a second vacancy on the five-person Board.74
Believing he held a 2-1 majority, Bäcker schemed to take control of QLess.75 At the meeting, Bäcker demanded that Grauman and D’Addario disconnect from the meeting.76 Grauman left the meeting, but D’Addario refused. Over the objections of D’Addario and Anderson, Bäcker and his father passed Board resolutions purporting to, among other things, terminate Grauman’s appointment as CEO, reappoint Bäcker as CEO, appoint Bäcker to the CEO director seat and fill the second common director seat with a person of Bcker’s choosing, and amend the QLess bylaws to require a quorum of three directors when the Board is six members.77
Palisades filed suit in the Delaware Court of Chancery to void the actions taken at the Board meeting, arguing in principal that D’Addario was validly elected to the Board prior to the Board meeting, and, even if he was not, equity required that the court void the actions taken by Bäcker at the Board meeting.78
The court began its analysis by considering whether an email from Altos to QLess’s general counsel, in which Altos requested that counsel prepare a stockholder consent for Altos to elect D’Addario to the Board, caused D’Addario to be validly elected to the Board.79 The court held that the email constituted neither a vote nor a written consent of the Series A-1 preferred stockholders to elect D’Addario.80 The court reasoned that the General Corporation Law of the State of Delaware (the “DGCL”) is clear that stockholders vote at meetings and that an email requesting another to facilitate a stockholder consent is not a stockholder “vote” under Delaware law.81 The court also observed that to hold that an email by the holders of a majority of the Series A-1 preferred stock constituted a “vote” of the entire Series A-1 preferred stock would disregard the minority Series A-1 preferred stockholders’ right to exercise their franchise.82 The court further concluded that the email was not a written consent because a mere expression of intent, without executory language, did not “set forth the action so taken” as required by section 228 of the DGCL.83
However, the court invalidated all of the actions taken at the contested Board meeting on equitable grounds. The court stated that “[i]t is bedrock doctrine that this court will not sanction inequitable action by corporate fiduciaries simply because the act is legally authorized.”84 While Bäcker did not interfere with Altos’ right to elect the Series A-1 director, he deceived his fellow directors into attending the Board meeting by affirmatively misrepresenting that he wanted Grauman on the Board and that he assumed Grauman had already joined the Board.85 The court found that making these affirmative misrepresentations, while remaining silent as Bäcker and his father planned their ambush, was inequitable.86 If Anderson had known Bäcker’s true intent, he would have refused to participate in the Board meeting, defeating a quorum. Given that Anderson’s presence was secured under deliberately false pretenses, the court voided all actions taken at the Board meeting as a matter of equity.87
The decision in Palisades serves as a cautionary reminder for directors of Delaware corporations that legally authorized actions may be subject to equitable intervention if the actions involve affirmative deception of fellow directors. The court’s decision also stresses the importance of understanding the mechanics by which board vacancies may be filled under the corporation’s governance documents and the formalities required for doing so under the DGCL.
In In re Altor Bioscience Corp.,88 the Delaware Court of Chancery held that letter agreements signed by former directors of Altor Bioscience Corp. (“Altor”), a venture-backed company, prohibiting the directors from bringing “any action” against Altor for a period of five years, operated as waiver of the directors’ right to bring breach of fiduciary duty claims, but not as a waiver of statutory appraisal claims in connection with the subsequent acquisition of Altor.89 The court reasoned that a waiver of a statutory right must be express, and the letter agreements did not expressly address appraisal rights.90 With respect to fiduciary duty claims, the court noted that a broad release or covenant not to sue for future misconduct may violate public policy if the release eliminates an entire class of plaintiffs, but the letter agreements did not preclude all stockholders from bringing breach of fiduciary duty claims and therefore did not violate public policy.91
Altor was an early stage life sciences company controlled by Patrick Soon-Shiong.92 Prior to the events giving rise to this action, two of Altor’s directors resigned and entered into letter agreements with Altor to resolve longstanding disputes between two factions of Altor’s board.93 Subsequently, Altor agreed to be acquired by another entity controlled by Patrick Soon-Shiong in exchange for a combination of cash and equity.94 Prior to the consummation of the transaction, plaintiffs brought this action, alleging that Altor’s board of directors and Patrick Soon-Shiong breached their fiduciary duties of loyalty and disclosure in connection with the acquisition.95 Plaintiffs unsuccessfully sought to enjoin the transaction on disclosure grounds and thereafter asserted appraisal and quasiappraisal claims.96
Defendants sought disposition of the action, as it related to two plaintiffs who were former directors of Altor, on the basis that they signed letter agreements which barred the proceedings.97 Under section 3 of the letter agreements, these plaintiffs agreed not to “file, charge, claim, sue, or cause or permit to be filed or charged any action or claim for damages or other relief against any of the Company Releasees for any matter arising from the creation of the earth through the Closing Date.”98 Further, under section 7 of the letter agreements, the plaintiffs also agreed that for five years, they would not “directly or indirectly commence, prosecute or cause to be commenced or prosecuted against any Company Releasee any action or other proceeding of any nature before any court, tribunal, Governmental Authority or other body, except for the Company’s breach of this letter agreement.”99 The plaintiffs argued, among other things, that the letter agreements (1) violated public policy by immunizing the defendants from liability for future unknown wrongs, and (2) did not clearly waive the plaintiffs’ appraisal rights.100
In resolving the parties’ contentions, the court distinguished two types of claims: (i) breach of fiduciary duty claims and (ii) statutory appraisal claims.101 With respect to the breach of fiduciary duty claims, the plaintiffs alleged that the letter agreements were, among other things, against public policy because they released the defendants from claims of future misconduct and licensed the defendants to engage in tortious conduct without fear of liability.102 The court noted that there is no per se rule prohibiting releases of future claims and that the letter agreements did not bar all stockholders from bringing future claims for breach of fiduciary duty.103 The court also noted that section 7 of the letter agreements was a covenant not to sue, not a release, and the letter agreements were supported by valid consideration.104 Accordingly, the court held that the letter agreements barred plaintiffs from bringing breach of fiduciary duty claims.105
With respect to the appraisal claims, the court held that the letter agreements did not bar the plaintiffs from seeking appraisal because a waiver of a statutory right must be clearly and affirmatively expressed, and the letter agreements did not specifically address appraisal rights.106 Accordingly, the court held that plaintiffs’ statutory appraisal claims could proceed but dismissed their quasiappraisal claims because quasi-appraisal claims are not statutory in nature.107
Delaware will enforce a covenant not to sue with respect to future claims for breach of fiduciary duty provided that the covenant does not bind all stockholders. The court’s discussion of potential public policy constraints on agreements that would bar all stockholders from bringing claims against directors for breach of fiduciary duty has broad implications for standard private company deals in which the buyer typically seeks releases from all stockholders. This decision also confirms that while Delaware allows stockholders to waive their statutory appraisal rights, the waiver must be express. A general covenant not to sue is ineffective as a waiver of appraisal rights.
In Frederick Hsu Living Trust v. Oak Hill Capital Partners III, L.P.,108 the Delaware Court of Chancery held that the controlling stockholder, directors, and officers of ODN Holding Corporation, a holding company of Oversee.net (“ODN” or the “Company”), did not breach their fiduciary duties to ODN’s minority common stockholders by allegedly taking steps to accumulate cash in order to redeem the controlling stockholder’s preferred stock, instead of investing cash in ODN’s long-term growth. In so holding, the court found that defendants met their burden of proving that their actions were entirely fair because, given prevailing market forces, the investment of the Company’s available cash would not have generated any value for the common stockholders of the Company.
In February 2008, Oak Hill Capital Partners, through Oak Hill Capital Partners Fund III (collectively, “Oak Hill”), invested in ODN by acquiring 100 percent of the Company’s preferred stock.109 Pursuant to this investment, Oak Hill received the right to compel the Company to redeem Oak Hill’s preferred stock at a liquidation preference of $150 million beginning in February 2013 (the “Redemption Right”).110 Oak Hill subsequently gained control of the Company—at both the board and stockholder levels—by acquiring a majority of ODN’s common stock.111
ODN, a technology company founded in 2000, enjoyed great success during its first seven years in part due to ODN’s strategy of utilizing its earnings for investment and acquisitions.112 However, this business strategy shifted in 2011 when ODN’s gross revenues began to decrease significantly due to industry headwinds created by enhanced search technologies from Google, and Oak Hill began anticipating the exercise of Oak Hill’s Redemption Right in February 2013.113 The court found that, because ODN had insufficient funds legally available to satisfy the Redemption Right, the Company and ODN implemented a plan to maximize value for the Company in the short term, and Company management was promised cash incentives upon the successful exercise of the Redemption Right.114 The board formed a special committee comprised of two independent directors, and the committee engaged in negotiations with Oak Hill to discuss deferral of the redemption date and other amendments to the terms of the preferred stock.115 The negotiations between the special committee and Oak Hill, however, were unsuccessful.116
The ODN board subsequently approved a redemption of $45 million of Oak Hill’s preferred stock, which was less than the full amount due under the terms of the Redemption Right, and Oak Hill entered into a forbearance agreement that restricted its ability to seek further redemptions for a specified time period.117 To secure the funds required to consummate the redemptions, the Company, among other measures, cut costs, reduced headcount, and sold two of its four businesses in 2012.118
In 2014, after appointing another special committee of independent directors charged with evaluating the fairness of the sale price, the Company also divested its flagship domain monetization business.119 In lieu of the Company reinvesting cash garnered from the sale in an effort to grow or expand the business, a special committee approved the redemption of another $40 million of Oak Hill’s preferred stock in accordance with the Redemption Right.120 Again, the amount redeemed was less than the full amount to which Oak Hill was entitled under the terms of the Redemption Right, and Oak Hill entered into another forbearance agreement.121
In January 2016, the Frederick Hsu Living Trust, the Company’s second-largest stockholder and an entity controlled by ODN co-founder Frederick Hsu, sought books and records pursuant to section 220 of the DGCL, and the Company agreed to produce certain documents, including minutes from the Company’s board and committee meetings. In March 2016, Hsu filed suit in the Court of Chancery against Oak Hill and certain Company directors and officers, alleging that defendants breached their fiduciary duty of loyalty to the Company’s minority stockholders by causing the Company to accumulate cash rather than investing in the Company’s long-term growth. In April 2017, the Court of Chancery refused to dismiss breach of fiduciary duty claims against Oak Hill and the Company’s board, and the matter proceeded to trial.122
In its post-trial memorandum opinion, the Court of Chancery first determined that each of the defendants owed fiduciary duties to the Company and its minority stockholders. Oak Hill was a fiduciary based on its majority power and other indicia of control.123 The individual defendants similarly owed fiduciary duties to the Company in each defendant’s capacity as an officer or director of the Company.124
The court then found that Oak Hill, as ODN’s controlling stockholder, gained a unique benefit by driving the Company’s cash-accumulation strategy so that funds could be legally available to satisfy the Redemption Right, and the applicable standard of review was therefore entire fairness.125 Although defendants argued that plaintiff should bear the burden of establishing unfairness based on the procedural protections afforded by the special committee process, the court disagreed, finding that defendants had the burden of proving that their actions were entirely fair, in terms of process and price, to the Company’s minority common stockholders.126
The court further explained that the analysis of entire fairness is not a bifurcated one, but rather the court must consider all aspects of the challenged actions to determine whether they were entirely fair.127 Indeed, while the court found that defendants fell short in their efforts to prove a fair process, it ultimately determined that the defendants’ actions were entirely fair.128
In terms of procedural fairness, the court was skeptical, including with respect to the board’s failure to formally adopt the cash-accumulation strategy.129 The court also determined that Oak Hill and its nominees on the ODN board of directors drove the Company’s cash-accumulation strategy, overseeing the Company’s annual business plans, ousting the Company’s CEO, pushing Company management to cut costs, including by terminating employees, and using bonus agreements to incentivize management to ensure that Oak Hill would receive its liquidation preference.130 As such, the court found that the defendants failed to prove a fair process.131
However, with respect to the fair price inquiry, the court held that the defendants had met their burden of proof by showing that the true cause of ODN’s decline was not the cash-accumulation strategy, but rather “intense industry headwinds and competitive pressure.”132 Specifically, the court found that the Company’s common stock “would have ended up worthless with or without the cash-accumulation strategy.”133 This determination was based on evidence suggesting that significant competition from Google, including Google’s ability “to launch a direct competitor and dominate the space by giving its own site priority placement in the search results,” would have rendered vulnerable any further investment in the Company’s business.134 Of particular weight was testimony from the defendants’ damages expert, who had performed a counterfactual analysis showing that further investment in ODN’s business would not have generated sufficient value to exceed Oak Hill’s liquidation preference and, thus, the common stockholders would not have realized any value from such investment.135
The court also recognized that ODN had received full value for its divested business lines and, as such, could not have created greater value by retaining and investing in them.136
Finally, the court recognized that Oak Hill itself was the majority holder of the Company’s common stock and therefore had a strong incentive not to diminish the value of that stock.137 Indeed, the court found that Oak Hill and its director nominees had worked to enhance the value of the common stock in late-2011 by, for example, implementing layoffs, making changes in the Company’s management, and instructing management to make cuts in the Company’s expenses in order to restore the Company’s gross margins.138
Having found that the defendants’ actions were entirely fair to the Company and to its minority common stockholders, the court entered judgment in their favor.
While the Oak Hill opinion confirms that the Delaware courts will continue to enforce preferential rights granted to the holders of preferred stock as a matter of contract, the decision serves as a reminder that a controlling stockholder’s exercise of contractual redemption rights in a circumstance where the board lacks independence may invoke entire fairness review. And while the court ultimately determined that the defendants met the exacting entire fairness standard, the court engaged in a fact-intensive analysis of the circumstances surrounding the redemptions, and only reached its decision based on defendants’ ability to prove under a “fair price” analysis that the Company’s cash-accumulation strategy represented ODN’s best option, and that an alternative strategy would not have provided greater value to the Company’s common stockholders.
In Strategic Value Opportunities Fund, L.P. v. Permian Tank & Manufacturing Inc.,139 the Delaware Court of Chancery rejected defendants’ contention that by giving all stockholders the opportunity to participate on a pro rata basis in a note offering the defendant directors had cleansed any conflict existing by reason of the note offering benefiting their affiliated funds. The court reasoned that the disinterested stockholders may face financial barriers to participating in the note offering and thus the offering was not truly available to all stockholders on an equivalent basis.
Plaintiffs are two minority stockholders of defendant Permian Holdco 1, Inc. (“Holdco 1,” and, together with its two wholly owned subsidiaries, “Permian”), a Delaware corporation backed by three large private equity funds (the “Fund Defendants”), which collectively controlled approximately 75 percent of Permian’s outstanding voting power and designated five out of six members of Permian’s board of directors.140 Plaintiffs designated one member of the Permian board.141
In late 2018, Permian undertook a note offering to raise $15 million for working capital and to make payments to critical vendors.142 The note offering was structured in three rounds.143 In the first round, the Fund Defendants committed to invest approximately $11.3 million immediately; that is, by December 23, 2018.144 In the second round, stockholders other than the Fund Defendants could invest pro rata until January 30, 2019.145 Finally, in the third round, any stockholder that invested in either of the first two rounds could invest in the remaining balance of the $15 million offering on a pro rata basis relative to other stockholders who participated in either of the first two rounds.146
In the complaint, plaintiffs alleged, among other things, that the note offering was a conflicted transaction that resulted in unfair terms in at least two respects: First, the interest rate on the notes, which was 14 percent in cash or 18 percent if paid in-kind, allegedly was above market and two percentage points higher than the interest rate on notes Permian had issued just eight months earlier; and, second, the offering afforded a priority right for the total outstanding principal of the notes in the event of a liquidation that allegedly survived repayment of the notes.147 In addition, the note offering also was pushed through on Christmas Eve, when most businesses were closed, suggesting unfair dealing.148
Finding the plaintiffs’ breach of fiduciary duty claim to be derivative, the court first considered whether the plaintiffs had created a reasonable doubt as to whether the Permian directors were disinterested and independent such that making a demand on the Permian board would have been futile and plaintiffs’ failure to make a demand excused.149 Because plaintiffs alleged that a majority of the members of the Permian board were officers, directors, or managers of the Defendant Funds who were compensated based on the success of their respective fund’s investment in Permian, the court found that plaintiffs had established the futility of demand. Further, the court rejected defendants’ argument that the breach of fiduciary duty claims should be dismissed on the basis that all stockholders could participate in the note offering, creating a safe harbor for directors approving a conflict transaction.150 The court noted that some stockholders may have faced financial barriers to participating in the note offering and therefore it was not the case that the note offering was open to all stockholders on an equivalent basis.151 The court also denied the Fund Defendants’ motion to dismiss aiding and abetting claims against the Fund Defendants, finding, among other things, that it was reasonably conceivable that the Fund Defendants knowingly participated in the directors’ alleged breach of fiduciary duty based on, among other allegations, that the director designees of the Fund Defendants knew the terms of the note offering were very favorable to the Fund Defendants because of its unusual priority right distribution term and its allegedly above-market rate interest terms.152 The court found that the knowledge of a director or officer may be imputed to their respective principals for purposes of satisfying the knowing participation element of an aiding and abetting claim.153
This decision rejects the notion that a rights offering in which all stockholders are entitled to participate on a pro rata basis affords protection to a conflicted board conducting a down round financing. However, under longstanding case law, there are procedural protections that a board may deploy to protect it from liability in connection with a related-party transaction, namely, a special committee of disinterested and independent directors and a majority-of-the-minority stockholder vote. Conditioning the consummation of the transaction on approval by a properly functioning and empowered special committee or a fully informed, uncoerced majority-of-the-minority stockholder vote will result in the application of the business judgement rule to a transaction tainted by board conflicts other than a transaction between the corporation and a controlling stockholder or a transaction that benefits the controller.154 With respect to controlling stockholder transactions, the transaction must be conditioned ab initio on approval by both a special committee and a majority-of-the-minority vote to result in the application of the business judgment rule.155