In re Nine Systems Corp. Shareholders Litigation
(Del. Ch. September 4, 2014) (application of entire fairness standard of review and determination of breach of breach of fiduciary duties in approving a transaction because it was the result of an unfair process, despite fair price)
This recent Court of Chancery decision highlights the emphasis Delaware courts place on transaction process generally and, regardless of a company’s financial crisis or dwindling business alternatives, the requirement to discharge fiduciary duties by conducting a fair process regardless of fair transaction price.
For practitioners who regularly work with privately financed companies, the In re Nine Systems fact pattern is a familiar one. In 2002, faced with the prospect of winding down, the company board approved a recapitalization of the company that provided for (i) an investment of additional capital from two of its three existing majority equity holders and (ii) significant dilution of minority, non-participating stockholders. The five member board approving the transaction consisted of the company CEO and three designees of the existing investors who, together, owned more 54% of company equity and 90% of company debt. The stockholder vote approving the transaction was obtained only from equity holders “around the table.” The board did not obtain an independent valuation of the company prior to the recap or perform its own collective analysis; it did, however, accept a $4 million “back of the envelop” valuation developed by one of the investor’s principals.
Four years later the company was sold for $175 million and minority stockholders brought suit to challenge the 2002 recap. Similar to the Court of Chancery’s 2013 decision inIn re Trados Shareholder Litigation (read our prior summary), the Court held that the $4 million valuation used for the recap transaction was fair because, at the time, the Company’s equity was worth zero. In contrast to In re Trados, however, the Court in In re Nine Systems took one step further in its review of fiduciary duties under the entire fairness standard—it found the process employed for the review and approval of the recap unfair, despite a finding of fair price. In particular, the court noted the following board process failures: (i) refusal to hire an independent financial advisor; (ii) failure to be informed or involved in the $4 million valuation determination; (iii) refusal to obtain input or approval from the board’s sole independent director (who opposed the transaction); (iv) the choice not to obtain the separate vote of minority stockholders; and (v) materially deficient disclosure to stockholders following approval of the transaction. Although the Court declined to award money damages in the case, it did permit plaintiffs to seek attorneys’ fees and costs (while noting that a remedy for unfair process in this context could include a determination and award of a “fairer” price).
In particular, practitioners should note the Court’s clear statement that In re Trados should not be interpreted as a “broad proposition that a finding of fair price, where a company’s common stock had no value, forecloses a conclusion that the transaction was not entirely fair. Rather, the Trados conclusion reinforces the defining principle of entire fairness—that a court’s conclusion is contextual.” While the court made it clear that independent valuation opinions are not per se required in order to avoid entire fairness review in a context such as In re Nine Systems, companies faced with dilutive or similar extraordinary corporate transactions should work closely with counsel to ensure all appropriate process measures are in place prior to corporate action. Particular attention should be paid to the voice and approval of independent directors and the recognition of duties to all company stockholders (including minority and common stockholders). This can be complicated for venture-backed companies with limited budgets, but because the In re Nine Systems Court found the venture capital investors to comprise a control group with fiduciary duties (or, alternatively, potentially liable for aiding and abetting director’s breaches of their duties), boards will need to think tactically about these matters on a go forward basis.