After over seven years of litigation, the Delaware Supreme Court on December 11, 2015 upheld the Court of Chancery’s important decision in Nine Systems, which held that a 2002 recapitalization of a streaming media start-up unfairly diluted the minority stockholders when VC-backed directors failed to include the stockholders in an emergency round of financing that benefited the VC funds after the company was later sold to Akamai Technologies for $175 million. Despite finding that the transaction was unfair and that the board breached its duties of loyalty, the Court of Chancery declined to award any monetary damages because the plaintiff stockholders’ equity was worthless at the time of the financing.
Although the directors technically “won” the appeal (since the no-damages award was affirmed), the case highlights the need for VC-backed directors to adhere to their fiduciary duties to all stockholders (common and preferred) and in all contexts where the minority is adversely affected – not just in the M&A exit or change of control transaction. The protracted (and no doubt, costly) litigation involving this transaction also illustrates the potential advantages of using “cleansing” devices to help mitigate the likely litigation risks associated with “interested” deals.
In Nine Systems, the company faced a funding shortage and turned to its insider directors for a cash infusion. Critical to the trial court’s decision was the finding that the board was conflicted because the VC-backed directors comprised a majority. It also found that the VC investors, together, had majority control of the company and stood to benefit from the transaction in ways that the minority did not. Because the transaction was “interested,” it applied the “entire fairness” standard of review to the board’s actions.
In Delaware, if a “controlled” company enters into a transaction where the controller stands on both sides of the deal, “entire fairness” applies. This is the strictest standard under Delaware law and puts the initial burden of proof on the defendants to show that the transaction was objectively the product of both: (1) fair dealing and (2) a fair price. Because a fairness determination necessarily involves fact-finding (e.g., through discovery and trial), a transaction that falls under entire fairness will rarely be dismissed on the pleadings and the costs of litigation and settlement will increase dramatically.
Entire fairness will also apply in other transactions where a controller is involved, even if the controller does not stand on both sides of the deal, if there are other factors that demonstrate that the transaction is “interested.” For example, entire fairness will apply if a majority of the board is not disinterested or if an interested director is shown to dominate the board’s decisions. Courts have also applied entire fairness when the controller receives a benefit that the other stockholders do not receive, like premium consideration for high-vote stock or a continuing stake in the surviving entity. These scenarios are all too common among private venture-backed companies such as when the company needs a cash infusion and turns to its insiders.
A board can implement certain procedural safeguards to help shift the burden of proof to the challenger when entire fairness applies, such as by using a special committee or conditioning the transaction on the approval by a majority of the disinterested directors. In Kahn v. M&F Holdings (2014), Delaware’s highest court held that interested transactions can escape entire fairness review altogether if the transaction uses both cleansing devices, namely, if it is: (1) approved and negotiated by an informed and independent special committee of directors and (2) conditioned at the beginning on the approval by a majority of the disinterested directors. On November 19, 2015, in Swomley, the Court showed that Kahn had teeth when it blessed a deal involving a private company that employed these “MFW”-compliant procedures. The case was dismissed for failing to state a claim.
Whether to employ these devices will depend on the company’s business realities, such as the likelihood of obtaining the approval of a majority of the minority. Often, hiring a financial advisor to perform a valuation or forming an independent special committee is impractical for venture-backed companies with limited funds, time or resources. However, employing some or all of these devices can be impactful.
Ultimately, deal parties may conclude that the business risks outweigh the benefits. Parties may alternatively conclude that it is better to accept the higher standard but try to get the burden of proof shifted to the plaintiff. With private deals increasingly being scrutinized, a VC-backed company should consult with counsel early-on to assess these risks and consider tactical alternatives. In any case, a board should strive to build the transaction record in a way that demonstrates that it discharged its fiduciary duties in a process that is fair. See A Reminder on Adequate Process (Despite Fair Price): Delaware Court Addresses Breach of Fiduciary Duties in Dilutive Recapitalization Transaction for specific process guidance and considerations.
 In Trados (2013), the court criticized the board’s decision not to form a special committee to approve a management incentive plan in connection with a merger that was disproportionately funded by the common stockholders. The transaction was viewed as “interested,” which resulted in application of “entire fairness.” Although the court ultimately found that the transaction was fair, it noted that had the board used a special committee, it could well have resulted in business judgment review. See ftne. 39.