Need To Sell A Portfolio Company? Tread Carefully
Corporate & Finance Alert
September 8, 2009
In October 2008, we highlighted the fact that, during times of economic uncertainty and financial challenges, directors and senior officers need to take additional care when confronted with a possible conflict in the exercise of corporate fiduciary duties. This is because creditors and shareholders are increasingly looking to allocate blame for the company’s misfortunes and alleging a breach of fiduciary duty is one avenue to potentially recover losses from individual directors or their D&O insurers. [To view the article “The Duties of Directors in Uncertain Times” please click here]. In addition, in November 2008, we outlined the nuances between the fiduciary duties owed by directors of corporations and those owed by similarly placed individuals in limited liability companies. [To view the article “Fiduciary Duties for Control Persons of Limited Liability Companies” please click here]. A recent Delaware decision has prompted us to revisit the issue of directors’ fiduciary duties, this time in the context of a sale of a portfolio company instigated by the private equity designated directors.
In the case of In Re: Trados Incorporated Shareholder Litigation, the Delaware Court of Chancery denied the director defendants’ motion to dismiss breach of fiduciary duty claims arising out of the approval by the board of Trados Incorporated (“Trados”) of a transaction whereby Trados was sold to SDL, plc (“SDL”) at a price that yielded no return for the common stockholders. The decision was rendered in the context of a motion to dismiss which requires the Court to determine with reasonable certainty that the plaintiff would not be entitled to relief under any set of facts that could reasonably be inferred from the allegations. In other words, the Court must accept the plaintiff’s allegations of fact as true and draw all reasonable inferences that flow from those allegations in favor of the plaintiff. Although the decision does not represent a final finding of liability, the case is a timely reminder for private equity designated directors to be careful when faced with the decision to sell a portfolio company.
Some background to the case is useful. Trados started out as a German company in 1984. By the mid-90’s, it had moved to the United States and incorporated in Delaware. A number of private equity investors, including Wachovia Capital Partners LLC and Sequoia Capital, acquired preferred stock in the company. Over time, the private equity preferred stockholders ended up with four designees on Trados’ seven member board. In early 2004, in light of poor performance, the board began to discuss a potential sale of the company. By mid-2004, Trados’ financial adviser had identified potential buyers including SDL. In addition, to incentivize senior management to remain with the company in light of a potential sale, the board approved a management incentive plan (the “Plan”), which compensated management based on the price obtained in any sale.
Even though Trados’ financial condition improved through 2004, the board continued to work toward a sale of the company. In June 2005, Trados and SDL entered into a Merger Agreement for $60 million, approximately $8 million of which would go to management pursuant to the Plan, and the remainder to the preferred stockholders in partial satisfaction of their approximately $58 million liquidation preference. The common shareholders received nothing in the merger which closed in July 2005.
Three years later, a class action suit was brought by common stockholders against six of the directors who approved the sale claiming, amongst other things, that they breached their fiduciary duty of loyalty to Trados’ common stockholders by selling the company when they did. Their argument has two principal prongs.
First, that the director defendants, in approving the sale, never considered the interests of the common stockholders in continuing the company as a going concern, even though they were obliged to give priority to the common stockholders’ interest over the preferred stockholders’ interest. The plaintiffs’ claim that, at the time, the company was “well-financed, profitable, and beating revenue projections” and accordingly, there was no reason to sell the company and the sale deprived the common shareholders of the possibility of some value in the future.
The Court reiterated prior Delaware judicial decisions that the preferred stock provisions were merely contractual rights and that, where there is a conflict, it is generally the duty of the board to prefer the interest of the common stock to the interests created by special rights such those that accompany preferred stock.
As noted in our prior articles, directors are normally protected by the business judgment rule. Provided the directors act in an informed manner, in good faith and in a honest belief that the actions that they took were in the best interests of the company, a court will not second-guess their business decisions.
In Trados, the Court assumed the plaintiffs allegations were true and, if ultimately found to be true (an exercise reserved for trial) the plaintiffs had pleaded sufficient facts to rebut the presumption that the directors decision was protected by the business judgment rule. The Court noted that in a motion for summary judgment “it is 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 concluded 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 his duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders. The Court also noted that not every sale where the common stockholders receive nothing will automatically constitute a breach of the duty of loyalty by the directors – it will depend on the individual facts and circumstances.
The second prong attacked the directors’ independence and claimed that because they were entitled to receive material personal benefits as a result of the sale they were incapable of exercising disinterested and independent business judgment. Four directors were employees or owners of private equity firms that would see a return of most of their investment through a preferred liquidation preference and two directors were executives entitled to receive significant incentive bonuses as a result of the sale.
The Court in Trados stated that a director is interested in a transaction if “he or she will receive a personal financial benefit from a transaction that is not equally shared by the stockholders” or if “a corporate decision will have a materially detrimental impact on a director, but not on the corporation and the stockholders.” The receipt of any benefit is not sufficient to cause a director to be interested in a transaction. Rather, the benefit received by the director and not shared with stockholders must be “of a sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbable that the director could perform her fiduciary duties…without being influenced by her overriding personal interest.” The Court noted that simply designating a director to a board is not enough to cause a director to lose his independence.
If the Court ultimately determines that the directors decision was not protected by the business judgment rule, the burden of proof is shifted to the directors who must demonstrate that the sale was “entirely fair”, a significantly higher standard. If, ultimately, the directors are found to have acted in breach of their fiduciary duties, then they potentially face personal liability and may not be entitled to indemnification from the company or to recover under D&O insurance. In light of the severe consequences, private equity designated directors should consider taking some precautions when considering a sale of their portfolio company.
- D&O Insurance. Indemnification provisions should be carefully reviewed to see how robust these are. Directors whose policies have been in place for some time should dust them off. D&O coverage originally came in largely standard forms mostly favorable to companies. However, D&O coverage today has evolved and is now a significantly negotiated issue for directors. Directors should check to ensure that their policy is in line with the current market approach. Looking after the sale is too late.
- Corporation -v- LLC. Review the company’s constitutional documents. LLCs are permitted to prescribe the scope of the fiduciary duties owed to the company and even eliminate them entirely under the operating agreement. Similarly, the operating agreement can specify that the same duties apply “as if” the LLC were a corporation. If the operating agreement is silent then the law of the applicable state will apply. Directors should be aware of the scope of their fiduciary duties.
- Drag-Along Rights. In Trados, the Court referred on numerous occasions to the absence of a drag-along right that enabled the preferred stockholders themselves to contractually force through the sale. Private equity investors should be looking for an express right to force a sale and drag along common stockholders, this takes the decision away from the potentially conflicted directors.
- Special Committee. Create a special committee of truly independent, disinterested directors to make decisions relating to any possible sale. In Trados, a special committee was formed but it was comprised of three of the private equity appointed directors.
- Fairness Opinion. Obtaining an independent opinion as to the fairness of the transaction can be expensive and cause delay in completing a transaction, however, it does offer added protection to directors in exercising their fiduciary duties.
- Consider All Stakeholders. Board minutes and other documents should expressly reflect the fact that the board considered all of the interests involved in the context of the sale and that having considered all interests the best interests of the company were served by proceeding with the sale even though some stakeholders would be adversely impacted by it.
- Common Stock Valuations. The Court also noted that the Board made a determination that the common stock had a fair market value of 10 cents a share at about the same time that the company hired a banker to identify merger or sale opportunities for the company and received an acquisition proposal for $40 million. Board members should carefully consider common stock valuations, especially when a company is in play, and be cognizant of events that trigger reconsideration of such valuations.
- Mother Ship Communications. Directors should avoid written communications that imply that the director is acting only in the best interests of the private equity fund and not the company or its stockholders. In Trados, much was made of certain directors’ statements that suggested that the sale was the only way in which to recapture their initial investment, that they did not own enough of the company to make a meaningful return and that the investment was consuming too much time relative to the size of the investment.