Fair Is In The Eye Of The Beholder

Tuesday, December 1, 2009 - 01:00

A recent Delaware Chancery Court case serves as a reminder to private equity sponsors that portfolio company investments need to be carefully structured and documented to reduce the risk that unhappy co-investors could sue them or their board designees in connection with a less than wholly successful sale transaction. This case also illustrates some principles that directors should follow when contemplating the potential sale of a portfolio company in difficult market conditions.

In the case of In re Trados Incorporated Shareholder Litigation , common stockholders of Trados Incorporated challenged a transaction in which (i) the preferred stockholders received nearly 90 percent of the total merger consideration in partial satisfaction of their liquidation preference, (ii) management received the remaining 90 percent of the total merger consideration pursuant to a management incentive plan implemented to incentivize management to sell the company and (iii) the common stockholders received nothing. Notably, the court in In re Trados denied defendants' motion to dismiss claims that the director defendants breached their fiduciary duty of loyalty to the common stockholders. Although approval by the board of a transaction in which common stockholders receive no consideration as a result of liquidation preferences on preferred stock does not necessarily result in a breach of a director's fiduciary duties, directors must take extra care to satisfy their fiduciary duties (e.g., acting in good faith, in the best interests of the stockholders and not in one's self-interest) in such situations. Significantly, the court notes that, "it is possible that a director could breach her duty [of loyalty] by improperly favoring the interests of the preferred stockholders over those of the common stockholders."

Background Of In Re Trados

In 2004, encountering challenges to the business, the board of directors of Trados formed an M&A committee and hired an investment bank to assist in seeking strategic alternatives, including a potential sale or merger of the company. In June 2005, Trados entered into a merger agreement, pursuant to which the holders of preferred stock received $52.2 million in partial satisfaction of their $57.9 million liquidation preference and management received $7.8 million pursuant to a management equity incentive plan designed to encourage a sale of the company (total merger consideration of $60 million). The common stockholders received no consideration. Notably, it appears that the preferred stockholders did not have the contractual right to "drag along" the common stockholders in the sale and therefore the board of directors of Trados was required to approve a merger agreement to effect the transaction.

Plaintiffs alleged, among other things, that the director defendants' decision to approve the merger breached their fiduciary duty of loyalty to the common stockholders. Central to plaintiffs' theory was their claim that the improved financial condition of the company eliminated any need for a sale, particularly one returning nothing to the common stockholders. In addition, plaintiffs alleged that the director defendants favored the interests of preferred stockholders either by acting at the expense of common stockholders or by failing to consider the interests of the common stockholders, including the common stockholders' going forward interests if the company were to continue its operations without a sale. If the company continued operating (on an upward trajectory per plaintiffs' claims), the common stockholders contended they would have received a return on their investment greater than zero.

The business judgment rule affords protection to directors of a Delaware corporation by presuming that in making a business decision directors act (i) in good faith, (ii) on an informed basis and (iii) in the best interests of the company. Procedurally, a party challenging actions covered by the business judgment rule bears the burden of rebutting the presumption of the business judgment rule. As case law in Delaware shows, it is difficult to successfully rebut the presumption of the application of the business judgment rule. In order to rebut the presumption - and as a result, shift the burden to the defendants to prove the entire fairness of their actions - a party must show facts from which a reasonable inference can be drawn by the court that a majority of the board was interested or lacked independence.

For purposes of a motion to dismiss, the In re Trados court held that plaintiffs' pleadings successfully rebutted the business judgment rule presumption. The court based its decision on the fact that a majority of the directors were employees of private equity sponsors holding substantial amounts of preferred stock. In addition, two directors were entitled to receive payment under the terms of the management incentive plan put in place to induce a sale of the company. As a result, the court refused to dismiss plaintiffs' claim that the directors improperly favored the interests of preferred stockholders over those of the common stockholders. Although the case does not address whether the defendant directors are liable, plaintiffs' successful rebuttal of the presumption of the business judgment rule at the motion to dismiss stage of the proceedings is significant.

Although the rights of preferred stockholders are largely contractual in nature, Delaware courts have held that directors owe fiduciary duties to preferred stockholders. In particular, if a right claimed by preferred stockholders is shared equally by the common stockholders, preferred stockholders are owed fiduciary duties. In exercising their discretionary judgment in circumstances in which the interests of the common stockholders and the preferred stockholders are not aligned , however, directors must generally favor the interests of the common stockholders to those of the preferred stockholders.

Practice Tips

Private equity sponsors and their representatives on the boards of directors of portfolio companies should consider the following practice tips in connection with structuring investments in portfolio companies and the deliberations of boards of portfolio companies in connection with a potential sale transaction to reduce the risk that an unhappy minority stockholder may successfully challenge the transaction:

Structure of Investment . Private equity sponsors should consider whether to use a limited liability company rather than a corporate structure for the investment. Under Delaware law, for example, a limited liability company can contractually limit the fiduciary duties of managers of the company to the members in its limited liability company agreement.

Negotiate An Appropriate "Drag Along Right." If you are the controlling stockholder in the portfolio company, ensure that you have the right to "drag along" other stockholders in a sale transaction in your stockholders agreement or limited liability company agreement.

Deliberate Process. Courts carefully examine the process that boards follow in connection with a sale of a company. Specifically, it is important that the board of directors (i) carefully deliberate the impact of a proposed transaction versus other alternatives - including the prospect of not moving forward with a transaction - to all of the stockholders and (ii) retain appropriate outside advisors to advise the board on the transaction. Notably, the In re Trados court highlighted the lack of consideration given to the common stockholders during the negotiation and deliberation of the sale transaction. In addition, if some or all of the directors have a conflict of interest in light of the potential transaction, consideration should also be given to appointing a special committee of independent directors to assess the merits of a proposed transaction and the appropriateness of obtaining a fairness opinion from a financial advisor.

Exculpation, Indemnification and Insurance. Ensure that the company's organizational documents have whatever exculpation and indemnification provisions are permitted by state law. Consideration should also be given to providing each director with an individual indemnification agreement by the portfolio company as well as an indemnification agreement for the private equity sponsor. You should also ensure that the portfolio company has adequate D&O insurance and confirm that the D&O insurance provides "Side A" coverage to directors (which coverage is not subject to claims by the company or the creditors).

In re Trados serves as a reminder to private equity sponsors that they need to be careful both in structuring investments in portfolio companies and in connection with a sale of the company in difficult market conditions. However, the risk of a successful challenge to a sale transaction can be significantly reduced through careful planning when making the investment and contemplating the sale.

Patrick J. O'Toole, Jr. is Counsel in the Boston office of Weil, Gotshal and Manges, practicing in the Complex Commercial Litigation Section. Matt Goulding is an Associate in the Corporate Department of Weil, Gotshal & Manges, also practicing in the Boston office.

Please email the authors at patrick.otoole@weil.com or matthew.goulding@weil.com with questions about this article.