A recent decision by a Delaware Chancery Court raises the possibility of breach of fiduciary claims against directors of Delaware corporations who approve a transaction that favors the interests of preferred stockholders over those of common stockholders. On July 24, 2009, the Delaware Court of Chancery, in the case of In re Trados Incorporated Shareholder Litigation, denied defendants' motion to dismiss breach of fiduciary duty claims arising out of the approval by Trados' board of directors of a merger in which the company's preferred stockholders received $52 million in merger consideration and its common stockholders received nothing. The court's ruling in In re Trados is significant primarily because it raises the possibility of breach of fiduciary claims against directors of Delaware corporations who approve a transaction that favors the interests of preferred stockholders over those of common stockholders.
Prior to the merger at issue, Trados was a venture-backed Delaware corporation that had been losing money and had little cash to fund continuing operations. The Trados board of directors, which consisted of seven members, four of whom were designees of, and otherwise had financial interests in, venture capital funds that collectively owned 51 percent of the outstanding shares of the company's preferred stock. In April 2004, the board began to discuss the potential sale of the company. Approximately three months later, SDL made an acquisition proposal in the $40 million range.
Trados' financial condition improved markedly during the fourth quarter of 2004, in part because of the efforts of Trados' executives to reduce spending while bringing in additional cash through debt financing. In addition, Trados reported record revenue and profits from its operations in the fourth quarter of 2004, which, at the time, alleviated the immediate need for cash. Despite its improved performance, the board continued to work toward a sale of the company; and in July 2005, SDL acquired Trados for $60 million.
Of the $60 million received by Trados, approximately $52 million was distributed to its preferred stockholders in partial satisfaction of their liquidation preference, and approximately $8 million was distributed to its executive officers pursuant to a bonus plan put in place a few months earlier to incent the executives to pursue a sale of the company in light of the $57.9 million liquidation preference held by the preferred stockholders. Consequently, Trados' common stockholders received no consideration in the merger.
Breach of Fiduciary Duty Claim
Plaintiff claimed that the Trados board breached its fiduciary duty of loyalty when it approved the merger, alleging that (i) the merger was undertaken at the behest of certain preferred stockholders seeking a transaction that would trigger their large liquidation preference, thus allowing them to exit their investment in Trados because it was performing poorly; (ii) the merger favored the interests of the preferred stockholders, either at the expense of the common stockholders or without properly considering the effect of such merger on the common stockholders; and (iii) the four directors designated by the preferred stockholders had other relationships with the preferred stockholders and were incapable of exercising independent and disinterested business judgment, thus rebutting the protective presumption afforded by the business judgment rule.
Court Finds Facts Sufficient to Support Claim
Upon review of plaintiff's pleading, the court found that plaintiff had alleged facts sufficient, for purposes of deciding a motion to dismiss, by demonstrating that at least a majority of the members of Trados' seven-member board were unable to exercise independent and disinterested business judgment in deciding whether to approve the merger with SDL. The court further explained that plaintiff's allegations had sufficiently rebutted the presumptions of the business judgment rule for purposes of a motion to dismiss. Accordingly, the court refused to dismiss plaintiff's claim that the board breached its fiduciary duty of loyalty by improperly favoring the interests of the preferred stockholders over those of the common stockholders when it approved the merger.
No Alignment of Interests Between Preferred and Common Stockholders
The defendants attempted to counter plaintiff's allegations that the board approved the merger at the behest of certain preferred stockholders wanting to exit their investment in Trados, by arguing the obvious alignment of the interests of the preferred and common stockholders in obtaining the highest sale price available for the company. The court rejected this "obviously alignment" argument because the merger resulted in a large liquidation preference payout for the preferred stockholders, while the common stockholders did not receive anything for their ownership interests, which was the worst possible outcome for the common stockholders. In taking the well-pleaded facts in the light most favorable to the plaintiff, which is the standard for deciding a motion to dismiss, the court found that, based on the facts, a reasonable inference existed 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 explained that this inference was supported by plaintiff's allegation that Trados' performance had significantly improved in the months leading up to the merger, and the company had secured additional capital through debt financing during that time.
Duty of the Board to Favor the Interests of the Common Stockholders
Because the interests of the preferred and common stockholders were not aligned with respect to the decision to pursue the merger transaction, the court explained that Trados' board owed its fiduciary duties to the common stockholders and not the preferred. In support of its findings, the court explained that, although directors owe fiduciary duties to both preferred and common stockholders, this duty applies only when the right claimed by preferred stockholders is a right that is equally shared with the common. The court stated that where this is not the case, it will generally be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stockholders to the interests created by the special rights and preferences of preferred stock, where there is a conflict. The court, therefore, opined that in situations where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach a fiduciary by improperly favoring the interests of the preferred stockholders over the common stockholders.
The Directors Lacked Independence
For purposes of deciding a motion to dismiss, the court stated that pleading facts that support a reasonable inference that a director is "beholden to a controlling person or so under their influence that their discretion would be sterilized" is sufficient to defeat a motion to dismiss. The court held that alleging that four of Trados' seven directors (i) were designated to the board by preferred stockholders, (ii) had employment or ownership relationships with the entities that owned preferred stock, and (iii) were dependent on preferred stockholders for their livelihood, was sufficient, under the plaintiff-friendly pleading standard on a motion to dismiss, to rebut the business judgment presumption with respect to the board's decision to approve the merger.
Avoiding the Potential Pitfalls of In re Trados
It is important to note that the court did state that its decision in In re Trados was not intended to suggest that it would necessarily be a breach of fiduciary duty for a board to approve a transaction where the liquidation preference consumes all of the merger consideration. The question in this situation is whether a board of directors, in approving such a transaction, exercised independent judgment and properly considered the interests of the common stockholders.
Again, In re Trados was decided in light of the plaintiff-friendly standard required when deciding a motion to dismiss. Thus, the court was required to draw reasonable inferences from the allegations in the plaintiff's favor. Such inferences need not be drawn when the claim moves to the summary judgment stage or beyond. Indeed, the court specifically observed that there might be other reasonable and even more likely inferences that could not be drawn when deciding a motion to dismiss, but which could be drawn when deciding a summary judgment motion or the ultimate claim on its merits.
It is unknown whether the plaintiff will ultimately prevail on the breach of fiduciary duty claims related to the Trados board's decision to approve the merger with SDL. Until that question is decided, directors of Delaware venture-backed corporations should remain cognizant of the possible pitfalls created by In re Trados. Practical steps for directors to consider attempting to avoid those pitfalls, in situations where the liquidation preference of the preferred stockholders would consume all, or substantially all, of the proceeds in a sale of the company, include:
- Obtaining the approval of directors not designated by a preferred stockholder holding a liquidation preference or otherwise eligible to receive merger consideration from a management retention or bonus plan
- Engaging investment bankers to find other potential acquirers to find the highest possible price
- Carving out a piece of the merger consideration for the common stockholders, particularly when the company has positively trending financial performance or enough cash to operate as a going concern
- Seeking the unanimous approval of the merger by the common stockholders, whether by vote or written consent (the affirmative vote of a majority of common stockholders may be required for Delaware corporations with a substantial presence in California because of California Corporations Code Section 2115)
While these practical steps, either singularly or in combination, do not ensure that a claim for breach of fiduciary duty claim will be dismissed based on In re Trados, they may help minimize the risk that any such claim will be successful on the merits.