While management and the preferred stockholders of Trados, Inc. received all of the merger consideration in an end-stage transaction and the common stockholders received nothing, the Delaware Court of Chancery has found that the transaction was still “entirely fair” to the common stockholders because the common stock had no monetary value before the merger.
The 114-page opinion by Vice Chancellor J. Travis Laster in In re Trados Incorporated S’holder Litig.1 deals extensively with a variety of issues that directors and investors should consider.
Background: in US$60M sale of Trados, common stockholders received nothing
In July 2005, SDL plc acquired Trados for US$60 million. The Trados board of directors, composed primarily of management and appointees of venture capital investors in Trados, approved the merger and a management incentive plan that awarded incentives to management for a sale, even if the sale netted nothing for the common stock. The US$60 million sale price left the venture capital firms’ liquidation preferences almost fully satisfied and paid some money into the management incentive plan, but resulted in the common stockholders receiving nothing.
The plaintiff sought both appraisal and a fiduciary duty remedy, arguing that the board had a fiduciary duty to continue to operate Trados so that it could recover money for the common stock, rather than selling at a price that would get nothing for common stockholders.
The court first resolved the fiduciary duty claim before addressing appraisal, because a finding on that claim could moot the appraisal proceeding. Because six of the seven directors were materially interested based on their obligations to the venture capital firms and the incentives created by the management incentive plan, the court applied the entire fairness standard, which places the burden of proof on the directors to demonstrate that the transaction resulted from a fair process and produced a fair price.
In this case, notably, the board had made decisions that benefited preferred stockholders, notwithstanding the board’s duty to common stockholders. The court therefore began by asking to whom, precisely, directors owe fiduciary duties, among potentially competing classes of stockholders: “To reiterate, the standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm‘s value, not for the benefit of its contractual claimants. In light of this obligation, it is the duty of directors to pursue the best interests of the corporation and its common stockholders, if that can be done faithfully with the contractual promises owed to the preferred.”
The Trados directors failed to demonstrate they followed a fair process
Turning to the facts of this case, the court first found that the Trados directors failed to demonstrate that they had followed a fair process. Although Trados’s new CEO suggested that he might be able to develop a new line of business rather than sell the company, the board never considered any alternative to the sale. The court went so far as to say: “[T]here was no contemporaneous evidence suggesting that the directors set out to deal with the common stockholders in a procedurally fair manner.” The court held: “In this case, the VC directors pursued the Merger because Trados did not offer sufficient risk-adjusted upside to warrant either the continuing investment of their time and energy or their funds’ ongoing exposure to the possibility of capital loss.”
The court pointed to a number of particular procedural failings. The Court intimated that the board should have at least considered the sale from the standpoint of the common stockholders. Instead, “The VC directors did not make this decision [to sell Trados] after evaluating Trados from the perspective of the common stockholders, but rather as holders of preferred stock with contractual cash flow rights that diverged materially from those of the common stock and who sought to generate returns consistent with their VC funds’ business model.”
Further evidence of unfair dealing was found in the management incentive plan. To address a conflict of interest, the court held that directors must at the very least understand the nature of the conflict. “Directors who cannot perceive a conflict or who deny its existence cannot meaningfully address it.” This principle applied with great force in this case because one director admitted, during his deposition, that the board never even discussed the conflict of interest between the common and preferred stock until the litigation began.
The court also held that the defendants missed chances to improve the record on the process by failing to either secure a fairness opinion or condition the transaction on the approval of a majority of the common stockholders.
Despite the flawed process, the court found the defendants established a fair price
With respect to the fair price analysis, the court found that the defendants had satisfied their burden of establishing that the price was entirely fair to the common stockholders.
The plaintiff proffered an expert report suggesting that the common stockholders should have received more, but that report included comparable companies that yielded an extremely wide range of values. The court ultimately concluded that no companies were comparable to Trados. Instead, the Court relied on a discounted cash flow valuation prepared by the defendants’ expert, which incorporated a variety of plaintiff-friendly assumptions but nevertheless demonstrated that there was no realistic scenario in which the common stock would have any economic value, even if Trados had successfully developed a new line of business rather than entering into the sale.
In making this determination, the court emphasized that the preferred shares held an 8 percent accumulating dividend, meaning that the preferred shares’ liquidation preferences grew by 8 percent per year. The court found that Trados “did not have a realistic chance of generating a sufficient return to escape the gravitational pull of the large liquidation preference and cumulative dividend.”
Because the common stock had no value, the court found that the directors did not breach their fiduciary duty. “In light of this reality, the directors breached no duty to the common stock by agreeing to a Merger in which the common stock received nothing.” On the strength of that same factual finding, the court held that the “fair value” of Trados’ common stock for appraisal purposes was zero.
The plaintiff also made a request for fee-shifting. Despite the defendants’ successful defense of the claims, the court signaled its willingness to entertain a separate fee application because of the defendants’ bad faith conduct. The court emphasized that the defendant directors changed their testimony between their depositions and trial, and even explicitly disavowed “four sets of minutes in which the Board ostensibly determined in good faith that the fair value of the common stock was $0.10 per share and upon which this court previously relied.” The court also pointed to the defendants’ decision to file three summary judgment motions, one of which the court considered potentially frivolous, and that the plaintiff was forced to file four separate motions to compel, all of which resulted in the defendants providing additional discovery material, due to conduct the court summarized as “serial failures to produce.”
Four key takeaways
1. Take into account that director independence is no automatic safe harbor for non-employees
Directors are not automatically independent if they do not work for a venture capital firm directly. One of the directors had worked collaboratively with the venture capital firm on several companies, and he had invested approximately US$300,000 in one of the funds. This director was also CEO of another company in which the venture capital firm was an investor and had a director designee. The court found that these relationships “resulted in a sense of owingness that compromised [the director’s] independence.” Accordingly, companies should consider these types of relationships when appointing a director believed to be independent or relying on his independence in connection with corporate action.
2. Understand the nature of directors’ fiduciary obligations to preferred shareholders
The court also held that directors do not owe fiduciary duties to preferred stockholders when considering an action that might violate or circumvent the preferred shares’ contractual rights. The preferential rights of preferred stockholders, even if set forth in a company’s certificate of incorporation, are contractual in nature. Directors must act in good faith and on an informed basis to maximize the value of the corporation for the benefit of residual claimants (that is, common stockholders and preferred stockholders not relying on a liquidation preference or some other preference). The board only owes fiduciary duties to preferred stockholders when such holders are relying on a right shared equally with common stockholders.
3. Reevaluate management bonuses in change-in-control plans
Companies may wish to revisit their change-in-control bonus plans, because this opinion criticizes a bonus plan that functions in a common way. The court held that the structure of the management incentive plan (MIP) gave further evidence that the Trados board dealt unfairly with the common stockholders.
This holding shows that directors may violate their duty of loyalty if they improperly structure a change-in-control bonus plan to favor preferred stockholders over common stockholders or to incentivize management to take action for the benefit of the preferred stockholders. The MIP paid a bonus to management tied to the proceeds to be received in a sale transaction. The bonus was paid before any proceeds were paid to stockholders. These types of bonus plans are often implemented in venture-backed companies in which the value of the company is believed to be too low relative to the liquidation preference to provide management with sufficient incentive value in their common equity.
The structure of the MIP was similar to a structure often seen. The MIP provided an escalating percentage of proceeds based on deal consideration. The plan also offset amounts payable to management by any dollars received by management by virtue of their holdings of common stock. The court found that the MIP skewed management’s approach to a sale transaction in a manner adverse to common stockholders. First, the MIP’s structure resulted in the MIP’s cost being allocated disproportionately between the preferred and common stockholders. As deal proceeds exceeded the liquidation preference, common stockholders increasingly bore the cost of the MIP. The court did not provide guidance as to what would be an appropriate allocation, other than to say that an allocation in which 100 percent of the cost comes from the preferred stock would raise no fairness issues and an allocation in which 100 percent of the cost comes from the common raises serious fairness issues.
Second, the offset for common proceeds caused management to focus on maximizing their return under the MIP versus their return as common stockholders and incentivized management to pursue a sale even at valuations at which the common stockholders received nothing. It also caused management to favor a sale rather than remaining independent in the hope of obtaining a higher value at a later date.
The court noted that, while the plaintiff in Trados did not bring a claim that the directors breached their duty of loyalty by implementing the MIP as designed, the directors would have found it difficult to prove that their doing so was fair to the common stockholders to whom the directors’ owed fiduciary duties.
4. Remember that courts place great weight on contemporaneous written communications
Finally, this opinion illustrates the importance of contemporaneous written communications of management, directors and investors (including internal reports and communications solely within the venture firms). The court placed particular significance on the reports made by the board designees of the venture firms to the designees’ partners inside the firms. The opinion recites and references these reports more than 15 times.
Written materials made contemporaneously with an event are often given more evidentiary weight than subsequent testimony or statements given by the same persons. Rarely are these communications written with an eye towards litigation, and they are often more informal and conclusory than would otherwise be the case. When considering a sale of a company or other corporate action that may be later challenged, involved persons should take extra care to ensure that their written communications are accurate and consistent with their fiduciary obligations.