The Delaware Court of Chancery issued a recent opinion that affords common stockholders an avenue for challenging decisions by boards of directors resulting in preferential payments to preferred over common stockholders in a company sale. In Carsanaro v. Bloodhound Technologies, Inc., 2013 WL 1091048 (Del. Ch. March 15, 2013), the company at issue was sold pursuant to a transaction in which the lion‟s share of the proceeds was paid to preferred stockholders in liquidation preferences and to then-current management in the form of transaction bonuses. Practically no consideration was paid to the common stockholders, including the company‟s founder. In this regard, the Carsanaro decision is reminiscent of In re Trados Inc., 2009 WL 2225958 (Del. Ch. July 24, 2009).
Trados: Light Shed on Fiduciary Duties to Common Stockholders
In Trados, a common stockholder alleged that the interests of the preferred stockholders and common stockholders diverged because the merger triggered a multimillion-dollar liquidation preference for the preferred stockholders, while leaving the common stockholders with nothing. The Delaware Court of Chancery refused to dismiss claims against the company‟s directors for breach of fiduciary duties to common stockholders, finding that it was reasonable to infer that the board designees of the preferred stockholders, who made up a majority of the board, were conflicted and had differing interests in the transaction from the common stockholders, given the preferred stock liquidation preferences, and may have breached their duty of loyalty. The plaintiff argued that the company‟s prospects were improving, and although the sale paid off the preferred stockholders‟ liquidation preference, the holders of common stock were deprived of the opportunity to defer the sale to a later point in time, when the company could be worth more. Thus, a key issue in Trados was whether the board could properly make the decision to sell the company at a point in time and at a price that provided no consideration to the common stockholders, given the differing interests of the preferred and common stockholders, and the alleged conflicts of interest of board members who were designees of the preferred or members of current management who received sale bonuses.
Carsanaro: Dilutive Financings Under Scrutiny
In Carsanaro, however, the key issue was not whether the company should have been sold at that particular time and at that particular price. Rather, the case focused on whether liquidation preferences paid to preferred stockholders should be set aside because much of the preferred stock was issued pursuant to earlier financing transactions that were wrongfully dilutive to the common stockholders.
In Carsanaro, Bloodhound Technologies, the company at issue, developed web-based software applications to monitor fraudulent healthcare claims. The plaintiffs were five software developers, including the company‟s founder, who held common stock and claimed that their years of hard work laid the foundation for the company‟s success. They claimed that after Bloodhound raised its initial rounds of venture capital funding, the venture capitalists took control of the board, forced founding members to resign from the board and management, and from that point on, financed the company through self-interested and highly dilutive stock issuances. According to the complaint, the plaintiffs were not aware of these stock issuances or their effects until the company was sold for $82.5 million, at which point the plaintiffs were collectively left with less than $36,000 of the proceeds based on their diluted one percent equity ownership.
The plaintiffs challenged previous dilutive stock issuances, the allocation of $15 million of merger proceeds to management pursuant to a management incentive plan, and the fairness of the merger. The plaintiffs sued the members of the board who approved the transactions and their affiliated venture capital funds, and the defendants moved to dismiss. With limited exceptions, the motions to dismiss were denied.
In contrast with earlier rounds of preferred stock financing when then-CEO and founder Carsanaro led wide-ranging efforts to raise funds through arm‟s length negotiations with prospective investors, after the venture capitalist takeover, the defendants‟ control of the board allowed them to provide additional financing themselves (and from other like-minded venture capitalists) on terms they set unilaterally.1 According to plaintiffs, some of the later financings were done on the basis of lower company valuations and thus higher dilution to the holders of common stock.2 Despite the upward trajectory of the company, the complaint alleged that the board continued to approve additional preferred stock issuances by way of inside rounds at low company valuations. In addition to approving these financings, in connection with a later round of preferred stock financing, the company engaged in a 10-for-1 reverse split of its common stock without adjusting the conversion price of certain series of preferred stock. The effect of this reverse split and other offsetting and questionable transactions approved by the board was that the preferred stock became ten times more valuable, and the interests of common stockholders were diluted even further.
The plaintiffs challenged previous dilutive stock issuances, the allocation of $15 million of merger proceeds to management pursuant to a management incentive plan, and the fairness of the merger.
The Chancery Court found that the facts set forth in the verified complaint laid out a prior history of financing and related transactions evidencing a level of self-dealing by the board, rebutting the presumption of the business judgment rule3 and shifting the burden of proving entire fairness of the transactions to the defendants. Under Delaware law, if the various transactions were not approved in each case by a board majority consisting of disinterested directors, the business judgment rule does not apply and the defendants have the burden of proving that each transaction is entirely fair.
Lessons From the Carsanaro Decision
Of course, the Carsanaro decision sets forth allegations of facts that show egregious and secretive self-dealing in various financings that well-counseled boards will avoid. Typical "down round" financings are carried out with various protections for the minority, such as rights offerings and notice, which are completely absent on the facts alleged in Carsanaro. Moreover, boards will typically employ established processes to assure independent decision-making and to provide directors and investors protection for decisions made in interested transactions, such as the use of special committees of independent directors or obtaining the vote of a majority of unaffiliated stockholders.
In any case, as Carsanaro demonstrates, the board‟s decision to sell the company, and at what price and on which terms, are not the only decisions open to challenge in a company sale in which one or more groups of stockholders receive significantly less or no proceeds. Earlier decisions of the board regarding dilutive financing or other transactions preferential to one group of stockholders may also be challenged, particularly if the result of the earlier transactions is to reduce the proceeds allocable to the common stockholders from a company sale. Carsanaro provides a good reminder that all board decisions that favor one group of stockholders over another are potentially subject to judicial scrutiny. Whenever possible, the board should provide independent approval of such transactions either by a special committee of independent directors or by conditioning the deal on the approval of a majority of the unaffiliated stockholders, or should be advised to provide other indicia of fairness such as a rights offering, a fairness opinion taking into account the different classes of stock, or some other evidence that the interests of all stockholders were appropriately considered.
As Carsanaro demonstrates, the board‟s decision to sell the company, and at what price and on which terms, are not the only decisions open to challenge in a company sale in which one or more groups of stockholders receive significantly less or no proceeds.