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MERGER
&
ACQUISITION
LAW
UPDATE
November 20, 2014
In re Nine Systems Corporation Shareholders Litigation
(Delaware Court of Chancery, decided September 4, 2014)1Overview: Delaware courts continue to recognize potential liability against officers, directors and the investors that appoint them. Some of these issues were discussed in our June 2014 M&A Law Update.2
Decision: The Delaware Court of Chancery found the main Defendants were liable for breach of fiduciary duty (or aiding and abetting those breaches) in connection with a recapitalization of the corporation. The Court would have found them liable for unjust enrichment but, for other reasons, it did not need to make this decision. The Court held that even though a “fair price” was offered in the recapitalization, the recapitalization process was “grossly inadequate.”
Main Defendants: The main Defendants were (i) three investors, (ii) their director-appointees to the board of a Delaware corporation, and (iii) the Company’s current and previous CEO.3 The investor-Defendants seem to be venture capital or private equity investors, although they are not identified as such by the Court.
Damages sought: Plaintiffs (viz., mostly the common stockholders) sought over $130 million in damages. The Court found that the main Defendants were liable for Plaintiffs’ damages. The Court, however, held the Plaintiffs’ damages model was “too speculative” to award damages in large part because nearly four years elapsed between the recapitalization and the sale of the company. The Court encouraged the Plaintiffs to seek recovery of their attorneys’ fees and costs.
1 2014 WL 4383127 (Del.Ch. 2014). 2 http://www.kutakrock.com/files/Publication/42391d3d-3e2a-458f-88eb-c6574b9dc9b7/Presentation/PublicationAttachment/93f5e476-63cb-4a58-a959-cad222dd96b9/Woolery061014.pdf (accessed November 8, 2014). 3
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Facts: In reaching its decision, the Court noted the following facts were important:
1. The Company was a privately owned corporation. The five members of the Company’s board of directors were each appointed to reflect the interests of different stockholders: the CEO, three investor director-appointees, and one director appointed to represent some of the minority investors.
2. The Company was facing a cash-flow crisis, and the investors arranged a recapitalization for the Company to be funded by the investors.
3. There was not an independent valuation of the Company. Instead, one of the investors did a “back of the envelope” calculation that served as the basis of the valuation. That calculation said the Company was worth around $4 million around the time of the recapitalization.
4. The Company had engaged a financial advisor to raise capital but those efforts were “generally unsuccessful.” Instead, the Company raised several million dollars from existing investors.
5. In the recapitalization, the Defendant-investors increased their equity ownership and diluted the Plaintiffs. The new capital was to enable the Company to make two acquisitions.
6. After the recapitalization was completed, the Company recovered from its cash-flow crisis and about four years later sold for $175 million.
7. The Plaintiffs claimed the investors “unjustly enriched” themselves in the recapitalization and thereby the investors received too much of the sale proceeds. 8. Prior to the recapitalization, the investors owned approximately 54% of the
Company’s stock and held over 90% of its senior debt. The Plaintiffs owned approximately 26% of the Company’s stock. Through the recapitalization, two investors invested additional money in exchange for convertible preferred stock. Another investor received an informal “right” to participate in the capital raise on the same terms as the two investors.
9. The Plaintiffs were not aware of the recapitalization until after it was implemented. They were not offered the chance to participate.
10.Specific details about the recapitalization’s key terms–most importantly, who was receiving the convertible preferred stock and on what terms–were not disclosed to the Company’s other stockholders, including the Plaintiffs.
11.After the recapitalization, the Company had sporadic, if any, communications with most of its stockholders. There were no annual stockholder meetings or director elections.
12.The Defendant-investors, who had little common connection to one another, were nevertheless held by the Court to be a “control group” that owed fiduciary duties to the Plaintiffs.
a. The Court believed the investors were a control group that used their collective ownership of a majority of the Company's stock to cause the Board to implement the recapitalization by which they received additional equity at an unfair price.
b. Even though one of the investors did not invest, it was held to be part of the control group because it had an informal right to invest later.
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c. The members of the control group stood on both sides of the recapitalization because each received a benefit not shared with the Company’s other stockholders like the Plaintiffs.
13.One of the investors that did not invest (but which had an informal right to invest) had prepared an internal memorandum that said it and the other two investors would “control” the Board and the Company.
Legal Analysis:
In reaching its decision, the Court applied the “entire fairness” standard of review instead of the more traditional “business judgment rule.” The entire fairness test is employed in cases like this when, in essence, the control parties stand on “both sides of the transaction.” The entire fairness test means that the Defendants (not the Plaintiffs) have the burden of proving that the recapitalization was entirely fair which means, in effect, proving “fair price” and “fair dealing.”
The Court found there was a Fair Price in the Recapitalization. Fair price “relates to the economic and financial considerations of the proposed [recapitalization], including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.” In determining whether there was a fair price, the Courts look to then-contemporary statements, projections and, if there are any, independent valuations.
Here, there was not a contemporary independent valuation. The Court rejected management’s financial projections as being “wholly unreliable” because they were “grossly inconsistent” with the company’s recent performance. After a lengthy and expensive trial on the merits, the Court relied upon the Defendants’ expert valuation witness at trial and found that the recapitalization price was fair.
The Court found there was not Fair Dealing in the Recapitalization. The Court determined there had not been fair dealing in the recapitalization even though it decided that price was fair. Fair dealing is an inherently subjective determination. In determining that the process employed by the Defendants was “grossly inadequate” the Court cited the following factors:
1. the lack of reliable management projections,
2. the Board’s ignorance of the valuation methodology,
3. the decision not to have any input from the sole independent director or an independent financial advisor,
4. not telling the Plaintiffs about the recapitalization and not giving them the opportunity to participate,
5. not holding annual stockholders meetings or director elections,
6. not seeking approval from a majority of the minority stockholders, and 7. not getting an independent valuation.
4 Conclusions
1. The Court will award damages in the “right” case. Plaintiffs sought $130 million in damages. The Court, however, held the Plaintiffs’ damages model was “too speculative” to award damages in large part because nearly four years elapsed between the company’s wrongful recapitalization and the company’s sale. But what if the sale occurred only four months (rather than four years) after the recapitalization? We believe the Court will be prepared to award significant damages in the “right” case.
2. Companies should fix the easy things: hold an annual stockholders meeting, give the common stockholders the right to participate in the offering, etc. The Court identified several items that showed there was not “fair dealing.” In most cases, these items could have been handled easily and properly at the beginning. Generally, it is not a great imposition on the company to hold an annual stockholders meeting, or to allow common stockholders the right to participate in the stock offering (subject to securities laws restrictions), or to do the other easy things that “fix” the allegations about “fair dealing.” 3. Consider hiring an independent financial advisor. Concerning the independent
valuation, the Court said: “Although hiring an independent financial advisor is not prescribed by Delaware law, the presence of an advisor could demonstrate that the Board was reasonably informed about the Company’s value.” If the company decides not to hire an independent financial advisor, recognize that the company will need more than a “back-of-the-envelope” calculation to prove “fair price.” In either event, ensure that the Board members understand the financial valuation model and its underlying assumptions. 4. The definition of “control group” seems to be broad and can be formed by several
investors who each own less than a voting majority and who otherwise have seemingly “tenuous” relationships among each other. In this case, the investor-Defendants had minimal relationships among each other. Nevertheless, the Court held that they were a control group that used their collective ownership of a majority of the Company’s stock to cause the Board to implement the recapitalization by which they received additional equity at an unfair price.
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