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March 27, 2015
Delaware Chancery Court Finds Merger "Entirely Fair" to Common Stockholders Despite the Merger Leaving Common Stockholders With No Consideration for Their Shares
In In re Trados Inc. Shareholder Litigation, Case No. 1512-VCL, 2013 Del. Ch. LEXIS (Del. Ch. Aug. 16, 2013), Vice Chancellor Laster of the Court of Chancery of the State of Delaware resolved the long-pending dispute involving the 2005 sale of Trados Inc. (“Trados”) to SDL plc for approximately $60 million. The Court held that the transaction, which benefited the preferred stockholders and certain executives of Trados but left the common stockholders with nothing, was procedurally flawed but ultimately fair to the company’s stockholders. The Court reviewed the decision of the board of directors approving the sale under the “entire fairness standard” which is the most stringent standard of review in Delaware. The decision serves as a cogent reminder to private equity and venture capital investors that they should run a proper sale process when planning a liquidity event in particular if certain constituents of the corporation will not benefit from the liquidation.
This decision resolves a dispute which started in 2005 when a common stockholder of Trados initiated an appraisal lawsuit shortly after the sale of the company to SDL plc. At the time of the sale, Trados was backed by venture capital firms who had received preferred stock and placed representatives on the Trados board of directors. The directors also adopted a management incentive plan that compensated management for achieving a sale of the company.
The transaction constituted a liquidation event that entitled the preferred stockholders to a liquidation preference of $57.9 million, and management to $2.1 million under the incentive plan. With a purchase price of approximately $60 million, the common stockholders received no consideration for their shares.
A complaint alleging breach of fiduciary duty was subsequently added to the appraisal claim and the two cases were consolidated. Plaintiffs argued that the merger occurred at the behest of certain preferred stockholders, who wanted to exit their investment and that “instead of selling to SDL, the board had a fiduciary duty to continue operating Trados independently to generate value for the holders of common stock.”
In 2009, the Court denied a motion to dismiss filed by the defendants, noting that “in circumstances such as here where the interests of the common stockholders diverge from those of the preferred stockholders, it is possible that a director could breach his or her duty by improperly favoring the interests of the preferred stockholders over those of the common stockholders.” The case survived a second motion to dismiss in 2012.
At trial, plaintiffs proved that six of the seven Trados directors either had a direct economic interest in the proposed merger, or were appointed by venture capital firms with liquidation preferences. However, no special committee was created in connection with the transaction. In view of the lack of independence of the board, the Court applied the entire fairness standard of review to determine whether the directors of Trados breached their fiduciary duties of care and loyalty to the corporation and its stockholders which required them “to strive prudently and in good faith to maximize the value of the corporation for the benefit of its residual claimants.”
The Court finally held that, despite the directors’ failure to follow an optimally fair process and take such steps as the creating a special committee, defendants carried their burden of proof on this issue and demonstrated that they did not commit a breach of fiduciary duty. The Court held further that the entire fairness test was met because Trados common stock had no economic value before the merger and the common stockholders who received none of the proceeds received the substantial equivalent of what they had before. The Vice Chancellor stated:
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. The common stock had no economic value before the Merger, and the common stockholders received in the Merger the substantial equivalent in value of what they had before.
Regarding the appraisal complaint, the Court similarly concluded that “the appraised value of the common stock is likewise zero.”
The Trados case should serve as a reminder that investors should proceed with caution and insist upon a proper sale process when planning a liquidity event. More specifically, the board should carefully consider (a) appointing a special committee of directors comprised of independent and disinterested directors having the power and authority to evaluate the proposed transaction and the proposed allocation of the sale proceeds to the various classes of stockholders, to hire advisors, and to negotiate the transaction with the proposed buyer; (b) obtaining a fairness opinion with respect to the sale transaction or a valuation report with respect to the company from a third party advisor; and (c) thoroughly documenting how the board members exercised their fiduciary duties and reached a decision regarding a liquidity event (this is particularly important if certain constituents of the corporation will not benefit from the liquidation).