Controller Breaches Fiduciary Duties By Coercing Onerous Financing Terms
In Basho Technologies, Inc. v. Georgetown Basho Investors, LLC, C.A. No. 11802-VCL (Del. Ch. July 6, 2018), the Delaware Court of Chancery reaffirmed the principle that a stockholder with actual control of a corporation violates its fiduciary duties by advancing its own interests to the detriment of the corporation. Applying the entire fairness standard in its decision following trial, the court held that Georgetown Basho Investors, LLC (“Georgetown”), the controlling stockholder of Basho Technologies, Inc. (“Basho”), owed and breached fiduciary duties to Basho as a stockholder with actual-but not majority-control. The court ultimately awarded plaintiffs Earl Gallaher (“Gallaher”) and various investment funds under his control (the “Plaintiff(s)”) damages in the aggregate amount of $20,268,878.
This case arises out of Chester Davenport’s (“Davenport,” and together with Georgetown and other Georgetown affiliated Basho directors, the “Defendants”) management of Georgetown, where he served as its President and Managing Member, and, in 2010 through which he invested in Basho and joined its board of directors (the “Board”). Over the next three years, Georgetown led or co-led a series of preferred stock financings for Basho through which Georgetown gained blocking rights that enabled it to control Basho’s access to capital, which the Defendants used to strong-arm Basho into a 2012 loan agreement between Basho and Georgetown (the “Loan Agreement”). Plaintiffs alleged Georgetown leveraged this effective control by maneuvering Basho into a positon of maximum financial distress, and that the Defendants forced through a Series G financing round (the “Series G”) that was highly favorable to Georgetown and unfair to Basho and its other investors, from which Georgetown gained hard control of Basho. The Defendants attempted to use this position to secure financing deals for itself and other investors at terms onerous to Basho. Instead of viewing such terms favorably, potential investors viewed them as indicative of a company on the verge of failure due to mismanagement. Basho’s stock price crashed before the company was ultimately forced into receivership and liquidation. As part of that receivership, Plaintiffs purchased all of Basho’s derivative claims.
Plaintiffs claimed that the Defendants breached their fiduciary duties by forcing the Company to accept the onerous Series G, and that afterward the Defendants separately breached their fiduciary duties a second time by managing Basho to serve Georgetown’s interests alone. The crux of this case was the Defendants’ conduct in obtaining the Series G, the initial breach.
While Davenport’s fiduciary status was clear as a Board member, Georgetown’s was less so because it was not the majority stockholder. Under Delaware law, a minority stockholder may be a controller, and therefore a fiduciary, if “they, as a practical matter, are no differently situated than if they had majority voting control.” In re PNB Hldg. Co. S’holders Litig., 2006 WL 2403999, at *9 (Del. Ch. Aug. 18, 2006). The finding of actual controls rests on the totality of the facts and circumstances, considered in the aggregate. At trial, the court found Georgetown exercised effective control over Basho as a result of (1) Georgetown’s use of contractual blocking rights to channel Basho into a position where it had no option other than to accept Georgetown’s Series G terms; (2) the spread of misinformation to potential investors by the Defendants because any investment would have diluted Georgetown’s control; (3) Georgetown’s use of the Loan Agreement to dominate Basho management by forcing out two Basho CEOs; (4) Georgetown’s instruction to Basho’s engaged investment bank, Cowen & Co., which was to cut off all communication with Basho’s new CEO, Greg Collins, and Gallaher, Basho’s Chairman of the Board; and (5) Georgetown’s threats to halt funding via the Loan Agreement and institute personal lawsuits against Basho directors if Basho did not accept the onerous terms for the Series G.
Entire fairness, Delaware’s most onerous standard of review, puts the burden on the defendant to show that the transaction in question was entirely fair by examining two basic concepts: fair dealing and fair price. Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983). These two concepts are not elements of entire fairness, but rather, guide the inquiry as a whole. Id.
The Defendants failed to demonstrate fair dealing behind the Series G. In fact, the evidence presented at trial established the process was decidedly unfair. “Fair dealing encompasses questions of how the transaction was negotiated and structured,” but Georgetown refused to negotiate or even answer questions about the term sheet it provided to Basho for the Series G. In re Trados Inc. S’holder Litig., 73 A.3d 17, 58 (Del. Ch. 2013). Fair dealing also “encompasses questions of how director approval was obtained;” Georgetown coerced the Board approval by threatening to starve Basho of the cash necessary to run its business. Id. at 58. Finally, Georgetown engaged in obvious self-dealing by interfering with two competing offers that were attractive to new investors, and would prevent Georgetown’s future control.
The Defendants thorough corruption of the process behind the Series G made it so entirely unfair, that it infected the fair price inquiry as well. The Defendants attempted to show that the price must have been fair by presenting the absence of a competing offer, which “often provides meaningful evidence of fairness by indicating that the challenged transaction provided a market-clearing price.” However, “the Defendants drove away the investors who were most interested in [Basho]” and “the absence of competing offers say more about Georgetown’s actual control over [Basho] and the Defendants’ acts of unfair dealing than it does the fairness of the Series G.” Here, the most telling source of market evidence against Georgetown was that it was unable to convince third parties to participate in the Series G because investors saw its oppressive terms as a warning sign of how Georgetown treated Basho and its fellow investors.
The Defendants’ raised the affirmative defense of acquiescence, claiming Gallaher acquiesced to the Series G terms by approving them, and therefore was as much at fault for Basho’s failure as the Defendants and not entitled to court remedy. For the affirmative defense of acquiescence to prevail, “the defendants must show that [the plaintiff] essentially consented to the [challenged action] before or after the fact.” Stengel v. Rotman, 2001 WL 221512, at *6 (Del. Ch. Feb. 26, 2001) (Strine, V.C.). The court denied this contention because Georgetown and Davenport were controllers in the challenged transaction and did not cleanse their involvement by empowering a sufficiently disinterested board committee and obtaining an affirmative vote of unaffiliated stockholders.
This case stands for and reinforces the principle that “a fiduciary may not play ‘hardball’ with those to whom he owes fiduciary duties, and [Delaware] law provides recourse against disloyal fiduciaries or controllers who use their power to coerce the minority into economic submission.” Auriga Capital Corp.v. Gatz Props., 40 A.3d 839, 870 (Del. Ch. 2012) (Strine, C.).