Merger Paying Common Shareholders $0 Found To Be Entirely Fair
On August 16, 2013, the Delaware Court of Chancery issued a post-trial opinion holding that the directors of Trados Inc. did not breach their fiduciary duties when approving a merger notwithstanding the fact that holders of common stock received nothing in the transaction.
The case concerned a typical fact pattern: Trados had issued several series of preferred stock in exchange for venture funding, the holders of the preferred stock had gained control of the Trados board, the venture capitalists were unwilling to invest more in Trados, the Trados directors approved a merger transaction that resulted in the common shareholders receiving nothing, and the holders of preferred stock, whose designees on the Trados board approved the transaction, received all of the merger consideration in partial satisfaction of the preferred stock liquidation preference.
A holder of common stock brought suit alleging that the directors breached their duties by approving a transaction that benefitted the preferred at the expense of the common. The plaintiff emphasized the interested nature of the transaction (a majority of the directors who approved the transaction were affiliated with the holders of preferred who benefitted from the transaction), the contractual nature of preferred stock, the limited fiduciary duties directors owe to holders of preferred stock, and the Delaware case law, which recognizes that, when directors can exercise discretion, they should generally prefer the interests of common stockholders to those of preferred stockholder, and argued that the directors should have continued operating Trados for the benefit of the common.
The Court began by concluding that a majority of the directors were interested in or had a conflict with respect to the transaction. In reaching this conclusion, the Court noted that venture capitalists seek to receive outsized economic returns in a compressed time frame and that the funds that had invested in Trados (and their director designees on the Trados board) were following this business model when they were looking to exit their investment. This objective can be at odds with a board member’s fiduciary duties: “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.”
Because the directors were interested in the transaction, they bore the burden of proving that the transaction was “entirely fair” to the common stockholders. Entire fairness has two basic components: fair process and fair price. Fair process concerns how the transaction was initiated, structured, negotiated and disclosed to the directors, as well as how the approvals of the directors and the stockholders were obtained. Fair price relates to the economic consideration of the transaction. Although fair process and fair price can be examined separately, entire fairness involves a unitary analysis with the court considering all aspects of the issue since the inquiry is one of entire fairness.
Based on the evidence presented at trial, the Court found that the directors had not engaged in fair dealing when approving the merger. The Court concluded the sale process had been initiated to obtain an exit for the preferred holders and that the board had failed to consider the interests of the common or how those interests might be protected by allocating merger proceeds in a different manner. Nevertheless, the Court determined that the transaction was entirely fair to the common shareholders and the board had not breached its fiduciary duties because the evidence showed that the economic value of the common stock at the time of the transaction was zero, exactly what the holders of common stock received in the merger. As the holders of the common received through the merger the equivalent of what they held before the merger, the merger was entirely fair to them. As explained by the Court: “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.”
The Trados case highlights the difficulties directors can face when they have conflicting duties. Resolving these conflicts and/or determining the best way to proceed can be a difficult process, and individuals and entities should consult with their counsel to navigate and attempt to minimize these difficulties.