On Aug. 16, 2013, the Delaware Court of Chancery issued an opinion1 finding that the directors of TRADOS Inc. (Trados) did not breach their fiduciary duties in deciding to sell Trados despite the common stockholders receiving no sale consideration; (ii) a majority of the directors approving the transaction having a conflict of interest; (iii) the court’s review under the entire fairness standard; and (iv) the directors’ failure to follow a fair process, because the common stockholders received a fair price (i.e. the value of the common stock immediately prior to the merger was zero and the common stockholders received zero in the merger).
Though In re Trados is not groundbreaking in the sense that it does not present any novel legal issues, it nonetheless serves as an important illustration of common conflict of interest and fiduciary duty issues that arise in a typical exit transaction fact pattern, particularly for venture capital or private equity backed companies. Through the next several weeks, we will discuss in more detail some of the important takeaways from In re Trados in a series of blog posts.
Factual Background of In re Trados
Trados was a venture capital (VC) backed private Delaware corporation that developed translation software. Between 2000 and 2003, Trados issued several rounds of convertible participating preferred stock to different VC firms. Pursuant to the terms of the preferred stock, the VC firms were entitled to appoint five of the seven directors on the board of Trados. The board of directors was composed of
- three individuals that were principals of the VC firms that appointed them;
- two purported outside directors that were appointed by the VC firms; and
- two management directors (the CEO and CTO of Trados).
In 2005, the board of directors of Trados approved a $60 million sale to SDL, plc pursuant to a statutory merger. Trados management received the first $7.8 million pursuant to a management incentive plan (MIP) that had been adopted in 2004. The VC firms received the remaining $52.8 million in respect of the $57.9 million of outstanding liquidation preference of their preferred stock. The common stockholders received nothing.
The Trados case arose when a holder of 5 percent of the outstanding common stock brought an appraisal action to value his shares. Based on discovery from his appraisal action, the common stockholder subsequently filed a class action suit alleging that the Trados directors breached their duty of loyalty in approving the merger.
Outcome of In re Trados
The court determined that a majority of the Trados directors had conflicts of interest, thereby triggering an entire fairness review. Upon considering the facts of the case, the court determined that the board did not deal fairly with the common stockholders because they failed to recognize their own conflicts of interest and failed to put in place any procedural protections to address these conflicts for the benefit of the common stockholders. However, because the court determined that the fair price of the common stock was zero, the court held that the transaction was fair to the common stockholders and the directors did not therefore breach their fiduciary duties.
Usefulness of In re Trados
In re Trados presents a very common fact pattern in which a VC, private equity or other outside investor makes a preferred stock investment in a company that entitles them to control a majority of the board of directors. Then, the value of the investment remains at or near the preferred stock liquidation preference for a few years and the investor concludes that it needs to exit the investment and redeploy the capital to another investment with more potential. However, when the prospective exit transaction is for consideration at or near the liquidation preference, the common stockholders will receive little or nothing in the exit transaction.
What fiduciary duties do directors appointed by preferred stockholders have to the common stockholders? When will a director that is employed and appointed by a preferred stockholder be deemed to have a conflict of interest in an exit transaction? What standard of review will courts use in reviewing an exit transaction in these circumstances? How will a court conduct an entire fairness review in the context of an exit transaction in these circumstances? These are the questions that are answered in In re Trados and will be explored in more detail in an upcoming series of blog posts.
1 In Re Trados Incorporated Shareholder Litigation, C.A. No. 1512-VCL, slip op. (Del. Ch. Aug. 16, 2013).