In our previous posts about In re Trados available here and here, we provided some background about the facts, outcome and usefulness of the Trados case, as well as a discussion of the conflicting interests of the preferred stockholders and common stockholders. In this installment, we will discuss the issue of director independence and conflicts of interest of the Trados directors, and the related analysis conducted by the Delaware Court of Chancery.
In determining whether directors have met their fiduciary duties, the standard of review used by the court is critical to the inquiry. The entire fairness standard, Delaware’s most onerous standard, applies when the directors have actual conflicts of interest.1 To obtain review under the entire fairness standard, a plaintiff must prove that a majority of the directors making the challenged decision were not independent and disinterested.2 In Trados, the plaintiff successfully proved that six of the seven Trados directors were not disinterested and independent, making entire fairness the operative standard of review.3
A thorough discussion of the court’s director by director analysis in Trados illustrates the Delaware courts’ willingness to find that directors of venture capital and private equity portfolio companies are conflicted, thereby triggering an entire fairness review.
Background Information about Directors
At the time of the merger of Trados and SDL, the board of directors of Trados consisted of the following seven directors.
|Director||Designating Party / Status|
|CEO Director||Management director; CEO of Trados|
|CTO Director||Management director; Chief Technology Officer and co-founder of Trados|
|Sequoia Director||VC director; designated by Sequoia, a VC firm owning preferred stock in Trados|
|Wachovia Director||VC director; designated by Wachovia, whose VC entity owned preferred stock in Trados|
|Hg Director||VC director; designated by Hg, a VC firm owning preferred stock in Trados|
|Invision Outside Director||Outside director; designated by Invision, a VC firm owning preferred stock in Trados|
|Sequoia Outside Director||Outside director; designated by Sequoia, a VC firm owning preferred stock in Trados|
Delaware Standard for Director Conflict of Interest
Delaware courts have recognized that “a director is interested in a transaction if ‘he or she will receive a personal financial benefit from a transaction that is not equally shared by stockholders’”4 Further, “the benefit received by the director and not shared with stockholders must be of sufficiently material importance, in the context of the director’s economic circumstances, as to have made it improbably that the director could perform her fiduciary duties … without being influenced by her overriding personal interest.”5
The court next conducted a director by director analysis of the benefits each director received in the transaction compared to that director’s personal wealth and financial circumstances.
The Management Directors: CEO Director and CTO Director
CEO Director received the following benefits in connection with the merger with SDL:
- $2.34 million transaction bonus pursuant to Trados’s Management Incentive Plan (MIP);
- Bargained for post-transaction employment as SDL’s President and Chief Strategy Officer; and
- Membership on SDL’s board of directors, earning $50,000 per year for his service.
In determining CEO Director’s economic circumstances, the court examined the benefits received in the context of his net worth of $5 million to $10 million and his annual income. The court noted that CEO Director’s post-transaction board membership, standing alone, would not have been sufficient to disqualify his independence. However, when taken together with the fact that the payments CEO Director received in connection with the merger represented 23% to 47% of his net worth and nearly 10 times his annual income, the court concluded that CEO Director received material benefits and was not independent and disinterested.
CTO Director received the following benefits in connection with the merger with SDL:
- $1.092 million transaction bonus pursuant to the MIP, which was increased from $936,000 million before the merger; and
- Post-transaction employment with SDL in the same position for the same compensation ($190,000 salary, plus bonus).
In determining CTO Director’s economic circumstances, the court examined the benefits received in the context of his net worth of €2 million to €4 million (approximately $2.6 million to $5.2 million). The court noted that CTO Director’s post-employment was a material benefit, without providing any insight into how it made this conclusion aside from citing its opinion in In re Primedia Inc. Deriv. Litig.6 that compensation from employment is generally material. The court also noted CTO Director’s admission that his $1.092 million transaction bonus was “significant.” Because of CTO Director’s receipt of these material benefits, the court concluded that was not independent and disinterested.
The court also noted in its examination of CEO Director and CTO Director that their defense counsel obstructed the plaintiffs efforts to explore the materiality of the payments by declaring the questions to be “inappropriate” and instructing CEO Director and CTO Director not to answer any further questions on their financial circumstances. The court noted that this opposition to discovery warrants an inference that the benefits received were material.
The VC Directors: Sequoia Director, Wachovia Director and Hg Director
The court noted that each of the VC directors, in addition to being fiduciaries for Trados in their role as directors, were also fiduciaries for the VC funds that received disparate consideration in the merger in the form of a liquidation preference. In other words, they were dual fiduciaries.
The Delaware Supreme Court held in this situation that there is “no dilution” of the duty of loyalty when a director “holds dual or multiple” fiduciary obligations.7 If the interests of the beneficiaries to whom the dual fiduciary owes duties are aligned, then there is no conflict of interest. If, however, those interests diverge, the fiduciary faces an inherent conflict of interest.8
The court noted that the plaintiffs in Trados had the burden to prove on the facts of the case, by the preponderance of the evidence that:
- The interest of the VC firms in receiving their liquidation preference as holders of preferred stock diverged from the interests of the common stock; and
- The VC directors faced a conflict of interest because of their competing duties.
The court then examined the economic incentives of VC firms generally and noted that the cash-flow rights of typical VC preferred stock (i.e., the liquidation preference) cause the economic incentives of its holders to diverge from those of the common stock.9 The court then examined the behavior of VC firms and noted that VC firms often sell entities that are profitable and require ongoing VC monitoring, but where growth opportunities and prospects for an exit are not enough to generate an attractive internal rate of return. The court suggested that it is in this context that the VC directors’ conduct must be evaluated.
The court found that Sequoia Director faced a conflict and acted consistent with Sequoia’s interest in exiting from Trados and moving on to other investments. The court based this determination of testimony from Sequoia Director that, within six months of Sequoia’s investment in Trados, Sequoia Director had concluded that Trados would not deliver outsized returns and that Sequoia’s only real opportunity was to recover a fraction of its $13 million investment and move on to better investments.
The court found that Wachovia Director faced a conflict. The court’s analysis with Wachovia Director was very similar to that of the Sequoia Director analysis regarding the desire for an exit transaction so his VC firm could redeploy capital to more profitable investments. The court also noted as evidence of Wachovia Director’s one-track mindset to sell Trados was that he recommended and designed the MIP to incentivize top management to favor a sale even at valuations where the common stock would receive zero.
The court also noted that in late 2004, Wachovia Director decided to leave Wachovia. When Wachovia Director informed CEO Director of his departure, CEO Director asked Wachovia Director to stay on as a director of Trados until the SDL merger closed. Wachovia Director agreed to stay on as a director and the court said that this demonstrated Wachovia Director’s loyalty to his former employer, Wachovia.
The court found that Hg Director faced a conflict. The court’s analysis with Hg Director was very similar to that of the Sequoia Director and Wachovia Director analysis regarding the desire for an exit transaction for her VC firm. However, the court noted that Hg Director was the least aggressive in seeking an exit, as she was more open to considering a sale in 12 to 18 months rather than pushing for an immediate exit.
Hg Director felt that Trados needed to develop a business plan for her to understand the company’s potential before making any decisions. However, within days of being presented the business plan, Hg Director and the other directors authorized CEO Director to negotiate a sale to SDL for $60 million.
The Outside Directors: Invision Outside Director and Sequoia Outside Director
Invision Outside Director and Sequoia Outside Director were neither members of management nor principals at VC firms invested in Trados. The plaintiff did not challenge Invision Outside Director’s disinterestedness and independence, so the court did not review his independence.
Sequoia Outside Director was designated to the board by Sequoia and had a long history with Sequoia, dating back to Sequoia’s investment in a company where Sequoia Outside Director was President and COO. After that, Sequoia asked Sequoia Outside Director to work with them on other companies, including a number where Sequoia Outside Director and Sequoia Director worked very collaboratively, including a company that was acquired by Trados. The court concluded that Sequoia Outside Director’s current and past relationships with Sequoia Director and Sequoia resulted in a sense of “owingness” that compromised his independence.
Sequoia Outside Director had invested about $300,000 in Sequoia funds, including one Sequoia fund that owned Trados preferred stock. Sequoia Outside Director also had an interest in another investment vehicle that owned preferred stock in Trados. As a result, he received $220,633 in the merger and the court concluded that this was material to Sequoia Outside Director.
In determining Sequoia Outside Director’s economic circumstances, the court examined the benefits received in the context of his net worth of $4 million to $6 million. The court also noted that at the time of the merger, Sequoia Outside Director was the CEO of a software company backed by Sequoia for which he received $125,000 salary and Sequoia Director served on the board of that company
The court focused on the fact that $220,633 in merger proceeds received by Sequoia Outside Director was nearly double his annual salary and was 3.7% to 5.5% of his net worth, which made it material to Sequoia Outside Director. Because the merger benefits were material to Sequoia Outside Director, the court concluded that he was not disinterested and independent.
Because six of the seven directors were deemed to be interested and not independent for purposes of the merger, the entire fairness standard is the applicable standard of review. Our next post in the In re Trados series will examine the court’s entire fairness analysis.
1. For employees of private equity or VC firms that are directors of portfolio companies, your fiduciary duties to the common stockholders will generally trump any diverging duties owed to the private equity firm or VC firm or to the preferred stockholders.
2. The director conflicts present in Trados, especially for the Management Directors and the VC Directors, are fairly common in private equity or VC portfolio companies.
- Members of management of portfolio companies often serve on the board of directors and often receive change in control transaction bonuses as part of their employment agreements, thereby creating a potential conflict of interest where a director could prefer a transaction in order to receive his or her transaction bonus over another alternative.
- Employees of private equity or VC firms that hold preferred stock often serve on the board of directors of portfolio companies, thereby creating a potential conflict of interest where a director could prefer a transaction in order for his or her private equity or VC employer to receive its liquidation preference over another alternative.
- Outside directors of portfolio companies of private equity or VC firms often have a preexisting relationships with the private equity or VC firms appointing them. This makes sense, as the private equity or VC firms would want to appoint someone that they know is competent and will do a good job. However, private equity and VC firms will want to consider whether an appointee could withstand the court’s scrutiny of whether the appointee would have a sense of “owingness” to the private equity or VC firm appointing them.
3. The court imposed a relatively low threshold in determining whether a director has received a material benefit. In the case of the Sequoia Outside Director, the merger proceeds of $220,633 that he received were deemed to be material while representing double his annual salary and only 3.7% to 5.5% of his net worth. While double his annual salary may sound high, this threshold could be surpassed frequently by directors, particularly management directors receiving large transaction bonuses.
4. Courts may conclude that compensation from employment with the post-transaction entity is material. This is important to consider in your conflict analysis, as many management directors are often asked to sign employment agreements with the post-transaction entity as a condition to closing the transaction.
5. Courts will look unfavorably upon management incentive plans that provide transaction bonuses at valuations where the common stockholders receive no consideration. You should review your incentive plans and ensure that management only receives transaction bonuses when the common stock is “in the money.”
6. Failure to cooperate in discovery, depositions and/or on the witness stand can result in the court imposing an inference that is against your interests.
1 Trados at p. 47.
2 Trados at p. 47.
3 Trados at p. 48.
4 Trados (quoting In re Trados Inc. S’holder Litig. (Trados I), 2009 WL 2225958 (Del. Ch. July 24, 2009); Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993)).
5 Trados (quoting Trados I at p. 6) (emphasis added).
6 In re Primedia Inc. Deriv. Litig., 910 A.2d 248, 261 n.45 (Del. Ch. 2006)
7 Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983)
8 Trados at p. 52.
9 Namely, the court noted that liquidation preferences can cause preferred stockholders to gain less from increases in firm value than they lose from decreases in firm value. This could cause a board dominated by preferred stockholders to choose lower-risk, lower-value investment strategies over higher-risk, higher-value investment strategies.