The following post is based on a memo released by Pepper Hamilton LLP on September 4, 2013. 

A recent post-trial decision by Vice Chancellor J. Travis Laster of the Delaware Court of Chancery puts directors serving as designees of preferred investors on notice that they must attempt to maximize value for common shareholders, or risk being found liable for breach of fiduciary duty. The opinion, In re Trados Inc. Shareholder Litigation, C.A. No. 1512-VCL (Del. Ch. Aug. 16, 2013), is available at http://courts.delaware.gov/opinions/download.aspx?ID=193520.¹

The court observed that directors serving on behalf of preferred shareholders may face a unique “dual fiduciary problem.” Specifically, “a particular class or series of stock may hold contractual rights against the corporation and desire outcomes that maximize the value of those rights.” Nonetheless, “it is the duty of the directors to pursue the best interests of the corporation and its common stockholders, if that can be done faithfully with the contractual promises owed to the preferred.” If the interests of the common and preferred stock diverge, the fiduciary (who is a representative of the preferred stockholder) may face an inherent conflict of interest. But there is “no dilution” of the duty of loyalty when a director “holds dual or multiple” fiduciary obligations, and there is no “safe harbor” for such divided loyalties in Delaware corporate law.²

Trados was sold in a transaction in which the preferred shareholders received more than $50 million pursuant to their liquidation preference, while the common shareholders received nothing. Of the seven directors, three were designated by preferred investors, two were members of management who were parties to a management incentive plan that aligned their interests closely to the preferred and provided material payments in the event of a sale, and one had current and past relationships with the preferred investors sufficient to compromise his independence.

The court noted that venture capitalists “operate under a business model that causes them to seek outsized returns and to liquidate (typically via a sale) even profitable ventures that fall short of their return hurdles and which otherwise would require investments of time and resources that could be devoted to more promising ventures.” Expanding further, the court wrote:

The different cash flow rights of preferred stockholders are particularly likely to affect the choice between (i) selling or dissolving the company and (ii) maintaining the company as an independent private business. … [L]iquidity events promise a certain payout, much or all of which the preferred shareholders can capture through their liquidation preferences. … The distorting effects “are most likely to arise when, as is often the case, the firm is neither a complete failure nor a stunning success.” … [I]n intermediate cases, preferred stockholders have incentives to “act opportunistically.”

The court found that the director defendants did not understand that their job was to maximize the value of the corporation for the benefit of the common stockholders,³ and that they refused to recognize the conflicts they faced. “A director’s failure to understand the nature of his duties can be evidence of unfairness,” and “[d]irectors who cannot perceive a conflict or who deny its existence cannot meaningfully address it.” Moreover, in light of the directors’ intelligence and background, the court believed that they “fully appreciated the diverging interests of the VCs, senior management, and the common stockholders.” The board had adopted a management compensation plan that incentivized a sale. The board did not consider forming a special committee to represent the interests of the common shareholders. The board did not obtain a fairness opinion to analyze the sale or evaluate other possibilities from the perspective of the common shareholders. Indeed, the court wrote that “[t]he Board’s ex post embrace of stakeholders did not in actuality encompass any consideration of the common stockholders. When pressed, the directors could not recall any specific discussion of the common stock ….” Thus, the evidence regarding “fair dealing” by the board in connection with the sale “decidedly favored the plaintiff.” Because it was convinced, however, that the defendants had proven that the common stock had no economic value in light of the company’s prospects and obligations, the court refrained from imposing liability for the board’s decision to approve the sale of the company.

¹ The case is not final and the decision may be subject to appeal to the Delaware Supreme Court.

² In a footnote, the court wrote that “The VC contracts in this case did not attempt to incorporate any mechanism for side-stepping fiduciary duties (such as a drag-along right if the VC funds sold their shares), nor did they explicitly seek to realign the directors’ fiduciary duties in a manner that might alter the traditional analysis.” The court did not express a view as to the effectiveness of any such mechanism or realignment.

³ The court noted that “[s]ome scholars also have argued that in lieu of a common stock valuation maximand, directors should have a duty to maximize enterprise value, defined in the common-preferred context as the aggregate value of the returns to the common stock plus the preferred stock, taking into account the preferred stock’s contractual rights.” Expressing concern over, among other things, the potential decline in accountability that might result from “multivariate fiduciary calculus,” the court wrote that “Delaware case law as I read it does not support the enterprise value theory. As long as a board complies with its legal obligations, the standard of fiduciary conduct calls for the board to maximize the value of the corporation for the benefit of the common stock.”