It’s been almost seven years since the Delaware chancery court issued its initial opinion in the Trados litigation and instigated a flood of law firm memos, law review articles, and changes to the way deals get done in Silicon Valley.  The dust still hasn’t settled.

By way of review, Trados involved claims against the board of a startup company that was sold in a merger transaction.  Plaintiffs, who held common stock of the company, alleged that board members affiliated with the company’s VC investors were conflicted in approving the transaction.  The VC investors held preferred stock that provided for a “liquidation preference” in the event of a company sale.  Because of that liquidation preference, the VC investors received all of the merger consideration while common shareholders received nothing.   In an initial opinion, the court denied defendants summary judgment and determined that the claims should be evaluated under the plaintiff-friendly fairness standard. [1]  In a subsequent trial court opinion, the court confirmed applicability of the fairness standard but ultimately found in favor of the defendants because the common stock likely had no value (making zero a fair price).[2]

The trial court opinion, in particular, is an impressive missive on corporate fiduciary law.  The decision spans more than 60 pages, extensively cites law review and corporate finance literature, and takes on a number of fundamental corporate law questions.[3]  Not surprisingly, courts and commentators continue to work out its precise meaning.[4]

In Opportunity-Cost Conflicts in Corporate Law, I explore a fundamental question: what precisely triggered fairness review in Trados?  Early analysis of the case focused on differences between preferred and common cash flow rights.    Analogizing to creditor-shareholder conflicts, these commentators noted that a fixed claimant (like a creditor) will have different incentives than a residual claimant (like a common shareholder).[5]  Fixed claimants may want to act conservatively in situations where residual claimants prefer rolling the dice.  And so a director affiliated with a VC fund holding preferred stock may want to sell the company and collect the liquidation preference while common shareholders might instead want to attempt a risky turnaround with at least some prospect of return to common holders.

While the trial court did partly embrace this creditor-shareholder analogy, it also identified a second and conceptually distinct source of conflict between a VC-controlled board and common shareholders.  Citing corporate law scholarship, the court noted that VC investors may shut down even moderately successful companies because time is scarce and more promising companies in the VC’s portfolio may require the VC’s attention.  I deem this an “opportunity-cost conflict,” in reference to the bedrock economic principle that the cost of a course of action is the highest value alternative forsaken.

Importantly, an opportunity-cost conflict can occur even with an all-common capital structure.  Consider a moderately successful startup with one class of stock owned ½ by the founder and ½ by a VC fund.  If the VC fund has a number of hot prospects in  its portfolio that require full attention, it will be tempted to sell the moderately successful startup in circumstances that do not maximize value of that particular company’s stock.  Under one reading of Trados, such an opportunity-cost conflict might warrant fairness review of a VC-controlled board’s actions even if the VC fund and the founder split the proceeds of the sale evenly.

So how far will courts take this novel reasoning? I advocate for a narrow doctrine of opportunity-cost conflicts. In one way, Trados was an exceptional case. One of the defendant directors admitted in his testimony that he felt the pull of other opportunities in the fund’s portfolio.[6] That made it easy for the court to decide that enhanced judicial scrutiny was warranted.

This type of smoking-gun evidence will likely be rare in future cases. What then should trigger enhanced scrutiny sufficient to defeat a motion for summary judgment and allow discovery?    Should industry-wide generalizations about VCs suffice?  Is it enough that an active investor has other successful investments occupying its time?

By reserving fairness review for clear indicia of impaired incentives (such as self-dealing), corporate law exhibits a careful balance between policing misconduct and guarding against litigation abuse.  Liberally inferring opportunity-cost conflicts might upset that balance.  This may be one of those many instances in corporate law where the realities of litigation (and its potential abuse) warrant a cautious approach by courts.

ENDNOTES

[1] In Re Trados Inc. Shareholder Litigation, 2009 WL 2225958 (Del Ch. 2009).

[2] In re Trados Incorporated Shareholder Litigation, 73 A.3d 17 (Del. Ch. 2013).

[3] Such issues include: to whom fiduciary duties are owed (common shareholders or the enterprise as a whole), the extent to which informal associations between directors and VC investors result in cognizable conflicts, and the relationship between price and process in fairness review.

[4] For an interesting interpretation of the case, see Kobie Castille, Vice Chancellor Laster and the Long-Term Rule, Harvard Law School Forum on Corporate Governance and Financial Regulation (March 11, 2015).  For an example of a subsequent court attempting to interpret Trados’s holding on the mechanics of fairness review, see In re Nine Systems Corporation Shareholder Litigation 2014 WL 4383127 (Del. Ch. 2014).

[5] For one of several insightful analyses along these lines, see William W. Bratton & Michael L. Wachter, A Theory of Preferred Stock, 161 U. Pa. L. Rev. 1815 (2013).

[6] Abraham J.B. Cable, Opportunity-Cost Conflicts in Corporate Law, 66 Case W. Res. L. Rev. 51, 75-76 (2015).

The preceding post comes to us from Abraham J. B. Cable, Associate Professor at the University of California Hastings College of the Law.  The post is based on his article, which is entitled “Opportunity-Cost Conflicts in Corporate Law” and available here.