While the financial world focuses on lapses in corporate governance by boards of directors of large U.S. companies, venture capital investors controlling struggling emerging companies are faced with complex fiduciary duties of their own. Unhappy with the results of a down-round financing, Benchmark Capital recently filed suit against the directors and controlling stockholders of Juniper Financial Corp. claiming, among other things, breaches of fiduciary duties. While Benchmark did not pursue fiduciary duty claims during a preliminary injunction proceeding, the case firmly and directly places directors’ responsibilities to venture-backed companies at center stage.
Like the down round at Juniper Financial, new venture capital investments in emerging companies are frequently being made at lower valuations. Common stockholders and even preferred stock investors that refuse to continue to invest are often “washed-out”-so severely diluted that they retain merely a nominal stake in the company. In a down-round financing, directors affiliated with controlling stockholders that are making down-round investments face conflicts of interest. Under these circumstances, controlling stockholders also have fiduciary duties to other stockholders of the company.
While it appears that no case under Delaware law has found a breach of fiduciary duty by directors or controlling stockholders in a washout or other down round, the claim has been raised in the Benchmark case and other pending cases. At least one such case brought under California law in 1994 was settled for a significant sum. In that case, founders of Alantec Corp. sued Alantec’s controlling venture capital investors for fraud and breach of fiduciary duty in diluting the founders’ ownership of Alantec from 8% to 0.007% through several down-round financings. The case went to a jury trial in 1997 before the defendant venture capital investors settled by paying the founders $15 million.
Alantec was sold at the time of settlement for approximately $820 million, making the $15 million payment for plaintiffs’ ownership of the company equivalent to a 1.8% equity interest at the time of sale. This payment of more than 250 times plaintiffs’ equity interest in Alantec at the time of its sale is a warning shot to every venture capital investor and its director affiliates involved in down-round financings
Director and Stockholder Duties
Members of a board of directors of a Delaware corporation are bound by duties of care and loyalty. These are broad obligations to act in the best interests of the corporation and its stockholders as a whole. These duties are to all stockholders, without regard to whether a director is elected by holders of a particular class or series of stock or whether the director is designated as a “representative” of a particular investor or group pursuant to a voting agreement.
In its simplest terms, the duty of care requires that directors exercise the care that a typical person in a similar position would exercise under comparable circumstances. This duty requires a director to exercise his business judgment on an informed basis after due consideration of and deliberation on all relevant issues and, where appropriate, to seek input of experts. The duty of care is designed to encourage directors to exert themselves diligently on behalf of stockholders in an effort to ensure effective oversight of management of the corporation.
The business judgment rule is the general standard by which a director’s duty of care is evaluated. The rule creates a legal presumption that directors act in a disinterested and independent manner, on an informed basis, and in the honest belief that their actions are in the best interests of the corporation and its stockholders. If stockholders challenge a board of directors’ decision, those stockholders must allege and prove facts overcoming the presumption that directors acted in this disinterested manner. If stockholders challenging a board action successfully allege and prove facts that overcome the presumption that the directors’ action is attributable to a rational business purpose, the board of directors will be obliged to prove that the challenged transaction was entirely fair to the corporation and its stockholders.
The duty of loyalty owed by a director is undivided loyalty to the corporation and all of its stockholders. The duty requires directors to discharge their duties in good faith and in a manner they reasonably believe to be in the interests of the corporation and its stockholders. The duty of loyalty requires, among other things, that a director not promote or oppose a particular strategy, decision or transaction out of financial self-interest or for the benefit of any other person or any organization other than the corporation and its stockholders as a whole.
Directors’ duties of care and loyalty are fundamental principles of corporate governance. These principles and Delaware law do not prohibit a director who has a self-interest from dealing with the corporation that he serves as a director, so long as some neutral decision-making body approves the interested director transaction. Section 144(a) of the Delaware General Corporation Law provides three acceptable neutral decision-making bodies: a majority of disinterested directors; a majority of stockholders; or a court, by determining that the challenged transaction was entirely fair to the stockholders.
For a transaction involving a self-interested director to meet the disinterested directors or the stockholders test of Section 144(a), all material facts of a director’s self-interest must be disclosed. Delaware courts have also concluded that stockholder approval of an interested director transaction will not satisfy the requirements of Section 144(a) unless approval comes from a majority of the corporation’s disinterested stockholders. If neither disinterested director nor disinterested stockholder approval is obtained, a challenge to the transaction is subject to court review under the entire fairness test discussed below.
Stockholder Fiduciary Duties
While controlling stockholders are entitled to act and vote their economic interests, a controlling stockholder does have a fiduciary duty to other stockholders when the controlling stockholder stands on both sides of a transaction, or, as one court said, when the controlling stockholder “receives something … to the exclusion of and detriment to the minority stockholders.” Delaware courts have concluded that the self-interest of the controlling stockholder precludes the business judgment rule protection of the board of directors’ action, even though some or all of the directors may be unaffiliated with the controlling stockholder. As a result, the transaction must be “entirely fair” to minority stockholders.
Entire fairness requires a demonstration by the controlling stockholder that a fair price was paid and that the controlling stockholder dealt fairly with minority stockholders in reaching that price. The burden of proof of entire fairness can be shifted from the controlling stockholder to the challenging minority stockholders through the use of a well-functioning committee of independent directors to evaluate and negotiate the transaction. The burden can also be shifted if the transaction is approved by a fully informed majority of the minority stockholders.
Fiduciary Duties of VCs
How could director and controlling stockholder fiduciary duties be breached in a down-round financing? Stockholders-such as venture capital firms-that control the board of directors of an emerging company and intend to invest in a new equity financing of the company are on both sides of the financing transaction. If the board approves the new financing at a valuation below the company’s fair market value, then the controlling stockholders will receive something-the bargain purchase-to the exclusion and detriment of the remaining stockholders.
Are fiduciary duties implicated if controlling stockholders hold convertible preferred stock entitled to anti-dilution protection in a down round? It would appear that stockholders and affiliated directors in this situation are self-interested in the transaction. If the preferred stock is subject to full- ratchet anti-dilution protection, rather than weighted average anti-dilution protection, the potential conflict seems more acute, because even the smallest down-round investment would result in a full repricing of the conversion price of the preferred stock to the price of the down round.
Venture capital investors are struggling on a regular basis with transactions that have these pitfalls. Transactions in which controlling stockholders are also new investors are at risk of challenge and judicial review based upon the entire fairness standard. Where it can be established that controlling stockholders did not stand on both sides of a new financing transaction, directors will nonetheless be subject to scrutiny if a challenge can establish that they were self-interested in the transaction. If independent director or stockholder action under Section 144(a) of the Delaware General Corporation Law cannot remove the taint of self-interested directors’ action, that action is also at risk of challenge and judicial review based on the entire fairness standard.
Remedies for Breach
Courts have broad power to fashion remedies for a breach of directors’ or controlling stockholders’ fiduciary duties. They include enjoining the transaction from proceeding, rescission of the transaction, creation of a constructive trust, invalidation of a stock issuance, disgorgement of profits, and assessment of money damages against the breaching directors or controlling stockholders in question.
While it is unlikely a Delaware court would rescind or invalidate a completed financing if arms-length, third party investors were also involved in the financing, offending directors or controlling stockholders could be subject to liability for money damages. If the directors have breached their duty of loyalty, they may not be entitled to indemnification by the corporation. Moreover, directors and officers liability insurance policies may not cover awards against directors for breach of the duty of loyalty.
Where unavoidable conflicts arise that implicate directors’ or stockholders’ fiduciary duties of loyalty, it is critical for principals of venture capital firms to minimize the risks involved. Actions taken without a second thought may result in venture fund or personal liability. On the other hand, in difficult situations, many venture capital investors knowingly take actions that may technically breach fiduciary duties because they believe these actions are in the best interests of the company and its stockholders. These controlling stockholders reason that the resulting exposure to minority stockholder litigation is a cost of doing business and just another risk to be managed in a venture capital portfolio.
To avoid the pitfalls of a breach of the duty of loyalty, or to minimize the risk of liability in a situation where a breach may be an unavoidable, acceptable risk, the following steps should be taken:
* Consider appointing independent directors. If there are no independent, disinterested directors on the board, consider appointing independent directors and constituting them as an independent committee to deliberate on the proposed financing. Or if there are already one or more disinterested directors who feel inhibited acting alone, adding additional disinterested directors to act with them may enable a majority of the disinterested directors to act on the financing. While appointing disinterested directors may appear to be a tidy solution to director conflicts, there is usually neither adequate time nor likely, credible candidates available who are willing to assume the risk of acting as a fiduciary for a company under the stress of a down round.
* Offer the financing to all stockholders. The new financing should be made available to all existing stockholders on a pro rata basis in accordance with their current ownership interest in the company. Giving every stockholder the opportunity to maintain its current ownership level obviates a claim that controlling stockholders “stole” the company by offering themselves the exclusive opportunity to invest at a bargain price. The offer may be an empty one for stockholders who do not have the resources to make a further investment, but the negative appearance of excluding washed-out stockholders suggests that, absent a good reason, every stockholder should be given the opportunity to invest in a washout financing.
* Secure disinterested stockholder approval. If the new financing does not trigger a fiduciary duty on the part of controlling stockholders and no independent director authorization is received, the company should nonetheless seek approval by a majority of the disinterested stockholders. Even in a transaction triggering the controlling stockholders’ fiduciary duty, informed, minority stockholder approval can shift to the stockholders challenging the transaction the burden of demonstrating that the transaction was not entirely fair.
* Independently validate the terms. If independent director or disinterested stockholder approval is not available in a situation involving only director self-interest, and in all cases involving controlling stockholder fiduciary duties, it is critical to structure and negotiate the down-round financing in a way that best prepares it, under the circumstances, for an entire fairness challenge. Three actions can be taken to show that efforts were made to independently validate the terms:
1. Conduct a full negotiation. Whether or not an independent board committee is created, full negotiation of terms is an important factor in demonstrating fairness. If the board has offered an opportunity to invest in the company on the proposed terms to several third-party investors that have declined to invest, there is evidence that the investment by self-interested stockholders on those terms may be favorable to the company. Helpful facts include the level of effort by the board, the amount of time spent seeking investors, the financial analysis used and the effort in negotiations with investors that have declined to invest.
2. Carry out a full deliberation. While full deliberation by a board of interested directors is not sufficient to meet the entire fairness test, it may demonstrate to a court that the interested directors made a good-faith attempt to carry out their fiduciary duty. Even if a court were to find a breach of duty, a showing that the interested board carefully considered the financing and made an effort to discharge its duty could minimize liability.
3. Obtain a fairness opinion. Acquiring a fairness opinion from an investment banking firm is a common way to support the fairness of a financing transaction. Even if feasible to obtain, any fairness opinion will be subject to limitations and qualifications that, while supporting the reasonableness of the board’s actions, does not necessarily satisfy the entire fairness standard. In evaluating a fairness opinion’s support of whether a transaction was done at a fair price to the company, Delaware courts will look at the qualifications of investment banking firm rendering the opinion, the scope of information made available to the firm for its evaluation, and the level of analysis undertaken.
Conflicts may be inevitable in a down-round financing, but if the emerging company is to survive, it will need capital. Investors that control the company may be the only parties willing to invest that capital. Accordingly, it is important to carry out a down-round financing in a way that minimizes the exposure of controlling stockholders and their affiliated directors to claims of breach of the duty of loyalty.
Christopher K. Aidun is a partner and head of the Venture Capital Practice of Weil, Gotshal & Manges LLP, a New York-based international law firm. The views expressed in this article are those of Aidun and do not necessarily reflect the views of Weil, Gotshal & Manges, its clients or partners. Stephen Radin assisted with this article.