In re Trados Incorporated Shareholder LitigationDelaware Court of Chancery Finds Conflicted Board Did Not Breach Fiduciary Duty in a Change of Control Transaction that Satisfied Fair Price But Did Not Satisfy Fair Process Sullivan & Cromwell LLP - August 29, 2013
In an opinion issued on August 16, 2013, the Delaware Court of Chancery (Vice Chancellor Laster) found that the board of directors of Trados Incorporated (“Trados”), consisting of a majority of directors who had conflicts of interest arising out of their affiliations with venture capital firms that invested in Trados through preferred shares, did not breach its fiduciary duty in approving a change of control transaction in which common shares received no consideration; and all consideration was paid first to fund a management incentive plan adopted to promote a sale and second to preferred stockholders to satisfy the liquidation preference of the preferred shares. Specifically, the court concluded that the entire fairness standard of review applied, and that, while the board did not satisfy the fair process prong of the standard, the zero consideration satisfied the fair price prong of the entire fairness standard.
The Trados decision has the following implications for directors and venture capital and other investors holding preference shares with liquidation preferences:
- Parties should recognize the conflict of interest that arises between preferred stockholders and common stockholders when a company has no common equity value but could potentially remain in business for some time. On boards with a majority of directors designated by preferred stockholders, this conflict of interest is sufficient to elevate the standard of review to the rigorous entire fairness standard.
- In evaluating a change of control transaction with a common-preferred conflict, a conflicted board should actively consider the interests of common shareholders and ways in which the process might mitigate the conflict. That deliberation should be memorialized in the minutes. Although helpful, the board is not required to employ procedural protections for the holders of common stock such as a special committee of directors independent from the preferred stockholders, a fairness opinion from a bank engaged by the special committee or a vote of a majority of the stockholders unaffiliated with the holders of the preferred stock.
- In sales or similar transaction, directors must conclude that the transaction consideration exceeds what they expect the corporation otherwise would generate for stockholders over the long term.
- In evaluating the adoption of a management incentive plan in the context of pursuing exit opportunities, the board should consider both the impact of such a plan on the incentives of management directors as well as the funding allocations of the plan. The board’s decision to fund the management incentive plan ahead of the preferred stockholders’ liquidation preference and any consideration that would otherwise have been received by the common stockholders and its approval of the management incentive plan without explicit consideration of the impact on common stockholders were both indicative of an unfair process.
- Although dicta, the Trados decision summarizes the fact that Delaware law does not require that directors fulfill the wishes of stockholders or a subset of stockholders and that the duty to manage the corporation may not be delegated to stockholders.
- A board that approves a change of control transaction that satisfies the fair price prong, even if it does not satisfy the fair process prong, can nonetheless be found not liable for breach of fiduciary duty. However, boards should not rely on this being the case in all situations, as the entire fairness standard is applied to a heavily facts-specific analysis; furthermore, whether this holding will be adopted by other Chancery Court judges or by the Delaware Supreme Court remains to be seen.