Fiduciary Duty - Watch Out When Approving Distressed Sales

Dennis White, an attorney at McDermott Will and Emery, had an interesting post in the New York Times recently regarding the In re Trados Incorporated Shareholder Litigation case. This case questions the degree of deference courts will give directors under the business judgment rule when they approve a sale of a business in which some or all of the directors have a possible conflict of interest and common stockholders are wiped out.

Essentially, a VC-backed company was sold for an amount that was small enough that no consideration went to the common stockholders due to the preferred liquidation preferences. At SRS, we see deals like this all the time. However, in this case, the common stockholders sued the company’s directors for breach of their fiduciary duty of loyalty to such stockholders, arguing that the company did not need to sell and the directors had conflicts of interest in approving the deal. The Delaware court rejected the defendant’s motion for summary judgment and found the plaintiffs had pleaded sufficient facts to rebut the business judgment rule (which usually gives significant protection to directors and officers against second guessing their business decisions). While this does not yet mean that the directors have any liability, it does significantly change their burden of proof in trying to show that they should not be liable for any damages or losses.

There were many facts specific to this case that may make the analysis less applicable to other deals., Nevertheless, this ruling could lead to a heightened level of scrutiny of actions taken by company directors when approving a sale of a business, especially one where the purchase price is low and does not clear preferences senior to common shareholders, such as debt, management carve-outs and preferred shares. Directors are in a tough spot because they will have to consider whether entering into the sale is in the best interests of all the shareholders, and those shareholders may have differing interests. For instance, there are quasi-fiduciary obligations to creditors when a company is in the “zone of insolvency.” The creditors may love the idea of selling the company, even at a low value, because it usually results in repayment of their loan. Similarly, the preferred holders may be in favor of doing a deal that gets them their investment back when the company is struggling. Those parties may not want the company to continue operations if they believe that will only result in it burning through its remaining funds until it eventually goes out of business.

In contrast, the common stockholders may have nothing to lose since they are not getting any merger consideration anyway. Their preference would be to have the company continue to operate as long as possible to see if it can turn the corner. This analysis for directors is further complicated when the company has some realistic, but far from certain, degree of upside potential. While companies that sell for distressed values are generally behind plan or not doing as well as anticipated, they might have some promising things in the pipeline, such as positive meetings with customers that just haven’t led yet to a contract or good progress on product development. Common stockholders who aren’t going to get anything if the company is sold today would understandably prefer to let these things play out longer. The end result is that it’s tough for directors to reconcile what i’s in the best interests of all of these parties when they have differing motivations. The Trados case’s rebuttal of the business judgment rule in connection with the decision to sell the business has the potential to heighten the risk involved with being a director who has to vote one way or the other on an M&A transaction, especially for VC or PE directors who may have a conflict of interest as preferred stockholders.