Recent Delaware Case Highlights Risks for Portfolio Company Directors and Investor FundsPDF
A recent Delaware case provides a painful reminder of the risks faced by fund investors when they appoint directors to serve on the board of a portfolio company.
In re Trados1 involved the 2005 acquisition by merger of Trados, a fund-backed translation software developer, following an extensive marketing process. The company’s 7-member board comprised four appointees of its fund investors, the CEO and CFO, and one independent member. The total merger consideration was $60 million, of which $7.8 million went to management under an incentive program and the remaining $52.2 million to the fund investors, who collectively held preferred stock with a liquidation preference of $57.9 million. The common stockholders received nothing; a 5% common stockholder sought both statutory appraisal of his shares and damages from the Trados board for breach of fiduciary duty.
The Delaware court ultimately rejected the plaintiff stockholder’s fiduciary duty claim, but only after eight years of litigation and not before pointedly criticizing the process employed by the Trados board. The court affirmed explicitly that all board members, including those appointed by the funds, owed fiduciary duties to the common stockholders and not to preferred investors, who must generally rely on contract protections such as their liquidation preference.2 In the final analysis, the court was persuaded that, notwithstanding a flawed process, the common stockholders were not damaged because their shares had no value and there was no reasonable prospect that continuing to operate the company would result in the build-up of value for common holders.
The court noted that the board could have taken several steps to protect the common stockholders and cleanse the sale process. For example, the board could have appointed a special committee to act solely on behalf of the common stockholders, required a separate class vote of common stock, or obtained an investment banking opinion regarding fairness of the merger consideration. The court also suggested that the fund investors might have utilized drag-along rights or other contract protections to “side-step” the fiduciary duty problems raised by the case, but was careful not to express a view as to the effectiveness of using such contract protections.
Although the Trados court ultimately ruled in favor of the board, the case emphasizes that fund-appointed directors have a “dual fiduciary problem”: as directors, they owe duties to the common stockholders and, as fund employees, to the investors who appointed them. Trados is a stark reminder that serving as a fund-appointed director can be perilous. Fund-appointed directors should be mindful of the dangers inherent in their positions and seek ways to mitigate the inherent risks, particularly when considering fundamental transactions. In addition, investor groups must be aware that the right to appoint directors of a portfolio company may not provide meaningful protection of the investors’ rights in all circumstances. Careful negotiation and drafting of drag-along rights and other protections against fiduciary-duty risk may furnish the best available safeguard.3
1. In re Trados Incorporated Shareholder Litigation, C.A. No. 1512-VCL, slip opinion (Del. Ch. Aug. 16, 2013).
2. The court expressly rejected a “control-contingent” approach, which would allow directors elected by preferred investors to promote the interests of the preferred stock over the common, and an “enterprise value” approach, which would require directors to take into consideration the highest aggregate value of returns for the preferred plus the common.
3. In some circumstances, fund investors may want to consider converting the portfolio company to an LLC, which affords greater flexibility to limit or eliminate the fiduciary duties of LLC managers.