On Aug. 16, 2013, the Delaware Court of Chancery found that the board of Trados Incorporated did not breach its fiduciary duties in approving a merger of its company with SDL plc, even though the common stockholders received nothing in exchange for their shares, because the price was fair. The result is all the more interesting in light of the fact that the court found that the vast majority of directors approving the merger were conflicted through their alignment or relationship with the preferred stockholders, never considered how to account for such conflicts and never considered the interests of the common stockholders in approving the merger.
Trados, a translation software company, was founded in 1984 and by 2004, Trados had sold several series of preferred equity to various venture capital investment firms (VCs). The preferred equity provided the VC investors with liquidation preferences and other common preferred stock features, including board representation rights and cumulative dividends of 8 percent per annum. The Board also adopted a management incentive plan (MIP) which rewarded key executives, some of whom served on the board, with a percentage of proceeds from a sale of the company, resulting in their alignment with the interests of the preferred stockholders.
In 2005, despite improving operational and financial circumstances, Trados was sold for $60 million in a cash-and-stock acquisition of the company by SDL, another software company. Under Trados’ certificate of incorporation, the acquisition constituted a “liquidation” that triggered the preferred stockholders’ liquidation preference. Of the $60 million, $7.8 million was paid to senior management pursuant to the MIP and the remaining $52.2 million was paid to the preferred stockholders. The common stockholders received nothing.
A common stockholder alleged that the Trados directors had breached their fiduciary duties in approving the sale and had a duty to continue operating the company on a stand-alone basis to maximize the value of the corporation for the ultimate benefit of the common stockholders.
The court evaluated the actions of the Trados board based on a standard of conduct that requires directors to promote the value of the corporation for the benefit of its stockholders. The court noted the divergent interests of the preferred stockholders, who receive a liquidation preference, and the common stockholders, where the business continued to make money but possibly not enough to satisfy the preferred stockholders. In determining the standard of review, the court found that six of the board’s seven directors were closely aligned with the holders of the preferred stock, either as beneficiaries of the MIP, as preferred stockholder designees or through business relationships or investments, resulting in an insufficient number of independent and disinterested directors at the time the board approved the merger. As a result, the court reviewed the case under the “entire fairness” standard, a heightened standard of review of board action applied where “the board labors under actual conflicts of interest.” To rebut an allegation of breach of fiduciary duties under this standard, the board must establish “to the courts satisfaction that the transaction was a product of both fair dealing and fair price.”
The court ultimately decided that while the board’s process of deliberation did not amount to fair dealing, the entire fairness standard was satisfied because the common stockholders had in fact received a fair price for their shares. The board did not meet its obligations of fair dealing because it failed to consider the common stockholders’ interests, failed to consider its own conflicts and the board-approved MIP resulted in aligning of the interests of the management directors with the preferred stockholders to the detriment of the common stockholders. Having the MIP be paid before the common stockholders in an acquisition with a value of $60 million (an amount in excess of the liquidation preference) resulted in the common stockholders losing a disproportionate amount of the proceeds of the sale of the company they would have received but for the MIP compared to the preferred stockholders. However, the court viewed the proper test of the entire fairness of a transaction as whether the minority stockholder received the substantial equivalent in value of what he had before. So, according to the court, if Trados’ common stock had no economic value before the merger with SDL, then the common stockholders received the substantial equivalent in value of what they had before. The court held that the directors were able to establish that the company did not have a reasonable prospect of generating value for the common stockholders and that no better alternative existed at the time, and the company had little hope of achieving the kind of corporate profitability required to provide value to the common stockholders after payments to the preferred stockholders without an infusion of outside funds, funds that at the time of the acquisition were not available to the company.
The Trados analysis may have different outcomes when applied to different circumstances. For this reason, the court’s finding that the board failed to pass the “fair dealing” aspect of the entire fairness standard should not be overlooked; thus inside counsel should keep in mind the following lessons of Trados:
- Be aware of the potential divergent interests of preferred stockholders and common stockholders and identify those directors with more than one set of fiduciary obligations and determine how to address it, if necessary.
- Ensure that board deliberations on the sale of the company, or other decisions where the interests of the common stockholders and preferred stockholders diverge, consider the interests of the common stockholders, and that such consideration is reflected in the meeting minutes.
- When implementing an incentive plan for management that closely aligns the interests of management with that of the preferred stockholders, consider the interests of the common stockholders as well and ensure the plan does not disproportionately impact the value of the common stock with respect to a sale of the company.