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Directors' & Officers' Liability: Delaware's "Entire Fairness" Test

Posted by Jon Elliott on Mon, Sep 09, 2013 and officers owe formal duties to their corporations and shareholders, commonly called “fiduciary duties” from the Latin root words for “trust.”  These duties developed over centuries of common law, and now appear in state corporation codes.  Most interpretations of these duties and how to meet them actually appear in court decisions, arising in cases where aggrieved shareholders sue claiming that a company’s directors and/or officers have breached one or more of these duties.

On August 16 the influential Delaware Court of Chancery issued its decision in the Trados Incorporated Shareholder Litigation case, in which common share stockholders sued Trados’ board after a merger in which preferred shareholders and corporate officials received the entire $60 million price, and common shareholder received absolutely nothing.

It shouldn’t surprise readers that the common shareholders sued, claiming the board had breached its fiduciary duties to them.  It also shouldn’t surprise you that the court was concerned that a majority of the board benefited from the transaction (directly or as representatives of preferred shareholders) and conducted a heightened review to consider whether board members breached their fiduciary duties to the common shareholders.  It may or may not surprise you that the court decided that the board did not even owe fiduciary duties to consider the preferred shareholders' contract rights during this transaction, but did owe such duties to the common shareholders.  But, given those points, does it surprise you that the court decided the board decision met this heightened standard?

The Case: Merging a Profitable Company and Paying Common Shareholders Nothing

Trados specialized in software for desktops and enterprises.  Its investors consisted primarily of venture capital (VC) firms that invested in anticipation that the company would go public.  As recounted in the decision:

The VC firms received preferred stock and placed representatives on the Trados board of directors. Afterwards, Trados increased revenue year-over-year but failed to satisfy its VC backers. In 2004, the VC directors began looking to exit. As part of that process, the Board adopted a management incentive plan (the “MIP”) that compensated management for achieving a sale even if the transaction yielded nothing for the common stock.

In July 2005, SDL plc acquired Trados for $60 million in cash and stock. Under Trados‘s certificate of incorporation, the Merger constituted a liquidation that entitled the preferred stockholders to a liquidation preference of $57.9 million. Without the MIP, the common stockholders would have received $2.1 million.  The MIP took the first $7.8 million of the Merger consideration. The preferred stockholders received $52.2 million. The common stockholders received nothing.

As the court saw it, the directors—most of whom had been designated for the board by the VC firms that held the preferred shares—made the discretionary decision to sell Trados in a transaction that triggered the preferred stockholders’ contractual liquidation preference, a right that the preferred stockholders otherwise could not have exercised.  This determination triggered heightened review of the transaction.

Three Levels of Review, Depending on Directors' Independence and Conflicts

Delaware defines three distinct levels of review in cases where directors’ decisions may have breached a fiduciary duty, which depend on the type of situation under review:

1. Business Judgment Rule. Delaware‘s default standard of review for board decisions. The rule presumes that in making a business decision, directors acted “on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”

2. Enhanced Scrutiny. Delaware‘s intermediate standard of review, applies to situations involving “potential conflicts of interest [that] can subtly undermine the decisions of even independent and disinterested directors.”

3. Entire Fairness. Delaware‘s most onerous standard, applies when the board is subject to actual conflicts of interest.

In this case, three of the seven directors had been placed on the board as representatives of the preferred shareholders, one had longstanding ties to the VCs, and two were covered by the MIP, which the court considered to pose conflicts of interest.  This majority of directors triggered Delaware’s strictest scrutiny.

Did the Decision Meet the “Entire Fairness” Test?

Under Delaware cases, a board decision can fail the “entire fairness” test if:

  • A finding that the directors acted in a manner that was not entirely fair.

  • A specification of the fiduciary duty breached (loyalty or care).

  • Rejection of any affirmative defenses raised by the directors.

When making this analysis, fairness has two basic aspects: fair dealing and fair price.

Fair dealing embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how directors' and stockholders' approvals were obtained.  In this case, the judge found that the “evidence pertinent to fair dealing weighed decidedly in favor of the plaintiff.”

Fair price relates to the economic and financial considerations of the proposed merger, including assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company‘s stock.  After a lengthy analysis, the decision determines that the $60 million price was a fair one for Trados.

Furthermore, the judge determined that Trados would have been unable to secure additional VC financing (noting that the existing VC shareholders had refused to invest additional money), and was unlikely to generate sufficient funds internally as a stand-alone going concern to improve its situation enough to overcome the VC' liquidation preference.  Ultimately, the determination that the sale price was fair trumped all other considerations, and the Court of Chancery approved the transaction.

Self-Assessment Checklist

  • Does my company have multiple classes of stock?

    • If there are preferred shares, what “preferences” do they carry (dividends, liquidation, etc.), and under what circumstances are they triggered?

    • Are preferred share preferences fully disclosed to purchasers and holders of common shares, including how the preferences do/would operate and the effect on common share values?

  • Do any board members serve as designees of preferred shareholders?

    • Do such board members constitute a majority of the board?

  • Do the company's bylaws provide for shareholder approval of transactions that trigger preferred shareholder preferences?

    • Can all classes vote?

Where Do I Go For More Information?

The Delaware Court of Chancery decision (In re Trados Incorporated Shareholder Litigation) (8/16/13) is available via the Internet here.

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About the Author Elliott is President of Touchstone Environmental and has been a major contributor to STP’s product range for over 25 years. He was involved in developing 16 existing products,including Workplace Violence Prevention: A Practical Guide to Security on the Job and Directors' and Officers' Liability.

Mr. Elliott has a diverse educational background. In addition to his Juris Doctor (University of California, Boalt Hall School of Law, 1981), he holds a Master of Public Policy (Goldman School of Public Policy [GSPP], UC Berkeley, 1980), and a Bachelor of Science in Mechanical Engineering (Princeton University, 1977).

Mr. Elliott is active in professional and community organizations. In addition, he is a past chairman of the Board of Directors of the GSPP Alumni Association, and past member of the Executive Committee of the State Bar of California's Environmental Law Section (including past chair of its Legislative Committee).

You may contact Mr. Elliott directly at:

STP also produces the following publications:

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Tags: Corporate Governance, Business & Legal, SEC, SOX